FNA1002

FINANCIAL ACCOUNTING
GROUP PROJECT

B31 GROUP 5:
CHAN SZE KI (U025743X)
CHU THI THANH BINH (U054177U)
LIM WEIMING (U054319L)
WEE CHOONG KIAT, EDMUND (U025350R)

TUTOR:
LIN ZHIXING

DEPARTMENT OF FINANCE & ACCOUNTING

SCHOOL OF BUSINESS
NATIONAL UNIVERSITY OF SINGAPORE

SEMESTER 1
SESSION 2005/2006
FNA1002 Group Project, B31 Group 5 2

Question 1
The nature of business undertaken by the Challenger Group (will be known as Challenger
in this project) includes merchandising and services. These include IT products and
services selling computer hardware, software and accessories, onsite IT solution and
services, and Electronic signage business which includes supplying, installing and
maintenance.1
Main types of revenue include IT products and services, electronic signage services, and
office supplies. The largest contribution comes from the provision of IT products and
services (93%). This is carried out by numerous superstores and small format outlets.
About 5% comes from the office supplies segment and another approximately 2% is from
CBDeVision in the Electronic signage category.2
Main types of expenses include cost of goods purchased ($60,326,000), staff costs
($4,891,000), and other operating expenses ($5,231,000).3

Question 2
Revenue recognition refers to recording revenue after realization (right to cash or right to
receive cash in the future) has occurred and the earning process is nearly complete.

Challenger’s revenue recognition policies include4:

·Sales revenue is recognized when buyers receive considerable amount of risks and
rewards of ownership while producers can provide objective evidence to the total amount
of both revenue and costs of transaction.

·Service revenue that happens in a short period of time is recognized when the service is
delivered to customers

·Franchise fee income is recognized on a “straight-line basis over the period of the
franchise agreement”.

·Interest revenue is recognized “on a time-proportion basis using effective interest rate”.
1
Challenger Technologies Ltd 2004 Annual Report, Corporate Profile, pg 2
2
Pg 39 Note 19
3
Pg 25 Consolidated Income Statement
4
Pg 28 Note 2, Revenue Recognition
FNA1002 Group Project, B31 Group 5 3

·Dividend revenue is recognized when it is legal for shareholders to claim dividend.

Challenger records revenue on the basis where revenue is measured at the fair value of
the consideration received or receivable, taking into account the amount of any trade
discounts and volume rebates allowed by the entity. Thus the amount recorded is the cash
value of the service transferred to the customer.
Revenue recognition from the sales of goods is appropriate because it is recorded when
there is transfer of ownership to the buyer and all the costs of transaction can be
measured reliably.5 The methods adopted are appropriate because they obey the revenue
principle, meaning realization has occurred and the earnings process is nearly complete.

Question 3
Plant and equipment and other assets (master franchise fee) are likely to have different
market values from the book values recorded. Book value of a fixed asset is the cost
minus accumulated depreciation. However, accumulated depreciation on fixed assets is
only an estimate, which may result in differences in the book value and the market value.
The Matching Principle and the Disclosure Principle account for this difference. The
Matching Principle states that the asset’s expense (depreciation) has to match its
generated revenue within the same period. The Disclosure principle requires this
depreciation amount to be computed to present the estimated residual value that remains.

Issued capital’s book value is also likely to differ from its market value. A share’s book
value is the shareholder’s equity divided by the number of issued shares. Whereas the
share’s market value is the price a person can buy or sell a share for. It is affected by the
financial position and future prospects, net profits, and the general economic conditions.
These factors will cause a difference in the 2 values.
The Reliability Principle and Disclosure Principle account for such difference. Since
market values are often determined by good-faith estimates, the Reliability Principle
states that the accounting records and statements should be based on the most reliable
data available, to be as accurate and as useful as possible. The Disclosure Principle
5
Pg 28 Note 2, Revenue Recognition
FNA1002 Group Project, B31 Group 5 4

requires Challenger to report enough information (relevant, reliable and comparable) for
outsiders to make decisions about the company.

Question 4
Title/Year 2004 2003
Accounts receivable ($ ’000) 2,011 1,764
Total assets ($ ’000) 22,702 13,333
Percentage of total assets hold as (2,011 / 22,702) x 100 = (1,764 / 13,333) =
accounts receivable (%) 8.9 13.2

Compared to the previous year, this is a fall of 4.3%.

Challenger accounts for its bad debt using the Allowance method. This method records
the amount of losses on the basis of estimates. This is unlike the Direct write-off method
in which a company waits till it is clear that customers cannot pay. Thus Challenger
records the estimated amount in the Provision for Doubtful debts.6 This is the contra
account to account receivables and is set up when there is enough objective evidence that
all original amounts of receivables will unlikely to be collected.
Challenger estimates its uncollectible amount at $1,000 which is relatively insignificant
as this is only 0.050% [(1,000 / 2,012,000) x 100] of the total accounts receivable. The
Allowance method is appropriate since account receivable is a small proportion of total
assets and it follows the Matching Principle by better matching expenses against revenue.

Question 5
a) In general, prices are subjected to inflation. It will difficult and troublesome to
account for such price fluctuations frequently. Therefore standardized cost flow
assumptions are used to cost inventories for easier accounting.

Challenger used the First-In First-Out (FIFO) method to cost its inventories.7

6
Pg 32, Note 6
7
Pg 28 Note 2, Inventories
FNA1002 Group Project, B31 Group 5 5

The assumption is appropriate. Challenger does not deal with unique inventories such
as antiques or jewelry that requires the specific unit cost to be recorded. In addition,
in the electronic and IT industries that Challenger is in, inventories purchased at the
beginning of the fiscal year are most probably sold not long after. This is because
inventories become obsolete very quickly. Hence, the FIFO method is appropriate.

b) Goods for resale at cost = $5,912,000

Goods carried at net realisable value brought to cost = $64,000 + $27,000 = $91,0008
Total historical cost at 31 December 2004 = $5,912,000 + $91,000
= $6,003,000

Question 6
a) Challenger’s depreciation is provided on gross carrying amounts in equal annual
installments over the estimated useful lives of the assets. Therefore, Challenger uses
straight-line depreciation where depreciable cost is divided by useful life in years to
determine the annual depreciation amount.

Depreciation Rates:
Renovation 12.5% to 33%
Plant and equipment 10% to 23%
Fully depreciated assets still in use are retained in the financial statements.9

Challenger also reviews the useful life of plant and equipment at least once each
financial year and depreciation charges are adjusted based on different estimates.
Based on the above information, Challenger renovates every 3 to 8 years and they
change their plant and equipment every 5 to 10 years.

The depreciation rates for renovation is appropriate. As for plant and equipment, the
estimate of their useful life between 5 to 10 years is too high. This is because

8
Pg 33 Note 8
9
Pg 29, Note 2 cont’d, Plant and equipment
FNA1002 Group Project, B31 Group 5 6

equipment such as computers become obsolete after 2 to 3 years therefore, their

depreciation rates should be much higher at 33% to 50%.
Managers consider the tradeoffs in choosing a depreciation method out of the 3 main
types. The straight-line method divides the depreciation equally throughout the asset’s
life; this makes computation easy and more convenient. The units-of-production
method provides a much better estimate of depreciation and the asset’s remaining
useful life as it is based on usage. Whereas the Double-declining-balance (DDB)
method accelerates depreciation in the early years, lowering reported net profits and
thus decreases income tax. There will be additional cash to invest using the DDB due
to avoidance of (more) tax.

b) Challenger made a loss of $33,000 on disposal of plant and equipment for the year
ended 31 Dec 2004.10

Journal entry for this transaction11:

31 Dec 2004 Accumulated depreciation……..………..… $129,000
Loss on Disposal of plant and equipment…. 33,000
Cash………………………………………... 30,000
Plant and equipment…………………… $192,000
To record loss on disposal of plant and equipment.

Question 7
3 other possible future obligations include:

·Guarantees given, e.g. bankers’ guarantee (secured) of $643,000 in 2004 12

,

·Servicing products which are under warranty (Provision for warranty),

·Possible lawsuits in the event of being sued
This information is significant because it provides a clearer outlook and better
understanding of the company’s future prospects should these obligations occur. Such
10
Pg 40, Note 23
11
Pg 35, Note 11
12
Pg 44 Note 32
FNA1002 Group Project, B31 Group 5 7

obligations will involve cash outflows in the future that result in lower cash and cash
equivalents. Investors may be misled if such future obligations are not declared properly.

Question 8
a) A share represents a unit of ownership that an investor has in a specific company.
Issuing share capital comprises of two parts: issuing of ordinary shares (consisting of
issued capital and share premium) and issuing of preference shares.13
The issued capital is the total par value of ordinary shares that have been issued by
the company and are fully paid for by the shareholders. Par value of each share is an
arbitrary amount decided by the company which represents the maximum legal
liability of the shareholder for each share. Share premium is the amount that
shareholders pay that is above the par value.

·Preference shares: This type of shares gives its owners certain advantages. For
example, if a company pays dividends, preference shareholders receive dividends
before ordinary shareholders. In 2004, Challenger did not issue any preference shares.

·Ordinary shares: Ordinary shareholders are entitled to 4 basic rights of share

ownership unless otherwise stated. They are: the right to vote on matters regarding
management of company, the right to receive dividends though after the preference
shareholders, the right to receive any proportionate share of any assets remaining
after the company pays its liabilities in liquidation and the right to maintain one’s
proportionate ownership in the company.

In 2003, Challenger issued 121,500,000 ordinary shares at par value of $0.04 each.
2003 Cash (121,500,000 * $0.04)………………… $4,860,000
Paid up capital, ordinary shares …………….. $4,860,000
To issue ordinary shares at par
In 2004 (14 January), 32,000,000 new shares were issued at premium of $0.19 each.
14 Jan 2004 Cash ………………………………….… $7,360,000

13
Pg 39, Note 18
FNA1002 Group Project, B31 Group 5 8

Paid up capital, ordinary shares……

$1,280,000
(32,000,000 * $0.04)
Share premium, ordinary shares…...
$6,080,000
(32,000,000 * $0.19)
To issue ordinary shares at premium

Hence, at 31 December 2004, total number of issued ordinary shares is 153,500,000

(121,500,000 + 32,000,000).

b) The company declared and paid a “first interim dividend of 0.56 cents net of tax per
ordinary share” on the 153,500,000 issued ordinary shares of the company totaling
$860,000 ($0.56 * 153,500,000) on September 2004. In the same year, the directors
of the company also proposed to pay a “dividend of 2.4 cents net of tax per ordinary
share”. However, this dividend is still subjected to approval and thus not included as a
liability in the financial statement.14

Question 9
a) The difference is due to the different accounting methods used. Under the Company
column, “Investment in associate” is recorded by the Cost method or Market value
method. Cost method is preferred because adjustments are not required when market
value changes. The investment is then recorded at the original purchase cost.
However, under the Group column, it must be accounted for by the equity method.
The equity method takes into account not only the purchase cost of investment, but
also the dividend receivable, and share of profits (loss) of associated companies.
Therefore, the values will differ.

b) Challenger records $2,000 as share of income tax of associates.15 The income tax of
the associate is $5,000 ($2,000/0.4). The income tax rate in Singapore was 20% and
14
Pg 42, Note 28
15
Pg 41, Note 26
FNA1002 Group Project, B31 Group 5 9

hence the net profit before tax is $25,000 ($5,000/0.2). Therefore net profit after tax
reported by associate company was $20,000 ($25,000 - $5,000).

Question 10
a) Consolidated statements combine the balance sheets, income statements and other
financial statements of the company with those of the majority owned companies into
an overall set of statements as if they were a single entity. A company is called a
subsidiary or considered a majority owned by Challenger when more than 50% of its
ordinary shares is owned by Challenger. As such, there are 7 legal entities accounts
consolidated in the Group’s accounts of Challenger as at 31 December 2004, namely:
1) Matrix Integration Pte Ltd 100% (Singapore)
2) Itech care Pte Ltd 100% (Singapore)
3) Challenger technologies Sdn Bhd 80% (Malaysia)
4) OA supplies Pte Ltd 55% (Singapore)
5) CBD eVision Pte Ltd 100% (Singapore)
- CBD eVision Sdn Bhd 60% (Malaysia)
- CBD eVision Company limited 52% (Thailand)

b) Minority interests arises when the parent company Challenger owns less than 100% of
the shares of a subsidiary company. In this case, the companies involved are:
1) Challenger technologies Sdn Bhd - 80% (Malaysia)
2) OA supplies Pte Ltd - 55% (Singapore)
3) CBD eVision Sdn Bhd - 60% (Malaysia)
4) CBD eVision Company limited - 52% (Thailand)

Specifically, “minority interests” on the consolidated balance sheet is the percentage of

the subsidiary’s equity not held by the parent company. For example, Challenger owns
55% of shares in OA supplies Pte Ltd. As such, minority interests to be reported will
be 45% of the total equity of OA supplies Pte Ltd.
FNA1002 Group Project, B31 Group 5 10

c) The OA supplies Pte Ltd was acquired at a premium over its fair market value. It is
because there is a presence of goodwill that amounts to $403,000. 16 Such conclusion
can be drawn because goodwill is an intangible asset which is the excess of the cost of
purchasing another company over the sum of the market values of its net assets or
assets less total liabilities. The excess is possible when the purchaser believes the other
company has an abnormal earning power and is willing to pay more for that.

d) Impairment loss for good will refers to the write down of intangibles when their value
decreases. This occurs when the impairment test that goodwill is subjected to every
year shows that its value has decreased. In Challenger group’s case, it recorded an
impairment loss for goodwill of $388,000 at the end of 2004. This is probably
attributed to the Group’s intention of disposing of OA Supplies in FY 2005 due to a
divergence in strategy and differences in management culture as well as the additional
capital required for the commercial expansion of OA Supplies business.

Question 11
Due to the page constraints for the project, please refer to the textbook for the ratios used.
Year/Ratio 2004 2003
Total current assets ($ ’000) 21,159 12,155
Total current liabilities ($ ’000) 7,875 7,040
Current ratio 2.69 1.73
Total liabilities ($ ’000) 8,094 7,204
Total assets ($ ’000) 22,702 13,333
Debt ratio 0.36 0.54
Net profit ($ ’000) 2,798 3,169
Preference dividend ($ ’000) 0 0
Average ordinary shareholders’ equity (14,573 + 6,129) / 2 (6,129 + 4,65917) / 2
($ ’000) = 10,351 = 5,394
Return of equity (%) 27 59
Net profit ($ ’000) 2,798 3,169
Preference dividend ($ ’000) 0 0
Number of ordinary shares issued ( ’000) 153,500 121,500
Earnings per ordinary share (cents/share) 1.8 2.6
Dividend per ordinary share (cents/share) 3.718 2.27
16
Pg 43, Note 29
17
Challenger Technologies Ltd 2003 Annual Report, Balance Sheet – 2002 Total equity
FNA1002 Group Project, B31 Group 5 11

Market price per ordinary share (cents/share) 23 4

Dividend yield (%) 16.1 56.8
Market price per ordinary share (cents/share) 23 4
Earnings per share (cents/share) 1.8 2.6
Price/earnings ratio 12.8 1.54

The current ratio measures Challenger’s ability to pay its current liabilities with current
assets, which has increased from 1.73 to 2.69. Challenger has adequate liquid assets to
maintain its normal business operations, and a current ratio of 2.69 suggests that
Challenger is at a strong financial position.
The debt ratio shows the proportion of Challenger’s liabilities that have to be financed by
assets. It decreased from 0.54 to 0.36 (a relatively low-risk position), meaning that
Challenger has lowered future obligations.
The current and debt ratios indicate that Challenger is currently in a safe and strong
financial position and is unlikely to go bankrupt within the next few years.

The return of equity is a measure of the amount of profit earned for every dollar invested
by the ordinary shareholders. The decrease of the return of equity from 59% to 27% was
mainly because of additional shares issued above par value (leading to increase in
reserves). As a result, the amount of profit for every dollar invested has decreased. This is
unfavourable for shareholders.
The earnings per ordinary share (EPS) give the amount of net profit per share of
Challenger’s issued ordinary shares. This ratio dropped from 2.6 to 1.8 due to decreased
net profit and an increased in the number of issued ordinary shares. Each share is linked
with a lower proportion of net profit, suggesting concerns about the value of shares.
The dividend yield measures the portion of a share’s market value that is returned as
dividend in a particular year. It has dropped from 56.8% to 16.1%. This is a concern as
the amount of return (as dividends) has significantly dropped for the year.
Price/earnings ratio (P/E) indicates the market price for every dollar earned; an important
ratio in deciding the status of the shares, i.e. to buy, hold or sell shares. Challenger’s P/E
increased significantly from 1.54 to 12.8, meaning that shares are sold at 12.8 times the
earnings. This high ratio indicates a high probability of market share price to fall.
18
Pg 5, Chief Executive’s Message: The Group
FNA1002 Group Project, B31 Group 5 12

The return of equity, EPS, and dividend yield ratios have dropped and indicate declined
returns to shares. The increased in P/E also suggest that the market price of Challenger’s
share will fall soon; selling the shares may seem inevitable in the near future.

Although Challenger does not seem to be in a bad financial position and/or facing
possible financial problems, the returns to shares to shareholders is declining and the
situation indicates a possible market price fall of Challenger’s shares. This speculation
may even lead to a sudden release of Challenger’s ordinary shares and making the price
fall. As shareholders, we will naturally be unhappy with such a pessimistic situation.

Question 12
Mr Tan’s happiness is not justified because the increase of $9.2 millions in cash and cash
equivalents does not mean that the Challenger has earned “plenty of profits”. This change
in cash and cash equivalents is comprised of changes in cash flows from operating
activities (CFO), investing activities (CFI) and financing activities (CFF).

Firstly, the increase in net cash and cash equivalents is largely due to the increase in CFF
of $7,820K from -$1,701K to $6,119K.19 It can be observed that the increase in cash
inflows is mainly due to the issuance of shares, short-term borrowings and paying less
dividend (which decreased cash outflow). This is in fact not a good sign since new shares
and more borrowings mean that Challenger will need to pay more dividends and interests
in future. This will put a strain on the amount of cash on hand that the company needs to
have. Moreover, it is not healthy to have the main source of cash inflows come from
borrowings from shareholders and creditors instead of operating business activities.

Secondly, the net profit before tax in 2004 ($3,715,000) is actually lower than that in
2003 ($4,024,000). This can be seen from the income statement and the CFO in the cash
flow statement. However, the net cash flows from operating activities is still higher than
that in 2003. This is because under the accrual accounting basis which is used to compute
net profit in the income statement, many transactions that do not involve cash exchange

19
Pg 27,Consolidated Cash Flow Statement
FNA1002 Group Project, B31 Group 5 13

are realized. Under this cash flow statement, those transactions are not realized and need
to be adjusted to the profit income tax. Apparently, in 2004, there are many more non
cash operating expenses which actually decrease the 2004 net profit. They are all added
back to the CFO in the cash flow statement resulting in higher result in 2004 than 2003.

Title/Year 2004 2003

Net profit after tax ($ ’000) 2,798 3,169
Net sales ($ ’000) 75,478 67,265
Profit margin (%) (2798 / 75478) x 100% (3169 / 67265) x 100%
= 3.7 = 4.7

Thirdly, the profit margin, which is the net profit after tax / net sales, fell from 4.7% in
2003 to 3.7% in 2004 shows that the company is not performing that well.
In conclusion, it is not justified to say that Challenger “did so well in 2004 to earn plenty
of profits”.

Question 13
Challenger’s external auditors are Chio Lim & Associates, and the Partner In-charge is
Lim Lee Meng.
The audit opinion given was unqualified/clean. It means that Challenger’s 2004
consolidated (group) financial statements, and the company’s balance sheet and statement
of changes in equity were prepared in accordance with the provisions of the Companies
Act, Cap. 50 (the “Act”) and Singapore Financial Reporting Standards. This reflects a
factual and reasonable view of the positions of both the group and of the company as at
31 December 2004.20
To external users, this opinion means that Challenger’s financial statements are justified
and reliable. Therefore, the financial statements portray a reasonable view of
Challenger’s financial status without any worries of its accounts being “cooked”.
External users can rely on these statements to assess the current and future prospects of
Challenger, and thus making their investment decisions.

20
Pg 23, Auditors’ Report
FNA1002 Group Project, B31 Group 5 14

Question 14
Item 1021, accountability is important to investors. Challenger displays this by providing
shareholders with a balance and understandable assessment of the Group’s performance,
position and prospects on a regular basis and communicating major developments in its
business operations. In doing so, this increases the transparency of the workings in the
Challenger, which would greatly help in investment decisions.
The provision of quarterly updates of management accounts of the Group to the Directors
also enables the Directors to make informed decisions for the future direction of the
Group to investors.
Item 1422, communications with shareholders, is another item that is important to
investors. Challenger fulfills its obligation to provide timely disclosure of material
information to the shareholders. It does this through annual reports, announcement of the
half and full year results, press releases on the major developments of the company, and
the company’s website. The annual general meeting is also a good opportunity for
shareholders to communicate with the CEO and board of directors. This can be useful to
an investor since they will be able to know how they can relate to the Board of directors
of the company, once they have any problems regarding the financial health of the
Challenger or need to obtain more information on the company. By stating it clearly in
this way, investors can save on time and effort in finding out the various means of
communication. Furthermore, by stating it clearly in the financial statement, Challenger
has shown that it cares about the shareholders and it is willing to listen to any feedback
from them as well as to answer their needs and requirements. This psychological effect
might induce investors to find out more about the company and to invest in it.

Question 15
When CEOs of companies are interviewed, their opinions of “healthy” or “strong”
financials often relate to high profits, increased sales, low debts, high market price of
shares, and capability of declaring dividends. These are usually associated with high

21
Pg 16, Corporate Governance, Accountability
22
Pg 18, Corporate Governance, Communications with shareholders
FNA1002 Group Project, B31 Group 5 15

gross (profit) margin, high inventory turnover, high rate of return on net sales, high rate
of return on total assets, low debt ratio, high dividend yield, and high return on equity.

Analysis of Challenger:
Reasonable gross (profit) margin: increased by 0.5, from 19.5 to 20.0.
Reasonably high inventory turnover: increased by 0.17, from 9.83 to 10.
High rate of return on net sales: considered relatively high even though it decreased by
0.01, from 0.047 to 0.037.
High rate of return on total assets: still considered high even though it decreased by 9%,
from 24.7% to 15.7%.
Low debt ratio: decreased by 0.18, from 0.54 to 0.36.
High dividend yield: still considered high despite decreasing by 40.7%, from 56.8% to
16.1%. This decrease is due to issuance of new shares at prices above par value.
High return on equity: decreased by 32%, from 59% to 27%.

Due to the page constraints for the project, please refer to the textbook for the ratios used.
Year/Ratio 2004 2003
Cost of goods sold (= Beg. Inventory + (6,063 + 60,326 – (4,952 + 55,226 –
Purchases – Ending Inventory) ($ ’000) 5,976) = 60,413 6,063) = 54,115
Gross profit ($ ’000) (75,478 – 60,413) (67,265 – 54,115)
= 15,065 = 13,150
Net sales ($ ’000) 75,478 67,265
Gross (profit) margin (%) 20.0 19.5
Cost of goods sold ($ ’000) (6,063 + 60,326 – (4,952 + 55,226 –
5,976) = 60,413 6,063) = 54,115
Average inventory (6,063 + 5,976) / 2 = (4,952 + 6,063) / 2 =
6,019.5 5,507.5
Inventory turnover 10.0 9.83
Net profit after tax ($ ’000) 2,798 3,169
Net sales ($ ’000) 75,478 67,265
Return on net sales 0.037 0.047
Net profit after tax ($ ’000) 2,798 3,169
Interest expense ($ ’000) 39 3
Average total assets ($ ’000) (22,702 +13,333) / 2 (13,333 + 12,338) / 2
= 18,017.5 = 12,835.5
FNA1002 Group Project, B31 Group 5 16

Rate of return on total assets (%) 15.7 24.7

From the above ratios used for analysis, we can see that Challenger’s 2004 overall
financials can be considered “healthy” and/or “strong”.
Challenger appears to be in a healthy financial position in 2004. However as potential
investors, we will consider the trends of these ratios and the returns of shares/equity. As
computed and discussed in Question 11, the returns to shareholders (such as return of
equity, EPS, and dividend yield) are declining and there is a risk of price fall of the shares
(from high increase in P/E). As such, we will not invest in Challenger’s shares solely
based on the current (2004) statistics, but keep a lookout for its business in the next year
and further analyse the trend before making any decisions.