Final Edition, Fna Project

FNA1002 FINANCIAL ACCOUNTING GROUP PROJECT

B31 GROUP 5: CHAN SZE KI (U025743X) CHU THI THANH BINH (U054177U) LIM WEIMING (U054319L) WEE CHOONG KIAT, EDMUND (U025350R) TUTOR: LIN ZHIXING

DEPARTMENT OF FINANCE & ACCOUNTING SCHOOL OF BUSINESS NATIONAL UNIVERSITY OF SINGAPORE SEMESTER 1 SESSION 2005/2006

FNA1002 Group Project, B31 Group 5

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Question 1 The nature of business undertaken by the Challenger Group (will be known as Challenger in this project) includes merchandising and services. These include IT products and services selling computer hardware, software and accessories, onsite IT solution and services, and Electronic signage business which includes supplying, installing and maintenance.1 Main types of revenue include IT products and services, electronic signage services, and office supplies. The largest contribution comes from the provision of IT products and services (93%). This is carried out by numerous superstores and small format outlets. About 5% comes from the office supplies segment and another approximately 2% is from CBDeVision in the Electronic signage category.2 Main types of expenses include cost of goods purchased ($60,326,000), staff costs ($4,891,000), and other operating expenses ($5,231,000).3 Question 2 Revenue recognition refers to recording revenue after realization (right to cash or right to receive cash in the future) has occurred and the earning process is nearly complete. Challenger’s revenue recognition policies include4:

·Sales

revenue is recognized when buyers receive considerable amount of risks and

rewards of ownership while producers can provide objective evidence to the total amount of both revenue and costs of transaction.

·Service revenue that happens in a short period of time is recognized when the service is delivered to customers

·Franchise

fee income is recognized on a “straight-line basis over the period of the

franchise agreement”.

·Interest revenue is recognized “on a time-proportion basis using effective interest rate”. 1

Challenger Technologies Ltd 2004 Annual Report, Corporate Profile, pg 2 Pg 39 Note 19 3 Pg 25 Consolidated Income Statement 4 Pg 28 Note 2, Revenue Recognition 2

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·Dividend revenue is recognized when it is legal for shareholders to claim dividend. Challenger records revenue on the basis where revenue is measured at the fair value of the consideration received or receivable, taking into account the amount of any trade discounts and volume rebates allowed by the entity. Thus the amount recorded is the cash value of the service transferred to the customer. Revenue recognition from the sales of goods is appropriate because it is recorded when there is transfer of ownership to the buyer and all the costs of transaction can be measured reliably.5 The methods adopted are appropriate because they obey the revenue principle, meaning realization has occurred and the earnings process is nearly complete. Question 3 Plant and equipment and other assets (master franchise fee) are likely to have different market values from the book values recorded. Book value of a fixed asset is the cost minus accumulated depreciation. However, accumulated depreciation on fixed assets is only an estimate, which may result in differences in the book value and the market value. The Matching Principle and the Disclosure Principle account for this difference. The Matching Principle states that the asset’s expense (depreciation) has to match its generated revenue within the same period. The Disclosure principle requires this depreciation amount to be computed to present the estimated residual value that remains. Issued capital’s book value is also likely to differ from its market value. A share’s book value is the shareholder’s equity divided by the number of issued shares. Whereas the share’s market value is the price a person can buy or sell a share for. It is affected by the financial position and future prospects, net profits, and the general economic conditions. These factors will cause a difference in the 2 values. The Reliability Principle and Disclosure Principle account for such difference. Since market values are often determined by good-faith estimates, the Reliability Principle states that the accounting records and statements should be based on the most reliable data available, to be as accurate and as useful as possible. The Disclosure Principle 5

Pg 28 Note 2, Revenue Recognition

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requires Challenger to report enough information (relevant, reliable and comparable) for outsiders to make decisions about the company. Question 4 Title/Year Accounts receivable ($ ’000) Total assets ($ ’000) Percentage of total assets hold as

2004 2,011 22,702 (2,011 / 22,702) x 100 =

2003 1,764 13,333 (1,764 / 13,333) =

accounts receivable (%)

8.9

13.2

Compared to the previous year, this is a fall of 4.3%. Challenger accounts for its bad debt using the Allowance method. This method records the amount of losses on the basis of estimates. This is unlike the Direct write-off method in which a company waits till it is clear that customers cannot pay. Thus Challenger records the estimated amount in the Provision for Doubtful debts.6 This is the contra account to account receivables and is set up when there is enough objective evidence that all original amounts of receivables will unlikely to be collected. Challenger estimates its uncollectible amount at $1,000 which is relatively insignificant as this is only 0.050% [(1,000 / 2,012,000) x 100] of the total accounts receivable. The Allowance method is appropriate since account receivable is a small proportion of total assets and it follows the Matching Principle by better matching expenses against revenue. Question 5 a) In general, prices are subjected to inflation. It will difficult and troublesome to account for such price fluctuations frequently. Therefore standardized cost flow assumptions are used to cost inventories for easier accounting. Challenger used the First-In First-Out (FIFO) method to cost its inventories.7

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Pg 32, Note 6 Pg 28 Note 2, Inventories

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The assumption is appropriate. Challenger does not deal with unique inventories such as antiques or jewelry that requires the specific unit cost to be recorded. In addition, in the electronic and IT industries that Challenger is in, inventories purchased at the beginning of the fiscal year are most probably sold not long after. This is because inventories become obsolete very quickly. Hence, the FIFO method is appropriate. b) Goods for resale at cost = $5,912,000 Goods carried at net realisable value brought to cost = $64,000 + $27,000 = $91,0008 Total historical cost at 31 December 2004 = $5,912,000 + $91,000 = $6,003,000 Question 6 a) Challenger’s depreciation is provided on gross carrying amounts in equal annual installments over the estimated useful lives of the assets. Therefore, Challenger uses straight-line depreciation where depreciable cost is divided by useful life in years to determine the annual depreciation amount. Depreciation Rates: Renovation

12.5% to 33%

Plant and equipment

10% to 23%

Fully depreciated assets still in use are retained in the financial statements.9 Challenger also reviews the useful life of plant and equipment at least once each financial year and depreciation charges are adjusted based on different estimates. Based on the above information, Challenger renovates every 3 to 8 years and they change their plant and equipment every 5 to 10 years. The depreciation rates for renovation is appropriate. As for plant and equipment, the estimate of their useful life between 5 to 10 years is too high. This is because

8 9

Pg 33 Note 8 Pg 29, Note 2 cont’d, Plant and equipment

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equipment such as computers become obsolete after 2 to 3 years therefore, their depreciation rates should be much higher at 33% to 50%. Managers consider the tradeoffs in choosing a depreciation method out of the 3 main types. The straight-line method divides the depreciation equally throughout the asset’s life; this makes computation easy and more convenient. The units-of-production method provides a much better estimate of depreciation and the asset’s remaining useful life as it is based on usage. Whereas the Double-declining-balance (DDB) method accelerates depreciation in the early years, lowering reported net profits and thus decreases income tax. There will be additional cash to invest using the DDB due to avoidance of (more) tax. b)

Challenger made a loss of $33,000 on disposal of plant and equipment for the year ended 31 Dec 2004.10 Journal entry for this transaction11: 31 Dec 2004 Accumulated depreciation……..………..… $129,000 Loss on Disposal of plant and equipment….

33,000

Cash………………………………………...

30,000

Plant and equipment……………………

$192,000

To record loss on disposal of plant and equipment. Question 7 3 other possible future obligations include:

·Guarantees given, e.g. bankers’ guarantee (secured) of $643,000 in 2004

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·Servicing products which are under warranty (Provision for warranty), ·Possible lawsuits in the event of being sued This information is significant because it provides a clearer outlook and better understanding of the company’s future prospects should these obligations occur. Such 10

Pg 40, Note 23 Pg 35, Note 11 12 Pg 44 Note 32 11

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obligations will involve cash outflows in the future that result in lower cash and cash equivalents. Investors may be misled if such future obligations are not declared properly. Question 8 a)

A share represents a unit of ownership that an investor has in a specific company. Issuing share capital comprises of two parts: issuing of ordinary shares (consisting of issued capital and share premium) and issuing of preference shares.13 The issued capital is the total par value of ordinary shares that have been issued by the company and are fully paid for by the shareholders. Par value of each share is an arbitrary amount decided by the company which represents the maximum legal liability of the shareholder for each share. Share premium is the amount that shareholders pay that is above the par value.

·Preference

shares: This type of shares gives its owners certain advantages. For

example, if a company pays dividends, preference shareholders receive dividends before ordinary shareholders. In 2004, Challenger did not issue any preference shares.

·Ordinary

shares: Ordinary shareholders are entitled to 4 basic rights of share

ownership unless otherwise stated. They are: the right to vote on matters regarding management of company, the right to receive dividends though after the preference shareholders, the right to receive any proportionate share of any assets remaining after the company pays its liabilities in liquidation and the right to maintain one’s proportionate ownership in the company. In 2003, Challenger issued 121,500,000 ordinary shares at par value of $0.04 each. 2003

Cash (121,500,000 * $0.04)………………… $4,860,000 Paid up capital, ordinary shares ……………..

$4,860,000

To issue ordinary shares at par In 2004 (14 January), 32,000,000 new shares were issued at premium of $0.19 each. 14 Jan 2004 13

Pg 39, Note 18

Cash ………………………………….… $7,360,000

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Paid up capital, ordinary shares…… $1,280,000 (32,000,000 * $0.04) Share premium, ordinary shares…... $6,080,000 (32,000,000 * $0.19) To issue ordinary shares at premium Hence, at 31 December 2004, total number of issued ordinary shares is 153,500,000 (121,500,000 + 32,000,000). b)

The company declared and paid a “first interim dividend of 0.56 cents net of tax per ordinary share” on the 153,500,000 issued ordinary shares of the company totaling $860,000 ($0.56 * 153,500,000) on September 2004. In the same year, the directors of the company also proposed to pay a “dividend of 2.4 cents net of tax per ordinary share”. However, this dividend is still subjected to approval and thus not included as a liability in the financial statement.14

Question 9 a) The difference is due to the different accounting methods used. Under the Company column, “Investment in associate” is recorded by the Cost method or Market value method. Cost method is preferred because adjustments are not required when market value changes. The investment is then recorded at the original purchase cost. However, under the Group column, it must be accounted for by the equity method. The equity method takes into account not only the purchase cost of investment, but also the dividend receivable, and share of profits (loss) of associated companies. Therefore, the values will differ. b) Challenger records $2,000 as share of income tax of associates.15 The income tax of the associate is $5,000 ($2,000/0.4). The income tax rate in Singapore was 20% and 14 15

Pg 42, Note 28 Pg 41, Note 26

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hence the net profit before tax is $25,000 ($5,000/0.2). Therefore net profit after tax reported by associate company was $20,000 ($25,000 - $5,000). Question 10 a) Consolidated statements combine the balance sheets, income statements and other financial statements of the company with those of the majority owned companies into an overall set of statements as if they were a single entity. A company is called a subsidiary or considered a majority owned by Challenger when more than 50% of its ordinary shares is owned by Challenger. As such, there are 7 legal entities accounts consolidated in the Group’s accounts of Challenger as at 31 December 2004, namely: 1) Matrix Integration Pte Ltd 100% (Singapore) 2) Itech care Pte Ltd 100% (Singapore) 3) Challenger technologies Sdn Bhd 80% (Malaysia) 4) OA supplies Pte Ltd 55% (Singapore) 5) CBD eVision Pte Ltd 100% (Singapore) - CBD eVision Sdn Bhd 60% (Malaysia) -

CBD eVision Company limited 52% (Thailand)

b) Minority interests arises when the parent company Challenger owns less than 100% of the shares of a subsidiary company. In this case, the companies involved are: 1) Challenger technologies Sdn Bhd - 80% (Malaysia) 2) OA supplies Pte Ltd - 55% (Singapore) 3) CBD eVision Sdn Bhd - 60% (Malaysia) 4) CBD eVision Company limited - 52% (Thailand) Specifically, “minority interests” on the consolidated balance sheet is the percentage of the subsidiary’s equity not held by the parent company. For example, Challenger owns 55% of shares in OA supplies Pte Ltd. As such, minority interests to be reported will be 45% of the total equity of OA supplies Pte Ltd.

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c) The OA supplies Pte Ltd was acquired at a premium over its fair market value. It is because there is a presence of goodwill that amounts to $403,000. 16 Such conclusion can be drawn because goodwill is an intangible asset which is the excess of the cost of purchasing another company over the sum of the market values of its net assets or assets less total liabilities. The excess is possible when the purchaser believes the other company has an abnormal earning power and is willing to pay more for that. d) Impairment loss for good will refers to the write down of intangibles when their value decreases. This occurs when the impairment test that goodwill is subjected to every year shows that its value has decreased. In Challenger group’s case, it recorded an impairment loss for goodwill of $388,000 at the end of 2004. This is probably attributed to the Group’s intention of disposing of OA Supplies in FY 2005 due to a divergence in strategy and differences in management culture as well as the additional capital required for the commercial expansion of OA Supplies business. Question 11 Due to the page constraints for the project, please refer to the textbook for the ratios used. Year/Ratio Total current assets ($ ’000) Total current liabilities ($ ’000) Current ratio Total liabilities ($ ’000) Total assets ($ ’000) Debt ratio Net profit ($ ’000) Preference dividend ($ ’000) Average ordinary shareholders’ equity

2004 21,159 7,875 2.69 8,094 22,702 0.36 2,798 0 (14,573 + 6,129) / 2

2003 12,155 7,040 1.73 7,204 13,333 0.54 3,169 0 (6,129 + 4,65917) / 2

($ ’000) Return of equity (%) Net profit ($ ’000) Preference dividend ($ ’000) Number of ordinary shares issued ( ’000) Earnings per ordinary share (cents/share) Dividend per ordinary share (cents/share)

= 10,351 27 2,798 0 153,500 1.8 3.718

= 5,394 59 3,169 0 121,500 2.6 2.27

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Pg 43, Note 29

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Challenger Technologies Ltd 2003 Annual Report, Balance Sheet – 2002 Total equity

FNA1002 Group Project, B31 Group 5

Market price per ordinary share (cents/share) Dividend yield (%) Market price per ordinary share (cents/share) Earnings per share (cents/share) Price/earnings ratio

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23 16.1 23 1.8 12.8

4 56.8 4 2.6 1.54

The current ratio measures Challenger’s ability to pay its current liabilities with current assets, which has increased from 1.73 to 2.69. Challenger has adequate liquid assets to maintain its normal business operations, and a current ratio of 2.69 suggests that Challenger is at a strong financial position. The debt ratio shows the proportion of Challenger’s liabilities that have to be financed by assets. It decreased from 0.54 to 0.36 (a relatively low-risk position), meaning that Challenger has lowered future obligations. The current and debt ratios indicate that Challenger is currently in a safe and strong financial position and is unlikely to go bankrupt within the next few years. The return of equity is a measure of the amount of profit earned for every dollar invested by the ordinary shareholders. The decrease of the return of equity from 59% to 27% was mainly because of additional shares issued above par value (leading to increase in reserves). As a result, the amount of profit for every dollar invested has decreased. This is unfavourable for shareholders. The earnings per ordinary share (EPS) give the amount of net profit per share of Challenger’s issued ordinary shares. This ratio dropped from 2.6 to 1.8 due to decreased net profit and an increased in the number of issued ordinary shares. Each share is linked with a lower proportion of net profit, suggesting concerns about the value of shares. The dividend yield measures the portion of a share’s market value that is returned as dividend in a particular year. It has dropped from 56.8% to 16.1%. This is a concern as the amount of return (as dividends) has significantly dropped for the year. Price/earnings ratio (P/E) indicates the market price for every dollar earned; an important ratio in deciding the status of the shares, i.e. to buy, hold or sell shares. Challenger’s P/E increased significantly from 1.54 to 12.8, meaning that shares are sold at 12.8 times the earnings. This high ratio indicates a high probability of market share price to fall. 18

Pg 5, Chief Executive’s Message: The Group

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The return of equity, EPS, and dividend yield ratios have dropped and indicate declined returns to shares. The increased in P/E also suggest that the market price of Challenger’s share will fall soon; selling the shares may seem inevitable in the near future. Although Challenger does not seem to be in a bad financial position and/or facing possible financial problems, the returns to shares to shareholders is declining and the situation indicates a possible market price fall of Challenger’s shares. This speculation may even lead to a sudden release of Challenger’s ordinary shares and making the price fall. As shareholders, we will naturally be unhappy with such a pessimistic situation. Question 12 Mr Tan’s happiness is not justified because the increase of $9.2 millions in cash and cash equivalents does not mean that the Challenger has earned “plenty of profits”. This change in cash and cash equivalents is comprised of changes in cash flows from operating activities (CFO), investing activities (CFI) and financing activities (CFF). Firstly, the increase in net cash and cash equivalents is largely due to the increase in CFF of $7,820K from -$1,701K to $6,119K.19 It can be observed that the increase in cash inflows is mainly due to the issuance of shares, short-term borrowings and paying less dividend (which decreased cash outflow). This is in fact not a good sign since new shares and more borrowings mean that Challenger will need to pay more dividends and interests in future. This will put a strain on the amount of cash on hand that the company needs to have. Moreover, it is not healthy to have the main source of cash inflows come from borrowings from shareholders and creditors instead of operating business activities. Secondly, the net profit before tax in 2004 ($3,715,000) is actually lower than that in 2003 ($4,024,000). This can be seen from the income statement and the CFO in the cash flow statement. However, the net cash flows from operating activities is still higher than that in 2003. This is because under the accrual accounting basis which is used to compute net profit in the income statement, many transactions that do not involve cash exchange 19

Pg 27,Consolidated Cash Flow Statement

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are realized. Under this cash flow statement, those transactions are not realized and need to be adjusted to the profit income tax. Apparently, in 2004, there are many more non cash operating expenses which actually decrease the 2004 net profit. They are all added back to the CFO in the cash flow statement resulting in higher result in 2004 than 2003. Title/Year Net profit after tax ($ ’000) Net sales ($ ’000) Profit margin (%)

2004 2,798 75,478 (2798 / 75478) x 100%

2003 3,169 67,265 (3169 / 67265) x 100%

= 3.7

= 4.7

Thirdly, the profit margin, which is the net profit after tax / net sales, fell from 4.7% in 2003 to 3.7% in 2004 shows that the company is not performing that well. In conclusion, it is not justified to say that Challenger “did so well in 2004 to earn plenty of profits”. Question 13 Challenger’s external auditors are Chio Lim & Associates, and the Partner In-charge is Lim Lee Meng. The audit opinion given was unqualified/clean. It means that Challenger’s 2004 consolidated (group) financial statements, and the company’s balance sheet and statement of changes in equity were prepared in accordance with the provisions of the Companies Act, Cap. 50 (the “Act”) and Singapore Financial Reporting Standards. This reflects a factual and reasonable view of the positions of both the group and of the company as at 31 December 2004.20 To external users, this opinion means that Challenger’s financial statements are justified and reliable. Therefore, the financial statements portray a reasonable view of Challenger’s financial status without any worries of its accounts being “cooked”. External users can rely on these statements to assess the current and future prospects of Challenger, and thus making their investment decisions.

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Pg 23, Auditors’ Report

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Question 14 Item 1021, accountability is important to investors. Challenger displays this by providing shareholders with a balance and understandable assessment of the Group’s performance, position and prospects on a regular basis and communicating major developments in its business operations. In doing so, this increases the transparency of the workings in the Challenger, which would greatly help in investment decisions. The provision of quarterly updates of management accounts of the Group to the Directors also enables the Directors to make informed decisions for the future direction of the Group to investors. Item 1422, communications with shareholders, is another item that is important to investors. Challenger fulfills its obligation to provide timely disclosure of material information to the shareholders. It does this through annual reports, announcement of the half and full year results, press releases on the major developments of the company, and the company’s website. The annual general meeting is also a good opportunity for shareholders to communicate with the CEO and board of directors. This can be useful to an investor since they will be able to know how they can relate to the Board of directors of the company, once they have any problems regarding the financial health of the Challenger or need to obtain more information on the company. By stating it clearly in this way, investors can save on time and effort in finding out the various means of communication. Furthermore, by stating it clearly in the financial statement, Challenger has shown that it cares about the shareholders and it is willing to listen to any feedback from them as well as to answer their needs and requirements. This psychological effect might induce investors to find out more about the company and to invest in it. Question 15 When CEOs of companies are interviewed, their opinions of “healthy” or “strong” financials often relate to high profits, increased sales, low debts, high market price of shares, and capability of declaring dividends. These are usually associated with high

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Pg 16, Corporate Governance, Accountability Pg 18, Corporate Governance, Communications with shareholders

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gross (profit) margin, high inventory turnover, high rate of return on net sales, high rate of return on total assets, low debt ratio, high dividend yield, and high return on equity. Analysis of Challenger: Reasonable gross (profit) margin: increased by 0.5, from 19.5 to 20.0. Reasonably high inventory turnover: increased by 0.17, from 9.83 to 10. High rate of return on net sales: considered relatively high even though it decreased by 0.01, from 0.047 to 0.037. High rate of return on total assets: still considered high even though it decreased by 9%, from 24.7% to 15.7%. Low debt ratio: decreased by 0.18, from 0.54 to 0.36. High dividend yield: still considered high despite decreasing by 40.7%, from 56.8% to 16.1%. This decrease is due to issuance of new shares at prices above par value. High return on equity: decreased by 32%, from 59% to 27%. Due to the page constraints for the project, please refer to the textbook for the ratios used. Year/Ratio Cost of goods sold (= Beg. Inventory +

2004 (6,063 + 60,326 –

2003 (4,952 + 55,226 –

Purchases – Ending Inventory) ($ ’000) Gross profit ($ ’000)

5,976) = 60,413 (75,478 – 60,413)

6,063) = 54,115 (67,265 – 54,115)

Net sales ($ ’000) Gross (profit) margin (%) Cost of goods sold ($ ’000)

= 15,065 75,478 20.0 (6,063 + 60,326 –

= 13,150 67,265 19.5 (4,952 + 55,226 –

Average inventory

5,976) = 60,413 (6,063 + 5,976) / 2 =

6,063) = 54,115 (4,952 + 6,063) / 2 =

Inventory turnover Net profit after tax ($ ’000) Net sales ($ ’000) Return on net sales Net profit after tax ($ ’000) Interest expense ($ ’000) Average total assets ($ ’000)

6,019.5 10.0 2,798 75,478 0.037 2,798 39 (22,702 +13,333) / 2

5,507.5 9.83 3,169 67,265 0.047 3,169 3 (13,333 + 12,338) / 2

= 18,017.5

= 12,835.5

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Rate of return on total assets (%)

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15.7

24.7

From the above ratios used for analysis, we can see that Challenger’s 2004 overall financials can be considered “healthy” and/or “strong”. Challenger appears to be in a healthy financial position in 2004. However as potential investors, we will consider the trends of these ratios and the returns of shares/equity. As computed and discussed in Question 11, the returns to shareholders (such as return of equity, EPS, and dividend yield) are declining and there is a risk of price fall of the shares (from high increase in P/E). As such, we will not invest in Challenger’s shares solely based on the current (2004) statistics, but keep a lookout for its business in the next year and further analyse the trend before making any decisions.