AFR580S/2023

ADVANCED FINANCIAL REPORTING

(AFR580S)

Postgraduate Diploma in Management Accounting

Department of Management Accounting

(Exam Revision Questions Bank)

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 AFR580S/2023
Notes to students:

• Accounting success requires practise, practise, and more practise. Please keep in mind that the
sole purpose of these questions is for you to practise and assess your understanding of some of
the most important concepts in each topic.
• Identify the issues in each question and use highlighting, notes, timelines, etc. (or any method
you are familiar to) to obtain a comprehensive understanding of the information in each question.
Carefully read both the "Question" and "Required" sections.

References:
• Kaplan. 2023. Advanced Financial Reporting (F2), CIMA Notes, 2019 Edition. London: Kaplan
Publishing.
• Service, C. 2022. Gripping GAAP: Your guide to International Financial Reporting Standards,
22nd Edition. Durban: LexisNexis.

Contents:
Topic 1 Long-term Finance
Topic 2 Cost of capital

Topic 6 Revenue from contracts with

costumers
Topic 7 Provisions, Contingent Liabilities
and Contingent Assets
Topic 8 Intangible Assets

Topic 10 Foreign currency transactions

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 AFR580S/2023
Topic 1 Long-term Finance

Question 1.1

Which TWO of the following are the advantages of listing?

A. Flexible reporting requirements

B. Easy stock exchange rules for obtaining a quotation
C. Raises company’s profile
D. Raises funds for future investments

Question 1.2
ABC LTD has 5m R1 ordinary shares in issue, with a current market value of R5 per share. It offers a 1
for 4 rights issue at R4 per share.

Required
Calculate theoretical ex-right price (TERP).

Question 1.3
Which ONE of the following types of charge can cover any other assets that are not already
subject to fixed charge?

A. Floating charge
B. Fixed charge
C. Both of them
D. None of them

Question 1.4
Which segment of bond market is traditionally made up of investment banks and other financial
institutions that help the issuer to sell the bonds in the market?

A. Purchasers
B. Underwriters
C. Issuers
D. None of them

Question 1.5

Which TWO of the following are similar to each other?

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A. Venture capital and business angels
B. Venture capital and grants
C. Business angels and grant
D. Retained earnings and grant

Question 1.6
Mega Ltd receives the following bids for shares at different possible prices:

Price (cents) Number of bids

400 2,000,000
375 2,800,000
350 3,800,000
325 1,700,000
300 500,000

Required:
1.6.1 Calculate the issue price at which Mega Ltd will raise R30 million.
1.6.2 Calculate the price at which Mega Ltd will maximise proceeds from the public offer.

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Question 1.7

END OF TOPIC 1 LONG TERM FINANCE!!!!

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 AFR580S/2023
Topic 2 Cost of capital
WACC formula

The weighted average cost of capital is the average cost of the company’s finance (equity, loan
notes, bank loans, and preference shares) weighted according to the proportion each element
bears to the total pool of funds.

WACC Formula = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * (1-Tax Rate)]
Where,
ke - Cost of equity
kd - Cost of debt (to the company)
Ve - Market value of equity in the company
Vd - Market value of debt in the company

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Use of WACC as the discount rate in project appraisal
AFR580S/2023
WACC can be used to evaluate the company’s investment projects if the following conditions
apply:

๏ No change in financial risk

The company will maintain its existing capital structure. Using the existing market value mix of
funds as weights in the calculation assumes that in the long run funds will be raised in this
proportion (i.e. in the long run the capital structure of the company will remain unchanged). This
implies that the current gearing ratio is thought to be optimal.

No change in business risk

The cost of capital is only valid for the existing level of risk in the enterprise. The project mu st
therefore have the same level of business risk as the company does currently and will cause
no change in this risk.

Small project
The project is small relative to the size of the company thus representing a marginal
investment. This is because the costs of capital calculated refer to the minimum required
return of marginal investors and therefore are only appropriate for the evaluation of marginal
changes in the company’s total investment.

‘Pooled funds’
No attempt is made to match a project with a particular source of funds. All funds are
regarded as forming a pool out of which all projects are financed.

Perfect capital markets

Only under conditions of perfect capital markets will the costs of capital calculated represent the
true opportunity cost of funds used.

Calculating market values of sources of finance

WACC is calculated based upon market values, therefore it is important to ensure that you convert book
value of all sources of finance as follows:
๏ Ordinary shares Ex-div price per share x number of shares in issue
๏ Preference shares Ex-div price per share x number of shares in issue
๏ Debentures Book value x market value / 100
๏ Bank loans Book value (market value does not exist)
Cost of Equity (ke)
AFR580S/2023
The cost of equity for an incorporated entity can be calculated using the dividend valuation model. The
dividend valuation model states that the current ex-div market value (P0 ex-div) is equal to the present
value of future dividends (D0), discounted at the required rate of return of the equity shareholder
(ke)
D0 (1 + g)
P0 ex-div =
ke – g

We can then re-arrange the formula to find the cost of equity (k e) that shareholders must have used to
arrive at the share value.
D0 (1 + g)
ke = +g
P0 ex-div

g = dividend growth rate (assumed constant)

D0 = current dividend

P0 ex-div = current ex-div market value of the share

Example 1 - Banks
Banks Ltd has an ex-div share price of $2.50 and has recently paid out a dividend of 10 cents. Dividends are
expected to grow at an annual rate of 4%.

Calculate the cost of equity.

Note:
“ex-div” is the share price immediately after a dividend has been paid
“cum-div” is the price immediately before a dividend is paid
The difference between “ex-div” and “cum-div” is the value of the dividend, D 0, so that the “cum- div”
share price can be expressed as follows;
P0 cum-div = P0 ex-div + D0
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Example 2 – Cohen
Cohen Ltd has a cum-dividend share price of $4.15 and is due to pay out a dividend of 35 cents per
share. Dividends are expected to grow at an annual rate of 5%.

Calculate the cost of equity.

Estimating Growth
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Historic growth method

 D0 
g  D  1

Where;
D0 = current dividend
Dn = dividend n years ago
n = number of years

The current
share price is $5.50 ex-div.

The current
share price is $2.36 cum-div.
Gordon’s growth model
AFR580S/2023
g= rxb

Where;
r = Return on reinvested funds
b = Proportion of funds retained

Example 5 - Charlton
The ordinary shares of Charlton are quoted at $4.45 cum div and a dividend of 45 cents is just about to be paid.
The company has a return on capital employed of 15% and each year pays out 25% of its profits after tax as
dividends.
Calculate the cost of equity.

Cost of Preference shares (kp)

Preference shares carry a fixed rate charge to the company in the form of a dividend rather than in
terms of interest.
Preference shares are normally treated as debt rather than equity but they are not tax deductible.
Their cost can be calculated using the dividend valuation model with no growth, giving the following
formula;
D0
kp
P0 ex-div
=

Example 6 - Moore
Moore’s 8% preference shares ($1) are currently trading at $1.10 ex-div.
Calculate the cost of the preference shares.
Cost of Debt (kd)
AFR580S/2023
There is only one approach to calculate the cost of debt. We can’t call it “dividend” valuation model since
debt doesn’t pay dividends but it follows the same principle of future cash flows related to current
market value.

Non-tradable debt

Bank loans and other non-traded loans have a cost of debt equal to the coupon rate adjusted for
tax. So we can use the following formula;

kd = Interest rate(%) x (1 – T)

Example 7 - Ball
Ball has a loan from the bank at 8% per annum.
Corporation tax is charged at 25%.
Calculate the cost of debt.

Traded debt

Traded debt is always quoted in $100 nominal units or blocks. Therefore all calculations are done
by reference to $100, regardless of the total amount borrowed.
Interest paid on the debt is stated as a percentage of nominal value ($100 as stated). This is known as
the ‘coupon rate’. It is not the same as the cost of debt.

Debt can be:

๏ Irredeemable.
๏ Redeemable (at par or at a premium)
๏ Convertible (investor has the choice of redeeming for cash or a specified number of shares in
place of cash).
Irredeemable debt
AFR580S/2023
To calculate the cost of debt we will need to calculate the IRR of the future cash flows, which gives the
following formula:
I (1
kd =
T) P0
ex-int

Where;
I - Coupon interest rate
T - Tax rate
P0 ex-int - Ex-interest market value of debt

Example 8 - Bobby
Bobby has 10% irredeemable loan notes that are quoted at $120 ex-int. Corporation
tax is payable at 25%.
Calculate the cost of debt.

Redeemable debt

To calculate the cost of debt we will need to calculate the IRR of the future cash flows, which now includes
the redemption value of the debt in n years’ time. The relevant cash flows would be:
Time Narrative Cash
flow
0 Market value of debt (P0)
1–n Annual coupon interest paid (net of tax) I (1 – T)
n Redemption value of debt RV
To then calculate the IRR we need to use linear interpolation.

Example 9 - Peters
Peters has 10% loan notes quoted at $95 ex-interest redeemable in 5 years’ time at par.
Corporation tax is paid at 25%.
Calculate the cost of debt.
 Convertible debt
AFR580S/2023
In this situation the holder of the debt has the option to redeem for cash or for shares.
To calculate the cost of debt using IRR the redemption value is assumed to be the greater of either:
๏ The share value on conversion, or
๏ The cash redemption value if not converted.

Example 10 - Hunt
Hunt has convertible loan notes in issue that may be redeemed at a 10% premium to par value in 4
years. The coupon is 8% and the current market value is $110.
Alternatively the loan notes may be converted at that date into 25 ordinary shares.
The current value of the shares is $5 and they are expected to appreciate in value by 2% per
annum.

The tax rate is 25%.

Calculate the cost of debt for the convertible loan notes.

WACC - Calculation

Example 11 - Ramsey

The following information is in the statement of financial position of Ramsey:

$000s
Ordinary shares (25c) 4,000
8% redeemable bonds 6,000
5% bank loan 4,000
The current ex-div share price is $4.00 and a dividend of 25c has just been paid which is 10c higher
than the dividend paid 5 years ago.
The 8% bonds are trading on an ex-interest basis at $94.00 per $100 bond and are redeemable in
seven years’ time.
Corporation Tax is 25%
Calculate the weighted average cost of capital.

END OF TOPIC 2 COST OF CAPITAL

 AFR580S/2023
Topic 6
Revenue from contracts with costumers

Question 1: (Intermediate)
Question 2: (Intermediate)
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Question 3: (Advanced)
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Question 4: (Advanced)
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End of topic 6 Revenue from contracts with customers

 AFR580S/2023

Topic 7
Provisions, Contingent Liabilities and Contingent Assets

Provision

Present obligation Probable Measure the

as a result of a past transfer/outflow of outcome
event economic benefit reliably

Measurement

๏ Best estimate of expenditure

๏ Expected values (various different outcomes)
๏ Discount to present value if materially different

Illustration – Best estimate (single obligation)

Following the explosion of an oil rig in the North Sea that resulted in large amounts of
environmental damage the company was taken to court by the local authority who were looking to
recover the costs of the clean-up operation. The company has been informed by their lawyers that it
was probable that they would be liable for the costs of the clean-up operation. The lawyers
estimated that following financial settlements and their likelihood:
Settlement amount Likelihood of
($m) settlement
25 20%
40 45%
65 35%

For a single obligation that is being measured, i.e. the payment to clean-up the environmental
damage, the best estimate of the liability is the individual most likely outcome.
The most likely outcome is the settlement for $40 million and so this is the amount that would be
provided for within the financial statements.
 AFR580S/2023

Illustration – Best estimate (large population)

months will require no

repairs, however 15% will require minor repairs and the remaining 5% will require major repairs.
The company has estimated that if all the cars were to have minor repairs then this would cost

the possible
outcomes. The expected value of the repair costs is $40,000 [(80% x $nil) + (15% x
$100,000) + (5% x $500,000)] and so this is the amount that would be provided for within the financial
statements.

HR Co has a year end of 31 December 2018, and it was notified that on the 1 July 2018 a former employee
brought about a legal claim for unfair dismissal. HR Co’s legal team have said that it is probable that that HR
Co would lose the case, resulting in a payment of $495,000 on 30 June 2019.
HR Co has a cost of capital of 10% per annum. A one-year discount factor at 10% is 0.9091.
Calculate the amounts to be recognised in the financial statements of HR Co for the year
ended 31 December 2018

Subsequent treatment

Review the provision annually

Only use the provision for expense originally created
Contingent liability

Possible obligation Present obligation

๏ Possible transfer, or
๏ Cannot measure
reliably (rare)
 AFR580S/2023

The following items have to be considered when finalising the financial statements of G-Star Co, a limited liability
company:
The company gives warranties on its products. The company’s statistics show that about 5% of sales give rise
to a warranty claim.
under the
guarantee is assessed as possible.

1 2

Disclose by note only No action

Disclose by note only Disclose by note only

Justina supplies fish to a local restaurant. In August 2009 she supplied the restaurant with some
food-poisoning. The restaurant
has claimed that this is because of Justina’s shell-fish and has commenced a legal action against her.
42% chance of
losing the case, and that, if she does lose, she will probably have to pay $300,000 to settle the liability.

What is the nature of Justina’s liability, if any, and how should it be treated in her financial
statements for the year ended 31 August, 2009?
 AFR580S/2023
Specifics

Future operating losses

No provision can be made for anticipated losses as there is no obligation.

Onerous contracts
An onerous contract is whereby the cost of fulfilling the contract exceed the benefits received from the
contract (e.g. non-cancellable operating lease).

A provision is recognised at the lower of:

๏ Present value of continuing under the contract, and
๏ Present value of exiting the contract

Example 4 – Onerous contract

Daiva has a contract to buy 900 metres of cloth each month for $7 per metre. From each 3 metres
of cloth she can make a dress which she can sell for $30. She also incurs labour costs of $4 per dress.
Alternatively she can sell the cloth immediately for $6.25 per metre.
If she decides to cancel the cloth purchase contract without notice she must pay a cancellation
penalty of $700, for each of the next two months.
In December 2009 the market price of dresses fell to $22.
She is considering ceasing production since she believes that the market will not improve.
There is 2 months notice stated in the contract in case of breach of a contract.
(a) Is there a present obligation?
(b) What will appear in respect of the contract in Daiva’s financial statements for the year
ending 31 December, 2009.
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Restructuring
๏ Sale or closure of a line of business
๏ Ceasing activities in a geographical location
๏ Relocating activities
๏ Re-organisation (management or focus of operations)

A provision is recognised if there is a detailed formal plan and the plan has been announced.
The provision only includes costs which are necessarily to be incurred and not associated with
continuing activities.

Example 5 – Restructuring
On 18 August 2017 the directors of Paulius decided to close the Kaunas Factory.

(a) Assuming that no steps were taken to implement the decision and the decision was not
communicated to any of those affected by the Statement of Financial Position date of
31 August, 2017 what is the appropriate accounting treatment?
(b) What would be the appropriate accounting treatment for the closure if a detailed plan
had been agreed by the board on 26 August 2017, and letters sent to notify suppliers?
The workforce in Kaunas has been sent redundancy notices.

Contingent asset

Remote/Possibl Probabl Virtually certain

e e

Ignore Disclos Recognise an asset

e
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Illustration – Contingent asset
A business has a reporting date of 31 December and inventory worth $100,000 was stolen just prior to
the reporting date. The business has made a claim on its insurance and has heard from the
insurers who have said that it is probable that the full amount will be reimbursed, but no further
confirmation of when any payment will be made has been received.
The business will disclose a contingent asset within the notes to the accounts as it is probable that
the $100,000 will be received, however an asset cannot be recognised as it is not yet virtually
certain as the final confirmation has not been received of when the payment will be received.

Case Study 1 (adapted)

Company A gives warranties at the time of sale to purchasers of its product. Under the terms of the
contract for sale Company A undertakes to make good, by repair or replacement, manufacturing defects
that become apparent within one year from the date of sale. On the basis of experience, it is probable
(ie more likely than not) that there will be some claims under the warranties.

At 31 December 20X1 Company A appropriately recognised a R50,000 warranty provision. Company A

incurred and charged R140,000 against the warranty provision in 20X2. R80,000 of this is related to
warranties for sales made in 20X2.

At 31 December 20X2 Company A estimated that it would incur expenditures in 20X3 to meet its warranty
obligations at 31 December 20X2, as follows:
5% probability of R400,000; 20% probability of
R200,000; 50% probability of R80,000; and 25%
probability of R20,000.
Assume for simplicity that the 20X3 cash flows for warranty repairs and replacements take place, on
average, on 30 June 20X3.

Company A is also the defendant in a lawsuit for breach of patent. Its lawyers believe that there is a 70%
chance that Company A will successfully defend the case. However, if the court rules in favor of the
claimant, the lawyers believe that there is a 60% chance that the entity will be required to pay damages of
R2 million (the amount sought by the claimant) and a 40% chance that the entity will be required to pay
damages of R1 million (the amount that was recently awarded by the same judge in a similar case). Other
amounts of damages are unlikely.

The court is expected to rule in late December 20X3. There is no indication that the claimant will settle out
of court.
 AFR580S/2023
Ignore discounting and risk adjustments.

REQUIRED:
A. Prepare accounting entries to record the necessary entries relating to the warranty expense and
provision in the accounting records of Company A for the years ended 31 December 20x1 and 20x2.
B. Draft extracts to the financial statements showing how Company A should present and disclose its
provisions and contingent liabilities in its financial statements for the year ended 31 December 20x2.

END OF TOPIC 7
Provisions, Contingent Liabilities and Contingent Assets
 TOPIC 8
Intangible Assets

An identifiable, non-monetary asset with no physical substance but has value to the business.
๏ patents
๏ brand names
๏ licences
3 factors to consider

Identifiability Control Future

economic
benefits

Separate acquisition
Capitalise at cost (purchase price, import duties and non-refundable purchase taxes less any trade
discounts) plus any directly attributable costs (e.g. legal fees, testing costs). Amortisation is
charged over the useful life of the asset, starting when it is available for use.

Research
Research expenditure is charged immediately to profit or loss in the year in which it is incurred.

Development
Development expenditure must be capitalised when it meets all the criteria.
๏ Sell/use
๏ Commercially viable
๏ Technically feasible
๏ Resources to complete
๏ Measure cost reliably (expense)
๏ Probable future economic benefits (overall)

Internally generated
Internally generate brands, mastheads cannot be capitalised as their cost cannot be separated from the
overall cost of developing the business.
Revaluations
An intangible asset can only be revalued if there exists an active market.
An active market is one where the following conditions are all met:
๏ The items traded are homogenous
๏ Willing buyers and sellers can normally be found at any time
๏ Prices are available to the public

Amortisation
If an intangible has a finite life then it should be amortised over its useful economic life.
Residual value is normally assumed to be zero unless there is a commitment from a buyer or an
active market exists.
An intangible could be considered to have an indefinite useful life if there is no foreseeable limit to the
period over which the asset is expected to generate net cash flows for the entity. It will therefore
be subject to annual impairment reviews.

Example 1 – Intangibles
GKS is a large pharmaceutical business involved in the research and development of viable new
drugs. It commenced initial investigation into the viability of a new drug on 1 February 20X5 at a
cost of $40,000 per month. On 1 August 20X5 GSK were able to demonstrate the commercial
viability of the new drug and intend to sell it on the open market once fully complete.
Costs subsequent to 1 August 20X5 remained at $40,000 per month. At 31 December 20X5, GSK’s
reporting date, the drug was not yet complete but it is believed that by mid-20X6 the drug will be
available for sale.
The finance director is confident of the success of the drug’s sales that he wishes to revalue the
intangible at the reporting date, using a discounted future cash flow model to establish the fair
value.
Explain the treatment of the above costs in GSK’s financial statements for the year-ended 31
December 20X5.

Intangibles and business combinations

If an intangible asset is acquired in a business combination (i.e. acquisition of a subsidiary, that has a
previously unrecognised internally generated brand), the cost of that intangible asset is
recognised at fair value in the consolidated financial statements.
If a fair value cannot be established the intangible is not recognised separately and becomes part of
the overall goodwill established on acquisition of the subsidiary.

END OF TOPIC 7 INTANGIBLE ASSETS

 Topic 10
Foreign currency transactions

Functional Currency

“The functional currency is the currency of the primary economic environment in which the entity operates.”
The primary economic environment in which an entity operates is normally the one in which it primarily
generates and expends cash. An entity’s management considers the following factors in determining its
functional currency:
๏ The currency that dominates the determination of the sales prices
๏ The currency that most influences operating costs
๏ The currency in which an entity’s finances are denominated is also considered.
IAS 21 Foreign currency translation says that, when an individual company has transactions that are
denominated in a foreign currency, they should translate them at the rate prevailing when the
transactions occurred i.e. the historic rate (HR).
At the year end, the statement of financial position items need to be classified as either monetary or non-
monetary items. The monetary items are then re-translated at the year-end using the closing rate (CR).
Any exchange gains or losses that arise are taken directly to profit or loss.

The non-monetary items are not re-translated at the year-end.

Non-current asset investments, tangible non-current assets and inventory are deemed to be non-
monetary and everything else is monetary.

Flower Inc. has its functional currency as the $USD. It trades with several suppliers overseas and bought goods
costing 400,000 Dinar on 1 December 20X5. Flower paid for the goods on 10 January 20X6. Flower’s year-end
is 31 December. The exchange rates were as follows:

1 December 20X5
31 December 20X5
 QUESTION 2

XYZ Ltd bought a machine from a British supplier on 1 August 2018 at a cost of 48 000
British Pound (BP). XYZ Ltd carries property, plant and equipment at cost less
accumulated depreciation. It was agreed that the debt owed to the british supplier would
be settled in two equal annual instalments of 24 000 BP each, payable on 31 July 2019
and 31 July 2020 respectively. Over and above the instalments of 24 000 BP each to
redeem the capital amount due, interest at 8% per annum is paid at the same dates as the
instalments. The useful life of the machinery is estimated as five years with no residual
value. The reporting date of XYZ Ltd is 31 July.

The applicable exchange rates were as follows:

Spot rate at 1 August 2018 1 BP = R15.30
Spot rate at 31 July 2019 1 BP = R17.35
Spot rate at 31 July 2020 1 BP = R18.65
Average rate 2019 reporting period 1 BP = R16.60
Average rate 2020 reporting period 1 BP = R18.00

A forward exchange contract taken out on 31 July 2019, maturing on 31 July 2020, would
trade for 1 BP = R18.40.

Required:
Journal entries to record the above events during the reporting periods ended
31 July 2019 and 2020, assuming that XYZ Ltd took out a forward exchange contract on
1 January 2019 for only the second instalment plus interest, at a fixed exchange rate
of 1BP = R18.02.

Narrations and closing transfers may be omitted.

 QUESTION 1 (25 marks)

Usurna Ltd purchased a machine from a Singaporean supplier. The details are
as follows:
Cost 300 000 S$
Currency of Singaporean $ S$
purchase Date of 01 October 2018
Purchase

It was agreed that the debt owed to the Singaporean supplier would be settled
in three instalments as follows:
Date 5$
01 October 2018 75 000
30 September 2019 100 000
30 September 2020 150 000
325 000

The above instalments include interest (per annum) at: 6.84192%

Additional Details relating to the machine:

Useful life estimate: years
Residual Value: S$
Date that the asset was ready for use: 01 October 2018

The company carries property, plant and equipment at cost less accumulated
depreciation.

The applicable exchange rates were as follows:

Spot rate at 01 October 2018 R10.275
Spot rate at 30 September 2019 R11.501
Spot rate at 30 September 2020 R12.150
Average rate 2019 reporting period R11.345
Average rate 2020 reporting period R11.875

Forward Exchange Contract

Date Taken 01 January 2020
Relates to the instalment of 150 000 S$
payable on 30 September 2020
Fixed Exchange Rate 1 S$ = R12.201

The reporting date of the company 30 September I

is:
 AFR580S/2023
Required:
Journal entries to record the above events during the reporting periods
ended 30 September 2019 and 30 September 2020
Narrations and closing transfers may be omitted.

END OF TOPIC 10 FOREIGN CURRENCY TRANSACTIONS