Preparing to pass AAT Paper FNST

The Financial Statements (FNST) paper at Level 4 of the Association of Accounting Technicians (AAT) qualification has come in for a certain element of criticism from students who appear to be struggling with the unit.  The AAT refer to ‘Learners’ of this unit, but I will refer to them as ‘candidates’ for the purposes of this article.

FNST is the final level financial reporting paper for AAT candidates and as such it is important that this paper is set at an appropriate level of difficulty.  AAT candidates are training to be accountants and accountants have to prepare statements of financial position and comprehensive income statements as well as the statement of cash flows.  This applies whether a candidate works in practice, industry or commerce and candidates cannot afford to under-estimate the complexity of this paper, as well the unpredictability of the FNST exam.  However the examiner will only ever test topics that fall within the parameter of the syllabus, hence it is imperative that all candidates go into the exam having adequately covered the entire syllabus by way of examination standard question practise.

Overall objective

So what is the FNST examiner looking for to be able to pass candidates as competent in this unit?  The competency level is set at 70%, hence candidates are going to have to make sure they enter that exam hall with a sound grasp of the entire syllabus.  Firstly, it is important to understand what FNST is all about.

The paper requires candidates to demonstrate competency in:

• drafting financial statements for limited companies; and
• interpreting financial statements.

Candidates will be examined under International Financial Reporting Standards (IFRS) and the paper will contain a mixture of both computational and discursive elements to it.

It is important that a candidate can demonstrate competency in, not only the numerical aspects of the paper, (ie preparation of the primary financial statements), but that they can also demonstrate an ability to communicate what it is the numbers are saying.  Remember – candidates are training to become qualified accounting technicians and as such they need to have the skills to communicate to non-financially orientated individuals.  If you work in practice you will more than likely have to explain to a client what the statement of comprehensive income and/or statement of financial position and/or statement of cash flows is saying about a client’s particular business.  If you work in industry or commerce, you will more than likely have to communicate to non-financially orientated individuals about certain aspects of the management accounts or year-end statutory financial statements.  This is the reason why a candidate cannot afford to go into the FNST exam without a sound understanding of the technical ‘number-crunching’ and the ability to write about those numbers.  Effective and clear communication is a significant aspect of an accountant’s job and this skill is vital so it is important that you view FNST as a practical examination because candidates are more than likely going to come across such skills in real life.

Consolidated financial statements

It is important to understand WHY consolidated financial statements are prepared.  The objective of a consolidated set of financial statements is to show the group as a single reporting entity.  This is achieved by replacing the cost of the investment in the parent’s individual financial statements and adding in 100% on a line-by-line basis the subsidiary’s assets, liabilities, income and equity to represent the control obtained by the parent.  Remember, for a parent/subsidiary relationship to be triggered, the parent company must control the subsidiary.  This is usually achieved when the parent owns 51% or more the entity’s shares.

All intra-group trading and the effects of such trading need to be eliminated during the consolidation process.  If you are preparing the consolidated statement of financial position, candidates can expect to have to eliminate intra-group receivables and payables and unrealised profits (when a member of a group sells goods to another and all/some of these goods remain in the inventory of the purchasing company at the period end).  If preparing the consolidated income statement, candidates can expect to have to eliminate intra-group sales, purchases and expenses.  Remember, if P is owed money by S, then reduce the value of the receivables in current assets, but do not forget to reduce the payable under current liabilities also! Similarly for intra-group sales/purchases, reduce the value of the sales for the selling company and reduce the value of the purchases for the buying company.

If intra-group trading (and the effects thereof) were not eliminated on consolidation then the consolidated comprehensive income statement and statement of financial position would be seriously distorted.  Candidates need to understand that sales of goods or services between members of the group are merely intra-group transfers.  A sale is only a ‘true’ sale when the sale occurs with a third party outside of the group structure (ie a customer of the group).

Candidates are guaranteed to have to prepare consolidated financial statements as well as single entity financial statements.  In terms of the consolidation, candidates will need to ensure that they can explain the process of basic consolidation as well as demonstrating some technical skills in the consolidation itself, such as:

• elimination of intra-group balances;
• elimination of intra-group profits (see below);
• treatment of non-controlling interests;
• goodwill;
• fair values; and
• pre- and post-acquisition profit.

The key to preparing a consolidated set of financial statements is to do it in a methodical manner.  There is a renowned ‘five-step’ approach to dealing with consolidations which is as follows:

Step 1 – establish the group structure

Parent owns (say) 80% of the subsidiary.

Step 2 – deal with the net assets of the subsidiary at the date of acquisition and at the year-end date

Step 3 – calculate the goodwill on acquisition

Step 4 – deal with the non-controlling interests

In step 1, P owns 80% of S so the non-controlling interests = 20%

Step 5 – work out group retained earnings

The main pitfalls which I have seen when I used to teach the old DFS were students who:

• Forgot about double-entry principles with regards to goodwill impairment.  If the goodwill is impaired at the year-end, clearly the credit will be to goodwill in the consolidated statement of financial position to reduce goodwill down to recoverable amount.  What candidates often forget to do is to deal with the debit side!  Remember, to put the debit side to group retained earnings (steps 3 and 5 above) – do not forget that double-entry principles still apply when producing consolidated financial statements.
• Got mixed up with pre- and post-acquisition reserves. Remember, pre-acquisition reserves belong to the non-controlling interests and these go into the goodwill calculation (step 3 above). Post-acquisition reserves go to group retained earnings (step 5).

Remember, in the consolidated statement of financial position the share capital is ALWAYS the parent’s share capital only! Get that easy mark in the bag first.

Unrealised profit in closing inventory

Each company in a group is a separate legal entity and may wish to treat other group companies in the same way as any other customer.  In this case, a company (say A Ltd) may buy goods at one price and sell them at a higher price to another group company (B Ltd).  The accounts of A Ltd will quite properly include the profit earned on sales to B Ltd; and similarly, B Ltd’s statement of financial position will include inventory at their cost to B Ltd., i.e. at the amount at which they were purchased from A Ltd.

From a group perspective, transfers from one member of the group to another member merely constitutes an internal transfer and not a sale.

Although A Ltd makes a profit as soon as it sells the goods to B Ltd, the group does not make a profit until a third party customer buys the goods from B Ltd.

Any purchases from A Ltd which remain unsold by B Ltd by the year end will be included in B Ltd’s inventory.  Their statement of financial position value will be their cost to B Ltd, which is not the same as their cost to the group.

In a consolidated statement of financial position the only profits recognised should be those earned by the group in providing goods and services to outsiders; and similarly, inventory in the consolidated statement of financial position should be valued at cost to the group (per IAS 2 Inventories).

Illustration

H plc sold goods for resale to S plc for $2,000, which represents cost plus 25%.  At the reporting  date, goods of $1,200 were still unsold and included in S plc’s inventory.

Cost       $1,600

Profit     $   400

Sales

Price      $2,000

Unrealised profit in inventory (also known as a PURP adjustment) = $1,200 / $2,000 x $400 = $240.

Journals:

CR           Inventory (in the CSoFP)

DR          Group retained earnings

Consolidated income statement

The consolidated income statement is less complex than the consolidated statement of financial position and traditionally does not tend to come up as much but it would be reckless of candidates to either ignore the consolidated income statement or neglect it.  In the consolidated income statement, you include all of the subsidiary’s income and expenses (100%) on a line-by-line basis, all the way down to profit after tax.  At the end of the consolidated income statement you reflect the subsidiary’s ownership by showing the amounts attributable to the equity holders of the parent and the amount attributable to the non-controlling interests.

Single entity financial statements

Candidates often get bogged down with the consolidated aspects of FNST and forget that they need an awareness of how to prepare financial statements for a single limited company.  Typically students will be presented with a draft trial balance at the year-end which needs further adjustments incorporating within the trial balance prior to preparation of the primary statements, for example:

• accrued and prepaid expenses;
• returned goods from customers;
• loan interest to be provided;
• provision for income tax expense; and
• dividends paid to shareholders.

Candidates must also be prepared to draft a single entity’s statement of changes in equity and a statement of cash flows.  It is the statement of cash flows that generally causes candidates the most problems and candidates need to be familiar with the two methods of preparation prescribed in IAS 7 Statement of Cash Flows: that of the ‘direct’ and the ‘indirect’ method of preparation.

The primary purpose of the statement of cash flows is to show how an entity has generated and spent cash in the accounting period.  IAS 7 splits the statement of cash flows into three separate sections:

• Operating activities;
• Investing activities; and
• Financing activities.

Operating activities are basically the day-to-day revenue producing activities of the business.  Under the indirect method this figure is calculated as follows:

Remember: ‘outflows’ are (deducted) from operating profit, ‘inflows’ are added to operating profit.

Investing activities show how a company has invested in long-term assets (such as showing the total amount paid for purchasing non-current assets) as well as the proceeds from the disposal of such assets.  The main complexity that candidates are faced with here is the calculation of additions to non-current assets in the year because there is an element of incomplete records knowledge required.  Here is a formula that I suggest candidates learn to arrive at the figure for non-current asset additions:

• Net book value of PPE b/f from previous statement of financial position
• Deduct: depreciation
• Deduct: net book value of any PPE sold in the year (usually in the question)
• Deduct: net book value c/f from current year’s statement of financial position
• Balancing figure = additions in the year

Financing activities shows a company’s capital and borrowing structure and candidates can expect to have to include the proceeds from a share issue in this section, or dividends paid to shareholders.  Pay particular attention to increases in share capital/share premium and an increase in loan balances in the current year.

The statement of cash flows can be fairly complicated and is sometimes the most feared primary statement to prepare when it comes to the actual exam.  Candidates are therefore encouraged to practise as many past questions as possible and if this is an area where you feel particularly weak, you are advised to go back to the basics and work questions on a piecemeal basis.  In other words, slowly work out the cash flows from operating activities, review your answer against the suggested answer and then move on to cash flows from investing activities.  Do this until you feel comfortable with how each section works in the overall statement of cash flows because this way will ensure that you become familiar with how all the pieces of the jigsaw fit together.

Do not forget the overall objective of the statement of cash flows! It is the only primary financial statement that is prepared on a cash basis to show how a company has generated and spent cash in the year and the figure you are eventually balancing to is the cash at bank figure in the statement of financial position at the current period end.

Ratio analysis

As I mentioned earlier, an important part of an accountant’s job is the ability to communicate to non-financially orientated individuals.  Many non-accountants may struggle in interpreting financial statements and understanding what it is the statements are telling them.

Ratios are tools that help to understand the information conveyed in financial statements and are split into four areas:

• Profitability
• Liquidity
• Use of resources
• Financial position

Candidates must ensure they are comfortable with the ways in which these are calculated and the FNST Guidance booklet on page 12 shows how these ratios are to be calculated.  Not only is it important to have an understanding as to how to calculate the ratios, but you must be prepared to explain what it is the ratios are telling.

A typical (but not definitive) scenario in the exam may entail you acting on behalf of a potential investor.  You may be given two sets of financial statements and be asked to calculate various ratios.  You may then be asked to interpret these ratios with a view to forming an opinion as to which company your client should invest.  Remember – a ratio on its own is meaningless and you therefore must calculate the ratio for BOTH years in order to make a comparison.

A crucial aspect of this area in the syllabus is that candidates must be able to come to a conclusion as to which is the best investment.  Do not ‘sit on the fence’ where this is concerned.  In real life investors want a ‘yes’ or ‘no’ answer and this is how FNST works, so candidates must go into the exam equipped with the technical knowledge of calculating and then explaining and then concluding!

Accounting standards

This area of the syllabus is probably the area that candidates tend to get bogged down in too much.  The Guidance to FNST identifies 21 accounting standards that candidates must ensure they have a sound understanding of.  Candidates are not expected to be accounting standard ‘gurus’ but candidates can expect to be tested on a few accounting standards in isolation.  The Guidance identifies the following accounting standards as assessable:

IFRS 3 Business combinations

IFRS 5 Non-current assets held for sale and discontinued operation

IFRS 8 Operating segments

IAS 1 Presentation of financial statements

IAS 2 Inventories

IAS 7 Statement of cash flows

IAS 8 Accounting policies, changes in accounting estimates and errors

IAS 10 Events after the reporting period

IAS 12 Income taxes

IAS 16 Property, plant and equipment

IAS 17 Leases

IAS 18 Revenue

IAS 20 Accounting for government grants and disclosure of government assistance

IAS 23 Borrowing costs

IAS 27 Consolidated and separate financial statements

IAS 28 Investments in associates

IAS 33 Earnings per share

IAS 36 Impairment of assets

IAS 37 Provisions, contingent liabilities and contingent assets

IAS 38 Intangible assets

IAS 40 Investment property

Candidates will not be expected to have to learn each assessable standard inside out, but you must be prepared to explain them.  For example, the old DFS paper in June 2009 asked candidates to define a ‘current’ asset and a ‘current’ liability in accordance with IAS 1 Presentation of financial statements.  Many candidates saw the word ‘asset’ and ‘liability’ and immediately started to write the definitions of such.  Assets and liabilities are dealt with in the IASB’s Conceptual Framework not IAS 1 so it is vital to carefully read the requirement so you fully understand what it is that is being asked!  Don’t fall into the trap of seeing a ‘keyword’ and going on autopilot!

The FNST Guidance details exactly what candidates need to understand where accounting standards are concerned and is covered on pages five to 11.

Conceptual framework

This is an area which is often overlooked by some candidates because they are too focused on the other areas of the syllabus.  The Conceptual Framework is the backbone to IFRS and it is important that you study this area carefully.  Learning outcome number 1 in the Guidance on page 3 specifies what candidates will need to know where the Conceptual Framework is concerned, so make sure you are prepared for questions on the IASB’s Conceptual Framework.

Conclusion

By getting adequate coverage of the syllabus through study and question practise, candidates attempting FNST can comfortably pass this exam.  The key to success in FNST is to accept that you will have to calculate the numbers (thus demonstrating the technical competence), but also explain what those numbers mean to demonstrate that you have the ability to communicate to non-financially orientated individuals what it is the financial statements are saying.

A final key bit of advice is to avoid – at all costs – the act of ‘question spotting’.  This happens when students will discuss previous exams and highlight what came up and which some future candidates will focus their studies on.  Remember, every exam is different and nobody knows until the day of the exam what is going to appear.  If you find yourself question spotting just think as to how disappointed you would feel in the real exam if that topic(s) did not actually come up!  This is why it is important that all candidates adequately cover the syllabus by way of question practise.  If you are receiving formal tuition you must be prepared to put in (at the very least) an extra day’s study on top.  If you are a home student then you must devise a realistic study plan and stick to it.  Where you find areas of weakness devote extra time to these areas and if you find a topic overwhelming then go back to basics – in other words get out the text book and start studying that topic from scratch, breaking it down into manageable pieces until the topic becomes less overwhelming.  The only way you can comfortably pass FNST is to practise, practise and do more practise!

Category: Accounting and standards