Section A – THIS ONE question is compulsory and MUST be attempted
The following information relates to the financial statements of the Weston Group:
Weston Group: Statement of financial position as at 31 January
Weston Group: Statement of profit or loss and other comprehensive income for the year ended 31 January 2016
Notes:
(i) On 31 July 2015, Weston disposed of their entire 80% equity holding in Northern for cash. The shares had been acquired on 31 July 2011 for a consideration of $132 million when the fair value of the net assets was $124 million. This included a fair value uplift of $16 million in relation to plant with a remaining useful life of eight years. Deferred tax at 25% on the fair value adjustment was also correctly provided for in the group accounts and is included within the fair value of net assets. The fair value of the non-controlling interest at acquisition was $28 million. Goodwill, calculated under the full fair value method, was tested annually for impairment. At 31 January 2015, goodwill relating to Northern had been impaired by 75%. A goodwill impairment charge has been included within administration expenses for the current year but does not relate to Northern.
The carrying values in the individual accounts of Northern at disposal are listed below. The fair value adjustment and subsequent deferred tax were not incorporated into the individual accounts of Northern.
(ii) The loss for the period from discontinued operations in the consolidated statement of profit or loss and other comprehensive income relates to Northern and can be analysed as follows:
(iii) Weston purchased a 40% interest in an associate for cash on 1 February 2015. The associate paid a dividend of $10 million in the year ended 31 January 2016.
(iv) The retirement benefit liability relates to Weston as other companies in the group operate defined contribution schemes. The latest actuarial valuation is as follows:
Prepare a group statement of cash flows using the indirect method for the Weston group for the year ended 31 January 2016 in accordance with the requirements of IAS 7 Statement of Cash Flows.
Weston Group Statement of cash flows for year ended 31 January 2016
Workings
(1) Impairment on amortised cost financial asset
The financial asset has only one year to run at 31 January 2016. The remaining cash flows to be received are therefore $21·6m (($20m + (8% x $20m)). Since there is a 40% chance of default, the expected cash flow at present value would be $12m (60% x $21·6m/1·08). A further impairment of $7m ($19m – $12m) is required against profits. Additionally, the overall impairment charged for the year of $8m, including the expected 12-month credit loss of $1m, should be added back to operating profits within the operating activities reconciliation. (Tutorial note: The carrying value of the investment is $19m which is after $1m impairment for 12 months expected credit losses.)
(2) Goodwill on acquisition of Northern
(3) Proceeds on disposal of Northern
The fair value of the property, plant and equipment at disposal will be $80m as per the question plus $16m fair value uplift less 4/8 depreciation = $88m. A deferred tax liability on the fair value adjustment would arise of (25% x $16m) = $4m. This will be released in line with the extra depreciation, so the carrying value at disposal will be only $2m ($4m – ($4m x 4/8)). The carrying value of the entire deferred tax liability at disposal is therefore $8m ($6m per question + $2m).
The revised carrying values at disposal are therefore:
(4) Associate
Therefore, cash paid for the associate is $90 million, and cash received from the dividend is $4 million.
(5) Taxation
The 31 January 2015 deferred tax asset for the pension scheme would be (25% x $72m) = $18m. At 31 January 2016, the deferred tax assets would only be (25% x $60m) = $15m. Since the actuarial gain of $4m would be recorded in other comprehensive income, the deferred tax on the actuarial gain of $1m (25% x $4m) will also be in other comprehensive income. The net gain included within other comprehensive income is $3m ($4m – $1m). The remaining movement in the deferred tax on the pension of $2m will already be included within the charge for the year.
(6) Other intangibles
(7) Property, plant and equipment
(8) Contingent consideration and finance costs paid
The $10m contingent consideration would have been discounted at 10% and should therefore be unwound with $1m ($10m x 10%) charged to finance cost. A gain on settlement therefore arises of $4m ($10m + $1m – $7m). The finance cost per P&L is $23m.
Cash paid is therefore $23m less $1m unwinding = $22m.
(9) Trade payables
(10) Non-controlling interest
The directors of Weston have been reviewing the International Integrated Reporting Council’s Framework for Integrated Reporting. The directors believe that International Financial Reporting Standards are already extensive and provide stakeholders with a comprehensive understanding of an entity’s financial position and performance for the year. In particular, statements of cash flow enable stakeholders to assess the liquidity, solvency and financial adaptability of a business. They are concerned that any additional disclosures could be excessive and obscure the most useful information within a set of financial statements. They are therefore unsure as to the rationale for the implementation of a separate, or combined, integrated report.
Required:
Discuss the extent to which statements of cash flow provide stakeholders with useful information about an entity and whether this information would be improved by the entity introducing an Integrated Report.
Statements of cash flows provide valuable information to stakeholders on the financial adaptability of an entity. Cash flows are objective and verifiable and so are more easily understood than profits. Profits can be manipulated through the use of judgement or choice of a particular accounting policy. Operating cash flows are therefore useful at highlighting the differences between cash and profits. The cash generated from operations is a useful indication of the quality of the profits generated by a business. Good quality profits will generate cash and increase the financial adaptability of an entity. Cash flow information will also have some predictive value. It may assist stakeholders in making judgements on the amount, timing and degree of certainty on future cash flows.
Cash flow information should be used in conjunction with the rest of the financial statements. The adjustment of non-cash flow items within operating activities may not be easily understood. The classification of cash flows can be manipulated between operating, investing and financing activities. It is important therefore not to examine the cash flow information in isolation. It is only through an analysis of the statement of financial position, statement of comprehensive income and notes, together with cash flow, that a more comprehensive picture of the entity’s position and performance develops.
It is true that International Financial Reporting Standards are extensive and their required disclosures very comprehensive. This has led to criticism that the usefulness may be limited where the most relevant information is obscured by immaterial disclosures. An integrated reporting system would increase disclosure as well as imposing additional time and cost constraints on the reporting entity. However, integrated reporting will provide stakeholders with valuable information which would not be immediately accessible from an entity’s financial statements.
Financial statements are based on historical information and may lack predictive value. They are essential in corporate reporting, particularly for compliance purposes but do not provide meaningful information regarding business value. The primary purpose of an integrated report is to explain to providers of capital how the organisation generates value over time. This is summarised through an examination of the key activities and outputs of the organisation whether they be financial, manufactured, intellectual, human, social or natural.
An integrated report seeks to examine the external environment which the entity operates within and to provide an insight into the entity’s resources and relationships to generate value. It is principles based and should be driven by materiality, including how and to what extent the entity understands and responds to the needs of its stakeholders. This would include an analysis of how the entity has performed within its business environment, together with a description of prospects and challenges for the future. It is this strategic direction which is lacking from a traditional set of financial statements and will be invaluable to stakeholders to make a more informed assessment of the organisation and its prospects.
Shortly before 31 January 2016, Weston gave a $5 million, zero interest, short-term loan to its subsidiary, Eastern. Eastern repaid the loan in full during February 2016. Since the loan was repaid within Weston’s usual credit terms of 30 days, it was classified as a trading item as at 31 January 2016. Consequently Weston included the balance within trade and other receivables and Eastern included it within trade and other payables at the year end. Eastern has several bank loans with substantial debt covenants linked to both interest cover and its gearing ratio. The bank loans would have become immediately repayable should Eastern breach any of the terms of the covenants. Before receiving the loan, Eastern had a bank overdraft balance of $4·5 million.
Required:
Discuss the impact which the $5 million loan would have on the debt covenants of Eastern and whether there are any ethical implications arising from the situation. You do not need to adjust your answer to part (a) in relation to this issue.
It is not unusual for members of a group to provide financial assistance in the form of loans or acting as a guarantor between one another. Provided that the loan was not issued to manipulate the financial statements and that there was full disclosure as a related party transaction, then no ethical issues may arise. However, this would appear to be unlikely in this scenario.
Since the loan is interest free, the loan will have no impact on the interest cover of Eastern. Neither profits nor finance expenses will be affected. The impact on the gearing ratio of Eastern is unclear and would depend on how debt was classified within the terms of the covenants. Should the overdraft be included within debt, the loan would substantially improve the gearing ratio through the elimination of the Eastern overdraft. Accountants have the responsibility to issue financial statements which do not mislead the stakeholders of the business. It would appear that the financial statements are being deliberately misrepresented, which would be deemed unethical. The cash received would improve the liquidity of Eastern and may enable them to avoid a breach on the debt covenants. Accountants should be guided by ACCA’s Code of Ethics. Deliberate overstatement of the entity’s liquidity would contravene the principles of integrity, objectivity and professional behaviour.
The timing and nature of the loan may provide further evidence that the rationale for the loan was to ensure no breach of the covenants took place. The loan is for an unusually short period given that it was repaid within 30 days. In addition, the timing is very suspicious given that it was issued just prior to the 31 January 2016 year end. In any case, the classification of the loan within the trade and other receivables and trade and other payables balances would be misleading. The loan is not for trading purposes and a fairer representation would to be to include the loan within the current asset investments of Weston and as a short-term loan within the current liabilities of Eastern. This would ensure that the loan would be treated as debt within the gearing calculation of Eastern and would not be misleading for the bank when assessing whether a breach of the debt covenants had taken place.