November 2021

Question 1

Explain the factors that influence a regulatory structure for financial reporting

Answer 1

(1) national/company law: the legislation that regulates businesses, e.g. 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. Sarabanes-Oxley Act is important to all business 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 sustainable reporting: there are national and international standards for social, environmental and sustainability reporting

Question 2

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

Answer 2

(1) 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 consolidated suitable (e.g. a property acquired many years ago that is revalued).

Measurement bases may include:
- (1) 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

Question 3

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

Answer 3

(1) 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) 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

(1) 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

(1) 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

(1) 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

(1) 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 4

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

Answer 4

(1) 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.

These constraints are with reference to:
- (1) 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

Question 5

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

Answer 5

• (1) 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 dividend payments to shareholders, as they represent profits not distributed from the current and previous years.