CGI Past Papers - Section A Question and Answers

Question 1

Explain how social accounting operates in companies that are committed to this aim.

Answer 1

Such a company would have commitment to behave ethically and remaining sensitive to
the needs of all stakeholders, whilst contributing to economic development (1).

Stakeholders would include employees and their families, but also the local community
and society at large (1).

A company operating social accounting would make decisions
based not only on financial factors but also on the social and environmental consequences
of their actions (1).

Such a company would undertake regular evaluation to verify its commitment through
independent social audit, certification on standards and periodic independent reviews (1).

Using feedback from stakeholders, a company can monitor, adjust and plan its activities to
achieve its social objectives (1).

Social accounting adds value to such a company’s annual
report by providing information about non-financial activities and the related costs of
business behaviour in society (1).

Question 2

Explain the concept of capital maintenance and how it can be applied to company financial
statements.

Answer 2

Under the concept of capital maintenance, profit earned by a company can be recognised
only if the value of its net assets at the end of an accounting period exceeds those at the
beginning of an accounting period (1).

The IASB Conceptual Framework for Financial Reporting identifies two concepts of capital
maintenance, without indicating a preference for either. These are the two main ways in
which the concept can be applied:
* Financial concept of capital maintenance – the concept works where the value of net
assets has increased (1).

This is adjusted for any dividends paid, or capital raised via
equity shares in the period (1).

• Physical concept of capital maintenance – the concept works where the capital is
  regarded as production capacity (1).

This may be based on units of output but is harder to apply than the financial concept (1).

Question 3

Outline how the differences between public and private financial markets affect investors.

Answer 3

A public market is one in which the general public can participate, whereas a private
market is one where transactions are held and executed through private security dealers
(1).

A person with as little as £10 can participate in a public market, whereas private
markets would require a more significant minimum sum (1).

Public markets are highly regulated because the exposure of the general public is greater.
Private markets are not as regulated as the main participants are normally banks, venture
capitalists etc (1).

Public markets offer greater liquidity, offering a smoother purchase or sale, whereas in
private markets the buyer and seller personally negotiate and execute the transaction (1).

Investments in private markets carry greater risk than public market investments, and
hence investors would expect a greater return (1).

Question 4

Describe how the dividend valuation model can be used to estimate the value of equity.

Answer 4

The model is based on the principle that the current value of an equity share is the
discounted value of all the expected dividend payments that the share is expected to yield
in future years (1).

The net present value (NPV) is calculated using an appropriate risk-adjusted rate that
discounts the value of future cash flows to today’s date (1).

Future cash flows would include dividends and the selling price of the share when sold (1).

The model assumes dividends will be paid in perpetuity and will be constant or growing at
a fixed rate (1).

For shares that do not pay dividends, the future cash flows would be equal to the intrinsic value of the selling price of the share (1)

Question 5

Explain how scenario analysis can assist when evaluating a possible investment.

Answer 5

Scenario analysis can be used to provide information on possible outcomes for a possible
investment by creating various scenarios that may occur in the future (1).

It evaluates the expected value of a proposed investment in different scenarios expected in a certain
situation (1).

Scenario analysis involves calculating NPV, so is based on a consideration of the time
value of cash flows (1).

The most used scenario analysis involves calculating NPV’s in 3
possible states – a most likely view, an optimistic view and a pessimistic view (1).

By changing several key variables simultaneously, decision makers can examine each possible outcome from the potential downside or upside of a possible investment (1).

Candidates might refer to the limitations of scenario analysis (award a maximum of 2
marks for this):
* It does not look at the probability of each scenario occurring when evaluating possible
outcomes (1);
* It does not consider other scenarios that may occur (1); and,
* As the number of variables that are changed increases, the model can become
increasingly difficult and time consuming (1).

Question 6

Explain the nature and purpose of environmental reporting for a company.

Answer 6

A company has a duty to account for its environmental impacts using environmental
reporting (1).

This is the process of communicating the environmental effects of a company’s economic
activity through the corporate annual report or a separate environmental report (1).

This is a response to pressures on companies with regards to their wider social role, and
to act responsibly in reducing any impact they have on the environment to a minimum (1).

The nature of the environmental reports, in terms of their quality and quantity, depends on
the nature of the business (1).

For example, oil and gas companies might have more to
report on in terms of environmental issues (1).

The demand for environmental-related information has led to pressures on companies,
requiring them to make a range of disclosures, such as information on policies, procedures
and processes in their environmental audit reports. (1)

Question 7

Explain the two fundamental qualitative characteristics identified in the International Accounting
Standards Board’s (IASB) Conceptual Framework for Financial Reporting.

Answer 7

Award up to five marks from the following. Award a maximum of three marks for
one characteristic and two marks for the other.

Award up to 3 marks from the following:

Relevance
Financial information is regarded as relevant if it can influence the decisions of users (1).

In determining what is relevant to users, preparers of the financial statements should
consider whether information is material and the extent to which reliable information may
be omitted (1).

Information may be material (and therefore relevant) simply because of its magnitude, or because its omission from the financial statements could affect decision
making (1).

Award up to 3 marks from the following:
Faithful representation

This means that financial information must meet criteria of completeness, neutrality (or
unbiased) and be free from error (1):
* Completeness – all information that users need to understand the item is given (1).
* Neutral – no bias in the selection or presentation of the information (1).
* Free from error – no omissions, errors, or inaccuracies in the process to produce
the information (1).

Answers may refer to concept of prudence in terms of measuring uncertainty and its
impact on faithful representation (1).

Question 8

Explain how ‘cost of sales’ is calculated for different types of company in the statement of profit or loss.

Answer 8

Cost of sales is the accumulated total of all the costs used to create a product or service which have been sold in the period being reported (1).

The various costs of sales fall into the general sub-categories of direct labour, direct materials, and overheads (1).

The accounting concepts of matching and accruals are key,
as the cost of sales must relate to the revenue recognised (1).

Cost of sales for a service company is most likely to be based on the direct labour costs of
providing services (and would not usually be based on inventory) (1).

Cost of goods sold for a manufacturing company is the cost of its finished goods in its
opening inventory, plus the costs of goods manufactured during the accounting period,
minus the costs of its finished goods in its closing inventory (1).

Cost of goods sold for a retailer is the cost of merchandise in its opening inventory, plus
the net cost of merchandise purchased during the accounting period, minus the cost of
merchandise in its closing inventory (1).

Question 9

Define the price/earnings (P/E) ratio and explain its limitations when analysing a company as an
investment opportunity.

Answer 9

Award up to one mark for the definition:

The P/E ratio of a company is also referred to as the earnings multiple. It measures the
current market price of the share of a company relative to its earnings per share (EPS) (1).

Award up to four marks for the limitations:

• The earnings are based on accounting policies, which are more subjective (and
  open to being inflated) than cash flows (1).
• The P/E ratio assumes the market is valuing earnings, rather than looking at earnings growth, dividends, risk etc (1).
• The P/E ratio assumes the market accurately values shares (1).
• The P/E ratio is a backward-looking measure (1).
• The share price used may not fully reflect the level of financial risk which results
  from increased levels of debt finance (1).

Question 10

Explain the purpose and use of the Capital Asset Pricing Model (CAPM).

Answer 10

The purpose of CAPM is for determining an estimate of the cost of equity for a company
(1).

The cost of equity is the rate of return investors expect to achieve on their shares in a company (1).

The rate of return an investor requires is based on the level of risk associated with the
investment (1).

Equity investors face the greatest risk of all investors and therefore
demand a higher rate of return to justify the risk taken (1).

The CAPM model establishes an equilibrium relationship between the expected returns from each of a company’s securities and the associated risks (1).

It can be used to assess risk in individual company shares. The cash flows from riskier assets will be discounted at a higher rate (1).

CAPM can also be used to be a minimum target level of return for an investment project (1).

The risk inherent in a project depends on the type of activity involved. Higher risk does
not necessarily make a project or investment unattractive (1).

Question 11

Explain the role and objectives of external audit.

Answer 11

External audit is a common approach used on behalf of the shareholders (principal) to
monitor the directors’ (agents’) activities and take corrective action where necessary.
External audit fees, therefore, are an agency cost. (1)

The key objective of an external audit is to protect the interests of shareholders by independently reporting the state of a company’s finances (1).

The auditors should:
* ensure that the Board receives accurate and reliable information (1), and

• assess the appropriateness of the accounting principles (1).

An audit results in an audit opinion about whether the financial statements give a “true and fair” view of the company’s financial situation and operations for the period (1)

Question 12

Describe the differences between a ‘principles-based’ and a ‘rules-based’ financial reporting
system.

Answer 12

A principles-based system, such as International Financial Reporting Standards (IFRS), uses an underlying set of principles (a “conceptual framework”) within which standards are
developed (1).

Therefore, the principles provide the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to users (1).

Where there is not such a framework, then rules must be designed to cover every eventuality, and this means there will be a rules-based system (such as some national
Generally Accepted Accounting Principles (GAAPs)). (1)

Therefore, in a rules-based
system the exercise of judgement is minimised (1).

This could be preferred by auditors, who may fear litigation. However, this may lead to a large volume of regulatory measures,
which do not always detect or prevent financial irregularities (1).

Question 13

Explain, using an example, what is meant by the ‘accruals basis of accounting.

Answer 13

The accruals basis of accounting is one of the overriding concepts for financial statements.
International Accounting Standard 1 (IAS 1) requires financial statements, except for cash
flow information, to be prepared using the accruals basis of accounting (1).

The accruals concept requires transactions to be accounted for in the period when income
is earned or expenses are incurred (1), not when they are received or paid in cash (1).

For example, a company delivers goods to one of its clients in November and raises an
invoice to the client. The client settles the invoice in the following January. Under the
accruals accounting concept, the company must record the revenue in November, as that
is when the income is earned (1).

However, the cash payment from the client is not received until the following January, at which point the cash would be recognised in the cash flow statement (1)

Question 14

Outline the factors which companies and shareholders should be aware of when a company issues new shares by a rights issue.

Answer 14

A rights issue offers existing shareholders the right to buy new shares in proportion to their
existing shareholdings (1).

Therefore, a rights issue enables shareholders to retain their existing share of voting rights. (1)

Usually, the price at which the new shares issued by a rights issue is at a discount to the current share value (i.e., less than the current share price in the market) (1).

This bypasses the pricing problem for share issues since the shares are offered to existing shareholders at an attractive price. (1)

Shareholders also have an option to sell their rights on the stock market (1).

Note, however, that quoted and unquoted companies can make rights issues. (1)

With a rights issue for a quoted company, because more shares are issued to the market,
the share price is diluted and is likely to fall. (1)

Dilution occurs because a rights offering spreads a company’s net profit over a larger number of shares. Thus, the company’s
earnings per share (EPS) decreases as the allocated earnings result in share dilution. (1)

Question 15

Explain what factors would constitute a ‘significant influence’ by a company over an associate
company, according to IAS 28 (Investments in Associates and Joint Ventures).

Answer 15

An entity over which the investor has significant influence, and which is neither a subsidiary nor a joint venture, is called an associate. (1)

The key criterion here is
significant influence. This is defined as the “power to participate in the financial and
operating policy decisions of the investee, but not to control or have joint control over
those policies.” (1).

Significant influence is presumed with an equity shareholding of between 20% and 50%
(1).

Award up to 2 marks from the following:
In IAS28 significant influence can be evidenced in one or more of the following ways:
* Representation on the Board of directors (or equivalent) of the investee; (1)
* Participation in the investee’s policy-making process; (1)
* Material transactions between investor and investee; (1)
* Interchange of management personnel; or, (1)
* Provision of technical information. (1)

Question 16

Explain the factors that influence a regulatory structure for financial reporting.

Answer 16

There are many factors that influence a regulatory structure, which could
include:

• National or company law: the legislation that regulates businesses, e.g. in the UK Companies Act 2006; (1)
• A financial reporting standards body: the bodies with the overall
  responsibility for producing financial reporting standards, e.g. in the UK, the Financial Reporting Council (FRC); (1)
• Market regulations: legislation from other jurisdictions may affect
  accountability in the global market, e.g. Sarbanes-Oxley Act is
  important to all businesses with US listings; (1)
• Industry-specific and securities exchange rules: there are
  various industry-specific regulatory bodies and systems in place, e.g. in the UK the Financial Conduct Authority (FCA) oversees the financial services industry; (1)
• Corporate governance frameworks: these seek to enhance financial reporting by providing confidence to the users of accounting information, e.g. the Cadbury Report; (1)
• Environmental and sustainability reporting: there are national
  and international standards for social, environmental and
  sustainability reporting. (1)

Question 17

Explain the current value basis of measurement of the elements of financial statements, which are
identified in the Conceptual Framework for Financial Reporting.

Answer 17

The current value basis is measurement using the current monetary value, updated to reflect conditions at the measurement date. (1)

This method can be applied in circumstances in which a historical cost amount is not available or not considered suitable (e.g. a property acquired many years ago that is revalued). (1)

Measurement bases may include
* Fair value – the price that would reflect market participants’ current
expectations of the amount to be received to sell an asset or paid to
transfer a liability. (1)

• Value in use for assets/fulfilment value for liabilities – the value that
  reflects the entity-specific current expectations about the amount,
  timing, and uncertainty of future cash flows. (1)
• Current cost – reflects the current amount to be paid to acquire an equivalent asset or received to settle an equivalent liability. (1)

Question 18

Explain, using an example, why it is necessary to account for the substance of a transaction rather
than its legal form.

Answer 18

This is referring to the accounting concept of “substance over form”, which means the transactions recorded in financial statements must reflect the economic (or commercial) substance rather than its legal form. (1)

The financial statements of a business should reflect the underlying realities of its accounting transactions. (1)

This entails the use of judgement on the part of the preparers of financial statements. This makes this area of accounting subjective. (1)

Award up to 2 marks for any one of the following examples:
* Leases – as per IFRS 16 the lessee has to recognise assets,
representing its right to use the assets, even though it does not own them;
* Sale and leaseback arrangements – does the transfer of an asset to
another entity and then leasing it back qualify as a sale under IFRS
15, or is its nature that of a lease, and accounted for under IFRS 16;
* Preference shares – although legally equity, they may be treated as debt rather than equity for accounting purposes when they carry a fixed rate of dividend or a clear arrangement for repayment;
* Consignment stock (inventory) – still treated as stock of the seller,
rather than sold to the buyer. The buyer holds the goods on behalf of
the seller, with a view to sell on the seller’s behalf e.g. one party (the
seller) legally owns the inventory, but another party (the buyer) keeps the inventory on its premises;
* Debt factoring – is this just a collection process or have the risks
and rewards in the receivables substantially transferred from the
company (which sold the goods and services) to the factor.

Question 19

Explain what is meant by a loan covenant and the constraints that might be imposed on the
borrower.

Answer 19

A term loan is conditional on a loan covenant. A loan covenant places a restrictive clause in a loan agreement that places certain
constraints/restrictions on the borrower. (1)

These constraints are with reference to:
* Financial reporting – requiring borrowers to submit management
reports, including cash flow and forecasts, on a regular basis; (1)

• Financial ratios – getting or keeping debt or liquidity ratios within an agreed range and/or requiring working capital to be maintained at a certain level; (1)
• Regulatory reporting – requiring the statutory financial statements
  to be audited annually; (1)
• Debt covenants - restricting the borrower’s ability to take on more
  debt without the prior consent of the lender. (1)

Question 20

Explain the benefits of using retained earnings as a source of finance.

Answer 20

They are internally generated funds, with no issue costs, so are the cheapest source of capital; (1)

• The cash is immediately available (if it has not already been spent); (1)
• There is no obligation to either pay any interest or pay back the earnings to shareholders; (1)
• Management have flexibility in how or where this money can be used;
  and (1)
• Can be used to smooth dividends payments to shareholders, as they
  represent profits not distributed from the current and previous years. (1)

Question 21

Explain how the key objectives of international accounting and financial reporting standards were influenced by corporate collapses.

Answer 21

The objective to improve the transparency of financial reporting and make financial information reliable, relevant and easier to understand was, in part, needed in order to make it easier for stakeholders to see companies’ financial performance and position. (1)

• The objective to reduce the risk of creative accounting because this was a contributory factor in several of the collapses. (1)
• Making the financial statements of different periods or of different
  entities comparable, so that stakeholders can better understand and
  compare them. (1)
• Increasing the credibility of financial statements by improving the uniformity of accounting treatment between companies, again to make them easier for stakeholders to compare and contrast with each other,
  and because several of the collapses had resulted from irregularities in the accounting procedures. (1)
• Providing quality financial reports and accounting information which can be relied upon for consistency, commonality and overall transparency, as irregularities in accounting procedures was seen as a significant factor in some of the collapses. (1)

Question 22

Explain the purpose of the International Accounting Standards Board’s (IASB) Conceptual
Framework for Financial Reporting.

Answer 22

When it was introduced, the primary purpose of the Conceptual Framework
was to assist the IASB in the development of future IFRSs and in its review of existing IASs and IFRSs. It is a statement of generally accepted theoretical principles that underlie the framework for the preparation and presentation of financial statements. (1).

In doing so, it also provided increased transparency to the work of the IASB, by providing those who are interested in the work of the IASB with information about its formulation of IFRS. (1)

The IASB wanted the Conceptual Framework to provide a basis for reducing the number of alternative accounting treatments permitted by IFRSs. Those
that conflicted with the Framework could be reviewed and potentially
removed. (1)

However, the Conceptual Framework has also helped numerous other people and bodies and may assist:
* preparers of financial statements in developing accounting policies
for transactions or events not covered by existing standards; (1)
* national standard setting bodies in developing national standards;
(1)
* preparers of financial statements in applying IFRS; (1)
* auditors in forming an opinion as to whether financial statements
comply with IFRS; (1) and
* users of financial statements in interpreting the financial statements prepared in compliance with IFRS; (1)

Question 23

Describe the objective of portfolio management and the elements of an efficient investment
portfolio.

Answer 23

The objective of portfolio management is to select the right investments in the
right proportions (1)

to generate optimum returns, whilst minimising risk (1).

The key elements of an efficient investment portfolio are (Award up to 3 marks from the following):
* Return – steady returns that at least match the opportunity cost of the funds invested. (1)

• Risk reduction – minimise the overall risk to an acceptable level. (1)
• Liquidity and marketability – assets which can be marketed without difficulty. (1)
• Tax shelter – developed considering the impact from taxes and possible mitigations. (1)
• Capital appreciation – some of the assets appreciating in capital
  value to protect from inflation. (1)

Question 24

Explain the overriding concepts for the preparation of published financial statement

Answer 24

Going concern – financial statements are normally prepared assuming the entity will continue in operation for the foreseeable future. (1)

• Accruals basis of accounting – requires transactions to be accounted for in the period when income is earned or expenses incurred, not when they
  are received or paid in cash. (1)
• Materiality – each material class of similar items should be presented separately. (1)
• Reporting period – should produce financial statements at least annually, and make disclosures if the reporting period is changed. (1)
• Offsetting – assets and liabilities, and income and expenses, shall not be offset unless required or permitted by a standard. (1)

Question 25

Describe the movements that could be reported in a statement of changes in equity

Answer 25

Changes in equity share capital, including issues for cash (capital
contributions) and redemptions. (1)

• Dividends, representing distribution of wealth attributable to
  shareholders. (1)
• Profit or loss attributable to shareholders during the period as reported
  in the statement of profit or loss. (1)
• Revaluation gains or losses recognised during the period (to the extent
  they are recognised outside the statement of profit or loss). (1)
• Any other gains or losses, such as actuarial gains or losses on employee benefits. (1)
• Transfers between components of equity, for example when an asset
  held for sale is eventually disposed of, any gain held in the revaluation
  surplus will be transferred within equity to retained earnings. (1)
• Prior period adjustments, to correct any material mistakes or
  adjustments from a change to an accounting policy from prior periods or
  new or revised accounting standards. (1

Question 26

Describe how the two fundamental qualitative characteristics of financial information, identified in the IASBs’ ‘Conceptual Framework for Financial Reporting’, guide the production of financial statements.

Answer 26

The two fundamental qualitative characteristics of financial information are:
* relevance; and
* faithful representation. (1)

Financial information is regarded as relevant if it is capable of influencing the
decisions of users. (1)

In determining what is relevant to users, preparers of accounts should
consider whether information is material and the extent to which reliable
information may be omitted. (1)

Faithful representation means that financial information must meet three
criteria: completeness, unbiased (or neutral) and free from error. (1)

Note that it may be necessary to override the legal form of a transaction to
portray a true economic position. The idea of “substance over form” is key for
the faithful representation of financial information. (1)

Reward other valid responses.
Other valid responses: Answers may refer to prudence, in the exercise of
caution when making judgements under conditions of uncertainty. This
supports neutrality of information by ensuring that assets and income are not
overstated, and liabilities and expenses are not understated. (1)

Question 27

Describe the main principles that underpin the consolidation of financial statements.

Answer 27

Award 1 mark for identifying the control concept and 1 mark for a definition of it:

The first major principle is the control concept. A group of companies is an economic entity made up of a set of companies where one entity (the parent) has control over another entity (the subsidiary). (1)

In accordance with IFRS 10, more than one factor needs to be considered in deciding whether control exists, for example:

• Power over the investee (the subsidiary), typically through having a majority of the voting rights;
• Exposure or rights to variable returns from its involvement in the investee; and,
• The ability to use that power to affect the amount of investor returns. (1)

Award up to 3 marks from the following:

In a simple group structure, a parent company has a direct interest in the shares of its subsidiary companies. However, control could be indirect (for example, via a contract, via de facto control such as a sub-subsidiary). (1)

The basic method of consolidation is where a parent company must produce financial statements which effectively add together the results of the parent and its subsidiary. The group financial statements must represent their assets, liabilities, equity, income, expenses and cash flows as those of a single economic entity. (1)

To avoid double counting, intra-group items including all transactions, balances and unrealised profits and losses resulting from intra-group trading must be eliminated. The parent entity’s investment in the subsidiaries is also eliminated through consolidation. (1)

Consolidated financial statements include – a consolidated statement of financial position, a consolidated statement of profit or loss and other comprehensive income, a consolidated statement of changes in equity, a consolidated statement of cash flows and notes to the consolidated financial statements. (1)

Answers may also refer to subsidiaries having the same accounting policies
and ideally the same reporting date as those of the parent company. (1)

Question 28

Explain how a company might approach a capital rationing situation.

Answer 28

Answers should explain single period capital rationing when there is a shortage of funds for one period. (1)

If projects are divisible, then the assumption is that the returns should be generated in exact proportion to the amount of investment undertaken. In such a case, a company would use a profitability index (PI) or benefit-cost ratio. (1)

A profitability index calculates the present value of cash flows generated by the project per unit of capital outlay, or PI = NPV / present value of investment (or initial investment) (1)

If PI is greater than 1 it adds value to the company and the project should be accepted. However, such projects should be ranked by greatest PI, and funds allocated to those with the greatest PI. (1)

If projects are indivisible, they have to be undertaken in their entirety or not at
all. A trial-and-error approach must be used to determine the optimum use of
capital available for investment. (1)

Reward other valid responses.
Marking guidance: the question asks for “how” a company would approach capital rationing, but award marks for comments about “why”, up to a maximum of 2 marks.

For example:

• Instead of the definition, answers could explain that this could be due to lending institutions imposing an absolute limit on the amount of finance available (hard capital rationing), or when the company itself is voluntarily imposing limits of the amount of funds available for investment projects (soft capital rationing).
• A company would need to adopt capital rationing as a strategy when it had more projects with a positive Net Present Value (NPV) than can be financed from existing funds.

Question 29

Explain the core principles in accounting for revenue from contracts with customers, under IFRS 15 ‘Revenue from Contracts with Customers’.

Answer 29

The five core principles of IFRS 15 for revenue recognition are:

• Identify the contract with the customer – this needs to have been agreed by both parties, and identify each party’s rights and payment terms regarding the goods or services to be transferred; (1)
• Identify the performance obligations in the contract – the goal is to separate the contract into parts or separate performance obligations when the performance of the good or service is distinct; (1)
• Determine the transaction price – this is the amount of consideration an entity expects from the customer in exchange for transferring goods or services; (1)
• Allocate the transaction price – an entity must allocate the transaction price to each separate performance obligation in proportion to the standalone selling price of the good or service underlying each performance obligation; (1) and,
• Recognise revenue as obligations are performed – an entity should recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service to the customer.(1)

Reward other valid responses but there must be clear identification of
the five-step model. Answers may refer to specific presentation and
disclosure requirements in IFRS 15.

Question 30

Using IAS 7 ‘Statement of Cash Flows’, explain how statements of cash flows are structured from the perspective of a lender.

Answer 30

Cash flows are classified under three main headings – operating, investing and financing activities. All published statements of cash flows should be under these same headings, for ease of comparison by a lender looking at multiple sets of financial statements. (1)

Cash flow from operating activities shows a lender the net cash flows generated from operations in a period, and as such is a/the best indicator of whether the company is generating cash, and if they are, at a level to meet their investing and financing needs. (1)

Separating out the cash flows from investing activities allows the lender to readily identify the extent of new investment in assets, which will be intended to generate future cash flows. These include the acquisition and disposal of long-term assets. The lender will be able to see how much the company has been investing and in what types of activities. (1)

Separating out the financing activities gives the reader an indication of likely future interest and dividend payments. Financing activities includes raising capital, repaying investors, adding or changing loans. So, a lender will be able to see what the company is already paying out by way of interest payments on other investments. (1)

IAS 1 has a requirement to provide the previous year comparative figures for all disclosures, so that trends might be looked for. From this the lender will be able to assess whether the generation of net cash flow from operating activities, or the interest payments for existing borrowings, are increasing or decreasing (1)
Reward other valid responses.

• For example, IAS 7 encourages companies to distinguish between replacement and expansionary capital expenditure – although few companies give this disclosure, the distinction could be of some interest to a lender. (1)

Marking guidance:
* Answers about the “structure” of a statement of cash flows do not require
the distinction to be made between the direct and indirect methods of
reporting operating cash flows (if the direct method is used on the face of
the statement the reconciliation by the indirect method is shown in the
notes). For any discussion regarding the direct/indirect method award no
more than 1 mark.

Question 31

IAS 1 ‘Presentation of Financial Statements’ requires the notes to the financial statements to disclose which of the following:

Answer 31

The basis for the preparation of financial statements, including the specific accounting policies chosen and applied.

Question 32

Explain any two differences in accounting treatment between IFRS and UK GAAP (FRS 102).

Answer 32

Goodwill and intangibles (1) – amortised in UK GAAP, but not in IFRS, where tested annually for impairment (1). Alternatively, could say have a finite life in UK GAAP (max 10 years) but can have indefinite life in IFRS. (1)

Impairment (1) – in UK GAAP, all non-financial assets are reviewed for indicators of impairment where there is an indication of impairment. In IFRS, all non-financial assets with finite lives are reviewed annually for indicators of impairment. (1)

Business combinations (1) – in UK GAAP, transaction costs are included as part of the acquisition cost. In IFRS, transaction costs are expensed. (1)

Assets held for sale (1) – in UK GAAP, the decision to sell an asset is assessed as an indicator of impairment, although this is not covered by FRS 102. [Note for marking purposes] IFRS requires classification of items as held for sale if their carrying amount is recovered through sale rather than use. (1)

Development costs (1) – in UK GAAP, choice to either expense as they are incurred or capitalise and amortise them over the useful life of the asset. In IFRS, capitalisation is mandatory where the criteria for capitalisation are met (IAS38 (Intangible assets)).(1)

Question 33

Explain propositions I and II of Modigliani and Miller’s theory of capital structure.

Answer 33

MM proposition I: With the assumption of no taxes, capital structure or leveraging does not influence the market value of the company. (1) It assumes that debt holders and equity shareholders have the same priority in the earnings of a company and that the earnings are split equally. (1)

MM Proposition II: The cost of equity is a linear function of the firm’s debt/equity ratio. (1) With an increase in gearing, the equity investors perceive a higher risk and expect a higher return, increasing the cost of equity. (1)

Reward other valid responses.
Marking guidance: Answers may cover more detail on proposition II than proposition I. In such cases 1 mark can be allocated to proposition I and up to 3 marks to proposition II. Other valid points on proposition II include:

The rate of return required by shareholders (Ke) increases in direct proportion to the debt/equity ratio. (1)
As the gearing increases, the cost of equity rises just enough to offset any benefits conferred by the use of apparently cheap debt (Kd). (1)
This means that WACC (Ko) remains constant at all levels of gearing. (1)

No mark allocation for just stating that the optimal capital structure is 99.9% gearing, as this is a result of the MM approach with taxes (the trade-off theory).

Question 34

Profit for a company is earned only if the financial or monetary value of the net assets at the end of the accounting period exceeds the monetary value of net assets at the beginning of the accounting period.

Answer 34

True (1)

Question 35

Explain the accounting concept of ‘materiality’ and how it is applied in producing financial statements.

Answer 35

IAS1 states that each material class of similar items should be presented
separately and items that are dissimilar in terms of nature or function should
be presented separately unless they are immaterial. (1)

[Answers may alternatively state that materiality is a key part of the fundamental qualitative characteristic of relevance.]

Award up to 2 marks for any two of the following:

The concept of materiality is a key feature of financial reporting and its considerations apply to all parts of the financial statements and disclosures. (1)

Materiality depends on the nature or size of the item, or a combination of both, and whether the non-disclosure thereof could influence the economic decisions of the users of financial statements. (1)

The decision about whether an item is material or not requires the application of judgement and its relative significance to the user of financial statements. (1)

The most common examples are directors’ remuneration and related parties’ disclosures. They may be small in size compared to the company’s overall net assets or profit but may be material due to its significance to the users of financial reports. (1)

Question 36

Describe the advantages and disadvantages of using the accounting rate of return (ARR), for the purposes of investment appraisal.

Answer 36

Award up to 3 marks for any three of the following:

Advantages:
 It is widely accepted and very simple to calculate. (1)
 It uses profits which are readily recognised by most managers. (1)
 Managers’ performance may be evaluated using ROCE. (1)
 As profit figures are audited, it can be relied upon to some degree. (1)
 It focuses profitability for the entire project period. (1)
 It is easy to compare with other projects as it links with other
accounting measures. (1)

Award up to 3 marks for any three of the following:
Disadvantages:
 It ignores factors such as project life (the longer the project, the greater the risk), working capital and other economic factors which may affect the profitability of the project. (1)
 It is based on accounting profits that vary depending on accounting
policies (such as depreciation policy). (1)
 It does not consider the time value of money. (1)
 It can be calculated using different formulas. For example, ARR can be calculated using profit after tax and interest, or profit before tax thus leading to different outcomes. It is important to ensure that ARR are calculated on a consistent basis when comparing investments. (1)
 It is not useful for evaluating projects where investment is made in
parts at different times. (1)
 It does not consider any profits that are reinvested during the project
period. (1)

Question 37

Outline three barriers which make it difficult for global harmonisation of UK GAAP and IFRS.

Answer 37

Award up to 6 marks for any three of the following.

 Legal system (1): this affects the accounting standardisation process –
such as whether the legal system is based on common law or code law.
The differences in the legal system can restrict the development of
certain accounting practices. (1)

 Business financing and accounting practices (1): decision making
processes regarding arrangement of funds may include accounting
practices. Many countries do not have strong independent accountancy
or business bodies which would press for higher standards and greater
harmonisation. (1)

 Tax system (1): a country’s tax system is very influential, particularly in
terms of its connection with accounting. In most countries, tax
authorities may influence the accounting rules around recording of
revenues and expenses. (1)

 Level of inflation (1): this is likely to influence valuation methods for
various types of assets. (1)

 Political and economic relationships (1): while Commonwealth
countries may share similarities in their accounting and tax systems,
cultural differences may still result in accounting systems differing from
country to country. In addition, developing countries may have less
developed standards and principles, although this is not always the
case. Some countries may be experiencing unusual circumstances (civil
war, currency restrictions) which affect all aspects of everyday life.
Others yet may resist the adoption of ‘another country’s standard’ for
nationalism reasons. (1)

Question 38

Which of the following characteristics was reintroduced by the IASB’s Conceptual Framework (2018), and refers to the need to exercise caution under conditions of uncertainty?

Answer 38

D - Prudence

Question 39

The IASB’s Conceptual Framework (2018) lists five elements of financial statements. Define any three of the five elements.

Answer 39

Award 1 mark for each definition of any three of the following:

 Assets - An asset is a present economic resource (a right that has the potential to produce economic benefits) controlled by the entity as a result of past events. (1)

 Liabilities - A liability is a present obligation or duty of responsibility to
transfer an economic benefit as a result of past events that the entity has no practical ability to avoid. (1)

 Equity (accept Shareholders’ Equity) - This is the ‘residual interest’ in the assets of the entity after deducting all its liabilities. It represents what is left when the entity is wound up, all the assets are sold, and all the outstanding liabilities are paid. (1)

 Income (accept Revenue) - Income is increases in assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from holders of equity claims. (1)

 Expenses - Expenses are decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims. (1) (Do not accept Expenditure or Costs.)

Question 40

There are four responsibilities for companies shown in Carroll’s Corporate Social Responsibility(CSR) Pyramid. Outline two of them.

Answer 40

Award 1 mark for identifying and 1 mark for defining any two of the
following:

 Philanthropic (accept “what is desired”) (1) - this is discretionary, but still important behaviour to improve the lives of others. It includes charitable donations in areas such as the arts, education, housing, health, social welfare, non-profit organisations, communities and the environment. (1)

 Ethical (accept “what is right”) (1) - this relates to acting morally and ethically in issues such as treatment of employees and suppliers. (1)

 Legal (accept “compliance”) (1) - this is the obedience of laws and regulations in the society, such as competition, employment, and health and safety laws. (1)

 Economic (accept “profit”) (1) - this is the responsibility of business to be profitable, to survive and to benefit society in the long term. For society to thrive, profitable businesses must be developed to create income, provide jobs, tax revenue and philanthropy for society. (1)

Question 41

Preference shares are legally a type of equity but should be treated as debt rather than equity for statutory reporting purposes as they carry a fixed rate of dividend.

Answer 41

True

Question 42

Outline the main factors that determine the length of a company’s working capital cycle (WCC).

Answer 42

Award 1 mark for identifying each of the following four main factors:
 The balance between liquidity and profitability. (1)
 Efficiency of management. (1)
 Terms of trade. (1)
 The nature of the industry. (1)

An alternative response would be identifying the main components of
the cycle. Award 1 mark for identifying each of the following:
 Level of cash balances held. (1)
 Length of inventory holding period. (1)
 Length of payables payment period. (1)
 Length of receivables collection period. (1)

Question 43

The capital asset pricing model (CAPM) was developed by Sharpe (1964) and Lintner (1965) to measure the cost of equity. Explain the main assumptions of the CAPM.

Answer 43

Award up to 6 marks from the following:

Investors are rational and possess full knowledge about the market. (1)
Investors expect greater returns for taking greater risks. (1)
It is possible for an investor to diversify the unsystematic risk by actively managing the portfolio. (1)
Borrowing and lending rates are equal. (1)
There are no transaction costs. (1)
Markets are perfect and market imperfections tend to correct themselves in
the long run. (1)
The Risk-Free Rate (RFR) is the same as the returns on the government bonds. (1)
There is no taxation and inflation. (1)

Question 44

Explain the need to report and account for the ‘substance of transactions’ in financial
statements. Include three examples to illustrate when and how this is important

Answer 44

‘Substance of transactions’ refers to the economic benefits or economic losses or any kind of economic implications related to the transaction. (1)

The accounting concept popularly termed as ‘substance over form’, emphasises a/the major consequence of accounting for the “substance” of transactions (1).

It means the transactions recorded in the financial statements must reflect their economic substance rather than their legal form. (1)

Award up to 3 marks for examples, from any three of the following:
Sale and leaseback arrangements (IFRS 16) whereby a company sells an asset (e.g. a property) to another party and gets it back via a lease. The substance of the transaction could be a sale of an asset, but it might not be a genuine sale if all the risks and rewards of ownership substantially remain with the lessee. (1)

Consignment stock whereby the consignor (seller) ships goods to the consignee (buyer), but the substance of the transaction is that the consignor still owns the stock until it is used, sold or distributed by the consignee. (1)

Debt factoring or invoice factoring, a type of debtor finance in which a business sells its trade receivables to a third party (called a factor) at a discount in exchange for the rights to cash collected from those receivables.The substance of the transaction will depend if all the risks and rewards of the debt have been transferred. (1)

Sale and repurchase arrangements: a kind of loan arrangement whereby
the sale of an asset takes place between two parties with a view to subsequently repurchase the same asset at a higher price. Whether this is a loan of an asset, or an outright sale of an asset, will depend on the substance of the transaction. (1)