Association of Accounting Technicians (AAT) Advanced Financial Reporting and Audit (Level 4) Syllabus

Under the indirect method, what is the starting figure for the operating activities section of the cash flow statement?

Profit before tax, which is then adjusted for non-cash items (e.g. depreciation), non-operating items, and changes in working capital.

When using the indirect method, how is depreciation treated in calculating cash from operations, and why?

Depreciation is added back to profit before tax because it is a non-cash expense that reduced profit but did not involve any cash outflow.

Under the indirect method, how does an increase in inventory affect operating cash flow?

An increase in inventory is deducted (a cash outflow), because more cash has been tied up in stock. Conversely, a decrease in inventory is added.

Under the indirect method, how does an increase in trade payables affect operating cash flow?

An increase in trade payables is added (a cash inflow effect), because the entity has retained cash by delaying payment to suppliers.

Give an example of a cash flow classified under 'investing activities'.

Purchase or sale of property, plant and equipment; purchase or sale of investments; interest or dividends received (where classified as investing). The defining feature is acquisition/disposal of long-term assets and investments.

Give an example of a cash flow classified under 'financing activities'.

Proceeds from issuing shares, proceeds from or repayment of loans/borrowings, and dividends paid to shareholders.

Define a 'parent' and a 'subsidiary' in group accounting.

A parent is an entity that controls one or more other entities. A subsidiary is an entity controlled by the parent (control usually arises from holding more than 50% of voting rights).

What is the underlying principle of consolidated financial statements?

The single-entity concept: the parent and its subsidiaries are presented as if they were one economic entity, combining assets, liabilities, income and expenses on a line-by-line basis.

Define goodwill arising on consolidation and give its basic calculation.

Goodwill is the excess of the consideration paid (plus non-controlling interest) over the fair value of the subsidiary's identifiable net assets at acquisition. $$\text{Goodwill} = (\text{Consideration} + \text{NCI}) - \text{FV of net assets acquired}$$

What is non-controlling interest (NCI) and where is it shown?

NCI is the portion of a subsidiary's equity not owned by the parent. It is shown within the equity section of the consolidated statement of financial position, separately from the parent's equity.

In consolidation, how are intra-group balances (e.g. a receivable in the parent and matching payable in the subsidiary) treated?

They are eliminated (cancelled) in full against each other, so that only amounts owed to/from parties outside the group remain.

What is unrealised profit on intra-group inventory, and how is it adjusted?

It is profit on goods sold between group companies that remain in closing inventory at the year end. It is eliminated by reducing inventory and reducing the selling company's retained earnings (and adjusting the consolidated profit), as no profit is earned until sold outside the group.

How is a parent's investment in a subsidiary treated in the consolidated statement of financial position?

The cost of investment in the parent's own books is cancelled against the parent's share of the subsidiary's equity at acquisition; any excess is recognised as goodwill. The investment line itself does not appear in the consolidated SOFP.

Which IAS deals with inventories, and at what value should inventory be measured?

IAS 2 Inventories. Inventory is measured at the lower of cost and net realisable value (NRV). $$\text{Inventory value} = \min(\text{Cost}, \text{NRV})$$

Which IAS governs property, plant and equipment, and what are the two measurement models permitted?

IAS 16. The cost model (cost less accumulated depreciation and impairment) and the revaluation model (fair value at revaluation date less subsequent depreciation and impairment).

Which IFRS deals with revenue, and what is its five-step model?

IFRS 15 Revenue from Contracts with Customers. The five steps: (1) identify the contract, (2) identify the performance obligations, (3) determine the transaction price, (4) allocate the price to obligations, (5) recognise revenue as each obligation is satisfied.

Which IAS governs provisions, and what three conditions must be met to recognise a provision?

IAS 37 Provisions, Contingent Liabilities and Contingent Assets. A provision is recognised when: (1) there is a present obligation from a past event, (2) it is probable an outflow of resources will be required, and (3) the amount can be reliably estimated.

Under IAS 10, distinguish between adjusting and non-adjusting events after the reporting period.

Adjusting events provide evidence of conditions existing at the reporting date and require the financial statements to be adjusted. Non-adjusting events arise after the reporting date and are only disclosed (not adjusted) if material.

What types of disclosure are typically required in the notes to financial statements?

Accounting policies used, breakdowns supporting the primary statement figures (e.g. PPE movements, components of cost of sales), contingent liabilities, related party transactions, and other information required by specific standards and the Companies Act.

State the formula for gross profit margin.

$$\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Revenue}} \times 100\%$$

State the formula for the operating profit margin.

$$\text{Operating profit margin} = \frac{\text{Operating profit (PBIT)}}{\text{Revenue}} \times 100\%$$

State the formula for Return on Capital Employed (ROCE).

$$\text{ROCE} = \frac{\text{Operating profit (PBIT)}}{\text{Capital employed}} \times 100\%$$ where capital employed = total equity + non-current liabilities (or total assets less current liabilities).

State the formula for the current ratio and a commonly cited benchmark.

$$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$$ A benchmark of around 2:1 is often quoted, though the ideal varies by industry.

State the formula for the quick (acid-test) ratio and explain how it differs from the current ratio.

$$\text{Quick ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$$ It excludes inventory, the least liquid current asset, giving a stricter test of short-term liquidity. A benchmark of around 1:1 is often cited.

State the formula for the inventory holding period (in days).

$$\text{Inventory days} = \frac{\text{Inventory}}{\text{Cost of sales}} \times 365$$ It measures the average number of days inventory is held before sale.

State the formula for the trade receivables collection period (in days).

$$\text{Receivables days} = \frac{\text{Trade receivables}}{\text{Credit sales (revenue)}} \times 365$$ It measures the average time taken for customers to pay.

State the formula for the trade payables payment period (in days).

$$\text{Payables days} = \frac{\text{Trade payables}}{\text{Credit purchases (or cost of sales)}} \times 365$$ It measures the average time taken to pay suppliers.

Define the working capital cycle and how it is calculated from the activity ratios.

The working capital (cash operating) cycle is the time between paying for inventory and receiving cash from customers. $$\text{Cycle} = \text{Inventory days} + \text{Receivables days} - \text{Payables days}$$

State the gearing ratio formula (debt to capital employed basis) and what high gearing indicates.

$$\text{Gearing} = \frac{\text{Non-current liabilities (debt)}}{\text{Total equity} + \text{Non-current liabilities}} \times 100\%$$ High gearing indicates greater reliance on borrowing and therefore higher financial risk.

State the interest cover ratio formula and what it measures.

$$\text{Interest cover} = \frac{\text{Profit before interest and tax (PBIT)}}{\text{Finance costs (interest)}}$$ It measures how many times profit covers interest payments; a low figure signals difficulty meeting interest obligations.

State the formula for earnings per share (basic EPS).

$$\text{EPS} = \frac{\text{Profit attributable to ordinary shareholders}}{\text{Weighted average number of ordinary shares}}$$

State the formula for the dividend cover ratio and what it indicates.

$$\text{Dividend cover} = \frac{\text{Profit available to ordinary shareholders}}{\text{Dividends paid to ordinary shareholders}}$$ It shows how many times the dividend could have been paid from profits; higher cover means the dividend is more secure.

List three limitations of ratio analysis.

Ratios are based on historical/past data; they can be distorted by different accounting policies and estimates; comparisons across firms or over time may be invalid due to differing year ends, size, or industry; and ratios ignore non-financial and qualitative factors.

Why must care be taken when comparing the ratios of two different companies?

They may use different accounting policies (e.g. depreciation methods, inventory valuation), operate in different industries with different norms, be of different sizes, have different year-end dates, or have one-off items distorting figures, making like-for-like comparison unreliable.

When reporting financial performance to stakeholders, what should a good report consider?

The information needs of the specific user (e.g. investors, lenders, employees), use of clear language with limited jargon, comparison to benchmarks/prior periods, inclusion of both financial and non-financial context, and a balanced (neutral) presentation of strengths and weaknesses.

Define internal control and state its main purpose.

Internal control is the system of processes, policies and procedures designed and implemented by management to provide reasonable assurance of achieving objectives relating to reliable financial reporting, effective and efficient operations, safeguarding of assets, and compliance with laws and regulations.

Name the five components of an internal control system (COSO framework).

Control environment, risk assessment, control activities, information and communication, and monitoring activities.

List four common types of internal control activities.

Authorisation/approval, segregation of duties, physical controls over assets, reconciliations, and verification/checks (e.g. arithmetic and accounting controls). (Often summarised by the SPAMSOAP mnemonic.)

What is segregation of duties and why is it an important control?

Dividing responsibilities so that no single person controls all stages of a transaction (e.g. authorising, recording, and custody of assets). It reduces the risk of error and fraud, because collusion would be required to conceal wrongdoing.

Distinguish the purpose of internal audit from that of external audit.

Internal audit is an independent appraisal function within the organisation that evaluates and improves risk management, control and governance, reporting to management/the audit committee. External audit gives an independent opinion to shareholders on whether the financial statements give a true and fair view.

State two key differences between internal and external auditors in terms of appointment and reporting.

Internal auditors are employees (or outsourced) appointed by and reporting to management/the audit committee; external auditors are appointed by the shareholders and report to them. Internal audit scope is set by management; external audit scope is largely set by statute and auditing standards.

What is a 'control weakness' (deficiency), and what should an auditor do when one is identified?

A control weakness is a missing or ineffective control that fails to prevent or detect errors or fraud. The auditor should evaluate its potential consequence (impact and likelihood) and report it to management together with a practical recommendation to remedy it.

When evaluating a control weakness, what three elements should a recommendation typically address?

The weakness/deficiency identified, the consequence or risk it creates (potential impact), and a specific, practical recommendation to correct it (the 'weakness–implication–recommendation' approach).

Define risk in the context of the finance function and name the broad stages of the risk management process.

Risk is the chance of an event occurring that adversely affects the achievement of objectives. The risk management process: identify risks, assess/evaluate them (impact and likelihood), respond/treat them, and monitor and review.

List the four common strategies (the '4 T's') for responding to an identified risk.

Tolerate (accept), Treat (reduce/control), Transfer (e.g. insure or outsource), and Terminate (avoid the activity).

Give two examples of risks specifically faced by the finance function.

Fraud and misappropriation of cash/assets, errors in processing or recording transactions, cyber/data security breaches, non-compliance with regulations, and cash flow/liquidity risk. (Any two relevant examples.)

What is the difference between a preventive control and a detective control? Give an example of each.

A preventive control stops errors or fraud before they occur (e.g. authorisation limits, passwords). A detective control identifies errors or fraud after they have occurred (e.g. bank reconciliations, exception reports).

Which IAS deals with intangible assets, and what is the basic rule for internally generated research costs?

IAS 38 Intangible Assets. Research costs must be expensed to profit or loss as incurred; development costs may be capitalised only if specific criteria are met (technical feasibility, intention and ability to complete and use/sell, probable future benefits, reliable measurement).

Under IAS 16, how is a revaluation surplus on property accounted for?

The gain on revaluation is credited to a revaluation reserve within equity and reported in other comprehensive income; it is not recognised in profit or loss (unless reversing a previous revaluation loss charged to profit or loss).

What does the 'going concern' assumption mean and why is it important to auditors?

Going concern assumes the entity will continue in operation for the foreseeable future (at least 12 months) and so will not be liquidated. It underpins asset/liability valuations; auditors must assess whether the assumption is appropriate, as its failure significantly affects the financial statements.