CHAPTER 2 SUGGESTED SOLUTIONS SOLUTION TO MULTIPLE CHOICE QUESTIONS 2.1 2.2 2.3 2.4 2.5
(e) (e) (a) (d) (c)
2.6 2.7 2.8 2.9 2.10
(b) (a) (a) (a) (c)
END OF CHAPTER QUESTIONS
2.1 Any five of the following groups of users could have been specified:
Equity investors – hold shares and bear the ultimate risk of failure Lenders – earn income through interest and need to be sure that the company will meet both the periodic interest payments, and the capital repayment at the end of the loan.
Management – responsible for the operations of the company in return for a salary. They may also be shareholders and their success is measured by the extent to which the company meets its objectives of profitability and growth.
Financial analysts – offer advice to others, mainly potential shareholders and lenders about the risks and expected returns of such investments. Their reputation depends on correctly forecasting which companies will be highly successful, which are likely to be limited in their growth and which are likely to fail.
Employees - their monthly income depends on the continued operation of the company and are concerned that their wages or salaries will be paid and also about future job security.
Official bodies – their concerns range from ensuring good corporate governance and protecting the general public from breaches in good practice which could result in financial loss, to compiling facts figures and statistics used to provide indicators of conditions and prospects in the country as a whole.
Other business enterprises – these would mainly be in the same or similar industry and their concerns relate to competition and how to deal with potential harmful effects on their business through the activities of their competitors. Each of the above categories of users has a direct relationship with the company, which can be elaborated upon by discussion.
2.2 Relevance Information is relevant if it has the capacity to enable users to formulate predictions based on past events and to influence their decisions. Information is also relevant if it assists users to confirm or correct prior expectations. The financial statements must provide information, which the user needs and which was not previously known. This information may not change the decision, but it may reduce uncertainty in that it may confirm a situation, which was already surmised. Reliability Reliability is the quality that assures that financial information is reasonably free from error and bias and faithfully represents what it purports to represent. This quality implies that the user may depend on the information. If a user cannot interpret the information correctly, or has a misconception about what it purports to represent, it may not be very reliable.
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Secondary qualitative characteristics identified by the Financial Accounting Standards Board include the following: Freedom from bias Bias in measurement is the tendency of a measure to fall more often on one side than the other of what it represents, instead of being equally likely to fall on either side. Bias in accounting measures means a tendency to be consistently too high or too low. Comparability Comparability enables users to identify similarities in and differences between two or more sets of accounting data. Completeness Completeness implies that everything that is pertinent is included in reported information. Conservatism A prudent approach to ensure that uncertainty and risks inherent in business situations are adequately considered. Consistency Conformity from period to period and within a period in respect of policies and procedures for reporting the effects of accounting transactions. Feedback value The quality of information that enables users to confirm or to amend prior expectations. Materiality The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgement of a reasonable person relying on the information would have been changed or influenced if the particular item were omitted or misstated. Neutrality Absence of bias in reported information intended to attain a predetermined result or to induce a particular mode of behaviour. Predictive value The quality of information that helps users to increase the likelihood of correctly forecasting the outcome of past or present events. Validity Correspondence or agreement between a measure or description and the phenomenon that it purports to represent. Timeliness Making information available to a decision-maker before it loses its capacity to influence decisions. Understandability The quality of information that enables users to perceive its significance. Verifiability The ability to confirm that events being reported actually have taken place and are accurately reflected. Although the above qualities may overlap to some extent, when considered as a whole, they represent the qualities, which ensure that information is useful.
2.3 The three major components of the financial message of a business are:
A statement of financial position which provides information with regard to the assets of a business and the claims which are held against those assets by outsiders and by owners of the business.
A statement of financial performance which indicates the profit or loss which the business has generated during a given period and the way in which such profit has been distributed.
A statement of financial management in the form of a cash flow statement, which reflects the movement of funds during the period under review and the liquidity of the business.
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These three statements are considered of primary importance because they reflect the value of a business, its ability to generate future income and the ability of management to control the funds of the business.
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2.4 This is a broad question and may be answered in a number of ways. The main objective is to identify some information needs of equity investors and the reason why those aspects are of importance. The broad response may initially relate to the value of the company. This can be assessed in two primary ways, using the Balance Sheet to determine the net asset value of the company, or the Income Statement, using past performance, in order to try and forecast expected future performance and then use the present value approach. (How much would an investor be prepared to pay to be the recipient of the future wealth, which the company is expected to generate) More specifically investors will want information about the following:
Profitability, in order to forecast the likely profit generating power of the company. This includes information on sales (volume and price if possible), gross profit (in the case of a trading company), expenses, interest and taxation.
Liquidity, in order to establish the strength of the company to meet its cash comittments Growth, in order to estimate the prospects for entering new markets and expanding sales Replacement cost or net realisable value of the assets, in order to establish value using figures different to those produced by the accounting process (which most frequently uses depreciated historic cost)
2.5 Trade Unions, as stakeholders in the economy as a whole, represent workers within companies. One of their primary functions is to ensure that working employees (in contrast with management), are being paid and receiving benefits, which are fair and equitable, and working under conditions which are not exploitative. Companies which report large profits attributable to owners and shareholders and/or generous benefits in the form of salaries, bonuses and other fringe benefits, offer opportunities to examine how this value added is distributed. Trade Unions would question whether workers should not receive a larger “share of the pie” (the wealth created by the company), as without the workers, the value could not have been created.
2.6 Equity investors: Equity investors may consider that the high losses are a result of poor management and may take steps to remove the current management and replace it with more competent managers. As equity investors control a company, they are able to do this through the exercise of their vote. Equity investors may also react by selling their shares, if the share price has not already dropped to reflect the effect of the high losses. Lenders Lenders may become concerned that the company may not be able to meet its interest commitments and, more seriously, that the company may not be able to repay the capital sum(s) loaned. Their reaction could be to demand repayment of the loan(s). Employees: As high losses could indicate a lack of demand for the company's products, employees may feel that their jobs are in jeopardy, and might seek alternative employment. On the other hand, if the company's corporate spirit is strong, employees may react by being more productive, in the hope of restoring the company to its former profitable position. The Johannesburg Securities Exchange: The Johannesburg Securities Exchange is likely to react to the reported losses by a fall in the share price of the company. However, if the investors in the market consider that the high losses are either temporary, or have been created artificially through the use of particular accounting policies, the market may ignore this information. As a result, the price may remain steady in anticipation of the fact that the company will do better in the future.
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2.7 In this question, any appropriate decision may be highlighted. Below is the typical process followed. Assume the item under consideration is a compact disk player. One would make predictions about questions such as whether the equipment is likely to last for an adequate length of time, whether the sound production will meet the quality standards which you have set yourself, whether you are likely to make frequent use of the item, and so on. No decision was essential to making any of those predictions. However, predictions would have been essential in order to make the decisions to purchase the item.
2.8 Value is an economic term and measures the satisfaction anticipated from the acquisition of something. It can be abstractly measured in “utiles”, so that economists tend to use the term “utility” as an expression of how much value is embodied in an item. The price on the other hand is what is being asked by the seller in exchange for the commodity in question. Items have different values depending on the circumstances. For example, we could consider the price of a can of ice cold Coke. If we assume it is R5, then clearly the buyer, who has a choice, will only part with the R5 in exchange for the coke, if the utility (or value) is in his or her mind greater than the cost (price) of R5. A Coke has much greater value to the purchaser under certain conditions, for example on a very hot day when a buyer would be prepared to pay more than the price of R5, or if someone was dying of thirst in the desert, the value would probably be everything they own. This principle is extended to the purchase of shares. The potential buyer places a value on the share (what they think it is worth, taking all considerations into account) and then finds out the price. If the price is lower than the value to the investor, they will purchase the share, if not they will seek another investment which offer value which is at least equivalent to the price. In a free market system, if the market is operating efficiently, then price and value are very closely aligned.
2.9 1) The student who paid R300 for a ticket to the cup final obviously has a dire need to attend such a sporting event. Such a student is unlikely to be one who is short of funds. However, whatever his financial position may be, he has decided that the cost of the ticket of R300 is well worth the benefit which he or she will derive from attending the cup final. 2) The statement that a more expensive TV will last longer is based on the assumption that price is a measure of value. While this is very often true, it may not always hold. The more expensive TV may be more highly priced as a result of inefficiencies in the factory which produced it, causing cost escalation, whereas another factory may have been able to produce a TV of the same standard at a lower cost. 3) This statement gives no indication of value, but merely of an increase in price levels .In general, an increase in prices is accompanied by an increase in income levels. It is quite likely that the 50 cents paid for a movie ticket in the old days was about the same proportion of disposable income being received by the complainant as is the R30 which he may be paying at present. The statement provides no indication of value. 4) A new car is likely to cost more in two years' time because of the effects of inflation. Once again, however, income levels generally will have risen in proportion to the price of the new car. It is therefore not correct to believe that buying the car at the present time will mean a smaller exchange of real value than buying it in two years' time 5) The sale of a Mercedes Benz bought new for R15 200 for a so-called profit of R9 300 is an illusion. General price level increases will have accounted for the bulk of the difference between the R15 200 and the R24 500. The cost of replacing the Mercedes Benz new is likely to be well over R30 000, possibly closer to R90 000.Thus the purchaser of a four year old vehicle for R24 500 will receive reasonable value, even though this price is higher than the original cost of the vehicle. (Wow – if only one could by a new Mercedes for that price) 6) Choosing to go to Durban by bus rather than by flying is an indication that the value to the person of the trip to Durban is less than the price of, say R2 000, for an air ticket. The student, by choosing to go by bus, is indicating that the value received from the trip at a cost of, say R300, is greater than that cost. There is an additional cost involved, which cannot be quantified, namely the discomfort and time taken for a bus trip as compared to an air trip. The price that a person is prepared to pay for this cost would determine its value.
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2.10 The following are possible categories of assets: Land Buildings Machinery and equipment Motor vehicles Furniture Crockery and cutlery Investments Debtors Cash at the bank Inventory of consumables The following are possible categories of liabilities: Creditors Long-term loans Bank overdraft
2.11 Returns on investments (1)
Fixed Deposit ROI
= =
R900 / R7 500 X 100 12%
In terms of the Income Tax Act, the first R2000 of interest earned is tax free. If the interest is subject to tax in the hands of the investor the ROI will be R900 (1-.3) / R7 500 X 100 = 8.4% (2)
Sole Proprietor The profits which are earned by a sole proprietorship are taxable in the hands of the owner. ROI = R21 000 (1-.3) / R100 000 X 100 = 14.7% Close Corporation ROI (20% membership)
= R30 000 / R50 000 = 60% Although no distribution of profits has been made, the profits, which have been reinvested in the business represent a return on the original investment. As the CC has already been subjected to tax, no tax is payable in the hands of the member, regardless of whether the profits have been distributed or not. (4)
Fund Manager: Investment in shares (Return calculated per share) ROI = [(1.30 + {19.80 –17.50})]/ 17.50 = 20.6% The shareholder has earned a capital gain of R2.30 (the market price after one year of R19.80, less the cost price of R17.50). Both the potential capital gain of R230 per share and the dividends received of R1.30 comprise a return on holding the share.
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2.12 Jack Paton: a potential investor The required rate of return on an investment may be considered to be a function of three main components. If the investment has no risk (only government securities fall into this category) and if there is no inflation (a situation which has not existed for at least 40 years), the only consideration would be the reward which Jack requires for foregoing the present use of his funds and allowing someone else to use them. This charge has been calculated historically to be between 2% and 3% of the funds invested for each year. If inflation is present in the economy, the lender expects to be reimbursed for the loss of purchasing power of the money invested from the time of investment to the time of repayment. So for example if R1 000 is invested at a time when inflation is averaging 15% per year an amount of R1 150 must be repaid at the end of the year merely to compensate for the fact that R1 150 is needed at the end of the year to buy the same quantity of goods and services which could have been purchased at the beginning of the year for R1 000. Finally, the risk of the investment must be considered. The calculation of the premium to be demanded by an investor for the possibility of not receiving a return on his capital or, in more serious cases, a return of his capital, assumes that investors do not place all their funds into a single investment, that is, they diversify. A very simple (and not rigorous) explanation of this principle would be to assume that the investor is considering placing his funds into the type of investment, which based on past records, indicates that one out of every twenty such investments has failed. If the investor places R5 into each of the twenty investments, the return from the nineteen which succeed must be adequate to reimburse the investor for the loss of both capital and revenue from the one failed investment. As he cannot know in advance which of the twenty investments will fail, a premium should be added to all twenty. To summarize Jake needs to estimate the following three components: Time value (reward for letting someone else use the money). Historically estimated at Inflation (compensation for loss of purchasing power of capital). Say it is currently estimated at Risk (compensation for possible loss of revenue and/ or capital from investments in the portfolio which may fail. This depends on the riskiness. A moderate risk would be REQUIRED RATE OF RETURN
3% 8%
10% 21%
Jake will estimate (using prediction skills and techniques) the income expected from the investment. The future cash flows (income) will then be discounted at the required rate of return of 28% in order to arrive at the present value of the investment. The value (calculated using estimates of cash flows and the required rate of return) will be compared to the price of the investment (the amount to be paid now to gain entitlement to the future estimated cash flows). It the price is lower than the calculated value, Jake should invest.
2.13 CLIENT ADVICE Required rates of return for the investment alternatives may be calculated or estimated as follows: (1)
Government Bonds offer a risk free rate of whatever the coupon rate is on the bond which is purchased. The question does not indicate the coupon rate, but the yield to maturity of 10.2%. If for example the coupon rate is 8%, the bonds will be selling at less than their nominal value. If interest rates in the market change, the value of the bond will change, so in that respect there is risk. If we assume that the current coupon rate of Government Bonds about to be issued is around 10%, then this may be used as the risk free rate..
(2)
Fixed deposit: There is only a very low possibility that a reputable building society will default on its agreed interest rate or on the return of capital. As a result the risk premium will be slightly higher than the Government Bond, One would therefore expect the Fixed Deposit to offer a return of say 12%.
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(3)
Share in Wooltru (now listed under Cyclical Services – General Retailers). The shares of this holding company are dependant upon the performance of two main groups of retailers, namely Woolworths and Truworths. This in turn is influenced by the general economy. Both groups have traditionally performed well and are not considered highly risky. A premium of around 9% may be considered adequate, thus resulting in an expected return of around 19%.
(4)
Given a risk free rate of around 10%, the other component of a required rate of return, namely the risk attached to a specific company in the gold mining industry, will have to be established. At the time of writing, the prospects for gold mines are uncertain and there is little reason to believe that this uncertainty will diminish in the near future. However, at the time of addressing this question, which is presumed to be the time of investing, new information may have been placed in the public domain that indicates a brighter future for the gold industry. An increase in the price of gold would reflect this optimism. A risk premium of 10%-15% would accordingly not be inappropriate. One would therefore consider investing in the shares of Afrikander Lease if a return of between 20% to 25% could be expected.
(5)
The purchase of a general equity unit trusts means that Coronation, receiving funds from many clients, will invest on their behalf across a broad spectrum of shares on the JSE. While some individual shares may perform poorly, others will perform well, and the return will be the average of these shares in which Coronation has invested in its portfolio. The risk premium required for the market as a whole is presently in the region of 12%, so a required return of approximately 22%, may be considered reasonable.
2.14 Types of reported income a)
The types of income which are most frequently reported are: Operating income. This is income which has been generated from the usual business activities of a company, typically the sale of goods or the provision of services. It may also include income received in the form of rentals or interest, if a company has entered into such transactions during the year. Extraordinary and/or Abnormal income. This results from events which occur neither regularly nor frequently, which are outside the normal scope of business operations. Under inflationary conditions, a further form of "income" may be created, which does not reflect a change in value, but only reflects the instability of the measuring monetary unit. Such income is referred to as a "holding gain"; it results not from an activity or event, but from holding a particular asset during a period of inflation. Any reported income thus comprises: a holding gain (which may have resulted in an asset being revalued); operating income, and/or extraordinary/abnormal income A distinction may also be drawn between income which has been realized and that which has not. So, for example, a realized holding gain would exist if the asset which has increased in measured value (but not in real value) has been sold and the original amount plus the holding gain have been realized. A holding gain would be unrealized if the asset which increased in measured value has not been sold.
b)
Users of information are constantly attempting to predict the most likely future cash flows, using past performance. Income earned is a good indicator of future cash flows, but only to the extent that it is likely to be repeated. Extraordinary income, while constituting a valid source of income in the year in which it is earned, cannot be expected to recur in future years. It should thus be ignored for the purpose of estimating future performance. To the extent that holding gains occur, they should be recognised as being the effect of inflation and not of efficient trading operations.
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2.15 Return to Shareholder Increase in shareholder wealth
=
Dividend of R5 plus the Capital Gain of R4 (R27 – R23)
% Return to shareholder
=
(9 / 23) x 100
=
39%
2.16 Types of Information provided to shareholders Financial Performance of the business. This is provided in the Income Statement which details the Revenue of the company received from its operations, less operational costs and any other income or expenses such as interest, tax, and abnormal items. It is time specific and relates to a period of time, usually the financial year
Financial Position of the business. This is provided in the Balance Sheet, which details the Assets, Liabilities and Equity of the business. These three major categories are often subdivided into further categories and may in addition, include further details in the notes provided. It is a statement at a moment in time, usually the last day of the financial year.
Movement of cash for the year. This is reported in the Cash Flow Statement for the year. It is usually divided into cash flows from operations (the activities of the business), investments (the acquisition and disposal of assets) and financing (the raising and repayment of capital).
2.17 Historic Cost reporting of a fixed asset
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Cost Residual Value Depreciable Amount
= = =
R500 000 R100 000 R400 000
Annual Depreciation
=
R400 000 / 4
= R100 000
Depreciation written off after 3 years =
R100 000 x 3
= R300 000
Book value at the end of 3 years
R500 000 – R300 000
= R200 000
=
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2.18 Alternative Valuation and Reporting Methods (a)
Historic cost asset value Cost Accumulated Depreciation Book value
Land 900,000 0 900,000
Non Current Assets (the Company) Calculation For Acc Dep (b)
1,212,000 R780 000 - (R780 000 / 5 x 3)
Replacement Cost Valuation Accumulated Depreciation Book value Non Current Assets (the Company) Calculation for Replacement Cost Land: no Depreciation Equipment: Cost of New Equip Equipment Replacement Cost
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Equipment 780,000 468,000 312,000
Land 1,449,459 0 1,449,459
Equipment 982,575 589,545 393,030 1,842,489
R900 000 x (1.10)5 R982 575 x (1.08)3 R982 575 - (R982 575 / 5 x 3)
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2.19 BALISTIC LTD (a)
Balistic Ltd Balance Sheet on 30 June 20.5 NON CURRENT ASSETS Buildings IT Equipment Machinery Vehicles INVESTMENTS Investment in subsidiary CURRENT ASSETS Inventory Accounts Receivable Cash in bank
1,165,400 850,000 35,400 90,000 190,000
ORDINARY SHAREHOLDERS Ordinary share capital Retained income
LONG TERM LIABILITIES Long term loan 67,100 Mortgage loan (10 years) 67,100 CURRENT LIABILITIES 682,600 Accounts Payable 450,000 Bank Overdraft 145,600 Dividends payable 87,000 Short term loans from banks
1,915,100 b)
875,600 300,000 575,600 1,000,000 800,000 200,000 39,500 23,000 7,300 2,500 6,700 1,915,100
If there are 400 000 shares in issue then from the Balance Sheet it appears that their original issue price was 75 cents per share (R300 000 / 400 000). The net asset value per share is equal to R2.19 (R875 600 / 400 000)
2.20 METEOR LIMITED Meteor Ltd Balance Sheet on 28 February 20.3 NON CURRENT ASSETS Buildings IT Equipment Machinery Vehicles INVESTMENTS Investment in subsidiary CURRENT ASSETS Inventory Accounts Receivable Cash in bank
1,195,700 345,000 76,300 123,500 650,900
LONG TERM LIABILITIES Long term loan 32,780 Mortgage loan (10 years) 32,780 CURRENT LIABILITIES 415,150 Accounts Payable 345,900 Bank Overdraft 56,900 Dividends payable 12,350 Short term loans from banks
1,643,630
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ORDINARY SHAREHOLDERS Ordinary share capital Retained income
865,600 140,000 725,600 495,680 350,000 145,680 282,350 78,900 124,500 1,900 77,050 1,643,630
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(b)
Meteor Ltd Balance Sheet at 28 February 20.3 EQUITY AND LIABILITIES SHAREHOLDERS EQUITY 865,600 Ordinary share capital 140,000 Retained income 725,600 LONG TERM LIABILITIES Long term loan Mortgage loan (10 years)
495,680 350,000 145,680
CURRENT LIABILITIES Accounts Payable Bank Overdraft Dividends payable Short term loans from banks
282,350 78,900 124,500 1,900 77,050 1,643,630
ASSETS NON CURRENT ASSETS Buildings IT Equipment Machinery Vehicles
1,195,700 345,000 76,300 123,500 650,900
INVESTMENTS Investment in subsidiary CURRENT ASSETS Inventory Accounts Receivable Cash in bank
32,780 32,780 415,150 345,900 56,900 12,350 1,643,630
(c) Total Assets Total Liabilities Shareholders Equity Net asset value per share (100 000 shares)
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= = = =
R1 643 360 R778 030 R865 600 R8.66
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2.21 VERTIKALE LTD (a)
BALANCE SHEET OF VERTIKALE LTD AT 30 JUNE
EQUITY AND LIABILITIES SHAREHOLDERS’ EQUITY Ordinary share capital Retained income LONG-TERM LIABILITIES Secured loans Unsecured loans
20.5
20.4
245,889 27,035 218,854 191,565 8,205 183,360
235,966 27,035 208,931 143,717 6,540 137,177
437,454 379,682 ASSETS NON CURRENT ASSETS Premises Equipment Motor vehicles Plant and machinery
94,871 24,225 18,129 7,685 44,832
84,596 24,512 17,657 7,085 35,343
INVESTMENTS
60,173
44,255
WORKING CAPITAL
282,411 250,832
CURRENT ASSETS Inventory Debtors Cash resources
610,907 567,056 330,417 308,873 260,384 234,053 20,106 24,131
LESS CURRENT LIABILITIES Short-term loans Creditors Overdrafts Shareholders dividends
328,496 316,224 29,294 19,829 296,690 265,370 1,250 24,905 1,263 6,122 437,454 379,682
Note there is a slight variation in the Balance Sheet format, showing the Working Capital as Current Assets less Current Liabilities – a format sometimes used in practice, but not specifically requested in the question (b) The Retained Income is the balancing figure for each of the two years. As calculated above at R208 931 for 20.4 and R218 854 for 20.5 (c) Total Assest Total Liabilities Shareholders Equit Number of shares Net asset value per share (50 000 shares)
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20.5 20.4 765,950 695,906 520,061 459,941 245,889 235,966 50,000 50,000 R 4.92 R 4.72
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2.22 MADJUID LTD (a)]
INCOME STATEMENT OF MAKJUID LTD FOR THE YEAR ENDED 30 JUNE Sales Less cost of sales Gross profit Operating expenses Profit before interest and tax Net finance charges Profit before tax Taxation Net profit after tax
20.5 245,800 122,900 122,900 47,600 75,300 2,340 72,960 20,000 52,960
20.4 189,000 75,600 113,400 45,670 67,730 1,890 65,840 20,000 45,840
(b)
STATEMENT OF CHANGES IN EQUITY OF MADJUID LTD FOR THE YEAR ENDED 30 JUNE
Net profit after tax Dividends to shareholders Retained profit for the year Retained income: Beginning Retained income: End
20.5 52,960 20,000 32,960 371,440 404,400
20.4 45,840 20,000 25,840 345,600 371,440
Shares in issue Earnings per share in cents Dividends per share in cents
20.5 200,000 26.5 10.0
20.4 200,000 22.9 10.0
(c)
Note: The question was deficient in that it did not state the number of shares in issue. As in all situations like this (both in theory and practice), make an assumption and continue based on that assumption. The suggested solution above has assumed 200 000 shares in issue.
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