Paper 8 – Financial Analysis

Post Exam Guide

May 2006 Exam

Examiner’s General Comments

While there were some excellent papers and a pleasing proportion of very good passes, a
significant number of candidates appeared to find this paper quite difficult. Time pressure
appeared to be a problem for some, apparently because of poor time management (more
detailed comments on this issue follow below).

The majority of candidates found certain questions in Section A of the paper quite
straightforward, with many scoring well on questions 1.1, 1.2, 1.4 and 1.8. However, many
were quite unable to attempt the calculations required to establish the equity element of the
hybrid financial instrument in question 1.6, and it is evident that few candidates understand
the regulation relating to the exclusion of subsidiaries from consolidation. Question 1.7 was
often badly answered, with some candidates making the mistake of writing all they know
(apparently) about IAS 19. Lengthy answers to a short 3 mark question are entirely
inappropriate. In question 1.5 many candidates were unable to say anything about the
accounting treatment of an investment and its hedging instrument, and some dealt with the
two items as separate and unrelated.

It should be noted by candidates that although marks are available for method for some of the
sub-questions in Section A, multiple choice questions for two marks are treated as either
correct or incorrect and it is a waste of time to provide detailed narrative and/or workings for
such questions.

Section B contained two fully written questions, and one requiring calculations only. As in the
November 2005 exam, one of the written questions related to Section D of the syllabus
(although to a different learning outcome). In both November 2005 and May 2006 the syllabus
Section D elements were often badly done because of a complete lack of relevant knowledge.
Candidates would be well advised to devote an appropriate share of their study time to
Section D. Question 3, requiring calculations only, was often although not always, done well.

Section C contained two interpretation and analysis questions for 25 marks each, and a
relatively complex consolidation question involving the part-disposal of an investment in a
subsidiary. It was notable in this diet that more candidates chose to do both of the
interpretation questions. Where they had allowed sufficient time to do justice to both, this
strategy often paid off well. Although a fair proportion of candidates answered the
consolidation question very well, some appeared to be confused by the disposal, and
promptly abandoned their knowledge of the basic principles of consolidation.

Some common problems with exam technique were observed. Time pressure does appear to
have been an issue for some candidates in this paper, but it appears to be a problem of poor
time management. Answers to questions 2 and 4 (for 10 marks each) were sometimes very
lengthy, while the answers to questions 5 and (especially) 7 (for 25 marks each) were quite
brief. Also, candidates should note that the questions in Section A are short, and that the
answers should be similarly brief. While it is important to structure long written answers and to
use an appropriate style, some candidates waste time, especially in Section C, on lengthy
introductions and scene-setting which are not appropriate in the context of an examination.

It is necessary to show full workings. It was noticeable this time, on questions 3 and 6, that
candidates were apparently taking short-cuts with the calculator and not recording the
separate steps of workings.

Poor written style continues to be a problem for many candidates. Also, a few candidates
persist in starting and finishing more than one question on a single page (you should always
start a new question on a new page of the answer booklet). A minority of candidates
apparently end an answer, but then pick it up again later in the booklet. If they feel they have
to use this approach, then markers would appreciate some indication that the answer
continues later.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

SECTION A – 20 MARKS

ANSWER ALL EIGHT SUB-QUESTIONS

Question 1.1

On 30 September 2005, GHI purchased 80% of the ordinary share capital of JKL for $1⋅45 million.
The book value of JKL’s net assets at the date of acquisition was $1⋅35 million. A valuation exercise
showed that the fair value of JKL’s property, plant and equipment at that date was $100,000 greater
than book value, and JKL immediately incorporated this revaluation into its own books. JKL’s
financial statements at 30 September 2005 contained notes referring to a contingent liability (with a
fair value of $200,000).

GHI acquired JKL with the intention of restructuring the latter’s production facilities. The
restructuring plan, including a detailed estimate of costs, was well advanced at 30 September 2005.
The estimated costs of the restructuring plan totalled $115,000.

Calculate goodwill on acquisition, and identify any of the above items that should be excluded from
the calculation in accordance with IFRS 3 Business Combinations.

(3 marks)

Answer

Goodwill on acquisition

$ $
Investment in JKL 1,450,000
Acquired:
Net assets at book value 1,350,000
Revaluation 100,000
Contingent liability (200,000)
1,250,000
80% of fair value of net assets 1,000,000
Goodwill on acquisition 450,000

According to IFRS 3, restructuring provisions can be taken into account only if the acquiree has an
existing liability for restructuring recognised in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets. This condition is not met in this case.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question 1.2

DA controls another entity, CB, owning 60% of its ordinary share capital. At the group’s year end,
31 December 2005, CB included $6,000 in its receivables in respect of goods supplied to DA.
However, the payables of DA included only $4,000 in respect of amounts due to CB. The difference
arose because, on 31 December 2005, DA sent a cheque for $2,000, which was not received by
CB until 3 January 2006.

Which ONE of the following sets of consolidation adjustments to current assets and current
liabilities is correct?

A Deduct $6,000 from both consolidated receivables and consolidated payables.

B Deduct $3,600 from both consolidated receivables and consolidated payables.

C Deduct $6,000 from consolidated receivables and $4,000 from consolidated payables, and
include cash in transit of $2,000.

D Deduct $6,000 from consolidated receivables and $4,000 from consolidated payables, and
include inventory in transit of $2,000.
(2 marks)

Answer

The answer is C

Question 1.3

PQR holds several investments in subsidiaries. In December 2005, it acquired 100% of the ordinary
share capital of STU. PQR intends to exclude STU from consolidation in its group financial
statements for the year ended 28 February 2006, on the grounds that it does not intend to retain
the investment in the longer term.

Explain, with reference to the relevant International Financial Reporting Standard, the conditions
relating to exclusion of this type of investment from consolidation.
(2 marks)

Answer

According to IFRS 5 Non-Current Assets held for Sale and Discontinued Operations, a subsidiary
that has been acquired and is held exclusively with a view to its subsequent disposal, does not
require consolidation. However, the investment can be regarded as ”held for sale” only if its
disposal is intended to take place within 12 months of the balance sheet date. In the case of PQR’s
investment in STU, the disposal would have to take place before 28 February 2007.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question 1.4

BLX holds several investments in subsidiaries. One of these, CMY, is located overseas. CMY
prepares its financial statements in its local currency, the crown.

Several years ago, when the exchange rate was 5 crowns = 1$, CMY purchased land at a cost of
170,000 crowns. On 1 June 2005, when the exchange rate was 6⋅5 crowns = $1 the land was
revalued at a fair value of 600,000 crowns. The exchange rate at the group’s year end,
31 December 2005, was 7 crowns = $1.

In accordance with the requirements of IAS 21 The Effects of Changes in Foreign Exchange Rates,
at what value in $s should the land be recognised in BLX’s group financial statements at
31 December 2005?

A $85,714

B $90,440

C $100,154

D $120,000
(2 marks)

Answer

The answer is A

Workings

600,000/7 = $85,714 (that is, translate both cost and revaluation at the closing rate.)

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question 1.5

During its financial year ended 31 March 2006, CDO acquired 100% of the issued share capital of
DEP for €750,000. The purchase was partially financed by a loan for €600,000. The loan is
designated by CDO as a hedging instrument. CDO’s functional currency is the $.

Explain the accounting treatment required for gains and losses on the investment and its hedging
instrument.
(2 marks)

Answer

Accounting for hedging relationships is regulated by IAS 39 Financial Instruments: Recognition and
Measurement. Gains and losses on designated hedging instruments and the items they hedge are
permitted to be set off against each other. In CDO’s case any gain or loss on the unhedged
element of the investment is recognised in profit or loss.

Question 1.6

On 1 January 2006, EFG issued 10,000 5% convertible bonds at their par value of $50 each. The
bonds will be redeemed on 1 January 2011. Each bond is convertible at the option of the holder at
any time during the five year period. Interest on the bond will be paid annually in arrears.

The prevailing market interest rate for similar debt without conversion options at the date of issue
was 6%.

At what value should the equity element of the hybrid financial instrument be recognised in the
financial statements of EFG at the date of issue?
(4 marks)

Answer

Bond principal: 10,000 x $50 = $500,000. Annual interest payment = $500,000 x 5% = $25,000.

Present value of principal: $500,000/(1⋅06)5 (factor from table = 0⋅747) 373,500

Present value of interest: $25,000 x cumulative discount factor
(from table = 4⋅212) 105,300
478,800
Balancing figure = equity element 21,200
Principal 500,000

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question 1.7

In the context of IAS 19 Accounting for Employee Benefits, explain how an experience gain or loss
arises.
(3 marks)

Answer

An actuary identifies the actuarial value of the pension plan’s assets and liabilities. Where the value
of assets exceeds liabilities, a gain arises, and a loss is created by the opposite effect. Part of the
gain or loss may arise because the actual out-turn of events has not coincided with the actuarial
assumptions that were made previously. This element of the difference between plan assets and
liabilities is known as the experience gain or loss.

Question 1.8

During its financial year ended 31 January 2006, TSQ issued share options to several of its senior
employees. The options vest immediately upon issue.

Which ONE of the following describes the accounting entry that is required to recognise the
options?

A DR The statement of changes in equity: CR liabilities

B DR The statement of changes in equity: CR equity

C DR The income statement: CR liabilities

D DR The income statement: CR equity

(2 marks)

Answer

The answer is D

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

SECTION B – 30 MARKS

ANSWER ALL THREE QUESTIONS

Question Two

Write the briefing paper, which should discuss the following issues:

• Any relevant regulatory requirements for an OFR;

• The purpose and, in outline, the typical content of an OFR;
• The advantages and drawbacks of publishing an OFR from the entity’s point of view.

(Total for Question Two = 10 marks)

Rationale

This question related to syllabus area D Developments in external reporting. Specifically, it tested
learning outcome D (i) ‘Discuss pressures for extending the scope and quality of external reports’.

Suggested Approach

The answer should follow the structure suggested by the question, covering all three issues.

Marking Guide Marks

Discussion of relevant regulatory requirements 3

Discussion of purpose and typical content 3
Discussion of advantages and drawbacks 4

Examiner’s Comments

Although there were some very good answers to this question, many candidates were hampered in
their efforts by a complete lack of knowledge about the OFR. They often guessed that it was an
environmental and/or social report, and in consequence some wrote lengthy answers that missed
the point entirely. The length of the answers was often in inverse proportion to the amount known
about the topic. This was the question most often omitted in incomplete papers.

Common Errors

Poor exam technique was frequently a problem. A number of candidates wrote an excessive
amount, given that this is a 10 mark question. Some candidates did not read the question properly
and failed to discuss the advantages and drawbacks from the entity’s point of view.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question Three

Prepare the consolidated income statement of the ST group for the year ended 31 January 2006.
(Total for Question Three = 10 marks)

Rationale

This question tested learning outcome A (vi) ‘explain the concept of an associate and a joint
venture, and the principles of how they are accounted for’ in the context of an income statement.

Suggested Approach

Calculate the adjustments required for intra-group trading and for unrealised profit, and incorporate
into the income statement, taking in the appropriate proportion on each line of the results of the
joint venture.

Marking Guide Marks

Consolidation aspects 5
Calculations 2
Eliminations and adjustments 3

Examiner’s Comments

Few candidates got this completely correct, but many scored well. Marks of 7, 8 or 9 were quite
common. The calculation of unrealised profit was the least well accomplished aspect of the
question. Even where the calculation was correct, the adjustment was often deducted from, rather
than added to, cost of sales.

Common Errors

Failure to demonstrate understanding of the principles of consolidating a subsidiary and a joint

venture. A few candidates included 70% of the results of the subsidiary, some used equity
accounting for the joint venture (despite the steer given in the question), and some either failed to
calculate minority interest at all or adopted an incorrect approach. It was by no means unusual to
find candidates who correctly incorporated a proportion of the joint venture’s results, line by line, but
then also included a minority interest figure for the JV.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question Four

Discuss the economic substance of the contractual arrangement between the two entities in
respect of the recognition of inventory and of sales. Refer, where appropriate, to IAS 18 Revenue.
(Total for Question Four = 10 marks)

Rationale

This question tested learning outcome B (iii) ‘discuss the principle of substance over form applied to
a range of transactions’ in the context of a trading arrangement involving consignment inventory.

Suggested Approach

Briefly describe the relevant principles of substance over form, identifying the issues relating to the
recognition of revenue and inventory. Apply the principles to the case, discussing the balance of
risks and rewards in the commercial arrangement between the two entities, deciding on which
entity should recognise the vehicles in inventory, and the point at which IJK should recognise the
sale of its vehicles.

Marking Guide Marks

Identification of benefits and risks 4

Discussion of substance over form 3
Identification of principle, risk and reward and point of sale issues 3

Examiner’s Comments

This question was quite well answered by a good proportion of candidates, but many used up quite
a lot of paper without gaining many marks.

Common Errors

• Listing the points given in the question without linking them to a discussion of risks/benefits
or identifying the relevant substance over form issues.
• Wasting a lot of time writing out journals for the accounting entries that would have to be
made by both parties.
• Trying to make the facts of the question fit the conclusion that the arrangement constitutes
a lease.
• Examining the risks and rewards from the perspective of either the manufacturer or dealer,
but not both.
• Wasting time by writing out the recognition criteria of IAS 18 in full, without necessarily then
incorporating them into the discussion.
• Discussing revenue recognition but not inventory recognition.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

SECTION C – 50 MARKS

ANSWER TWO QUESTIONS OUT OF THREE

Question Five

(a) Calculate the earnings per share figure for the BZJ Group for the years ended 31
December 2005 and 2004, assuming there was no change in the number of ordinary
shares in issue during 2004.
(3 marks)

(b) Produce a report for the investor that

(i) analyses and inteprets the financial statements of the BZJ Group, commenting upon
the group’s performance and position; and
(17 marks)

(ii) discusses the extent to which the chairman’s comments about the potential for
improved future performance are supported by the financial statement information for
the year ended 31 December 2005.
(5 marks)
(Total for Question Five = 25 marks)

Rationale

This question required candidates to calculate and interpret a range of accounting ratios and to
analyse the financial statements provided so as to comment upon the performance and position of
the entity. This question tested learning outcomes C (i) and (ii).

Suggested Approach

First, calculate the earnings per share figures to fulfil the requirements of part (a) of the question.
Then, calculate other relevant accounting ratios and produce the required report analysing the
financial statements and discussing the chairman’s comments.

Marking Guide Marks

EPS and weighted average calculations 3

Ratio calculations 8
Comments on decline in performance 5
Comments on financial position 4
Discussion of chairman’s comments/success of issue of shares 3
Discussion of other relevant points 2

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Examiner’s Comments

Part a) of the question was usually done badly. This was surprising as the calculations involved
were quite straightforward. Many candidates made no attempt to calculate the weighted average of
the shares and the majority picked up the wrong profit figure.
Many candidates, by contrast, did well on part b) i), and it seems that comments made on previous
post-examination guides have been heeded in some quarters. Marker comments for this diet
included the following: ‘The quality of analysis from home candidates was much improved from
previous diets, almost all commenting sensibly on both performance and financial position’; ‘…the
ratios were done well…’ and ‘…many did make sensible comments…’.

However, part b) ii) was usually either done badly or not done at all. Despite the fact that 5 marks
were available for discussing the chairman’s comments, many candidates chose not to mention
them at all, or to respond with a very brief, one-line comment. Candidates who wrote several pages
for a ten-mark question (see earlier comments on question 2) were satisfied with the briefest of
comments in this question for five marks.

While many candidates scored well on the ratio calculations, there were often basic errors in the
calculation of ratios. While there are many valid ways of calculating certain ratios, some ways are
logically invalid (e.g. calculating a return on capital ratio by comparing profit before deduction of
interest to shareholders’ funds rather than to total capital employed). Also, even when the
calculations were correct, candidates could not necessarily discern the significance of the change
in a ratio from one period to another.

Common Errors

• Inability to calculate basic earnings per share.

• Inclusion of large amounts of general preamble in the report (elaborate headings,
descriptions of the purpose of ratio analysis and of the techniques undertaken, and even in
some cases, a contents page for the report). While it is important to set the answer out
clearly and to use a logical structure, some candidates are producing up to two pages of
general introduction, little if any of which attracts a mark. Sometimes, candidates obviously
left themselves short of time to answer the main part of the question because they had
spent so long on the preliminaries.
• Tendency to repeat the same points.
• Difficulty in communicating ideas because of poor quality English.
• Failure to include discussion of the chairman’s comments.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question Six

(a) Calculate the profit or loss on disposal after tax of the investment in CX that will be disclosed
in

(i) AZ’s own financial statements;

(ii) the AZ group’s consolidated financial statements.

(6 marks)
b) Calculate the consolidated reserves of the AZ group at 31 March 2006.
(5 marks)

(c) Prepare the consolidated balance sheet of the AZ group at 31 March 2006.

(14 marks)
(Total for Question Six = 25 marks)

Full workings should be shown.

Rationale

This question tested learning outcomes A (iii) and (v), specifically requiring candidates to prepare a
consolidated balance sheet for a small group of companies at the end of a period in which a
disposal had taken place. The disposal altered the status of one of the group’s investments from a
subsidiary to an associate.

Suggested Approach

A sensible approach is suggested by the sub-sections of the question: first do the disposal
calculations, then the consolidated reserves calculation, and then the balance sheet.

Marking Guide Marks

Part a) Calculations 2
Part a) Correct demonstration of principles 4
Part b) Calculations 2
Part b) Correct demonstration of principles 3
Part c) Accounting for investment in associate – calculation and principles 3
Accounting for minority interest – calculation and principles 3
Correct calculation and application of principles in preparing group balance
sheet 8

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Examiner’s Comments

Quite a large proportion of candidates struggled with the consequences of the disposal, especially
in calculating the consolidated profit on disposal. The change of status from subsidiary to associate
confused many candidates and had the effect, apparently, of causing them to abandon much of
their knowledge of the basic principles of consolidation. For example, some candidates did manage
to include a line for investment in associates in the balance sheet (although the figure was rarely
completely correct) but also included a 60% minority interest in respect of the associate.

Having said all that, the question was quite frequently well attempted, and many candidates scored
a pass on it.

Common Errors

• Confusion between the profit on disposal in AZ’s own books and the consolidated figure.
• Omitting CX’s reserves from the consolidated reserves calculation
• Deducting 100% of the PURP from consolidated reserves
• Forgetting to include the investment gains tax on disposal in the consolidated balance
sheet
• Omitting or miscalculating the investment in associate
• Including goodwill on the acquisition of CX under goodwill in the balance sheet
• Consolidating CX as a subsidiary.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Question Seven

Prepare a report to accompany the summary of key data. The report should:

(a) analyse the key data, comparing and contrasting the potential takeover targets with each
other and with ABC itself.
(13 marks)
(b) discuss the extent to which the entities can be validly compared with each other, identifying
the limitations of inter-firm and international comparisons.
(12 marks
(Total for Question Seven = 25 marks))

Rationale

This question required candidates to write a report on key financial ratios given in the question, and
to discuss the limitations of accounting ratio analysis. It tested learning outcomes C (iii), (iv) and (v).

Suggested Approach

The answer to part a) is probably best approached by discussing groups of related ratios for all the
entities (rather than discussing each entity separately). A discussion of performance ratios might
logically be undertaken first, followed by a discussion of gearing, and then of efficiency ratios.
The answer to part b) should cover both general points about inter-firm and international
comparisons, and points specific to the scenario outlined in the question.

Marking Guide Marks

Comparative analysis of performance 4

Comparative analysis of working capital items 4
Comparative analysis of other items such as P/E ratios and tax rates. 5
Discussion of limitations such as accounting policy differences, dates, single period
comparisons 8
Discussion of problems of international comparison 4

Examiner’s Comments

A relatively large number of candidates selected this question together with question 5, and it would
seem that more candidates positively chose to do analysis rather than group accounting questions
(or possibly they didn’t much care for question 6). Amongst this group, the candidates who had left
sufficient time to do justice to both questions often did well. However, it was noticeable that the
answers to question 7 were often too short and that they didn’t cover a sufficient range of points to
score many marks. Poor time management was probably more evident in this question than in any
other on the paper. Sometimes answers to part a) were relatively good, but a skimpy answer to part
b) resulted in an overall fail grade for the question.

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 Paper 8 – Financial Analysis
Post Exam Guide
May 2006 Exam

Common Errors

Some candidates approached part a) of the question by discussing the ratios for each entity
individually. This approach tended to take up too much time, and those candidates who chose to
focus on differences and themes emerging from the data as a whole were probably more
successful.

Many candidates included part of the answer to part b) in part a) and then repeated points, thus
wasting time, when they got to part b). If candidates are finding themselves saying ‘as explained
earlier’ or ‘as noted above’ in answers it may mean that they haven’t structured their answers well.

Although part b) was very well done by some candidates, others couldn’t think of much to say and
ended up repeating points. Some candidates made good general points, but then failed to ground
them in the specifics of the scenario.

It was clear that many candidates do not understand the significance of a P/E ratio.

Not allowing enough time to answer the question properly.

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