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Dealing with the mixed question

by Francis Braganza

Writing in their outstanding Advanced Financial Accounting (Financial Times Prentice Hall) Richard Lewis and David Pendrill say, “As academic accountants, we find it extremely difficult to assimilate and understand the vast volume of official pronouncements and, therefore, have considerable sympathy for accountants working at the coalface. We are now firmly of the view that there is too much detailed regulation and that there should be a pause to reflect on whether or not the extensive changes which have been made are actually bringing improvements in practice.”

Most students preparing for the advanced accounting papers with their burgeoning syllabuses would wholeheartedly agree. Perhaps Sir David Tweedie’s retirement from chairmanship of the Accounting Standards Board will provide this longed-for hiatus!

In the meantime candidates must expect mixed i.e. ‘contrived’ questions as the examiner attempts to do justice to the vast syllabus (and reward the well-prepared candidate). In the following question candidates were asked to redraft a company’s financial statements in line with the auditor’s advice and relevant accounting standards. In my view the question was actually a standards question masquerading as a consolidation question. I have left off the four mark attachment on FRS 14 EPSs share options.

The summarised draft consolidated financial statements of Jensen plc to 31 March 2000 are shown below:

Jensen plc
Profit and Loss Account year to 31 March 2000
  £000 £000
Turnover   2,800
Cost of sales   (1,750)
Gross profit   1,050
Operating costs   (344)
Finance costs   (64)
Taxation   (150)
Profit after tax   492
Minority interest   (20)
Extraordinary charge (180)  
Tax (relief) on extraordinary charge 54  
Dividends   (100)
Retained profit for year   246
Balance Sheet as at 31 March 2000
  £000 £000
Tangible fixed assets   2,540
Current assets 1,900  
Creditors: amounts falling due within one year (1,520)  
Creditors: amounts falling due after more than one year    
12% Redeemable Debentures   (200)
Less: Minority interest   (140)
Net assets   2,580
Share capital and reserves: Ordinary shares £1 each   1,200
Profit and loss account:
– b/f 1 April 1999 1,134  
– year to 31 March 2000 246  

The above consolidated financial statements have been drafted by inexperienced accounting staff. The following information relates to issues that the accounting staff had particular difficulties with:

(i) Retail car sales
In September 1999 Jensen plc held a one-month promotional campaign aimed at increasing its retail sales of new cars. A special edition manufacturer’s model called the ‘Interceptor’ was sold during September. The promotion consisted of offering within the normal selling price:

  • free finance over two years;
  • an extended three year warranty against mechanical failure.

In total 100 of these cars were sold under the offer terms.
Details relating to the finance of the cars sold under the offer are:

Selling price included in turnover
(15,000 x 100)
Paid for by:
Initial deposit paid in September 1999
(£3,000 x 100)
Initial hire purchase debtor 1,200,000
Received 6 monthly instalments of
£500 x 100
Hire purchase debtor at 31 March 2000 900,000

• receivable within one year
12 x £500 x 100

• receivable after more than one year
6 x £500 x 100

Applying the same finance rates as Jensen plc uses for normal hire purchase sales the true finance cost of the promotional sales over the two-year finance agreement would be £1,200 per car. It has been calculated that this would normally be earned as follows:

In the year to
– 31 March 2000 £500 per car
– 31 March 2001 £450 per car
– 31 March 2002 £250 per car

The manufacturer of the cars will reimburse any warranty claims in the first 12 months. From past experience the second and third year’s ‘free’ warranty will cost an average of £150 per car. Jensen plc has not provided any amount for warranty claims in the year to 31 March 2000 as they are covered by the manufacturer’s warranty until September 2001.

(ii) Business combination
On 31 March 2000 Jensen plc issued 200,000 shares (market value £4 each) in a 1 for 1 share exchange to acquire the entire share capital of Aston plc. The business combination has been accounted for as a merger. The summarised results of Aston plc are:

Profit and loss account year to 31 March 2000
Turnover 600
Cost of sales (350)
Gross profit 250
Operating costs (90)
Taxation (60)
Profit after tax 100
No dividends have been paid or proposed by Aston plc.
Balance Sheet as at 31 March 2000  
Net assets 800
Ordinary shares £1 each 200
Profit and loss account 600
Net assets 800

The fair values of Aston plc’s net assets at the date of acquisition were equal to their book values.
Advice from the company’s auditors in respect of the combination is that it does not meet the requirements of a merger under FRS 6 and should be treated as an acquisition. Aston plc’s trading on 31 March 2000 can be taken to be negligible.

(iii) Extraordinary item
This was the cost incurred during the year of making the company’s computer “year 2000” compliant. As this cost will never recur it has been treated as an extraordinary item.

(iv) 12% redeemable debenture issue
On 1 April 1999 redeemable debentures with a nominal value of £200,000 were issued at a discount of 5% (i.e. at £95 per £100 nominal amount). They are redeemable on 31 March 2004 at a premium of 10%. Jensen plc has treated the whole of the discount as a finance cost and ignored the premium on redemption. On the grounds of materiality, amortisation of the discount and premium can be treated on a straight-line basis.

Jensen plc
Consolidated Profit and Loss Account for year ended 31.3.2000
Turnover (2,800 original – 120 (i) Retail Car Sales – 600
(ii) business combination: pre-acquisition turnover)
Less: Cost of Sales (1,750 + 15 (i) Warranty provision – 350 (ii) pre-acquisition COS)   (1,415)
Gross profit   665
Less: Operating costs i.e. Distribution & Administration Expenses
(344 - 90 (ii) pre-acquisition + 180 (iii) was treated as extraordinary, should be
exceptional, but in NOTES only: in P&L shown as Admin. Expenses)
Operating profit   231
Add: Other operating income (50 (i): HP Interest)   50
Less: Interest Payable and Similar Charges
(Finance Costs originally 64 – 10 (iv) removing old whole discount
+ 6 new, correct, charge)
Consolidated Profit before tax   221
Less: Taxation (originally 150 – 60 (ii) pre-acquisition tax – 54
(iii) tax relief on exceptional Admin. charge, shown under
Operating Costs above, formerly extraordinary charge shown separately,
and lower down the original P&L)
Consolidated Profit after tax   185
Less: Minority Interest (unchanged, not in Aston acquired during the year,
which is 100% held)
Consolidated Profit for the financial year   165
Less: Dividends   (100)
Consolidated Retained Profit for the financial year   65
Add: Retained Profit brought forward: could be shown directly in CBS instead
(original 1,134 – 500 (ii) Previous year’s pre-acquisition P&L Reserves
included under Merger accounting, but excluded under Acquisition accounting)
Consolidated Retained Profit carried forward   699
Jensen Group plc    
Consolidated Balance Sheet as at 31.3.2000    
  £000 £000
Tangible Fixed Assets (unchanged)   2,540
Current Assets:
(original 1,900 previously included 900 HP Debtors
including interest of 70, now eliminated since it relates
to future years \ 1,900 - 70 (ii))
Less: Creditors: Amounts falling due within one year
(original 1,520 + 15 (i) warranty provision)
Total Assets less Current Liabilities   2,835
Less: Creditors: Amounts falling due after more than one year
12% Redeemable Debentures
(original 200 – 10 + 6 (iv): see P&L finance cost charges
– the Balance Sheet reflects the double-entry)
Less: Minority Interest (unchanged)   (140)
Capital and Reserves
Called up Ordinary Shares of £1 each (unchanged)
Share Premium (600 (ii) whereas not recorded under
Merger accounting as formerly adopted, is recorded under Acquisition,
being 200 shares issued @ £3 i.e. £4 issue price less £1 nominal value)
Consolidated Profit and Loss Account   699

Redraft the consolidated financial statements of Jensen plc for the year to 31 March 2000 to comply with the auditor’s advice and relevant accounting standards in relation to items (i) to (iv) above.

The Examiner says:
This question was the worst answered question on the paper. Often candidates simply restated the original question with only a token attempt at the required adjustments. A major part of the redrafting concerned accounting for a business combination as an acquisition rather than as a merger. Although this may sound daunting, it was in fact quite straightforward. As the combination occurred at the year-end, the main effect was that all of the results of the subsidiary should be eliminated from the consolidated profit and loss account. Balance sheet adjustments involved eliminating pre-acquisition profits and calculating the share premium account. Good candidates scored well, but many candidates got very confused, sometimes adding rather than deducting the adjustments. It seems, from past examination experience, that candidates are quite able to account for mergers and acquisitions, but seem unable to appreciate the financial effects of the difference between them. This displays a ‘mechanistic’ approach to learning, rather than a more desirable understanding and application approach.

Other problem areas were:

  • many candidates appreciated that the year 2000 compliance costs should not be an extraordinary item, but were unable to properly account for the different tax aspects of an exceptional item;
  • for the sale of the retail cars, there was an appreciation that they should be treated as financed sales, but again were unsure how to account for them;
  • warranty provisions were omitted; and
  • the debenture issue discount and redemption premiums were not (or incorrectly) amortised.

WORKINGS and explanatory notes
Per Q. Y/e 31.3.2000

(i) Retail Car Sales: the “Interceptor”
FRS 5 requires that these have to be accounted for using the substance of the transactions. The key concept is that the so-called “free finance” is built into the price structure: there is no such thing as “free finance” despite the marketing slogan!

Therefore, we must eliminate the finance element included in the Selling Price and therefore in Turnover and HP Debtors:

DR Turnover (100 cars @ £1,200 true finance cost given in Q, to be used under FRS 5 principles) 120,000  
CR Interest Receivable (P&L A/c): other operating income 100 cars @ £500 – this is interest relevant to the current year i.e. y/e 31.3.2000)   50,000
CR HP Interest Receivable Suspense account (100 cars @ £700, being £450 regarding next year + £250 the year after next)   70,000

(Effect of above: removing £1,200 finance cost i.e. Interest, so that Turnover only includes cash selling price.)

The above sorts out the P&L and to some extent the Balance Sheet, which latter’s adjustment must be taken further:

Balance Sheet – there are three points here:

  • The HP Debtor £900,000 as per Q (in (i)) must be reduced by future HP Interest Receivable (in Suspense Account), i.e. reduced by £70,000. £900,000 as per Q less £70,000 = £830,000.
  • As part of this is receivable in more than 1 year, a Note should show £275,000 (being £300,000, as per Q less £25,000 which is 100 cars x £250 receivable in the year after next i.e. y/e 31.3.2002).
  • Incidentally UITF 4 requires this to be shown on the face of the Consolidated Balance Sheet, if it is material in the context of the rest of Current Assets.

Retail Car Sales – extended three year warranty aspect:
* the first year is covered by the manufacturer’s warranty \ no need to provide.
* based on past experience, provide for 100 cars x £150 = £15,000 at the time of sale i.e. by current year end of 31.3.2000. This treatment also satisfies the accruals concept (SSAP 2 and recent FRS 18) i.e. if sale made, automatically provide for £15,000: FRS 12, Provisions, Contingent Liabilities and Contingent Assets – if > 50% chance, provide.

Double Entry (to ensure books balance!)
DR P&L (Cost of Sales) 15,000
CR Provision for warranties 15,000
(Often shown under Creditors and Accruals in the CBS though some – with more information given in the Q – could be shown after > 1 year)

(ii) Business Combination: Acquisition of Aston
Key concept: Merger to be restated as an acquisition (this is really a test of understanding of the differences between FRS 2, Acquisitions and FRS 6, Mergers).

Notice that the acquisition occurred on the last day of the current financial year and therefore none of the pre-acquisition results should be consolidated, rather than all of them.

Therefore, remove all of the P&L figures of Aston from the Consolidated P&L:

  £000 £000
Reduce Turnover (earlier was a credit) 600  
& Reduce: Cost of Sales *   350
Operating Costs *   90
Tax *   60
(* these were in CPLA as debits)

NEXT aspect: the difference between Goodwill on Acquisition and Consolidation Difference on Merger:

Goodwill on Acquisition £000
Purchase Consideration (200 x £4) = 800
Less: Group Share of net Assets at FV at acquisition (= Book Value in this Q) 100% x 800 = (800)
/              \
OSC 200    P&L Res. 600
Goodwill \ = Nil

Consolidation Difference under Mergers

Investment: 200 x £1 (Share Premium not recorded under Mergers) 200
Less: 100% of OSC of Aston (Pre-Merger P & L Res. of 600 not frozen, but included in Consolidated Reserves) (200)
Consolidation Difference \ = Nil

(iv) Amortised over 5 years (debenture term) @ £6,000 p.a. \ Remove £10,000 and add £6,000 instead, to “finance costs” in the CPL Account and do the same to the Debentures in the CBS. (Alternatively, charge the discount on issue of debentures against the credit balance in Share Premium via a transfer from the P & L account reserve.)

Francis A Braganza BCom (Hons) FCA is a co-founder of Accountancy Tutors Ltd and a senior lecturer in AAP and Financial Reporting with AT Emile Woolf Colleges