October 2012 Q19 Part (i)

[Darragh Kelly]

Hi,

Just a question on part (i) of Q19 from 2012 paper.

From chapter 12 of the acted notes, section 1.2 deals with consolidated statements of financial position.

When combining financial statements, specifically the balance sheet, page 5 of chapter 12 highights issues regarding double counting entries.

For part (i) or Q19 when calculating the new ROCE employed figure after aqusition, the equity / capital employ is summed for Dayton and Echo/Foxton ie the share capital is doubled up which is not advised in the acted notes? For example ROCE for Dayton and Echo combined = (55+130/393 + 722)*100 = 17%?

This issue regarding entries being doubled up is touched on further down in the solution regarding the new gearing ratios (highlighted red below):

Both Echo and Foxton have lower gearing ratios than Dayton. Unfortunately both will be forced to cancel preacquisition equity if they are consolidated and so both will simply add liabilities to Dayton’s statement of financial position.Thus, in the short term, Dayton’s gearing will increase even further. In the longer term, Foxton can generate £140m × 33% = £46.2m of profit every year and Echo £250m × 22% = £55m and so both will start to accrue retained earnings for the group, thereby diminishing gearing.

To me that should be done with the ROCE calculation when combining the companies financial statements?

Seperately, I'm not sure why the solution touches on the profit in relating to gearing?The approach I would have taken for the gearing is to recalculate the combined new gearing as you have the gearing ratios, and level of equity so it's easy to work out the borrowings? And then just commented on which aquistion increasing overall gearing of Dayton more by?

Finally from acted notes, page 5 of chapter 12 actually states creating consolidated financial statements is no longer part of the syllabus so do I need to even practice this question?

Thanks very much,

Darragh

 

[Lynn Birchall]

Hi Darragh

For the ROCE I agree with you. The examiners report tries to estimate the ROCE impact, but there are some (unstated) big assumptions/simplifications going on in arriving at those estimates.

In relation to the gearing, you write 'The approach I would have taken for the gearing is to recalculate the combined new gearing as you have the gearing ratios, and level of equity so it's easy to work out the borrowings'. I may be missing something here (apologies if so) but I can't see that we have the levels of equity? Even if we do, we'd still have to make some assumptions (eg that Dayton doesn't have to borrow more in order to finance the acquisition).

You're correct that creating consolidated financial statements is no longer on the syllabus. However, I wouldn't say that this question is ruled out as a result. Understanding the purpose of consolidated accounts is still on the syllabus and arguably this question is more about the understanding than the actual construction. In fact part (i) is possibly as much about understanding ratios and (ii) about the purpose of financial statements more generally. There is though certainly less material in the Core Reading now about goodwill (part (iii)) than there was when this question appeared in 2012.

All the best
Lynn

 

[Darragh Kelly]

Hi Lynn,

Thanks firstly for the detailed reponse.

So if you made the assumption that equity was being summed to consolidate the accounts then it was an OK assumption as it's the best we can do given the information at hand (even though acted notes / core reading do not recommend this?) ie we don't have breakdown of equity to exlcude adding share capital?

On the gearing I was saying if we capital employed (equity + borrowings) derieved from the profit figure and ROCE ratio, for each company, we can then use formula gearing = borrowings / equity to calculate the borrowings for each company. The we can add/consolidate to get total borrowings (assuming no further borrowings to finance acquisition as you said). I guess though we still have the issue of not being able to cancel out share capital as there is no break down of the equity for each company ie share capital, reserves, retained profits, as we need to cancel out the share capital relationship? So in short it is not easy to calculate the revised gearing.

Not sure what the examiners solution means though, see below:

Thus, in the short term, Dayton’s gearing will increase even further. In the longer term, Foxton can generate £140m × 33% = £46.2m of profit every year and Echo £250m × 22% = £55m and so both will start to accrue retained earnings for the group, thereby diminishing gearing.


Hope that's clear.

Thanks for your help.

Darragh

 

[Lynn Birchall]

Hi Darragh

So if you made the assumption that equity was being summed to consolidate the accounts then it was an OK assumption as it's the best we can do given the information at hand (even though acted notes / core reading do not recommend this?) ie we don't have breakdown of equity to exlcude adding share capital?
That seems to be the approach the examiners were happy to take.

On the gearing ... So in short it is not easy to calculate the revised gearing.
Agreed!

Not sure what the examiners solution means though, see below:
Thus, in the short term, Dayton’s gearing will increase even further. In the longer term, Foxton can generate £140m × 33% = £46.2m of profit every year and Echo £250m × 22% = £55m and so both will start to accrue retained earnings for the group, thereby diminishing gearing.

In the short term, cancelling equity (to remove double counting) will reduce the amount of equity, so increase gearing. Longer term, as higher profits start to be made, presumably they won't all be paid out immediately as dividends. So those higher future retained earnings will then lead to higher equity in future (so reducing gearing).

Hope that helps
Lynn