Question on statement of cash flows – Carlo

The following draft financial statements relate to Carlo, a private company. On 1 October 2010 Cosmo acquired 60% controlling interest in Carlo. Carlo is one of Cosmo’s main customer who operates profitably.

Statement of Comprehensive Income for the year ended 30 September 2011
$’000
Revenue 8,000
Cost of Sales (4,800)

Gross profit 3,200
Distribution and administrative expenses (2,930)
Interest expense (260)
Interest income 40

Profit before tax 50
Income tax credit 50

Profit for the period 100

Statement of Financial Position
as at 30 September 2011 2010
$’000 $’000 $’000 $’000
Non-current assets
Property, plant and equipment (note i) 8,600 14,200
Intangible assets (note ii) 2,000 1,600
Loan receivables (note iii) 2,300 12,900 – 15,800

Current assets
Inventories 2,550 1,850
Trade receivables (note iv) 3,100 2,600
Cash and bank 50 5,700 1,200 5,650

Total assets 18,600 21,450

Equity
Ordinary shares ($1 each) 6,000 6,000
Revaluation reserves (note i) nil 1,600
Retained earnings 2,550 8,550 850 8,450

Non-current liabilities
Finance lease obligations (note i) 2,000 1,700
6% loan notes (note iv) 800 nil
10% loan notes nil 4,000
Deferred tax 200 500
Government grants (note i) 1,400 4,400 900 7,100

Current liabilities
Bank overdraft nil 550
Trade payables 3,600 2,650
Government grants (note i) 600 400
Finance lease obligations (note i) 900 800
Tax payable 100 1,200
Warranty provisions (note v) 450 5,650 300 5,900

Total equity and liabilities 18,600 21,450

The following information is relevant :
(i) The details of the tangible non-current assets are :
Cost Accumulated Carrying
depreciation value
$’000 $’000 $’000
At 30 September 2010 18,600 4,400 14,200
At 30 September 2011 14,000 5,400 8,600

During the year Carlo sold its factory at its fair value of $12 million and agreed to rent it back under an operating lease for a period of five years at $1 million per annum. At the date of sale it had a carrying value of $7.4 million based on a previous revaluation of $8.6 million less depreciation of $1.2 million since the revaluation. The profit on the sale of the factory has been included in operating profit. The surplus on the revaluation reserve related entirely to the factory. No other disposals of non-current assets were made during the year.

Plant acquired under finance leases during the year was $1.5 million.

Other purchases of plant during the year qualifies for government grants of $950,000. Amortisation of government grants has been credited to cost of sales.

In previous periods Carlo has included relevant borrowing costs as part of the carrying value of property, plant and equipment. On 30 September 2010 property, plant and equipment included $30,000 relating to capitalised finance costs. During the current period the directors decided to change their treatment of such costs and charge them as expense when incurred. For the year ended 30 September 2011 an amount of $70,000 (including $30,000 for previous periods) was charged as an interest expense in the income statement.

(ii) The company successfully completed the development of a new product during the current year, capitalising a further $500,000 before amortisation charges for the period.

(iii) Immediately after the acquisition by Cosmo, Carlo advances a non-dated loan of $2.3 million to Cosmo at market interest rate

(iv) The trade receivables include amount of $800,000 due from Cosmo

(v) The company makes a warranty provision when it sells its products and the cost of sales contain a charge for the cost of warranties on the goods sold by Carlo. Cash payments of $100,000 for such warranty claims taken place for the year ended 30 September 2011.

(vi) The 6% loan had been issued at a premium in October 2010 at an above-market interest. The carrying value of the loan at 30 September 2011 was after accounting for the premium allocation of $10,000 in respect of the current reporting period.

(vii) After Cosmo’s acquisition in Carlo, Carlo’s purchases from Cosmo were $4 million on which Cosmo had made a consistent profit of 35% of the selling price. Prior to the acquisiton of Cosmo, Carlo made all its sale at a uniform gross profit margin of 60%.

Required

(a) Prepare a statement of cash flows using the indirect method for Carlo in accordance with IAS7 Cash flows statements for the year ended 30 September 2011.

(b) Using the information in the question on your statement of cash flows, comment on the change in the financial position of Carlo during the year ended 30 September 2011.

Please help me with this question.

1. I can’t understand the part relating to borrowing costs. What is the implications of borrowing costs in a cash flow question ? I guess that the transfer of $30,000 (previous periods) to expense is non-cash and have to be added back to profit. But actually it’s not logical as interest expense of previous period can’t be included in this year’s expense (matching concept)

2. What is the term “premium allocation” of a loan ? This is the first time I’ve heard about it.