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Summary CIMA F2 Notes
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- Chartered Institute Of Management Accountants
- Everything you need to pass F2 - Detailed 43 pages of notes, complete with diagrams, graphs and formulae - My score: 77%
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Chartered Institute of Management Accountants Management Level F2F2 Advanced Financial Reporting
Structure
A.Financing capital projects (15%)
1. Long term finance
2. Cost of capital
B.Financial reporting standards (25%)
3. Financial instruments
5. Leases
6. Revenue from contracts with customers
7. Provisions, contingent liabilities and contingent assets
8. Intangible assets
9. Income taxes
10.Foreign currency transactions
C.Group accounts (25%)
4. Earnings per share
11.Group accounts - Subsidiaries (CSOFP)
12.Group accounts - Subsidiaries (CSPLOCI)
13.Group accounts - Associates and joint arrangements
14.Consolidated statement of changes in equity (CSOCIE)
15.Consolidated statement of cash flows (CSCF
16.Foreign subsidiaries
17.Related party disclosures
D.Integrated reporting (10%)
18.Integrated reporting
E.Analysing financial statements (25%)
19.Analysing financial statements
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,Chartered Institute of Management Accountants Management Level F2
F2A1: Long-term finance
Sources of long-term (settled >12 months from the date of issue) finance:
• Capital markets: shares in a company listed/quoted on a stock market; must fulfil both functions:
A.Primary function: to enable companies to raise new finance (either equity or debt)
B.Secondary function: to enable investors to sell their investments to other investors
• Stock Exchange (larger firms): high entry costs, stringent entry criteria, and intense scrutiny;
however the profile of the company is dramatically raised thus its shares are highly marketable
• Alternative Investment Market (AIM) (smaller firms): lower costs, less stringent entry criteria
• Entity must be listed on a recognised stock exchange to to raise finance from capital markets
• Banks and finance houses: ie loans
• Government and similar sources: ie government or charitable grants
EQUITY FINANCE (lenders face more risk due to greater uncertainty, thus expect higher return)
• Equity: shares or ownership rights in a business
• Share: fixed identifiable unit of equity in a business
• Nominal (par) value: arbitrary fixed value assigned to a share (linked to the primary function)
• Market value: trading variable/fluctuating price of a share, dependent on market conditions and
the forces of supply and demand (linked to the secondary function)
• Issue price: shares cannot be issued below nominal value; but may drop below it on the market
• Share premium: amount received by the business in excess of nominal value
Ordinary shares Preference shares
Ordinary shareholders own a % of the entity’s net assets Preference shareholders own a % of the entity’s share capital
Voting rights are attached to shares Voting rights are not attached to shares
Dividend paid at a variable rate (as an amount per share) Dividend paid at a fixed rate (as a % of share’s nominal value)
Dividend paid at discretion of directors based on entity performance Dividend paid in preference to (before) ordinary shareholders
Upon entity liquidation, ordinary shareholders are subordinate to all Upon entity liquidation, preference shareholders are subordinate to
other finance providers; they are only entitled to remaining profits/assets all debt holders/creditors except ordinary shareholders; they are
after all other interests/claims are settled entitled to remaining profits/assets before ordinary shares
Types of preference shares (not mutually exclusive; a preference share may be multiple types)
• Redeemable: shareholders are repaid their capital at a predetermined future date
• Irredeemable: shareholders are not repaid their capital in the future
• Cumulative: dividends can be rolled forward if the entity has insufficient reserves to pay
• Non-cumulative: missed dividends do not have to be rolled forward for later payment
• Participating: shareholders receive a fixed dividend plus a variable dividend linked to performance
• Convertible: can be exchanged for specified number of ordinary shares on given future date; thus
shareholders have both a steady income stream from fixed dividend (preference) and opportunity
to gain from potential future share price rise (convertible) due to the choice of redemption method
Advantages of a stock market listing Disadvantages of a stock market listing
The market will provide a more accurate valuation of the entity Costly for the entity; and does not guarantee target finance levels
Investor perspective: provides mechanism for buying and selling shares in future Regulatory compliance and reporting requirements are more onerous
Entity perspective: provides mechanism for raising long term finance for the entity
Employee share schemes more accessible Stock exchange rules and criteria are stringent
Raises entity profile (thus impacting revenue and credibility with suppliers) and Ensuring enough shares are available may dilute control of original
finance providers (thus increasing the amount of potential finance raised) owner; company performance will also be open to public scrutiny
Role of advisors in a share issue
• Investment banks: take a lead role in share issues, advising on:
• Appointment of other specialists, ie lawyers • Number of shares to issue, and issue price
• Stock exchange requirements • Underwriting arrangements
• Forms of any new capital to be made available • Publishing the offer
• Stockbrokers: provide advice on methods of obtaining a listing; working with investment banks on
identifying institutional investors but usually involved with smaller share issues
• Institutional investors: professional investors from large organisations with major influence on
share evaluation and who invest on behalf of clients; ie pension funds and insurance companies
• Registrars to an issue: administrative service; processing applications, monitoring payments, etc
• Public and investor relations: work with the entity to ensure communications are transparent and
information is understandable; thus may improve uptake of share issue and increase market value
• Reporting accountants: provide advice regarding share issue impact on financial statements
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,Chartered Institute of Management Accountants Management Level F2
• Underwriters: financial institutions that take on risk associated with a new issue and promote the
shares to third party investors, in turn retaining part of proceeds as a result of bearing the risk
Methods of share issue
A.Initial public offering (IPO): entity seeks a stock market listing/floatation for the first time; shares
are offered to investors via an issuing house either for:
A.i.Fixed price
A.ii.Tender offer: investors are invited to tender for new shares at their own suggested price; the
entity then sets a strike price to ensure the required finance is raised, with shares allocated to
bidders who met the strike price, with all paying the strike price irrespective of their original bid
B.Entity that already lists on a stock market may seek further financing via a new share issue
B.i.Placing: not offered to the public, shares are pre-arranged directly with institutional investors
via an issuing house; cheaper and quicker but does not lead to active post-flotation market
B.ii.Rights issue: existing shareholders are offered the right to subscribe to new shares in
proportion to the size of their current holdings, usually at a discount to market price;
• All companies can make rights issues, not just those with a stock exchange listing
• Existing shares are traded cum rights up to date of issue; then traded ex rights after issue
• Cum rights: protected by law, and can only be waived with shareholder consent, the purpose
is so existing shareholders are able to prevent their stake being diluted by new shares
• Ex rights: immediately after newly issued shares, the rights have expired
• Market price after issue: after announcing a rights issue, price often falls due to uncertainty;
and may fall again after the issue itself due to there being more shares issued at a discount
• Rights issue quantity: consider effect on earnings per share (EPS) and dividend cover
• Rights issue price: balance of shareholder acceptance yet avoiding excessive EPS dilution
• Theoretical ex rights price (TERP): theoretical price shares trade at immediately after issue
(N × C u m r i g h t s p r i c e) + R i g h t s i s s u e p r i c e
TERP = , where N = number of shares required to receive one rights issue share
N + 1
Implications of a rights issue, from the shareholder perspective Implications of a rights issue, from the company perspective
Option of buying shares at a preferential price Simple and cheaper than public share issue
Option of withdrawing cash by selling their rights Usually fully subscribed and successful
Able to maintain their existing relative voting position Often provides favourable publicity
DEBT FINANCE (lenders face less risk due to less uncertainty, thus expect lower return)
• Debt finance: loan of funds to a business without conferring ownership rights, creating an
obligation for the business to repay the capital and interest based on specifically arranged terms
• Debt finance can be issued at prices lower than nominal value (usually $100)
• Bank finance: often a loan repayable with interest at predetermined dates, based on specific terms
• Bonds (traded debt): bonds are formal contracts to repay borrowed money with interest at fixed
intervals, tradable in capital markets; the bond market may be broken down into three key groups
• Issuers: sell bonds to fund operations of their organisations; mostly governments, banks, etc
• Underwriters: financial institutions that help issuers sell bonds in the market
• Purchasers: can include any type of investor
• Bond holders are lenders of debt finance regardless of being traded on the capital markets
Bonds (debt) Shares (equity)
Bondholders have a creditor stake in the firm; are lenders Shareholders have an equity stake in the firm; are owners
Bonds usually have defined maturity after which they are repaid/redeemed Shares may be outstanding indefinitely
Security which can be traded on the capital markets Security which can be traded on the capital markets
Reduction of risk to lenders
• Security: in the event of default, the lender is able to take assets in exchange of the amount
owed; debt is therefore often subject to a fixed or floating charge on assets
• Fixed charge (preferable for lenders): debt is secured against a specific asset, ie land/property;
preferred as, in the event of a liquidation, lenders have the right to the specific asset secured
• Floating charge (less preferred for lenders): debt is secured against the underlying/general
assets that are subject to changes in quantity or value, ie inventory; repaid after fixed charge
holders but before other creditors
• Covenants: specific requirements or limitations that act as conditions on debt finance
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,Chartered Institute of Management Accountants Management Level F2
• Dividend restriction: prevent excessive dividend payments which may weaken future cash flows
• Financial ratios: specified levels below which certain ratios may not fall
• Financial reports: provided to the lender to monitor progress
• Issue of further debt: restrictions on the amount and type of debt that can be issued
Preference shares Debt finance
Dividends paid out of post-tax profits; hence there is no tax Interest is paid out of pre-tax profits; as a business expense
benefit to a company of paying preference share dividends
Certain circumstances permit the company to skip or defer Carries risk of withdrawal of debt finance if the company does not
payment of preference share dividends meet interest payments
Loan stockholders are creditors repaid in priority to all shareholders,
hence are more secure than preference share investments
OTHER SOURCES OF FINANCE
• Existing cash balances (not retained earnings): cash balances are a source of finance; while
retained earnings reflect profit accumulated over the entity’s life, which is not the same as cash
• Sale and leaseback: arises when an entity sells good quality fixed assets and immediately leases
them back over many (25+) years; thus funds are released without loss of asset use
• Grants: particularly importance to small and medium-sized business, they do not need to be
repaid; often related to technology, jobs, or regional policy, grants are provided by governments
• Debt with warrants attached: warrants are an option to buy shares at a predetermined future
date for a specified (exercise) price, often issued with a bond to encourage investors to purchase
• This has the advantage of potential capital gain, if the share price exceeds the exercise price
• Warrant and bond are considered separate items once issued, thus can be traded separately
• Convertible bond: option to convert debt into shares at a range of predetermined future dates for
a specified price, thus encouraging investors and improving the issuer’s chance of raising finance
• This has the advantage of potential capital gain above the return from debt repayment, if share
price exceeds the value of debt on the exercise date; or the debt can be held to maturity if not
• In exchange for the conversion option, bondholders usually accept a below market interest rate
• Option to convert debt to shares cannot be detached and traded separately
• Liability component of convertible debt must be recognised in SOFP
• Venture capital: provided to young, unquoted profit-making entities to aid expansion; venture
capitalists generally accept low dividends and expect to make most returns as capital gains on exit
• Business angels: wealthy investors providing equity finance to small businesses
TERMINOLOGY
Term Definition Example
Par value Nominal value $100
Coupon rate Minimum interest repayment per year based on par value 5% $100 debentures ∴ 0.05 x $100 = $5
Discount Cash amount received from the loan below the par value Discount of 4% ∴ 4% x $100 = $4
Redemption date Date of repayment of capital; maturity date redeemable after 5 years ∴ 5 years
Premium Additional amount repayable at redemption date based on par value 10% premium on par ∴ 0.1 x $100 = $10
Effective interest Rate of interest that spreads total finance costs across the loan Can be determined by IRR
rate lifetime at a constant rate; including coupon rate repayments,
discounts, premiums
Jack Gould 4 of 43
,Chartered Institute of Management Accountants Management Level F2
F2A2: Cost of capital
COST OF EQUITY: ke = rate of return ordinary shareholders expect on their investment
• Dividend valuation method (DVM): method of calculating the cost of equity ke based on the
theory of share valuation, which assumes that current market price of a share is the present value
of the future dividend income stream, discounted at the shareholders’ required rate of return
d
A. DVM with constant dividends: ke =
P0
ke = cost of equity
d = constant dividend
P0 = ex div market price of share
A.i. Preference shares kp pay a constant dividend, thus can be calculated using this same formula
Calculating ex div share price (P0)
• Cum div value of a share: price just before payment of a dividend
• Ex div value of a share: price just after payment of a dividend
E x d i v sh a r e pr i c e = C u m d i v sh a r e pr i c e − D i v i d e n d v a l u e
d1 d (1 + g)
B. DVM with constant growth: ke = + g OR ke = 0 +g
P0 P0
g = constant rate of growth in dividends
d1 = dividend to be paid in one year’s time
d0 = constant dividend
B.i. Estimating growth (g) within DVM:
n
d0 2. Growth model based on profit retention rate: g = r × b
1. Averaging method: g = −1
dn g = dividend growth rate
d0 = constant dividend r = % rate of return the firm receives on its investment
dn = dividend n years ago b = % of funds retained (not distributed as dividends)
• Assumptions of the growth model based on profit retention rate: the rationale is that an increase in
the level of investment by a company - as a result of not paying profits out as dividends - will give
rise to increases/growth in future dividend; hence it assumes that:
• The entity must be fully financed by equity
• The retained profits are the only source of additional investment
• A constant % of each year’s earnings is retained for reinvestment
• Projects financed from retained earnings earn a constant rate of return
COST OF DEBT: kd = rate of return debt providers require on the funds that they provide
A. kd for bank loans/borrowings: kd = r (1 − T )
r = annual interest rate %
T = corporate tax rate (reflects interest paid on debt is tax deductible)
i(1 − T )
B. kd for irredeemable bonds: kd =
P0
i = interest (yield) paid each year (per $100 of bond)
T = marginal tax rate (reflects interest paid on debt is tax deductible)
P0 = ex interest market price of bonds (normally quoted per 100 unit nominal)
C. kd for redeemable bonds:
• Calculated using the IRR on the relevant cash flows (bond market value, annual net interest, and
final redemption amount) associated with the bond; identify the cash flows then calculate IRR by
choosing 2 discount factors to calculate 2 NPVs
Year Cash flow $ Example
0 Ex interest market P0 $95 ex interest redeemable
value of debt at par in 5 years ∴ $(95)
1 to n Annual interest i(1 − T ) 10% bond, corporation tax is
payments net of tax 31% ∴ $10 x (1-0.31) = $6.90
n Redemption value RV Redeemable at par in 5
of the debt years ∴ $100
• kd for redeemable bonds traded at par: cost of debt of irredeemable bonds formula can be used
Jack Gould 5 of 43
,Chartered Institute of Management Accountants Management Level F2
( N P VL − N P VH )
N P VL
• Internal rate of return (IRR) (discount rate which gives zero NPV): L + (H − L )
NPV = net present value
L = lower discount rate
H = higher discount rate
D. kd for convertible bonds
• Convertibles offer the investor a choice of cash or conversion to shares at redemption date; hence
it is assumed investors choose the option that yields the highest redemption value
1. Work out which option yields the highest redemption value
• Cash: $100 redemption at par
• Conversion: n o . o f sh a r es × (c u r r e n t sh a r e pr i c e × a n n u a l g r o w t h %n ) = 10 x ($8.60 x 1.055) = $109.76
2. Determine the cost of capital
Year Cash flow $ Example
0 Ex interest market P0 $100 ex interest redeemable
value of debt at par in 5 years ∴ $(100)
1 to n Annual interest i(1 − T ) 10% bond, corporation tax is
payments net of tax 20% ∴ $10 x (1-0.2) = $8
n Higher of cash of RV Conversion > cash∴ $109.76
conversion options
WEIGHTED AVERAGE COST OF CAPITAL (WACC) (perspective of the entity seeking finance)
• WACC: the average cost of an entity’s capital (equity and debt) weighted according to the
proportion each element bears to the total pool of funds
1. Calculate weights/proportions for each source of capital based on market values (ex div)
2. Estimate the cost of each source of capital
3. Multiply the weight/proportion of each source of capital by the cost of that source of capital (1 x 2)
4. Sum the results of 3 to calculate the weighted average cost of capital (WACC)
[ VE + VD ] [ VE + VD ]
VE VD
WAC C = k 0 = ke + kd , where V is market value
• WACC example: ke = 4.8%, post-tax kd = 5.5%. 1m x $1 shares trading at $4.2 therefore Ve = $4.2 million, 5m x bonds trading at
$82.5 per $100 therefore Vd = $4.125m, therefore total market value of capital = $8.325m
• WACC = (4.8% × 4,200/8,325) + (5.5% × 4,125/8,325) = 5.1% WACC
Problems with WACC:
• Loans without market values: unlike bonds, bank loans do not have market values therefore
WACC weightings will be use book values as an approximation
• Cost of capital for small entities: small unquoted entities have no readily available share price
thus the cost of finance is more expensive
WACC considerations and benefits
• Sources of finance to include: WACC usually includes only long term finance, but inclusion of
short term finance should be considered if being used to fund long term projects
• Use of multiple finance sources: entities typically fund projects/investment from an existing pool
of funds rather than specifically allocating one source of finance to each project
• WACC as a discount rate: WACC may be used as a discount rate in NPV or IRR calculations,
but is only appropriate if the entity’s business risk and finance risk stay constant:
1. Capital structure is constant, otherwise WACC weightings will change
2. New investment does not carry a different business risk profile to the entity’s existing
operations; it is not a significant departure in strategy
3. New investment is marginal; thus cost of equity ke, debt kd, or WACC will not change materially
YIELD TO MATURITY (YTM) (perspective of the investor providing finance)
• YTM: the effective average annual % return to the investor, relative to current bond market value
• The investor seeks to determine the % yield, in order to make an informed decision on if the
investment is worthwhile
• Investors do not obtain tax relief from interest received, therefore YTM is calculated using pre-tax
interest receipts; no tax is deducted within the YTM calculation
a n nu al i nter est r eceived
A.Yield on irredeemable debt: × 100 %
c u r r e n t m a r k e t v a l u e o f d eb t
B. Yield on redeemable debt: IRR of the relevant cash flows (bond market value, annual net
interest, and final redemption amount)
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, Chartered Institute of Management Accountants Management Level F2
F2B3: IAS 32 & IFRS 9 Financial Instruments
• Financial instrument: any contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity; anything used to finance a business
• Financial asset: any asset that is:
• Cash
• Equity instrument of another entity
• Contractual right to receive cash or another financial asset from another entity
• Contractual right to exchange financial instruments with another entity under conditions that are
potentially favourable
• Examples: investing in debentures/loans/bonds (lending money); investing in ordinary shares
• Financial liability: any liability that is:
• Contractual obligation to deliver cash or another financial asset to another entity
• Contractual obligation to exchange financial instruments with another entity under conditions
that are potentially unfavourable
• Examples: issuing debentures/loans/bonds (borrowing money); trade payables; loans
• Equity instrument: any contract that evidences a residual interest in assets of an entity after
deducting all of its liabilities
• Examples: issue of ordinary shares
ACCOUNTING STANDARDS
IAS 32 financial instruments: presentation (classification of financial instruments and their
presentation in financial statements)
• Presentation of liabilities and equity: the issuer must classify financial instrument as a financial
liability or equity instrument on initial recognition
• Financial liabilities: issuer has contractual obligation to deliver cash or financial asset to another
entity, or exchange instruments with another entity under potentially unfavourable conditions
• Equity instruments: only if there is no such contractual obligation
• Interest, dividends, losses and gains relating to a financial instrument: will follow the
treatment of the instrument itself, ie:
• Dividends paid on shares classified as liability will be charged to SOPL as an expense
• Dividends paid on shares classified as equity will be reported in SOCIE as retained earnings
• Offsetting a financial asset and a financial liability: a financial asset or liability may only be
offset in limited circumstances; the net amount may only be reported when the entity:
• Has a legally enforceable right to set off the amounts
• Intends either to settle on a net basis, or simultaneously realise the asset and settle the liability
IFRS 9 financial instruments (measurement of financial instruments and their recognition in
financial statements)
• Initial measurement of financial instruments: recognised at fair value
• Subsequent measurement of financial instruments: equity instruments are not re-measured after
initial recognition; other financial instruments are measured depending on their classification
FINANCIAL LIABILITIES: measurement depends on classification as FVPL (B) or other (A)
• Entity issues bonds/loans/debentures/cumulative irredeemable preference shares to raise
finance, creating a financial liability
A.Amortised cost (default): all liabilities other than FVPL
• Initial recognition at fair value less transaction costs
• Subsequent measurement at amortised cost: interest is charged on the liability value each
period using effective interest rate, taken to the P/L as finance costs
1. 2. 3. 4.
1. Opening balance: fair value less transaction costs (cash - transaction costs = net proceeds)
• Dr Cash/Bank
• Cr Liability
2. Effective interest: calculated on the opening balance each period, charged to the P/L
• Dr Finance costs (cumulative irredeemable preference share dividend treated as finance cost)
• Cr Liability
3. Coupon paid: coupon % x debt nominal value, reduces liability carrying amount yearly
• Dr Liability
Jack Gould 7 of 43
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