by Paul Robins

Relevant to Paper 10 and of interest to Paper 13 (Professional)

This is the third in a series of articles that examines the issue of good examination technique in financial reporting papers. In the last two articles we considered a questions from Paper 13 – Financial Reporting Environment (FRE). This month and next month we will look at a question from Paper 10 – Accounting and Audit Practice. Future articles in the series will consider examination questions from other financial reporting papers. The material that is covered in this month’s and next month’s article is primarily of relevance to Paper 10 students but Paper 13 students may find the material to be useful for basic revision.

In previous articles we explained the key steps you should take in answering any examination question. Since Paper 10 students may well not have referred to the previous articles these key steps are reproduced below:

1. Read the requirements first – even if they are situated at the end of the question.
2. Read the question through thoroughly before starting to attempt any part of it.
3. As you read the question ask yourself why the information you are reading has been provided.
4. Decide on the particular knowledge and skills you need to be able to tackle the requirements. In practice you may sometimes do this as you read through the question itself (see the previous step). However if the scenario is particularly complicated you may need to go back and assess the required knowledge and skills as a separate step.
5. Assess whether you actually possess the knowledge and skills you have identified in the previous step.
6. Tackle as much of the question as you can in the time available.
7. Never overrun on time, even if you feel you can gain more marks in a particular question.

The format of Paper 10 is as follows:

• Section A contains 3 accounting questions for 25 marks each. You need to answer 2 of these 3. Questions 1 and 2 are usually fairly computational, whilst Question 3 tends to be more written. Very often Question 1 is a consolidation.
• Section B contains a compulsory integrated accounting and auditing question for 30 marks. The marks are split 50:50 between accounting and auditing.
• Section C contains a compulsory auditing question for 20 marks.

You can see that the split between accounting and auditing marks on this paper is 65:35. You can also see that there is a limited amount of choice in Section A. Where choice is available in an examination it is worth remembering the following.

• Make your choice early on in the examination. From then on try to imagine all the questions you have chosen are compulsory and the others don’t exist.
• NEVER cross through a ‘choice’ question after having spent significant time on it and change your choice. This is examination suicide. As we said in the previous article in this series, lack of time is your biggest enemy, not lack of knowledge.

In this first article on Paper 10 examination technique we will look at a computational question. Since consolidations is such a key area in this paper and indeed in the successor paper (Paper 13 under the current syllabus, Paper 3.6 under the new syllabus) we will devote this month’s article to a discussion of examination technique with reference to a consolidation question. Based on past papers the examiner seems to set a consolidated balance sheet rather more often than a consolidated profit and loss account. Therefore we will look at a past question that asks for the preparation of a consolidated balance sheet.

Examination technique for consolidated accounts
This series assumes you have already studied the basics of consolidated accounts and are reasonably familiar with the procedures involved. One of the problems in writing a generic article on examination technique in this area is that there are so many different ways of presenting the consolidation workings. In some respects, this shouldn’t matter too much because it is worth remembering that at the end of the day a consolidation question is basically an aggregation exercise. This means that there will usually be quite a few relatively easy marks available for adding up. In the experience of the writer many students approach consolidated balance sheet questions in the wrong order. Many start off by computing goodwill, minority interest, and consolidated reserves and produce the balance sheet only at the end of this exercise. Given that the big enemy in the examination is lack of time this means that such students run the risk of missing out on relatively easy marks. The writer’s suggested order of tackling a question that deals with the consolidated balance sheet would be:

• Read the question and identify the group structure. At Paper 10 the group structure is usually fairly straightforward – just one subsidiary and perhaps one associate.
• Identify information in the question that will affect the basic aggregation principle – for example, inter-group balances or unrealised inter-group profits.
• Produce the whole of the net assets side of the consolidated balance sheet (where the easy marks are) leaving a space for unamortised goodwill and investment in associates (if required).
• Slot in the share capital and share premium accounts as being the parent company figures – more easy marks.
• Compute the minority interest. This is more straightforward than goodwill and consolidated reserves since it is in the closing net assets of the relevant subsidiary. There is no need to distinguish between pre and post acquisition reserves.
• Compute the unamortised goodwill on acquisition of the subsidiary and associate (if included).
• Compute the investment in associate – share of net assets at the balance sheet date plus related unamortised goodwill.
• Slot in consolidated reserves as the balancing figure and prove if there is time – which there probably won’t be in the examination.

A typical past examination question
On 1 April 1998 Hample plc acquired 90% of the equity shares in Sopel Ltd. On the same day Hample plc accepted a 10% loan note for £200,000 which was repayable at £40,000 per annum (on 31 March each year) over the next five years. Sopel Ltd’s retained profits at the date of acquisition were £2,200,000. (See Balance Sheet)

The following information is relevant:

1. Included in Sopel Ltd’s property at the date of acquisition was a leasehold property recorded at its depreciated historic cost of £400,000. The leasehold had been sublet for its remaining life of only four years at an annual rental of £80,000 payable in advance on 1 April each year. The directors of Hample plc are of the opinion that the fair value of this leasehold is best reflected by the present value of its future cash flows. An appropriate cost of capital for the group is 10% per annum.
   The present value of a £1 annuity received at the end of each year where interest rates are 10% can be taken as:
   3 year annuity £2.50
   4 year annuity £3.20
2. The software of Sopel Ltd represents the depreciated cost of the development of an integrated business accounting package. It was completed at a capitalised cost of £2,400,000 and went on sale on 1 April 1997. Sopel Ltd’s directors are depreciating the software on a straight-line basis over an eight-year life (i.e., £300,000 per annum). However, the directors of Hample plc are of the opinion that a five-year life would be more appropriate as sales of business software rarely exceed this period.
3. The stock of Hample plc on 31 March 1999 contains goods at a transfer price of £25,000 that were supplied by Sopel Ltd who had marked them up with a profit of 25% on cost.
4. On 31 March 1999 Sopel Ltd remitted to Hample plc a cash payment of £55,000. This was not received by Hample plc until early April. It was made up of annual repayment of the 10% loan note of £40,000 (the interest had already been paid) and £15,000 of the current account balance.
5. Consolidated goodwill is amortised over a five-year life.

Required:

1. The Consolidated Balance Sheet of Hample plc for the year ended 31 March 1999 (20 Marks)
2. Included in Hample plc’s ‘other investment’ are 6,000 ‘A’ shares in Woodbridge Ltd. These shares were acquired during the year to 31 March 1999. The total share capital of Woodbridge Ltd is made up of:
   Ordinary voting A shares - 10,000
   Ordinary non-voting B shares - 20,000

All of Woodbridge Ltd’s equity shares are entitled to the same dividend rights; however during the year to 31 March 1999 Woodbridge Ltd made substantial losses and did not pay any dividends.

Hample plc has treated its investment in Woodbridge Ltd as an ordinary investment on the basis that:

• it is only entitled to a minority of any dividends that Woodbridge Ltd may pay (i.e., 6,000/30,000 = 20%);
• it does not have any directors on the Board of Woodbridge Ltd; and
• it does not exert any influence over the operating policies or management of Woodbridge Ltd.

Required:
Discuss the accounting treatment of Woodbridge Ltd by Hample plc’s directors and state how you believe the investment should be accounted for. (5 marks)
(25 marks)

Analysis of question

1. The two part question requires a consolidated balance sheet for 20 marks, and an analysis of the treatment of an investment for 5 marks.
2. If part (a) is done first there is a danger it will take up the whole of the allotted time for this question. Therefore it might be worth attempting part (b) first and then spending the rest of the available time on part (a). There’s nothing wrong with doing this in an examination provided it’s feasible.
3. Part (b) asks you to reflect on the fact that Hample owns only 6,000 of the 30,000 shares in Woodbridge. This looks on the face of it like a 20% holding which would not normally confer subsidiary status. However Hample owns 6,000 out of 10,000 voting shares (the ‘B’ shares are non-voting). Therefore under FRS2 this makes Woodbridge a subsidiary. This is the key issue for part (b). Notice we are told not to change the answer to part (a) for this conclusion.
4. The group structure here is relatively straightforward for part (a). Hample owns 90% of the equity share in Sopel. This means that the minority interest is 10%. The investment was made on 1 April 1998, the start of the year.
5. There are a number of reasons why we can’t simply aggregate the net assets of Hample and Sopel to give the consolidated figures. These are:
   
   • The need to restate the leasehold property of Sopel to fair value (based on the expected future cash inflows).
     
   • The need to ascribe a useful life of 5, rather than 8 years to the software of Sopel.
     
   • The need to eliminate unrealised profit on sales from Sopel to Hample.
     
   • The need to account for cash in transit of £55,000. £15,000 of this amount reconciles the current account difference (£75,000 – £60,000) and £40,000 the ‘loan note difference’ (£200,000 – £160,000).

Tackling part (a)
We will first produce the top half of the consolidated balance sheet figure by figure, excluding unamortised goodwill. We need workings for the figures that don’t just add across.

Working 1: Intangible asset – software
The group policy is to write this asset off over 5 (rather than 8) years. This implies a write-off of £480,000 each year (£2,400,000/5). The annual write-off in the individual financial statements of Sopel is £300,000 (£2,400,000/8). Since the asset arose on 1 April 1997 (two years before the balance sheet date) its written down value is £1,440,000 (£2,400,000 – £960,000) at the balance sheet date. The fair value of the software at the date of acquisition (one year after the software was originally included in the accounts of Sopel) is £1,920,000 (£2,400,000 – £480.000). The carrying value in the accounts of Sopel at the date of acquisition is £2,100,000 (£2,400,000 – £300,000).

Working 2: Property
The fair value of Sopel’s leasehold property at the date of acquisition is based on the present value of the expected future cash flows – £80,000 each year for four years in advance. Using the discount factors provided this gives a present value of:

£80,000 + £80,000 x 2.50 = £280,000 (notice that the cash flows are in advance). Therefore since the property has a useful life of four years from the date of acquisition its fair value at the balance sheet date is £210,000 (£280,000 X ¾). Its value in Sopel’s own accounts is £300,000 (£400,000 X ¾). Therefore an adjustment to closing assets of £90,000 is needed, and the consolidated property figure is £1,410,000 (£600,000 + £900,000 – £90,000).

Working 3: Stock
The unrealised profit in stock is £5,000 (£25,000 x 25/125). Therefore consolidated closing stock is £1,274,000 (£719,000 + £560,000 – £5,000).

Working 4: Cash
The closing cash figure includes the cash in transit of £55,000 and so is £75,000 (£20,000 + £0 + £55,000).

The share capital and share premium figures will be those for Hample plc so at this stage we can write out the majority of the consolidated balance sheet. We will put question marks where we haven’t yet worked out the figures:

Notice we have completed the vast majority of the consolidated balance sheet. All we have left to do is minority interest, goodwill and consolidated reserves. We will now compute these in turn.

Minority interest – Sopel

	£000
Net assets at the balance sheet date	3,955
Adjustments:
Software (W1) (£1,800,000 – £1,440,000)	(360)
Property (W2)	(90)
Stock (W3)	(5)
	3,500
Minority share (10%)	350

Goodwill on consolidation – Sopel

	£000	£000
Cost of investment		4,110
Net assets at the date of acquisition:
Share capital	1,500
Share premium	500
Retained earnings:
As per Sopel accounts	2,200
Adjustment for software
(£1,920,000 – £2,100,000)
– see W1	(180)
Adjustment for property
(£280,000 – £400,000)
– see W2	(120)
	3,900
Group share (90%)		(3,510)
So total goodwill equals		600
One year’s amortisation (1/5)		(120)
So closing unamortised goodwill equals		480

We have now computed every figure except the consolidated profit and loss reserve. If we were short of time at the end of the question would slot this in as a balancing figure. In this case you should be able to check that the figure required to balance the balance sheet is £2,320,000. The final consolidated balance sheet will therefore be:

	£000	£000
Fixed assets
Intangible – software (W1)	1,440
Intangible – goodwill	480
Tangible – property (W2)	1,410
Tangible – plant	2,610
Investments	275
		6,215
Current assets
Stocks (W3)	1,274
Debtors	852
Cash (W4)	75
	2,201
Current liabilities
Trade creditors	947
Taxation	402
Operating overdraft	27
Dividend payable	100
	1,476
Net current assets		725
Government grants		(270)
		(6,670)
Capital and reserves
Ordinary shares of £1		2,000
Share premium		2,000
Profit and loss account		2,320
		6,320
Minority interest		350
		6,670

It would be cheating in an article not to prove the consolidated profit and loss reserve figure so here goes:

Closing remarks
Exam technique is all important in any question, but particularly one in which you face acute time pressure. Consolidated accounts questions certainly fall into the ‘time pressure’ category. Whatever your method for consolidation workings of such figures as minority interest, goodwill etc., (and there are a number of perfectly sound methods) make sure you obtain the relatively straightforward aggregation marks. The best way to pass any examination is to get the vast majority of the straightforward marks available for each question and a reasonable proportion of the more testing marks.

Paul Robins BSc MBA ARCS FCA, is a freelance lecturer and consultant