The Association of Business Executives

Diploma

1.13 FA
FA0609

Financial Accounting
morning 2 June 2009

1 Time allowed: 3 hours.

2 SECTION A consists of one compulsory question.

3 Answer THREE questions from a choice of seven in SECTION B.

4 All questions carry 25 marks. Marks for subdivisions of questions are shown in brackets.

5 No books, dictionaries, notes or any other written materials are allowed in this
examination.

6 Calculators, including scientific calculators, are allowed providing they are not
programmable and cannot store or recall information. Electronic dictionaries and
personal organisers are NOT allowed. All workings should be shown.

7 Candidates who break ABE regulations, or commit any misconduct, will be disqualified
from the examinations.

8 Question papers must not be removed from the Examination Hall.

FA0609 © ABE 2009 T/500/3691


 SECTION A

Question 1 is compulsory.

Q1 The trial balance for Tor enterprise as at 31 December 2008 is as follows:

£000 £000
Revenue 59,200
Purchases 33,120
Inventory 1 January 2008 5,560
Distribution costs 4,320
Administration costs 5,840
Land at valuation (note (iv)) 42,000
Property at cost (note (iii)) 32,000
Property accumulated depreciation as at 1 January 2008 8,520
Plant and equipment at cost (note (iii)) 51,200
Plant and equipment accumulated depreciation as at
1 January 2008 9,920
Trade receivables 16,480
Trade payables 8,960
Bank 640
Ordinary issued 50p shares 56,000
Share premium account 16,000
Revaluation reserve as at 1 January 2008 12,000
Retained earnings as at 1 January 2008 12,560
8% loan redeemable 2112 (note (ii)) 8,000
––––––– –––––––
191,160 191,160
––––––– –––––––

(Note that figures in the above table are in £000s - thousands)

The following notes are applicable:

(i) Inventory as at 31 December 2008 amounted to £6,240,000 at cost. A review of
inventory revealed the following:
(a) Items costing £320,000 that had been included in the inventory at 31 December
2008 were found to have deteriorated. Their normal selling price was £480,000,
but even after remedial work of £80,000, these items could only be sold for
£360,000.
(b) Items sold on a sale or return basis had been omitted from the inventory as
at 31 December 2008 and included in sales in December 2008. The cost of
these items was £64,000 and their sale price was £96,000. All these items were
returned in good condition to Tor in January 2009.
(ii) The interest on the loan has not been paid for the year ended 31 December 2008 and
must be accrued.
(iii) Depreciation is to be calculated for the year ended 31 December 2008 as follows:
(a) Property 2% per annum on cost
(b) Plant and equipment 15% per annum on cost
Depreciation calculated for the year is to be charged 80% cost of sales,
10% distribution costs and 10% administration costs.
(iv) Land is to be revalued to £48,000,000 as at 31 December 2008.



FA0609 2 
 (v) Tax for the year ended 31 December 2008 is chargeable at 25% of profits for the year
before receiving or paying dividends.
(vi) Adjustments for accruals and prepayments are required as follows:

Accruals Prepayments
Distribution costs £76,000 £48,000
Administration costs £28,000 £24,000

Required:

Prepare the Income Statement for the year ended 31 December 2008 and the Balance Sheet
as at that date for Tor in accordance with International Accounting Standards (IASs).
(25 marks)

FA0609 3 [Turn over
 SECTION B

Answer THREE questions only. All questions carry equal marks.

Q2 On 1 January 2008 Sun enterprise acquired an 80% holding in Tan enterprise. The draft
Balance Sheets of Sun and Tan as at 31 December 2008 are as follows:

Sun Tan
£000 £000
ASSETS
Non-current assets
Patents – 475
Land, property, plant and equipment 3,138 552

Investment in Tan 600 –

––––– –––––
3,738 1,027
––––– –––––
Current assets
Inventory 927 403
Trade receivables 975 423
Bank 326 132
––––– –––––
2,228 958
––––– –––––
TOTAL ASSETS 5,966 1,985
––––– –––––

EQUITY AND LIABILITIES

Equity
Ordinary shares 50p 2,000 700
Revaluation reserve 475 –
Retained earnings 1,777 765
––––– –––––
4,252 1,465
––––– –––––
Liabilities
Current liabilities 1,714 520
––––– –––––
TOTAL EQUITY AND LIABILITIES 5,966 1,985
––––– –––––

(Note that figures in the above table are in £000s - thousands)


FA0609 4
 The following information is also available:
(i) At the acquisition date of 1 January 2008 the net assets of Tan had a book value of
£1,265,000. The following assets were revalued at the acquisition date as follows:

Book value 1 January 2008 Revaluation

Patents £475,000 £500,000
Land £250,000 £600,000

The fair value of all other assets and liabilities at the acquisition date was equal to book
value. No adjustments have been made to Tan’s accounts to reflect these fair values.
(ii) The consideration paid by Sun for the 80% share of Tan comprised cash £600,000
and 700,000 50p shares with a fair value at 1 January 2008 of £1.25. The share issue
made to acquire Tan has not yet been entered in Tan’s draft Balance Sheet as at
31 December 2008.

Required:

(a) Calculate the value of goodwill arising on the acquisition of Tan and explain the
treatment of this goodwill in the consolidated accounts of Sun group in accordance
with International Accounting Standards (IASs). (8 marks)

(b) Prepare the consolidated Balance Sheet for the Sun group as at 31 December 2008.
(17 marks)
(Total 25 marks)

FA0609 5 [Turn over
Q3 There are several International Accounting Standards (IASs) that consider the accounting
treatment of non-current assets. Two of these are:
� IAS 23 - Borrowing Costs
� IAS 36 - Impairment of Assets

Required:

(a) Describe the accounting treatments required by each of the two standards mentioned
above. (14 marks)

(b) (i) An item of plant was purchased several years ago by X enterprise at a cost of
£500,000. The current carrying value of this item of plant in X’s Balance Sheet
is £360,000. X estimates that it could currently sell the item of plant for £310,000
but would also incur £20,000 in selling costs. X further estimates that the present
value of the future expected cash flows to be derived from retaining the item of
plant is £270,000.

Identify at what value the item of plant would be recorded in X’s Balance Sheet,
showing all relevant accounting entries. (5 marks)

(ii) During the year ended 31 December 2008, X spent £12,000,000 on the
construction of a large development. X has a centralised function for finance
borrowing, and borrowing during the year ended 31 December 2008 was as
follows:
� £5,000,000 bank overdraft at 16% interest per annum.
� £6,000,000 5 year secured 8% loan note.
� £5,000,000 5 year unsecured 10% loan note.

X has a policy of capitalising borrowing costs where possible in accordance with

IAS 23.

Identify the accounting entries, including the amounts, to capitalise the relevant
borrowing costs. (6 marks)
(Total 25 marks)



FA0609 6 
Q4 (a) The Chief Executive Officer (CEO) of the enterprise you are employed by has asked
you to explain the requirements of IAS10, Events After the Balance Sheet Date. The
CEO particularly wishes to know:
� The difference between an adjusting and a non-adjusting event.
� The accounting treatment for both of the above events.
� The disclosure requirements of the standard.

Required:

Prepare a report giving the explanations requested by the CEO. (16 marks)

(b) The following events occur before the directors approve the financial statements of the
enterprise. The Balance Sheet date of the enterprise is 31 December 2008.
(i) A fire on 4 January 2009 destroys all the inventory in one warehouse. The
inventory had been valued as at 31 December 2008 at £350,000.
(ii) A customer who owed the enterprise £25,000 as at 31 December 2008 went into
liquidation on 9 January 2009 and it is estimated that no funds will be available to
pay creditors.

Required:

Identify the accounting treatment and any disclosure requirements for items (i) and (ii) in the
financial statements for the year ended 31 December 2008. (9 marks)
(Total 25 marks)

Q5 An enterprise may issue shares:

� At par
� At a premium
� Via a rights issue
� Via a bonus issue

Required:

(a) Describe, using numerical examples, each of the above four issues of shares.
(12 marks)

(b) Discuss the differences between shareholders and debenture holders. (7 marks)

(c) Explain the factors determining the capital structure of an enterprise with particular
reference to gearing. (6 marks)
(Total 25 marks)

FA0609 7 [Turn over
Q6 A substantial number of organisations are required to have their annual financial statements
audited. The auditors are required to provide an audit report that is published in the annual
report of the organisation.

Required:

(a) An organisation is subject to external audit. Describe the type of information an

external audit report should provide regarding the organisation and its financial
statements. (10 marks)

(b) Discuss the purposes of an external audit to all relevant stakeholders. (8 marks)

(c) Explain the relationship between internal and external audit within an organisation.
(7 marks)
(Total 25 marks)

Q7 Alpha enterprise, a computer hardware manufacturer, has obtained accounting ratios relating
to averages for similar organisations in the industry.

The average ratios for the period 1 January 2008 to 31 December 2008 are as follows:

Return on capital employed 21.6%

Net assets turnover 1.6 times
Gross profit margin 25%
Net profit (before tax) margin 10.5%
Current ratio 1.5:1
Quick ratio 0.8:1
Inventory holding period 42 days
Trade receivables collection period 41 days
Trade payables payment period 59 days
Debt to equity 35%
Dividend yield 5%
Dividend cover 4 times

The summarised financial statements for Alpha for the period 1 January 2008 to
31 December 2008 are as follows:

Income statement £000

Sales revenue 4,850
Cost of sales (3,740)
–––––
Gross profit 1,110
Other operating expenses (430)
–––––
Operating profit 680
Interest payable (68)
Loss on sale of obsolete stock (240)
–––––
Profit before tax 372
Tax (180)
–––––
Profit after tax 192
 –––––

FA0609 8
 Changes in equity
Retained profits 1 January 2008 358
Net profit for the period 192
Dividends paid (180)
–––––
Retained profits 31 December 2008 370
–––––

Balance sheet £000 £000

Non-current assets 1,080
Current assets:
Inventory 550
Trade receivables 640 1,190
––––– –––––
Total assets 2,270
–––––
Share capital and reserves:
Ordinary 50p shares 300
Retained profits 370
–––––
670
Non-current liabilities:
7% loan note 600
Current liabilities:
Bank overdraft 130
Trade payables 700
Tax 170 1,000
––––– –––––
Total equity and liabilities 2,270
–––––

(Note that figures in the above table are in £000s - thousands)

The following information is also relevant:

(i) The non-current assets cost £7,200,000 and accumulated depreciation as at
31 December 2008 is £6,120,000.
(ii) Alpha’s ordinary shares averaged a market price of £12 throughout the period.

Required:

(a) Calculate (to one decimal place) the ratios for Alpha equivalent to those for the
industrial averages. (7 marks)

(b) Write a report analysing the financial performance of Alpha based on a comparison
with industrial averages. (14 marks)

(c) Explain the problems that are inherent when using industrial averages to compare
performance. (4 marks)
(Total 25 marks)

FA0609 9 [Turn over
Q8 The financial statements for Spiral enterprise are as follows:

Income statement for the year ended 31 December 2008

£000 £000
Operating profit 338
Dividends received 40
Interest payable (28)
Interest receivable 12 (16)
––––– –––––
Profit before tax 362
Tax (88)
–––––
Profit after tax 274
–––––

Balance sheets as 31 December 2007 2008

£000 £000
Tangible non-current assets 784 1,088
Intangible non-current assets 60 54
Current assets:
Inventories 580 520
Trade receivables 500 560
Cash 92 364
––––– –––––
Total assets 2,016 2,586
––––– –––––
Ordinary shares 25p 360 488
Reserves 608 830
Non-current liabilities 360 320
Current liabilities 688 948
––––– –––––
Total equity and liabilities 2,016 2,586
––––– –––––

(Note that figures in the above table are in £000s - thousands)

The following information is also available:

(i) Dividends paid during the year amounted to £48,000.
(ii) The proceeds from non-current tangible assets disposed of during the year was
£84,000. These assets had a carrying value before disposal of £76,000. Depreciation
charged on all tangible non-current assets during the year was £148,000.
(iii) During the year £40,000 bonds were converted into 352,000 25p equity shares.
(iv) Spiral also issued 160,000 25p shares for 32.5p cash during the year.
(v) There was no purchase or disposal of intangible non-current assets during the year.



FA0609 
10
 (vi) Current liabilities as at 31 December 2007 and 2008 were as follows:

2007 2008
£000 £000
Bank overdraft 80 32
Trade payables 536 852
Tax 40 64
Dividends 32 –
–––– ––––
688 948
–––– ––––

Required:

Prepare a cash flow statement for Spiral enterprise for the year ended 31 December 2008 in
accordance with IAS7: “Cash Flow Statements”. (25 marks)

End of Question Paper

FA0609
FA0609 11 
11 [Turn over
 Diploma

Financial Accounting

Examiner’s Suggested Answers

SECTION A

Q1 Income statement for Tor enterprise for the year ended 31 December 2008

£000 £000
Revenue (59,200 - 96) 59,104
Opening inventory (1 January 2008) 5,560
Purchases 33,120
————
38,680
Closing inventory (6,240 - 320 + 280 + 64) 6,264
————
32,416
Depreciation charged to cost of sales (W1) 6,656 39,072
———— ———
Gross profit 20,032
Distribution costs (4,320 + depreciation 832 +
accrual 76 - prepayment 48) 5,180
Administration costs (5,840 + depreciation 832 +
accrual 28 - prepayment 24) 6,676
Loan interest 640 12,496
———— ————
Profit before tax 7,536
Tax (25% x 7,536) 1,884
————
Profit for the year 5,652
————

FA0609 12
 Balance Sheet for Tor enterprise as at 31.12.2008

£000 £000 £000

Cost/valuation Depreciation Nbv
ASSETS
Non-current assets
Land 48,000 48,000
Property 32,000 8,520 + 640 22,840
= 9,160
Plant and equipment 51,200 9,920 + 7,680 33,600
= 17,600
———— ——————— ————
131,200 26,760 104,440
———— ———————
Current assets
Inventory (see IS) 6,264
Trade receivables (16,480 - 96) 16,384
Prepayments 72
Bank 640 23,360
——————— ————
TOTAL ASSETS 127,800
————

EQUITY AND LIABILITIES

Equity
Ordinary 50p shares 56,000
Share premium account 16,000
Revaluation reserve (12,000 + 6,000) 18,000
Retained earnings (12,560 + 5,652) 18,212
————
108,212
Long-term liabilities
8% loan redeemable 2,112 8,000
Current liabilities
Trade payables 8,960
Interest payable 640
Tax payable 1,884
Accruals 104 11,588
——————— ————
TOTAL EQUITY AND LIABILITIES 127,800
————

Working 1 depreciation

Cost of sales Distribution Administration

Property 2% x 32,000 = 640 512 64 64
Plant and equipment 15% x 51,200 = 7,680 6,144 768 768
——— —— ——
6,656 832 832
——— —— ——

FA0609 13 [Turn over

 SECTION B

Q2 (a) Goodwill calculation

Fair value of consideration

Cash 600,000
Shares 700,000 x 1,25 875,000
—————
1,475,000
—————
Fair value of net assets of Tan as at 1.1.2008
Patents 500,000
Land 600,000
Other net assets (1,265,000 - 475,000 - 250,000) 540,000
—————
1,640,000
—————
80% of fair value of net assets = 1,312,000
—————
Goodwill 163,000
—————

International Accounting Standards require goodwill on consolidation to be measured

at cost less any impairment losses.

FA0609 14
 (b) Consolidated balance sheet of the Sun group as at 31 December 2008

£000 £000
ASSETS
Non-current assets
Goodwill on acquisition 163
Patents 500
Land, property, plant and equipment (600 + 302 + 3,138) 4,040 4,703
——— ———
Current assets
Inventory (927 + 403) 1,330
Trade receivables (975 + 423) 1,398
Bank (326 + 132) 458 3,186
——— ———
7,889
———
EQUITY AND LIABILITIES
Equity
Ordinary 50p shares (2,000 + 350) 2,350
Share premium (700 x .75) 525
Revaluation reserve 475
Retained earnings (1,777 + 160 W1) 1,937
Minority interest (W2) 368 5,655
———
Current liabilities (1,714 + 520) 2,234
———
TOTAL EQUITY AND LIABILITIES 7,889
———

Working 1
Net assets of Tan 1.1.2008 1,265
Net assets of Tan 31.12.2008 1,465
———
Therefore net earnings period ended 31.12.2008 200
———
Attributable to Sun group 80% 160
———

Working 2
Net assets of Tan 31.12.2008 1,465
———
20% attributable to minority interest 293
Add 20% of revaluation at date of acquisition 375 75
———
Minority interest 368
———

FA0609 15  [Turn over

Q3 (a) Accounting treatment - IAS 23 - Borrowing Costs
The standard states that borrowing costs shall be recognised as an expense in the
period in which they are incurred.

The standard goes on to state “except to the extent that they are capitalised”. Thus the
standard permits us to capitalise some borrowing costs. But which borrowing costs?

The answer is “borrowing costs that are directly attributable to the acquisition,
construction or production of a qualifying asset shall be capitalised as part of the cost
of that asset”.

A qualifying asset for the capitalisation of borrowing costs is one that necessarily takes
a substantial period of time to get ready for its intended use or sale.

Borrowing costs are defined as those costs that could be avoided if the asset had not
been acquired. It can be quite difficult to identify a direct relationship between an asset
and borrowing costs especially if funds are borrowed generally and controlled by a
central function within the business. In these cases the standard permits us to apply a
capitalisation rate to the expenditure on the asset. This rate is a weighted average.

Accounting treatment - IAS 36 - Impairment of Assets

The essential objective of IAS 36 is to ensure that all assets are not carried at a figure
greater than their recoverable amount. Its essential requirement is that when an asset
is impaired, that is its recoverable amount becomes less than its carrying amount in the
books, this loss must be written off.

The impairment loss is written off to the income statement unless it reverses a previous
revaluation in which case the impairment will be taken to the debit of the revaluation
reserve up to the amount of the revaluation.

Recoverable amount is the higher of fair value less costs to sell and value in use.

Value in use is the present value of the future cash flows expected from the use of the
asset.

(b) (i) Carrying value of plant 360,000

Fair value less costs to sell (310,000 - 20,000) 290,000
Value in use 270,000
Thus recoverable amount is 290,000
Therefore impairment is 70,000

Asset carried at 290,000 in balance sheet and 70,000 charge to income

statement as impairment. Thus credit asset account 70,000 and debit income
statement 70,000.

FA0609 16
 (ii) Weighted average cost of capital is calculated as follow:

amount interest rate weight

Overdraft 5m 16% 5/16 5
Secured loan note 6m 8% 6/16 3
Unsecured loan note 5 10% 5/16 3.125
——– ————
16 11.125%
——– ————

Borrowing costs to capitalise are £12m x 11.125% = £1.335m

Debit asset construction account 1.335
Credit interest expense 1.335

Q4 (a) To: Chief Executive Officer

From: anon
Date:
Subject: IAS 10, Events After the Balance Sheet Date

Introduction
IAS 10 concerns events that arise after the balance sheet date but for which evidence
exists at the balance sheet date. In the interests of accurate reporting, it is essential
that these be reflected in the financial statements. If a proper understanding of the
financial position cannot be obtained without some disclosure, then notes must be
provided to indicate those conditions existing at the balance sheet date.

Post-balance sheet events

A post-balance sheet event is any event that occurs between the balance sheet date
and the date on which the financial statements are approved by the board of directors.
There are two main categories of post-balance sheet events.

Adjusting events
These are events that provide additional evidence relating to conditions existing at the
balance sheet date. They require changes in amounts to be included in the financial
statements.

Examples are:

● The subsequent determination of the purchase price or the proceeds of sale of

fixed assets purchased or sold before the year-end.
● A valuation that provides diminution in the value of property.
● Guidance concerning the net realisable value of stocks, e.g. the proceeds of
sales after the balance sheet date, or the receipt or evidence that the previous
estimate of accrued profit on a long-term contract was materially inaccurate.
● The negotiation of amounts owing by debtors, or the insolvency of a debtor.
● Receipt of information regarding rates of taxation.
● Amounts received or receivable in respect of insurance claims which are in the
course of negotiation at the balance sheet date.
● Discovery of errors or frauds that show that the financial statements were
incorrect.

FA0609 17 [Turn over

 Non-adjusting events
These are events that arise after the balance sheet date and concern conditions that
did not exist at the time. As a result they do not involve changes in amounts in the
financial statements. On the other hand, they may be of such materiality that their
disclosure is required by way of notes, to ensure that financial statements are not
misleading.

Examples are:

● Mergers and acquisitions.

● Issues of shares and debentures.
● Purchases or sales of fixed assets and other investments.
● Losses of fixed assets or stocks as a result of catastrophe such as fire or flood.
● Decline in the value of property and investment held as fixed assets, if it can be
demonstrated that the decline occurred after the year-end.
● Government action, such as nationalisation.
● Strikes and other labour disputes.

Standard accounting practice

● Financial statements should be prepared on the basis of conditions existing at

the balance sheet date.
● A material post-balance sheet event requires changes in the amounts to be
included in the financial statements, where it is either an adjusting event, or it
indicates that application of a going concern concept to the whole or a material
part of the company is not appropriate.

Disclosure requirements

● A material post-balance sheet event should be disclosed where it is a

non-adjusting event of such materiality that its non-disclosure would affect the
ability of the users of financial statements to reach a proper understanding of the
financial position; or
● It is the reversal or maturity after the year-end of a transaction entered into before
the year-end, the substance of which was primarily to alter the appearance of the
company’s balance sheet.
● The disclosure should state, in note form, the nature of the event and an estimate
of the financial effect, or a statement that it is not practicable to make such an
estimate.
● The estimate of the financial effect should be disclosed before taking account of
taxation, and the taxation implications should be explained, where necessary, for
a proper understanding of the financial position.
● The date on which the financial statements are approved by the board of
directors should be disclosed in the financial statements.

(b) (i) The fire is a post-balance sheet event but non-adjusting and therefore no account
of it will be taken in the redrafting of the financial statements. However, a note to
the accounts will be required identifying the nature of the event and the amount
of the financial effect, i.e. the loss of £350,000.

(ii) Although the customer did not go into liquidation until 9.1.2008 this is an
adjusting event as the £25,000 debt is now not recoverable. The debt of £25,000
must be written off to the income statement as an expense and the debtors figure
in the balance sheet reduced by £25,000.

FA0609 18
Q5 (a) An issue of shares at par means that the issuer is asking the buyer to pay in cash the
nominal value of the shares. Thus, if 2 million ordinary shares with a nominal/par value
of 25p are issued the issuer will receive £500,000 in cash if all shares are bought.

An issue of shares at a premium means that the purchaser is being asked to pay a
higher price than the nominal value. This will be because reserves have been built up
in the enterprise issuing the shares and as the purchaser will have a share in these
reserves they must pay towards them. For example, an enterprise may issue 2 million
25p shares at 50p, that is a 25p premium. The issuer will receive, if all shares are
purchased, £1 millon and £500,000 will be recorded as ordinary shares issues and
£500,000 as share premium.

A rights issue is a useful means of raising fresh capital from the existing shareholders.
Under a rights issue the shares will be issued at a value below the current market value
which encourages the existing shareholders to purchase the rights. For example, an
enterprise with an issued share capital of 500,000 £1 shares may decide to raise an
additional £100,000 by means of a rights issue of one rights for existing ten shares at
£2 (where the current market value is £2.50). This rights issue will raise 50,000 x £2 =
£100,000.

A bonus issue of shares is normally made when an enterprise has substantial

undistributed profits generally much in excess of the issued capital. A bonus issue will
capitalise these reserves into shares. For example, an enterprise with issued share
capital of 500,000 £1 ordinary shares and retained profits of £1,000,000 may make a
2 for 1 bonus issue, thus issuing a further 1,000,000 £1 shares. It is important to note
that no cash is involved in this issue and neither the enterprise nor the shareholder are
any better off in theory.

(b) The differences between debenture holders and shareholders can best be seen from
the following table:

Debenture Holder Shareholder

Debentures are not part of the capital Shares are part of the capital of a
of a company. company.

Debentures rank first for capital and Shares are postponed to the claims
interest. of debenture holders and other trade
payables.

Debenture interest must be paid whether
there are profits or not and is a charge to
the profit and loss account.
Debentures are usually secured by a
charge on the company’s assets.
Dividends are payable out of profits
only (appropriations) but only if there
is adequate profit.
Shares cannot carry a charge.

Debenture holders are trade payables, Shareholders are members of the

not members of the company, and usually company and have indirect control
have no control over it. over its management.

Debentures are not capital and so they should not be grouped with the shares in the
balance sheet but shown as non-current liabilities.

FA0609 19 [Turn over

 (c) Factors determining capital structure are generally the ability of the earnings to
support the structure, the attitude of investors and the cost of capital. If an enterprise
earns 20% on its capital employed and can borrow further loan funds at 10% then the
shareholders will benefit through gearing up. However, if the return on capital employed
is only 8% then there will be a gearing down from borrowing at 10%. Investors
will also consider the security offered, that is the ability of the enterprise to meet
interest payments. Cost of capital is calculated on a weighted average basis and the
fundamental objective of financial management is to seek to provide adequate capital
for the business requirements at minimum cost. Since debt capital is generally cheaper
than equity capital the introduction of debt into the total mix will have the effect of
reducing the overall cost of capital.

Q6 (a) The audit report is addressed to the shareholders of the company and is the auditor’s
opinion on whether the financial statements show a true or fair view. The report should
also:

● State which financial statements have been audited.

● Place emphasis on the fact that it is management’s responsibility to prepare the
financial statements and auditor’s purely to audit them.
● State that compliance with auditing standards in carrying out the audit has been
adhered to.
● Provide a brief overview of the work done to provide the auditor with the
evidence for the opinion.
● Provide details of the auditor and the date of the report.
● Provide details of ‘emphasis of matter’ - this is where an issue arises during the
audit that does not affect the opinion but the auditor believes it should be brought
to the attention of recipients of the report.

An auditor may not be able to state that the financial statements provide a true and fair
view after his audit in which case he must provide a modified report to that effect. The
external report is included within the published financial statements.

(b) An external audit is carried out by persons from outside the organisation who
investigate the accounting systems and transactions and ensure, as far as they
are able, that the financial statements have been prepared in accordance with the
underlying books, the law and applicable accounting standards. The external auditor
needs from his investigation to place him/herself in a position to express an opinion
whether the financial statements being reported upon show a true and fair view or
not. This opinion, if positive, provides considerable reassurance to users of financial
statements, particularly the current shareholders, the owners, that these accounts
are reliable. It is important to identify what an external audit is not. It is not an attempt
to find fraud, and it is not a management control. Fraud may be discovered during an
audit, and the auditor will usually be well placed to give advice to management about
potential improvements in the internal control system, but these benefits are incidental.

FA0609 20
 (c) Relationship between internal and external audit
When carrying out an external audit the auditor may make use of the internal audit
function during the course of the audit. If the external auditor does rely on the work of
internal audit he will have to assure him/herself that the work has been:

● Carried out by suitably competent and proficient people.

● Well documented and evidenced in accordance with findings.
● Carried out using appropriate audit tests and techniques.
● Such that reasonable conclusions have been drawn and acted upon.
● Carried out without undue influence from others.

The external auditor will need to test the work of the internal audit function to confirm
its adequacy.

Q7 (a) Industry
Ratio Calculation Alpha
sector
Return on capital
372 + 68 interest/1,270 34.6% 21.6%
employed
Net assets turnover 4,850/1,270 3.8 times 1.6 times

Gross profit margin 1,110/4,850 x 100 22.9% 25%

Net profit margin 372/4,850 x 100 7.7% 10.5%

Current ratio 1,190/1,000 1.2:1 1.5:1

Quick ratio 1,190 - 550/1,000 0.6:1 0.8:1

Inventory holding period 550/3,740 x 365 54 days 42 days

Trade receivable collection
640/4,850 x 365 48 days 41 days
period
Trade payables payment
700/3,740 x 365 68 days 59 days
period
Debt to equity 600/670 x 100 90% 35%
Dividend per share =
180/600 = 30p market
Dividend yield 2.5% 5%
value £12 therefore
30/1,200 x 100
Dividend cover 192/180 1.1 times 4 times

FA0609 21  [Turn over

 (b) To:
From:
Subject: Analysis of Alpha’s financial performance compared to sector average for the
period ended 31 December 2008
Date:

Operating performance 1
Return on capital employed for Alpha is impressive being 1 2 times the sector average.
This performance is achieved by an asset turnover twice that of the sector. However,
the gross profit margin is slightly lower than the sector, as is the net profit. If the
loss on obsolete inventory is discounted the net profit margin for Alpha increases to
9,612/4,850) 12.6%. This is similar to sector averages. Indeed, excluding the issue of
the obsolete inventory, Alpha has better control of its operating costs than the sector in
general. Alpha’s superior performance is due to the fact that it makes its assets work
twice as effectively as competitors. However, the high asset turnover figure may be
misleading as Alpha’s non-current tangible assets appear quite old, (85% depreciated)
and are likely to need replacing. Given the fact that Alpha is already high geared this
may present problems for the future.

Liquidity
Alpha’s liquidity is poor compared to the sector which is probably due to a high trade
payables and bank overdraft figure. The inventory turnover is also an issue, 54 days
compared to 42 days, and could imply a need to write off further obsolete inventory.

Gearing
Alpha’s gearing is more than twice that of the sector which may lead to difficulties when
seeking further finance to replace the old assets. However, shareholders are benefiting
from this high gearing as a gearing up occurs due to the fact that overall return is
34.6% and loan notes only carry interest at 7%.

Investment ratios
Dividend yield is poor and dividend cover is dangerously low. If performance does not
improve overall in the future it is likely that dividend payments may be cut which could
lead to a reduction in share price.

Summary
Alpha’s liquidity and gearing position gives cause for concern although its profitability
appears good. Alpha needs to deal with the issue of obsolete inventory and future
financing of non-current tangible assets.

(c) Enterprises may use different accounting policies. For example, one enterprise
may revalue its assets which will reduce the return on capital employed due to a
higher depreciation charge and higher asset values. An enterprise may use different
accounting practices, for example debt factoring or finance leasing. Many ratios use
year-end balance sheet figures as a substitute for the average throughout the year. The
year-end balance may not be indicative of the year. Individual ratios cannot be used in
isolation. It is necessary to form a view of an enterprise's performance using several
ratios.

FA0609 22
Q8 Cash flow statement for Spiral enterprise for the year ended 31 December 2008.

£000 £000
Net cash flow from operating activities (note 1) 800
Tax paid (40 + 88 - 64) (64)
Interest paid (28) 708
———
Net cash used in investing activities
Payments to acquire tangible non-current assets (note 2) (528)
Sale of non-current tangible assets 84
Interest received 12
Dividends received 40 (392)
———
Net cash used in financing activities
Dividends paid (48)
Issue of shares 52 4
——— ———
Increase in cash balances 320
Opening cash (92 - 80) 12
———
Closing cash balance (364 - 32) 332
———

Note 1
Reconciliation of operating profit to net cash flow from operating
Profit before interest and taxation 338
Depreciation 148
Impairment (60 - 54) 6
Profit on sale (8) 146
——— ———
484
Decrease in inventory 60
Increase on trade receivables (60)
Increase in trade payables 316 316
——— ———
800
———

Note 2
Tangible non-current assets 31.12.2007 784
Depreciation (148)
———
636
Assets disposed of book value (76)
———
560
Therefore purchased 528
———
Balance 31 December 2008 1,088
———

FA0609 23 
FA0609 24 2343-113-1