INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION

26 September 2013 (pm)

Subject CT2 – Finance and Financial Reporting

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 20 questions. From question 11 onwards begin your answer to each
question on a separate sheet.

5. Candidates should show calculations where this is appropriate.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.

CT2 S2013 © Institute and Faculty of Actuaries

For questions 1–10 indicate in your answer book which one of the answers A, B, C or D is
correct.

1 An Australian trader is due to receive a substantial receipt in Euros in three months’

time. Which of the following best explains why the trader might use a currency
option rather than a currency future to hedge this transaction?

A The value of currency futures can be highly volatile.

B The counterparty to a financial future might default and leave the position
exposed.

C An option will provide scope for an upside if the Euro strengthens.

D An option will provide scope for an upside if the Euro weakens.

[2]

2 Which of the following is an unsystematic (specific) risk?

A Interest rates may change.

B Company directors may make bad decisions.
C Consumer demand can be affected by global economic cycles.
D Basic commodity prices can change.
[2]

3 A company has a policy of investing in projects on the basis of their internal rate of
return (IRR). Which of the following is a drawback of using IRR?

A Positive net present value projects may be rejected.

B High yield investment opportunities may be overlooked.

C IRR is more difficult to interpret than Net Present Value (NPV).

D Ranking mutually exclusive projects on the basis of IRR may give misleading
results.
[2]

CT2 S2013–2
4 Which of the following best illustrates an opportunity cost?

A Accepting a project with a negative net present value.

B Rejecting a project with a positive net present value because of funding

constraints.

C Understating the projected return on a potentially positive net present value

project in order to adjust for risk.

D Rejecting a project with a positive net present value because it has been
decided to invest the available funds in a different project.
[2]

5 Use the following information to calculate return on capital employed.

Profit before interest and tax £40m

Interest £8m
Ordinary shares £110m
Retained earnings £300m
Revaluation reserve £22m
Long term borrowings £90m

A 6.1%
B 6.4%
C 7.7%
D 8.0%
[2]

6 What is the most realistic interpretation of a low interest cover ratio in a highly cash
generative business?

A Any fluctuation in operating profit will lead to a greater fluctuation in earnings

per share.

B The company may be unable to meet its loan repayments.

C The company may be unable to pay its interest.

D The company may be in breach of its debt covenants.

[2]

CT2 S2013–3 PLEASE TURN OVER

7 What is the difference between profit and comprehensive income?

A Profit is calculated in accordance with International Financial Reporting

Standards (IFRS) and comprehensive income is not.

B Comprehensive income covers a longer period than profit.

C Profit must be disclosed but comprehensive income need not.

D Comprehensive income includes unrealised gains that are excluded from

profit.
[2]

8 An external auditor cannot conduct an adequate audit because the directors have
withheld a significant amount of vital audit evidence. What form of external audit
report would be appropriate in these circumstances?

A Adverse opinion
B Disclaimer of opinion
C Emphasis of matter
D Except for opinion
[2]

9 Which of the following best summarises the difference between straight line and
reducing balance depreciation?

A Reducing balance will lead to a higher charge in the short term after fresh
investment in assets and a higher total charge over the life of the assets.

B Reducing balance will lead to a lower charge in the short term after fresh
investment in assets and a higher total charge over the life of the assets.

C Reducing balance will lead to a higher charge in the short term after fresh
investment in assets but the same total charge over the life of the assets.

D Reducing balance will lead to a higher charge in the short term after fresh
investment in assets but a lower total charge over the life of the assets.
[2]

10 Who makes the final decision as to whether International Financial Reporting

Standards are used as the basis for accounting in any given country?

A The International Accounting Standards Board (IASB)

B The national government
C Professional accountancy bodies
D The national stock exchange
[2]

CT2 S2013–4
11 Describe the advantages of establishing a business as a limited liability partnership
rather than a traditional partnership. [5]

12 A quoted company has a policy of making relatively small dividend payments, with
profits being reinvested in the business. A period of slow growth in the industry has
left the company with a substantial cash surplus as a result of this policy.

Discuss the advantages to the company and shareholders of reducing this surplus by
means of a share buyback rather than a dividend payment. [5]

13 An investor has a policy of investing in a number of companies only in the oil and gas
industry. She believes that she knows this sector well and that her portfolio has been
well diversified internationally.

Discuss the logic of the investor’s investment strategy. [5]

14 Discuss the difficulties associated with charging tax on “fringe benefits” to

employees. (“Fringe benefits” can be thought of as non-monetary rewards – they
exclude wages and salaries.) [5]

15 A quoted company’s chief engineer has identified an opportunity to develop a project

that will offer a huge competitive advantage. Even a conservative estimate of net
present value shows that this is likely to be a successful investment. The directors
have advised the engineer that they will not proceed with the project because it will be
difficult to explain to the shareholders. The technology is simply too difficult to
understand and there will be a five year development phase.

Discuss the logic of the directors’ position with respect to this project. [5]

16 Discuss the assertion that the cash flow statement is unnecessary because it is easy to
see whether the closing bank balance is higher or lower than the opening bank
balance. [5]

17 A famous accounting scandal involved a company’s decision to recognise the

premiums from the sale of holiday insurance contracts when the contracts were sold,
rather than waiting until after the customer’s safe return from holiday (which was the
normal practice followed by other companies). There were no specific accounting
standards to deal with this matter.

Discuss the issues associated with recognising the profit from the sale of travel
insurance in this way in terms of accounting concepts. [5]

CT2 S2013–5 PLEASE TURN OVER

18 Alpha is reviewing bids for the construction of a major civil engineering project. One
of the shortlisted bidders is Global (Midlands) PLC (“Global”). Alpha is concerned
that Global may not have the necessary financial resources to complete this project
and has asked for reassurance. Global’s response is that the company is part of the
Mega Group, whose parent company is quoted and is based in Alpha’s home country.
Global has submitted the Mega Group’s latest consolidated financial statements to
demonstrate the solvency of the group.

Discuss the extent to which Alpha should rely on the Mega Group’s consolidated
financial statements in determining Global’s ability to service this contract. [5]

19 Paul has developed and patented a new product. He requires finance in order to put
the product into production. A venture capital company has offered to finance Paul
on the basis that Paul will incorporate his business as a limited company. The venture
capitalist will provide all of the funding necessary to commence the manufacture and
sale of the new product in return for 51% of the equity in this new company. The
venture capitalist will appoint a board member and Paul will also be a director of the
company. Paul will sign a five year employment contract with the company.

Paul’s role with the company will be to work on improvements to the original product
and to develop new products for sale by the company. In addition to working full-
time as an employee, he must patent any new ideas in the company’s name.

The company will be independently valued at the end of its first five years. The
venture capitalist will then offer Paul the opportunity to buy its 51% holding for that
proportion of the independent valuation plus 20%. If Paul does not take that offer
then the venture capital company will retain its shareholding and the question of
Paul’s contract will be reviewed by both sides.

(i) Discuss the benefits of this arrangement to both Paul and the venture
capitalist. [10]

(ii) Discuss the difficulties associated with the valuation of the company’s shares
at the end of year five. [5]

(iii) Recommend the approach that should be taken to valuing the company at the
end of year five. [5]
[Total 20]

CT2 S2013–6
20 Trent makes signs and banners for use in decorating venues for wedding receptions
and parties. Until recently, most of Trent’s sales were to private individuals who paid
for their purchases in cash or by credit card. During June 2013, Trent started to sell
its products to a major event planning company, who now buy their signage and
banners from Trent and who insist on trading on credit terms.

Trent’s directors are delighted at the massive expansion in sales, but they are starting
to become concerned about the impact on liquidity. The following information has
been extracted from the company’s monthly management accounts:

June 2013 July 2013 August 2013

£ £ £
Sales revenue
Credit sales to event company 400,000 850,000 1,213,000
Credit card sales 240,000 250,000 270,000
Cash sales 50,000 60,000 70,000
Total 690,000 1,160,000 1,553,000

Cost of sales 414,000 696,000 931,800

Inventory 358,800 583,742 781,510

Trade receivable from event company 200,000 765,000 1,273,000
Trade receivable from credit card
company 360,000 395,161 461,613
Bank 18,423
937,223 1,743,903 2,516,123

Trade payables 621,000 898,065 1,052,032

Bank 65,616 62,667
621,000 963,680 1,114,699

(i) Analyse Trent’s liquidity over the period covered by the extracts from the
management accounts. [12]

(ii) Recommend a suitable course of action for the management of Trent’s

liquidity. [8]
[Total 20]

END OF PAPER

CT2 S2013–7
INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS’ REPORT
September 2013 examinations

Subject CT2 – Finance and Financial Reporting

Core Technical

Introduction

The Examiners’ Report is written by the Principal Examiner with the aim of helping
candidates, both those who are sitting the examination for the first time and using past papers
as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The
Examiners have access to the Core Reading, which is designed to interpret the syllabus, and
will generally base questions around it but are not required to examine the content of Core
Reading specifically or exclusively.

For numerical questions the Examiners’ preferred approach to the solution is reproduced in
this report; other valid approaches are given appropriate credit. For essay-style questions,
particularly the open-ended questions in the later subjects, the report may contain more points
than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that
the examination was set. Candidates should take into account the possibility that
circumstances may have changed if using these reports for revision.

D C Bowie
Chairman of the Board of Examiners

December 2013

 Institute and Faculty of Actuaries

Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

General comments on Subject CT2

This paper examines basic finance including raising funds by a variety of methods, taxation,
net present value and project appraisal and other topics, it has both calculations and essay
type questions on these topics. The paper also examines financial reporting including
preparation of the main financial statements and interpretation of financial statements it also
considers the basis of the preparation of statements and the information needs of a variety of
end users of financial statements.

Different numerical answers may be obtained to those shown in these solutions depending on
whether figures obtained from tables or from calculators are used in the calculations but
candidates are not penalised for this. However, candidates may be penalised where excessive
rounding has been used or where insufficient working is shown.

Comments on the September 2013 paper

The general performance was similar to results in the past, well-prepared candidates scored
well across the whole paper. As in previous diets, overseas candidates did not perform quite
so well as UK candidates. The comments that follow the questions concentrate on areas
where candidates could have improved their performance. Candidates approaching the
subject for the first time are advised to include these areas in their revision. The main
problems were Q19 and 20, although many candidates scored high marks in all questions.

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Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

1 C
2 B
3 D
4 D
5 C
6 A
7 D
8 B
9 C
10 B

Workings for Question 5

A = (40  8)/(200 + 300 + 22) = 6.1%

B = (40  8)/(200 + 300) = 6.4%
C = 40/(200 + 300 + 22) = 7.7%
D = 40/(200 + 300) = 8.0%

Questions 1–10 were done well by most candidates.

11 The LLP structure protects the members from claims against their personal wealth.
The LLP is a separate legal entity and its creditors cannot pursue the partners if the
LLP’s assets prove insufficient. That is a significant advantage because the partners in
a traditional partnership are jointly and severally liable in a personal capacity. The
actions of one partner could impose enormous personal liabilities on all of the others.
The only real exception is when an individual partner behaves recklessly or
dishonestly. In that case he or she may be personally liable to compensate any injured
party.

This question was done well by most candidates.

12 Dividend policies tend to attract shareholders on the basis of their tax preferences. A
company that pays little or no dividends will attract shareholders who prefer to
receive capital gains. A share buyback would possibly leave the shareholders open to
a claim for capital gains tax, but the funds released would not be income. There is a
further issue with respect to signalling. The buyback does not imply that future
dividends will be increased and so there is no question of misleading and
inconvenient signals being sent to the shareholders.

This question was done reasonably well by most candidates.

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Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

13 The investor’s portfolio is not properly diversified. The capital markets do not offer
any return for accepting unsystematic risks because they can be diversified away. This
investor has accepted the risks borne by the oil and gas industry, but there will be no
benefit in the form of a higher return for this risk. The portfolio offers some
geographical diversification, but even that will be restricted to the countries that have
quoted oil or gas companies. This policy is only sound if she can genuinely identify
mispriced securities in this industry. Such an investment strategy is speculative.

There were some very good answers by candidates to this question.

14 One problem is in determining a value for those benefits. In some cases that could be
linked to the costs involved. For example, providing access to a company gym could
be viewed as a fringe benefit, but it will be very difficult to measure the value
obtained. This can lead to complicated arrangements, such as those relating to the
personal use of company cars in the UK, where records have to be maintained and the
tax authorities have to dictate the basis upon which the benefit should be provided.

There will be compliance problems because it may be difficult to maintain adequate

records of all of the benefits enjoyed by each of the employees.

There may also be motivational issues, if employees do not perceive the full value of
the benefit, but do see a cost in the form of a higher tax charge.

This question was not done very well by some candidates. In general candidates found it
difficult to write more than a short sentence or two. Benefits in kind are an important part of
the tax system.

15 Strictly speaking, the acceptance of a positive NPV project should increase the share
price. That will only be the case if the acceptance of the project is known and
understood and the shareholders agree with the directors’ evaluation. The company
may not wish to furnish the markets with details of this project for fear of attracting
competition. If the directors make an unsupported statement that profits are expected
to rise then the shareholders may dismiss that as self-serving disclosure by the board.
The decline in profits and cash flows in the short term will be observable and those
may affect the share price.

This question was answered well by many candidates. The link between positive NPV, share
price and the problems of disclosure was discussed reasonably well.

16 The comparison of the opening and closing balances can reveal a net cash inflow or
outflow, but cannot show the reasons for that change. A cash flow statement provides
the reader with details of the extent to which the operating activities are generating (or
consuming) cash. The cash flow statement also shows the other cash flows, broken
down into relevant categories. Thus, the cash flow statement can highlight the fact
that a net cash inflow occurred because the company has raised fresh borrowings. The
statement can also show how that cash inflow was applied. The cash flow statement

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Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

makes it easier to reveal whether the net movement was attributable to the working
out of a business strategy (e.g. the deliberate investment of surplus cash) or the first
sign of a problem (e.g. cash flow problems).

This question was answered very well.

17 The basic problem with this case is the decision as to when a profit has been earned.
The realisation concept would suggest that the sale of a policy is a significant part of
recognition. The company would not sell insurance if doing so was unprofitable.
Prudence would suggest that no profit be recognised on an insurance contract until
such time as the company knows whether or not there will be a claim, which is likely
to be shortly after the customer’s safe return. The accruals concept suggests that it
would be ideal if the costs could be recognised in the same period as the revenue. The
easiest way to do that would be to wait until after the date of travel. It could be
possible to estimate the costs of potential claims and create a provision at the time of
sale. The money measurement concept would make that feasible if the estimate was
deemed to be reasonably accurate.

This question was answered reasonably well by many candidates.

18 Groups of companies are not legal entities as such and so it is impossible to have a
direct relationship with a group. Alpha’s relationship will be with one group member,
Global. Alpha cannot take it for granted that Mega will support Global in the event
that it runs into difficulties and finds itself incapable of meeting its commitments. It
may be of some comfort to know that Global is part of a large group because it may
not be in Mega’s interest to permit Global to fail. If Alpha really intends to rely on
that possibility then it should seek written assurances that Mega will guarantee
Global’s future.

This question was not answered as well as expected.

19 (i) Paul will have the advantage of equity finance. The venture capitalist cannot
demand repayment in the event of short-lived cash flow problems. Paul may
also be able to request further financial support from the venture capitalist in
the event of any unforeseen contingencies. The venture capitalist has an
incentive to support the business because of the prospect of the capital gain in
the event of it being a success.

Paul will also benefit from the provision of an experienced director, who will
provide advice to the business while it is growing. That will leave Paul free to
work on developing and marketing the product.

The venture capitalist has the opportunity to make a substantial return if this
product proves a success. The cost of acquiring this right is linked to the cost
of setting up initial manufacturing and so it may not reflect the full value of
the product’s patent.

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Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

Paul will be committed to this business, partly because of the contract and
partly because of the right to buy back the equity. The venture capitalist would
probably find it difficult to attract such an entrepreneur without offering an
equity stake in this manner.

This is a risky investment, but the downside is restricted to the initial

investment and there is a very substantial upside.

This question was answered very badly by several candidates. A lack of knowledge of this
subject area was demonstrated.

(ii) Both parties will be at odds with one another over the valuation. Both will
wish to influence the independent valuer, who will have to draw upon
internally generated information and reports in order to undertake this
valuation exercise.

Paul may indulge in dysfunctional behaviour in order to lower the valuation in

the lead-up to the valuation date. New products in development may not be
revealed or may be made to look unprofitable.

The basic problem is that there will be no independent basis for the valuation
of the company. The lack of a market price means that the valuation exercise
will be highly subjective. There are likely to be a variety of different valuation
models and each will provide a different figure.

This part was done reasonably well.

(iii) One approach would be to identify one or more quoted companies that are
innovators in product design in the same area as this business. These
companies’ price/earnings ratios will be a matter of record. The business’
latest reported profit figure could then be multiplied by this comparator’s P/E
to give an estimated valuation.

The benefit of this approach is that it links valuation to profits and earnings,
which appears to be the focus of the business. It relates the value of the shares
to the most recent results of the business. It may be necessary to adjust profit
to allow for the possibility that there have been unusual transactions or that
there is a clear expectation of future growth.

Any valid alternative approach would be awarded credit.

This part of the question was poor with candidates finding it difficult to think of anything to
discuss.

Page 6
Subject CT2 (Finance and Financial Reporting Core Technical) – September 2013 – Examiners’ Report

20 (i)
June July August

Current ratio 1.5 1.8 2.3

Event company receivable turnover (days) 15 28 33
Credit card receivable turnover (days) 45 49 53
Inventory turnover (days) 26 26 26

Trent’s current ratio actually looks healthy. The problem is the composition of
current assets. The event company owes Trent a great deal of money. That
appears as a current asset, but recovery times are slowing dramatically. Trent
is also very exposed to the failure of the company’s one credit customer.

The credit card company is also slowing down its payments to Trent. That is a
further reason for the net outflow of cash.

Inventory turnover continues from month to month at a steady pace and the
increase in inventory holdings is in line with production.

The overdraft is a major cause for concern because it is potentially repayable

on demand. Trent could easily find itself totally insolvent if it does not
improve its cash management.

The calculations of the ratios was done well by candidates the discussion was done less well.

(ii) The first question is whether it would be possible to press the event company
for more rapid payment. It looks as if the whole of August’s sales remain
unpaid. It may even be worth risking the loss of the company’s business if
Trent is going to wait so long for payment that overdraft interest swamps the
profit.

Trent should also press the credit card company. It may be easier to threaten to
move to another provider of this service.

It does not look as if matters are deteriorating with respect to inventory, but
running inventory down to less than 26 days’ holding would release cash.
Once there is greater clarity about the payment stream from both receivables,
Trent should consider raising finance to support the cash flow until the bank
account is back in credit. That may be a matter of negotiating a larger
overdraft or taking out a short-term loan. Even if the payables cannot be
collected any more quickly, matters will improve when the expansion ceases
and sales and cash flows settle to a steady equilibrium.

This part was done reasonably well.

END OF EXAMINERS’ REPORT

Page 7