The Institute of Chartered Accountants in England and Wales
Corporate Reporting
Question Bank
For exams in 2022
icaew.com
Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-5097-3990-5
Previous ISBN: 978-1-5097-3321-7
e-ISBN: 978-1-5097-4007-9
First edition 2014
Ninth edition 2021
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examinations, and should not be used as professional advice.
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© ICAEW 2021
Contents
The following questions are exam-standard. They are not the original questions from the exams. The
marking guides provided with the answers are illustrative to help students understand how marks
may be allocated in the exam and to identify gaps in their answers.
Title
Marks
Time
allocation
(Mins)
Question
Answer
Page
Financial reporting 1
1
Kime
30
63
1
285
2
Mervyn plc
30
63
4
292
3
Billinge
30
63
6
297
4
Longwood
30
63
7
300
5
Upstart Records
30
63
10
304
6
MaxiMart plc
30
63
12
311
7
Robicorp plc
30
63
15
314
8
Flynt plc
30
63
17
319
9
Gustavo plc
30
63
19
324
10 Inca Ltd
30
63
23
331
11 Aytace plc
30
63
25
337
12 Razak plc
30
63
28
342
13 Melton plc
30
63
31
347
14 Aroma
30
63
34
351
15 Kenyon
30
63
36
354
16 Dormro
40
84
39
359
17 Johnson Telecom
40
84
43
366
18 Biltmore
40
84
47
372
19 Hillhire
40
84
50
377
20 Maykem
40
84
54
383
21 Tydaway
40
84
58
389
22 Wadi Investments
40
84
62
398
23 Lyght
40
84
64
403
24 Hopper Wholesale
40
84
66
411
25 Button Bathrooms
40
84
68
416
Financial reporting 2
Audit and integrated 1
ICAEW 2022
Contents
iii
Title
Marks
Time
allocation
(Mins)
Question
Answer
Page
26 Jupiter
30
63
71
423
27 Poe, Whitman and Co
30
63
74
429
28 Precision Garage Access
30
63
79
437
29 Tawkcom
30
63
82
443
30 Expando Ltd
30
63
85
447
31 NetusUK Ltd
30
63
88
452
32 Verloc Group
30
63
92
455
33 KK
30
63
96
464
34 UHN (July 2014) (amended)
45
95
98
470
35 Couvert (November 2014)
40
84
102
478
36 ERE (November 2014)
34
71
106
485
37 Congloma
40
84
111
495
38 Heston
30
63
114
502
39 Larousse
40
84
119
511
40 Telo
30
63
123
520
41 Newpenny (amended)
40
84
126
526
42 Earthstor
40
84
131
535
43 EyeOP
30
63
134
544
44 Topclass Teach
30
63
137
552
45 Zego
40
84
141
559
46 Trinkup
32
68
145
567
47 Key4Link
28
58
148
573
48 Konext
40
84
153
581
49 Elac
30
63
157
591
50 Recruit1
30
63
159
596
Audit and integrated 2
Real exam (July 2015)
Real exam (November 2015)
Real exam (July 2016)
Real exam (November 2016)
Real exam (July 2017)
iv
Corporate Reporting
ICAEW 2022
Title
Marks
Time
allocation
(Mins)
Question
Answer
Page
Real exam (November 2017)
51 EF
40
84
165
605
52 Wayte
30
63
168
612
53 SettleBlue
30
63
171
619
54 EC
40
84
177
625
55 Raven plc
30
63
180
632
56 MRL
30
63
183
641
57 Zmant plc
42
88
189
649
58 Chelle plc
30
63
192
658
59 Solvit plc
28
59
195
665
60 Vacance plc
40
84
199
671
61 JKL plc
30
63
202
681
62 Roada Ltd
30
63
205
688
63 Your Nature plc
45
95
209
695
64 RTone plc
30
63
213
704
65 Gentri plc
25
52
216
712
66 HC plc
40
84
221
719
67 React Chemicals plc
30
63
224
727
68 Hyall and Forbes
30
63
228
735
69 SSD
42
88
233
745
70 Beta World
30
63
237
754
71 GlamFood
28
59
240
761
72 Panther Metals Ltd
40
84
248
769
73 E-Van Ltd
30
63
252
781
Real exam (July 2018)
Real exam (November 2018)
Real exam (July 2019)
Real exam (November 2019)
Real exam (August 2020)
Real exam (November 2020)
Real exam (July 2021)
ICAEW 2022
Contents
v
Title
Time
allocation
(Mins)
Question
Answer
30
63
255
790
75 Practice Question 1
45
95
260
797
76 Practice Question 2
35
74
262
802
77 Practice Question 3
30
63
264
805
78 Practice Question 4
30
63
266
809
79 Practice Question 5
45
95
268
812
80 Practice question 6
40
84
275
823
Marks
74 Hughes Watson LLP
Page
Data Analytics Software
vi
Corporate Reporting
ICAEW 2022
Exam
Your exam will consist of:
•
Three written questions – 100 marks
•
Pass mark – 50
•
Exam length – 3.5 hours
The ACA student area of our website includes the latest information, guidance and exclusive
resources to help you progress through the ACA. Find everything you need, from exam webinars,
past exams, marks plans, errata sheets and the syllabus to examiner and tutor-written articles at
icaew.com/examresources.
The exam will be open book. Students will be able to access their personal ICAEW Bookshelf, and
any ICAEW digital learning materials held there, during the exam. Students will also be permitted to
take any written or printed material into the exam, subject to practical space restrictions. To see the
recommended text(s) for this exam, go to icaew.com/permittedtexts.
Corporate Reporting data analytics software resources
ICAEW has introduced data analytics software (DAS) into ACA exams, starting with the Audit and
Assurance exam in March 2021, followed by Corporate Reporting in July 2021.
The DAS in the Corporate Reporting exam will form part of Question 1 only. Advance Information will
be issued four weeks before the exam. The Advance Information comprises of two elements:
•
11 months data for a company in the data analytics software; and
•
An Advance Information document with scenario and background information.
In the exam, candidates will have access to the data in the DAS for the same company for the full 12
months. There will be no changes to the 11 months’ data which you will have already had an
opportunity to examine in the Advance Information.
Typically, there will be a total of around 15-20 marks in the Corporate Reporting exam for the direct
use of the DAS that cannot be obtained without using it. The DAS contains a series of visualisations
which you may be required to interrogate, analyse and interpret. However, you will not be able to
copy visualisations (or any other information) from the DAS into your answer. It is therefore important
that you demonstrate communication skills in your exam answer to convey your understanding and
analysis of the visualisations and data.
You will need to be familiar with how the software works and its various functions and you are
strongly advised to work through the guidance notes and practice questions that you will find on the
ICAEW website here: https://www.icaew.com/for-current-aca-students/changes-to-ourqualifications/exams/corporate-reporting-das-resources
The application of the DAS tools to the data may require using key skills including data assimilation,
structuring of data, exercising judgement and applying professional scepticism. These skills may be
needed, for example, to identify and investigate unusual patterns and trends from visualisations
produced by the DAS. Alternatively, they might be needed to identify and investigate a notable, and
potentially high risk, transaction.
Once an unusual trend or notable transaction has been identified, the nature of the investigations
could be to consider the underlying causes and any audit risks. For example, having found an issue
with one transaction, it may be appropriate to use judgement to widen the search for other similar or
related transactions which may exhibit the same risk.
It might not always be possible to clearly identify the nature and rationale of the notable transaction
or trend. However, the data may enable you to devise questions for management to obtain
information and explanations which would help you to identify key audit risks.
In using real company data and real-world commercial DAS, these skills are intended to replicate and
test the knowledge and understanding used in auditing in the workplace.
Applying professional scepticism to the DAS and to the data is important. For example, where the
DAS has analysed data and concluded that an account is low risk, it is appropriate to apply
professional scepticism to question whether that conclusion is appropriate, perhaps based on other
information provided in the Corporate Reporting exam.
ICAEW 2022
Introduction
vii
Professional skills
Professional skills are essential to accountancy and your development of them is embedded
throughout the ACA qualification. The level of competency in each of the professional skills areas
required to pass each module exam increases as ACA trainees progress upwards through each Level
of the ACA qualification.
The professional skills embedded throughout this Question Bank provide the opportunity to develop
the knowledge and professional skills required to successfully pass the exam for this module.
During your question practice, remain mindful that you should be demonstrating each of the four
professional skills within your answers. You are advised to familiarise yourself with the full ACA
professional skills development grids which can be found at icaew.com/examresources.
The following advice will help you demonstrate each of the professional skills when completing your
answers to questions in this Question Bank.
Questions in the Corporate Reporting exam are long, and often complex, and will require application
of the full set of professional skills, as well as knowledge and techniques. The exam is open book, so,
as in professional life, ability to use, find and apply information is more important than memorising it.
Below are the key skills required in the Corporate Reporting exam that you will need to master.
Professional skills focus: Assimilating and using information
The Corporate Reporting exam requires you to earn 100 marks in 210 minutes, which means around
84 minutes for Question 1 and around 63 minutes for each of questions 2 and 3, although the
allocation of marks may vary slightly. There is a great deal of information in each question, with
multiple information sources. Assimilating and using this information is a key skill, paying particular
attention to the requirements so as not to lose focus.
Professional skills focus: Structuring problems and solutions
Sometimes a structure will be provided by the nature of the question, for example explaining
financial reporting issues with calculations, then adjusting the financial statements. Sometimes an
appropriate structure will arise from an IFRS, for example IFRS 15 has a step-by-step process for
recognising revenue. However, the structure may well be implicit, rather than explicit. Question 1 will
require familiarity with live data analytics software to help you make sense of the case presented in
the scenario.
Professional skills focus: Applying judgement
The requirement to apply judgement is likely to arise in the context of an ethical dilemma, or a
complex audit scenario, for example reliance on the work of a component auditor. It will also be
needed in financial analysis, not least in determining what to focus the analysis on. While many
recent IFRS have eliminated choices in accounting policy, there is still scope for exercising
judgement, for example in impairment of financial assets.
Professional skills focus: Concluding, recommending and communicating
Most questions require you to come to some kind of decision or conclusion. If you make a mistake in
your calculations, but your conclusion is consistent with your figures and arrived at by reasoned
argument, you will be given credit for it, even if it is different from the model answer.
viii
Corporate Reporting
ICAEW 2022
Question Bank
x
Corporate Reporting
ICAEW 2022
Financial reporting 1
1 Kime
Kime plc is in the property industry, operating in both the commercial and private housing sectors.
Kime uses the cost model for measuring its property portfolio in its financial statements and has a 30
June year end.
You are Jo Ng, Kime’s recently appointed financial controller. Your role is to prepare the financial
statements for the year ended 30 June 20X2 before the auditors start work next week. The finance
director has supplied you with some work papers containing a trial balance and outstanding issues (
Exhibit) which have been prepared by a junior assistant. The finance director gives you the following
instructions:
“The auditors are due to start their audit work on Monday and I would like to be aware of any
contentious financial reporting issues before they arrive.
Review the outstanding issues identified by the junior assistant (Exhibit) and explain the potentially
contentious financial reporting issues. Determine any adjustments you consider necessary and
explain the impact of your adjustments on the financial statements, identifying any alternative
accounting treatments. The board of directors has indicated that accounting policies should be
selected which maximise the profit in the current year.
Using the trial balance and after making adjustments for matters arising from your review of the
outstanding issues (Exhibit) prepare a draft statement of financial position and statement of
comprehensive income.”
Requirement
Respond to the finance director’s instructions.
Total: 30 marks
Exhibit: Work papers prepared by the junior assistant
Trial balance at 30 June 20X2
Additional
information
Land
1
Buildings – cost
Debit
Credit
£m
£m
30.5
132.7
Buildings – accumulated depreciation
82.5
Plant and equipment – cost
120.0
Plant and equipment – accumulated
depreciation
Trade receivables
22.8
2
Cash and cash equivalents
174.5
183.1
Ordinary share capital (£1 shares)
100.0
Share premium
84.0
Retained earnings at 1 July 20X1
102.0
Long-term borrowings
Deferred tax liability at 1 July 20X1
80.0
3
33.0
Trade and other payables
54.9
Sales
Operating costs
ICAEW 2022
549.8
322.4
Financial reporting 1
1
Additional
information
Debit
Credit
£m
£m
Distribution costs
60.3
Administrative expenses
80.7
Finance costs
4.8
––––––
1,109.0
1,109.0
Additional information and outstanding issues
(1) Freehold land and buildings – at 30 June 20X2
Land
Buildings
Total
£m
£m
£m
34.0
118.4
152.4
Additions
–
26.8
26.8
Disposals
(3.5)
(12.5)
(16.0)
At 30 June 20X2
30.5
132.7
163.2
At 1 July 20X1
–
84.8
84.8
Charge for the year
–
5.9
5.9
Disposals
–––––
(8.2)
(8.2)
At 30 June 20X2
–––––
82.5
82.5
At 30 June 20X2
30.5
50.2
80.7
At 30 June 20X1
34.0
33.6
67.6
Cost:
At 1 July 20X1
Accumulated depreciation:
Carrying amount:
The accounting policy states that land is not depreciated and all buildings are depreciated over their
expected useful life of 50 years with no residual value.
Additions – total £26.8 million
The additions comprise two major commercial property projects (these are the first construction
projects undertaken by Kime for a number of years):
•
Renovation of Ferris Street property (£8.8 million)
Kime commenced this renovation during the year ended 30 June 20X2. The budgeted cost of this
project is £15 million, of which £12 million (80%) has been designated as capital expenditure by
the project manager. The remaining £3 million is charged in the budget as repairs and
maintenance cost.
In the year ended 30 June 20X2, the company incurred costs of £11 million on the project.
Therefore I have capitalised 80% of the cost incurred in line with the original budget.
•
Construction of a sports stadium in London (£18 million)
On 1 July 20X1, Kime began constructing a sports stadium for a local authority, which was
expected to take 20 months to complete. Kime agreed a total contract price of £34 million. The
contract specifies that control of the sports stadium is transferred to the local authority as it is
2
Corporate Reporting
ICAEW 2022
constructed and that Kime has an enforceable right to payment. Total contract costs were
expected to be £16 million, however costs incurred at 30 June 20X2 are £18 million and these
have been capitalised in the year ended 30 June 20X2. Reliable estimates of costs to complete
the project have been certified by the company’s own surveyor to be £4.5 million. He has also
provided a value of work completed to date of £23.8 million.
In the year ended 30 June 20X2, Kime raised invoices totalling £17 million to the local authority
and recognised this amount in revenue for the year. The local authority had paid all outstanding
invoices by 30 June 20X2.
Disposals
Kime disposed of two properties during the year:
Cost of land
Cost of buildings
Accumulated
depreciation at
disposal date
Property
£m
£m
£m
FX House
2.0
8.0
4.2
Estate agency buildings
1.5
4.5
4.0
Total
3.5
12.5
8.2
FX House
This property was leased to a third party under an agreement signed on 1 January 20X2. This is a 40year lease and the title to both the land and buildings transfers to the lessee at zero cost at the end
of the lease term. The annual rental is £2 million payable in advance. The present value on 1 January
20X2 of the lease payments discounted at the interest rate of 10% implicit in the lease was £21.5
million, which clearly exceeds the carrying amount at the date of disposal and the lease is therefore a
finance lease.
I have derecognised the property and recognised a loss on disposal equal to the carrying amount of
£5.8 million in administrative expenses for the year ended 30 June 20X2. The first annual lease
payment received on 1 January 20X2 has been credited to finance costs for the year ended 30 June
20X2.
Estate agency buildings
Due to the recession Kime has reconsidered its business model and closed down its high street
estate agencies buildings from which it operated its private housing business. The estate agencies
business is now operated entirely online.
In May 20X2 a contract for the sale of these buildings, including land was agreed for a price of £10
million, with the sale to be completed in September 20X2. A gain has been recognised in
administrative expenses in profit or loss of £8 million and a receivable of £10 million in trade
receivables.
(2) Trade receivables and forward contract
Included in trade receivables is an amount due from a customer located abroad in Ruritania. The
amount (R$60.48 million) was initially recognised on 1 April 20X2 when the spot exchange rate was
£1= R$5.6.
At 30 June 20X2, the exchange rate was £1 = R$5.0. No adjustment has been made to the trade
receivable since it was initially recognised.
Given the size of the exposure, the company entered into a forward contract, at the same time as the
receivable was initially recognised on 1 April 20X2, in order to protect cash flows from fluctuations in
the exchange rate. The forward contract is to sell R$60.48 million and the arrangement satisfies the
necessary criteria to be accounted for as a hedge, under IFRS 9, Financial Instruments.
At 30 June 20X2, the loss in fair value of the forward contract was £1.5 million. The company elected
to designate the spot element of the hedge as the hedging relationship. The difference between the
change in fair value of the receivable and the change in fair value of the forward contract since
inception is the interest element of the forward contract.
ICAEW 2022
Financial reporting 1
3
(3) Property management services
On 1 June 20X2, Kime entered into a contract to provide management services for 50 residential
properties owned by a local authority. The services are to be provided for three years at £8 million
per year starting on 1 July 20X2, and the local authority has paid a deposit of £1 million on 1 June
20X2. Kime has recorded this deposit as revenue.
(4) Current and deferred taxation
I have not yet made any adjustments for deferred or current taxation, but have been told to make the
following assumptions:
•
The tax rate is 24%.
•
Taxable profits are calculated on the same basis as IFRS profits except for temporary differences
arising on plant and equipment.
•
The deferred tax temporary taxable differences have risen by £14 million over the year to 30 June
20X2 after the effects of accounting for depreciation on plant and equipment only. No tax relief is
available on freehold buildings and land.
2 Mervyn plc
Mervyn plc manufactures electrical components for the motor trade. Mervyn is in the process of
finalising its financial statements for the year ended 30 September 20X7. Due to cash flow problems
Mervyn sold two pieces of its freehold land during the current financial year. The land was held in the
financial statements at cost. The finance director, reviewing the draft financial statements, has asked
for your advice on these sales as well as on some unusual features identified.
An extract from the statement of changes in equity in the draft financial statements shows:
Retained earnings
£‘000
At 1 October 20X6
2,190
Profit for the year
1,471
Dividends paid
(515)
At 30 September 20X7
3,146
There is a note explaining that there is no ‘other comprehensive income’ in the statement of profit or
loss and other comprehensive income as there are no gains and losses other than those recognised
in profit or loss for the year.
The statement of profit or loss and other comprehensive income shows an ‘exceptional’ gain relating
to gains on the two land bank sales:
£‘000
The Ridings
100
Hanger Hill Estate
250
350
A contract for the sale of land at The Ridings was entered into in June 20X7 conditional upon
obtaining a detailed planning consent, but only outline consent had been obtained by 30
September 20X7. Planning consent was received in October and the land sale was completed in
November 20X7. Tax of £27,000 has been provided on the sale.
The sale of land at Hanger Hill to the Beauford Corp on 1 October 20X6 took place under a sale and
leaseback arrangement. The terms of the lease arrangement were:
4
Lease term
Five years
Rentals first payable on 30 September 20X7
£80,000 per annum
Corporate Reporting
ICAEW 2022
On 1 October 20X6 the carrying amount of the Hanger Hill land was £900,000 and the proceeds of
the sale were equal to its fair value of £1,150,000. The first rental was paid on its due date and
charged to operating expenses.
Beauford Corp is obliged to take possession of this land at the conclusion of the lease and Mervyn
plc has no right to repurchase it.
The cumulative discount factor for a five-year annuity at 10% (the interest rate implicit in the lease) is
3.791.
Operating expenses include £405,000 relating to the company’s defined benefit pension scheme.
This figure represents the contributions paid into the scheme in the year. No other entries have been
made relating to this scheme. The figures included in the draft statement of financial position
represent opening balances as at 1 October 20X6:
£‘000
Pension scheme assets
2,160
Pension scheme liabilities
(2,530)
(370)
Deferred tax asset
85
(285)
After the year end, a report was obtained from an independent actuary. This gave valuations as at 30
September 20X7 of:
£‘000
Pension scheme assets
2,090
Pension scheme liabilities
(2,625)
Other information in the report included:
Current service cost
374
Payment out of scheme relating to employees transferring out
400
Reduction in liability relating to transfers
350
Pensions paid
220
Interest rate on high quality corporate bonds at 1 September 20X7
10%
All receipts and payments into and out of the scheme can be assumed to have occurred on 30
September 20X7.
Mervyn’s accounting policy is to recognise any gains and losses on remeasurement of the defined
benefit asset or liability (actuarial gains and losses) in accordance with IAS 19, Employee Benefits.
In the tax regime in which Mervyn operates, a tax deduction is allowed on payment of pension
contributions. No tax deduction is allowed for benefits paid. The rate of tax applicable to 20X6, 20X7
and announced for 20X8 is 23%.
In March 20X7, a customer of Mervyn brought legal proceedings against Mervyn for alleged injury to
employees and loss of business through a fault in one of Mervyn’s products. In September 20X7, the
case came to court but Mervyn’s lawyers think that it could be a very lengthy case and believe that
Mervyn will lose the case. The actual cost of damages and timing of the case are far from clear but
management have made a number of estimates. They believe that the best outcome for Mervyn will
be damages of £200,000 payable in one year’s time. The worst possible outcome would be for the
case to continue for three more years in which case the estimate of damages and costs is £1,500,000
payable in three years’ time. A further estimate, between these two extremes, is that damages of
£800,000 will be payable in two years’ time. Management’s estimates of probabilities are best
outcome 25%, worst case outcome 15% and middle ground outcome 60%. No provision nor any
disclosure has been made for this court case in the financial statements.
ICAEW 2022
Financial reporting 1
5
At the request of one particular customer, Mervyn has a new arrangement that it will hold the goods
that it sells until such time as the customer needs them, and they are kept in a separate storage area
exclusive to that customer. The customer is invoiced for the goods when they are ready for delivery,
but they are set aside until the customer needs them, ready for delivery. This particular component is
made exclusively for that customer. The accountant of Mervyn has not been recognising the revenue
on these sales until the delivery has taken place to the customer. At 30 September 20X7, there were
goods with a selling price of £138,000 and cost of £99,000 which had not yet been delivered to the
customer. These goods had been included at cost when the inventory count took place.
The company granted share appreciation rights (SARs) to its employees on 1 October 20X5 based
on 10,000 shares. The SARs provide employees at the date the rights are exercised with the right to
receive cash equal to the appreciation in the company’s share price since the grant date. The rights
vested on 30 September 20X7 and payment was made on schedule on 1 November 20X7. The fair
value of the SARs per share at 30 September 20X6 was £6, at 30 September 20X7 was £8 and at 1
November 20X7 was £9. The company has recognised a liability for the SARs as at 30 September
20X6 based upon IFRS 2, Share-based Payment but the liability was stated at the same amount at 30
September 20X7.
If any figures are to be discounted, a rate of 10% per annum should be used.
Requirement
Explain how each of the above transactions should be treated in the financial statements for the year
ended 30 September 20X7 and prepare a statement of amended profit for the year ended 30
September 20X7.
Total: 30 marks
3 Billinge
You are Anna Wotton, an ICAEW Chartered Accountant, and have recently been appointed as the
financial controller at Billinge, a manufacturer of electrical components for vehicles. Billinge is a
public limited company with a number of subsidiaries located throughout the country and one
foreign subsidiary, Quando.
Peter McLaughlin, Finance Director of Billinge, is in the process of finalising the financial statements
for the year ended 31 October 20X3. However, he is unsure about the impact of deferred taxation on
various transactions of the company, because the previous financial controller, Jen da Rosa, always
dealt with this side of the financial statements preparation.
Peter has provided you with a file (Exhibit) prepared by Jen before she left, which contains a number
of transactions that have deferred tax implications. He has asked you to prepare a briefing note
which provides explanations and calculations of the deferred tax implications for each of the
transactions in the file (Exhibit) on the consolidated financial statements of Billinge for the year
ended 31 October 20X3.
In the country in which Billinge operates, the applicable tax rate is 30%. Peter has asked you to use
the working assumption that Billinge will continue to pay tax at the current rate of 30%.
Requirement
Prepare the briefing note requested by Peter McLaughlin.
Total: 30 marks
Exhibit: Deferred tax issues identified by Jen da Rosa
(1) Fair value adjustment
On 1 November 20X2, Billinge acquired a 100% subsidiary, Hindley for £10 million. On that date,
the fair value of Hindley’s net assets was £8 million and the carrying amount was £7 million,
which is also the tax base under local tax law. The difference between the fair value and book
value of net assets relates to an item of property, plant and equipment which Hindley currently
has no plans to sell.
(2) Share options
On 1 November 20X1, Billinge granted 1,000 share options each to its 500 employees providing
they remained in employment until 31 October 20X4. The fair value of each option was £5 on 1
November 20X1, £6 on 31 October 20X2 and £7 on 31 October 20X3. Local tax law allows a tax
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deduction at the exercise date of the intrinsic value of the options. The intrinsic value of each
option was £3 at 31 October 20X2 and £8 at 31 October 20X3. The percentage of employees
expected to leave over the vesting period was 20% as at 31 October 20X2 and has been revised
upwards to 25% as at 31 October 20X3. The deferred taxation on this transaction was correctly
accounted for in the year ended 31 October 20X2 but the finance director is unsure how to
account for the deferred taxation in the current year.
(3) Goods purchased from subsidiary
A wholly owned subsidiary, Ince, sold goods for £5 million to Billinge on 20 September 20X3 at
a mark-up of 25%. At 31 October 20X3, Billinge has sold a quarter of these goods to third
parties. The financial director does not understand how this transaction should be dealt with in
the financial statements of the subsidiary and the group for taxation purposes.
(4) Profits from foreign subsidiary
Quando, the 100% owned foreign subsidiary of Billinge, has undistributed post-acquisition
profits of 5 million Corona which would give rise to additional tax payable of £0.4 million if
remitted to Billinge’s tax regime. As Quando is a relatively new and rapidly expanding company,
Billinge intends to leave the earnings within Quando for reinvestment.
(5) Property, plant and equipment
On 1 November 20X2, Billinge purchased an item of property, plant and equipment for £12
million which qualified for a government capital grant of £2 million. The asset has a useful life of
five years and is depreciated on a straight line basis. Capital allowances are restricted by the
amount of the grant. Local tax law specifies a tax writing down allowance of 25% per annum.
(6) Lease
Due to the age of its assets, Billinge has recently begun a programme of capital expenditure.
Until now, Billinge has always purchased its assets outright for cash. However, due to liquidity
problems, Billinge had to lease an item of machinery on 1 November 20X2. The asset has an
expected economic life of five years and the lease term is also for five years. Both the present
value of future lease payments and fair value of the asset are £6 million. The annual lease
payments are £1.5 million payable in arrears on 31 October and the interest rate implicit in the
lease is 8% per annum. Under local tax law the company can claim a tax deduction for the annual
rental payment as the asset does not qualify for capital allowances.
4 Longwood
The Longwood Group is a listed European entity specialising in high grade alloy production for civil
aviation, military and specialist engineering applications. On 1 January 20X7, Longwood completed
the acquisition of a private company, Portobello Alloys, to strengthen its product offering in high
performance electro-magnetic alloys.
The total price paid to acquire the entire share capital of Portobello Alloys was £57 million in cash
paid on the deal date, along with a further £10 million in deferred cash and 5 million shares in The
Longwood Group, both to be paid or issued in three years’ time. The share price of The Longwood
Group was £1.88 at 1 January 20X7, but rose to £2.04 shortly after the acquisition was completed.
The best estimate of the share price on the transfer date in three years is £2.25. The appropriate
discount rate for deferred consideration is 10%.
Longwood paid its bankers and lawyers fees of £0.8 million in connection with the deal. Longwood
estimates that £0.2 million of the finance department costs relate to time spent on the acquisition by
the Finance Director and his team.
Below is the draft ‘deal-date’ statement of financial position of Portobello Alloys. You may assume the
carrying amounts of assets and liabilities are equal to their fair values, except as indicated in the
information that follows.
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7
Portobello Alloys – Statement of financial position at 1 January 20X7
Carrying
amount
£m
Property, plant and equipment
18.92
Development asset
0.00
Investments in equity instruments
4.37
Deferred tax asset
0.77
Non-current assets
24.06
Inventory
7.33
Accounts receivable and prepayments
4.17
Cash and equivalents
4.22
Current assets
15.72
Total assets
39.78
Long-term debt
16.34
Post-retirement liability
0.37
Deferred tax liability
1.86
Non-current liabilities
18.57
Accounts payable and accruals
7.91
Current portion of long-term debt
3.40
Current liabilities
11.31
Share capital
2.50
Share premium
1.20
Retained earnings
6.20
Equity
Total liabilities and equity
9.90
39.78
Both Longwood and Portobello report to 31 December each year. The Board has asked your firm to
examine the deferred tax implications of various areas relating to the acquisition.
Research and development
Portobello Alloys applied a policy of expensing all development expenditure as incurred.
Longwood’s policy is to capitalise development cost as an intangible asset under IAS 38. The
carrying amount of the development asset in the deal-date statement of financial position was £0
million. The fair value of the development asset was actually £5.26 million at the deal date. None of
this development asset will be amortised over the next year.
Property, plant and equipment
Portobello’s premises are located on a prime piece of commercial real-estate. The surveyors have
indicated that the land is worth £2.73 million in excess of its carrying amount in the financial
statements of the company. The Longwood Group has no intention of selling the property as, if it
changed location, they could lose some of the key staff. Longwood’s policy is to carry assets at
depreciated cost, and it does not revalue any assets on a regular basis.
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Retirement benefit obligation
Portobello operates a defined benefit plan for its key research and production employees. The plan
asset manager has made some bad equity investments over the years, and the plan is in deficit by
£1.65 million. Portobello only recognised a liability of £0.37 million in its financial statements. The
local tax authorities grant tax relief on the cash contribution into the plan.
Tax losses
Portobello made a disastrous foray into supplying specialist alloys to a now defunct electronics
business, Electrotech. It set up a special division, took on new premises and staff, and spent a lot of
money on joint development with its client. Electrotech promptly went into liquidation. Portobello
incurred total tax losses of £7.40 million over the two years that it was involved with Electrotech – it
has now paid all the redundancy costs, sold all the assets and closed the division. To date, Portobello
Alloys has only relieved £1.20 million of the losses. The revised forecast numbers for Portobello’s
performance post-acquisition suggest it will be able to relieve the balance of losses in the next
couple of years (see below). Up to the date of the deal, the management forecasts used to calculate
the deferred tax in the financial statements had only anticipated relieving £2.20 million of the losses,
as indicated in the schedule below.
Profit forecasts for tax loss utilisation
20X7
20X8
Total
£m
£m
£m
Forecast taxable profit – original
0.98
1.22
2.20
Forecast taxable profit – revised
1.90
4.74
6.64
Enacted tax rates
Deferred taxes in the deal-date statement of financial position extracted above were calculated using
a tax rate of 30%. However, the corporate tax rate for Portobello has been enacted to fall to 23% for
the period after 1 January 20X7. A schedule of the composition of the deferred tax assets and
liabilities included in the deal-date statement of financial position is shown below.
Deferred tax schedule
Carrying
amount
Tax base
Temporary
difference
Deferred tax
30%
£m
£m
£m
£m
18.92
13.78
(5.14)
(1.54)
4.37
3.30
(1.07)
(0.32)
Post-retirement liability
(0.37)
0.00
0.37
0.11
Unrelieved tax losses –
recognised
0.00
2.20
2.20
0.66
Property, plant and equipment
Investments in equity
instruments (note)
(1.09)
Deferred tax liability
(1.86)
Deferred tax asset
0.77
(1.09)
Note: On initial recognition of the investments in equity instruments, an irrevocable election had
been made to record gains and losses in other comprehensive income.
The finance director has asked you to produce the following information:
(1) Calculate the adjustment required to the deferred tax figures in the financial statements of
Portobello Alloys solely in respect of the change in enacted tax rates and draft the required
journal.
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Financial reporting 1
9
(2) Calculate the adjustment required to the deferred tax asset relating to unrecognised tax losses in
Portobello’s financial statements resulting from the revised estimates of profitability over the next
two years. You should provide a draft correcting journal.
(3) Calculate the deferred tax effect of the consolidation adjustments in respect of:
(a) fair value adjustments to property, plant and equipment
(b) fair value adjustments to the development asset
(c) fair value adjustments to the post-retirement liability
(4) Calculate the goodwill arising in the consolidated financial statements in respect of this
acquisition.
(5) Explain the deferred tax treatment of goodwill under two possible deal structures for the
acquisition of Portobello Alloys:
(a) As the acquisition actually took place, with the purchase of the shares of Portobello Alloys.
(b) Under an alternative structure, with the purchase of the assets and liabilities of Portobello
Alloys instead, which would have granted tax relief charged over 15 years on the straightline basis on purchased goodwill.
Requirement
Prepare the information required by the finance director.
Total: 30 marks
5 Upstart Records
ca plc (Upstart) is a listed company and the parent company for a group that operates in the music
equipment industry. You are Thomas Mensforth, an ICAEW Chartered Accountant, and you joined
Upstart six months ago.
You have received the following email from Susan Ballion, the Group Finance Director of Upstart:
To:
Thomas Mensforth
From:
Susan Ballion
Date:
17 July 20X5
Subject: Upstart
I have been called away to an urgent meeting, so I need your assistance to finalise some aspects
of the Upstart consolidated financial statements for the year ended 30 June 20X5. I attach details
of transactions involving Liddle Music Ltd (Liddle) that occurred during the year ended 30 June
20X5 (Exhibit 1).
I also attach the draft statements of profit or loss for the Upstart Group and for Liddle for the year
ended 30 June 20X5. The draft group statement of profit or loss consolidates all group companies
except Liddle (Exhibit 2).
Finally, there are two financial reporting issues concerning the parent company that I have not had
time to deal with (Exhibit 3). These will need to be resolved before the consolidated financial
statements can be prepared.
I would like you to:
(1) show and explain, with supporting calculations, the appropriate financial reporting treatment
of goodwill and non-controlling interests for Liddle in Upstart’s consolidated statement of
financial position at 30 June 20X5. Use the proportion of net assets method to determine
non-controlling interests;
(2) explain, with calculations, the appropriate accounting treatment in respect of the issues in
Exhibit 3;
(3) prepare Upstart’s revised consolidated statement of profit or loss for the year ended 30 June
20X5 to include Liddle. This should take account of any adjustments arising from the
calculations above; and
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(4) explain (without calculations) the impact on Upstart’s consolidated financial statements if the
fair value method for measuring non-controlling interests were to be used instead of the
proportion of net assets method.
Requirement
Respond to Susan Ballion’s email.
Total: 30 marks
Exhibit 1: Transactions in respect of Liddle
Upstart purchased 250,000 ordinary shares in Liddle on 1 January 20X3 for £23 each, when Liddle
had in issue 1,000,000 £1 ordinary shares and retained earnings of £6.6 million. There are no other
reserves and there has been no change to Liddle’s ordinary share capital since that date. Upstart
appointed two of the six directors on the Liddle board and recognised the investment as an
associate in its group financial statements for the years ended 30 June 20X3 and 30 June 20X4.
Shares purchased on 1 October 20X4
On 1 October 20X4, Upstart purchased a further 450,000 shares in Liddle from existing shareholders.
At this date, the fair value of Upstart’s original 250,000 shares in Liddle had risen to £30 each. The
consideration was as follows:
•
800,000 new ordinary £1 shares in Upstart issued on 1 October 20X4; the market price of one
share in Upstart at this date was £11.50.
•
Cash of £2 million payable on 1 October 20X4.
•
Cash of £3 million payable on 1 October 20X6.
•
Cash of £3 million payable on 1 October 20X7, subject to Liddle increasing profits for the year
ending 30 June 20X7 by 35% compared with its profits for the year ended 30 June 20X4. The
board of Upstart believes there is a 50% probability of this profit increase being achieved.
Upstart paid professional fees of £250,000 in respect of this share purchase. These fees have been
debited to the cost of the investment in Liddle in Upstart’s individual company statement of financial
position.
Upstart has an annual cost of capital of 9%.
On 1 October 20X4, the fair value of Liddle’s assets and liabilities was equal to their carrying amount,
with the exception of buildings which had a carrying amount of £1.4 million and a fair value of £3
million. These buildings had a remaining useful life of 20 years at 1 October 20X4. Depreciation is
included in cost of sales. Liddle has not made any adjustment for the increase in the fair value of the
buildings in its financial statements.
Shares purchased on 1 April 20X5
On 1 April 20X5, Upstart purchased 100,000 shares in Liddle from other shareholders at a price of
£35 each.
Financing
On 1 October 20X4, to assist in funding the share purchases, Upstart borrowed €4 million from a
German bank when £1 = €1.30, taking advantage of a lower interest rate than offered by UK banks.
Interest on the loan, at 6% per annum, is payable annually in arrears on 30 September.
No accounting entries in relation to the loan have been made in Upstart’s financial statements except
to recognise the loan at 1 October 20X4 at £3.077 million in non-current liabilities. The average
exchange rate from 1 October 20X4 to 30 June 20X5 was £1 = €1.28 and the rate on 30 June 20X5
was £1 = €1.25.
Loan to Liddle
Upstart made a loan to Liddle of £2 million on 1 October 20X4 at an interest rate of 8% per annum.
The loan is repayable on 1 October 20X7. Loan interest has been correctly accounted for in the
individual statements of profit or loss for both Upstart and Liddle.
Trading with Liddle
Upstart made monthly sales of £120,000 to Liddle in the year ended 30 June 20X5. These sales were
at a mark-up on cost of 60%. At 30 June 20X5, Liddle had £560,000 of the purchases from Upstart in
inventories.
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11
Exhibit 2: Draft statements of profit or loss for the Upstart Group (excluding Liddle) and for Liddle
for the year ended 30 June 20X5
Upstart Group
Liddle
£’000
£’000
Revenue
23,800
15,600
Cost of sales
(7,400)
(5,400)
Gross profit
16,400
10,200
Operating costs
(3,500)
(1,500)
Profit from operations
12,900
8,700
890
180
(520)
(300)
Profit before tax
13,270
8,580
Taxation
(2,350)
(1,800)
Profit for the year
10,920
6,780
Note: Retained earnings at 1 July 20X4
15,840
9,000
Investment income
Interest paid
Exhibit 3: Outstanding financial reporting issues
Restructuring
Upstart has announced two major restructuring plans. The first plan is to reduce its capacity by the
closure of two of its retail outlets, which have already been identified. This will lead to the
redundancy of 20 employees, who have all individually been selected and communicated with. The
costs of this plan are £300,000 in redundancy costs, £200,000 in retraining costs and £50,000 in
lease termination costs. The second plan is to re-organise the finance and information technology
department over a one-year period but this will not be implemented for two years. The plan results in
20% of finance staff losing their jobs during the restructuring. The costs of this plan are £250,000 in
redundancy costs, £300,000 in retraining costs and £200,000 in equipment lease termination costs.
No entries have been made in the financial statements for the above plans.
Share options
On 1 July 20X3, Upstart made an award of 1,000 share options to each of its seven directors. The
condition attached to the award is that the directors must remain employed by Upstart for three
years. The fair value of each option at the grant date was £50 and the fair value of each option at 30
June 20X5 was £55. At 30 June 20X4, it was estimated that three directors would leave before the
end of three years. Due to an economic downturn, the estimate of directors who were going to leave
was revised to one director at 30 June 20X5. The expense for the year as regards the share options
had not been included in profit or loss for the current year and no directors had left by 30 June 20X5.
6 MaxiMart plc
MaxiMart plc operates a national chain of supermarkets. You are Vimal Subramanian, the Assistant
Financial Controller, and the accounting year end is 30 September 20X1.
It is now 15 November 20X1 and the company’s auditors are currently engaged in their work. Jane
Lewis, the Financial Controller, is shortly to go into a meeting with the audit engagement partner,
Roger MacIntyre, to discuss some unresolved issues relating to employee remuneration, hedging
and the customer reward card. To save her time, she wants you to prepare a memorandum detailing
the correct financial reporting treatment. She has sent you the following email, in which she explains
the issues.
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From:
jlewis@maximart.com
To:
vsubramanian@maximart.com
Date:
15 November 20X1
Subject: Financial statements of MaxiMart
I am pleased you can help me out with the information for my forthcoming meeting with Roger
MacIntyre – as you know, I have been tied up with other work, and have not had time to look into
these outstanding issues.
As you will see (Exhibit 1) the principal issues concern remuneration.
Historically we have had a problem with high staff turnover due to low salaries and having to work
evenings and weekends. To encourage better staff retention, we introduced a share option
scheme. Details of the scheme are given in Exhibit 1. I need you to show how the share option
scheme should be dealt with in the financial statements of MaxiMart for the year ended 30
September 20X1.
Exhibit 1 also has details of the company pension scheme, which was introduced a few years ago
to encourage management trainees to stay with us. Since many of our rivals no longer provide
defined benefit schemes, this gives MaxiMart an edge. It would help in the meeting if I could show
Roger MacIntyre the relevant extracts from the financial statements. You will need to show the
amounts to be recognised in the statement of profit or loss and other comprehensive income of
MaxiMart for the year ended 30 September 20X1 and in the statement of financial position at that
date so far as the information permits, in accordance with IAS 19, Employee Benefits (revised
2011). You should also include the notes, breaking down the defined benefit pension charge to
profit or loss, other comprehensive income, net pension asset/liability at the year end and
changes in the present value of pension obligation and the fair value of plan assets.
There will be a deferred tax effect arising from the pension plan, but we will deal with that on a
later occasion, as there isn’t time before the meeting.
I also attach details of three further issues (Exhibit 2). The first relates to our Reward Card. I believe
there is a recent IFRS relevant to the treatment of these schemes, but I can’t remember exactly
what it says. The second issue is a futures contract. It would be good if you could explain how we
should treat this and show the double entry. The third issue is a proposed dividend – we need to
know if the proposed treatment is correct.
Please draft a memorandum showing the appropriate treatment of these transactions together
with explanations and any necessary workings.
Requirement
Prepare the memorandum required by Jane Lewis.
Total: 30 marks
Exhibit 1: Staff remuneration
Share options
On 1 October 20X0, the board decided to award share options to all 1,000 employees provided they
remained in employment for five years. At 1 October 20X0, 20% of employees were expected to
leave over the vesting period to 30 September 20X5 and as at 30 September 20X1, this expectation
had risen to 25%. The fair value of these options at 1 October 20X0 was £2 and this had risen to £3
by 30 September 20X1. The number of options per employee is conditional on the average profit
before any expense for share options over the five years commencing 1 October 20X0 as follows:
Average profit
Number of options per employee
From £1m up to £1.2m
100
Above £1.2m up to £1.4m
120
Above £1.4m up to £1.6m
140
Above £1.6m up to £1.8m
160
ICAEW 2022
Financial reporting 1
13
Average profit
Number of options per employee
Above £1.8m
180
Profit before share option expense for the year ended 30 September 20X1 was £0.9 million and
profit for the following four years was forecast to rise by £0.2 million a year. The awarding of the
options was also conditional on the share price reaching at least £8 per share by 30 September
20X5. The share price at 30 September 20X1 was £6.
Pension scheme
MaxiMart set up a funded defined benefit pension plan for management-track employees three
years ago. The plan provides a pension based on 1/80th of the final salary for each year worked for
the company, subject to a minimum employment period of eight years.
The following information has been provided by the actuary for the year ended 30 September 20X1:
(1)
The present value in terms of future pensions from employee service during the year is £90,000.
This has been determined using the projected unit credit method.
(2) The present value of the obligation to provide benefits to current and former employees has
been calculated as £2.41 million at 30 September 20X1 and the fair value of plan assets was
£2.37 million at the same date.
(3) The interest rate on high quality corporate bonds relevant to the year was 5%.
The following has been extracted from the financial records:
(1) The present value of the defined benefit obligation was £2.2 million at 30 September 20X0 and
the fair value of the plan assets was £2.3 million at the same date.
(2) Pensions paid to former employees during the year amounted to £60,000.
(3) Contributions paid into the plan during the year as decided by the actuary were £68,000.
With effect from 1 October 20X0, the company amended the plan to increase pension
entitlement for employees. The present value of the improvement in benefits was calculated by
the actuary to be approximately £100,000 at 1 October 20X0. The present value of the plan
liability at 30 September 20X1 correctly reflects the impact of this increase.
(4) The company recognises gains and losses on remeasurement of the defined benefit asset or
liability (actuarial gains and losses) in accordance with IAS 19, Employee Benefits.
(5) Pension payments and the contributions into the plan were paid on 30 September 20X1.
Exhibit 2: Other transactions
Reward card
MaxiMart offers its customers a reward card which awards customers points based on money spent.
These points may be redeemed as money off future purchases from MaxiMart or as free/discounted
goods from other retailers. Revenue from food sales for the year ended 30 September 20X1
amounted to £100 million. At the year end, it is estimated that there are reward points worth £5
million arising from this revenue which are eligible for redemption. Based on past experience, it is
estimated that only about two in five customers are likely to redeem their points.
Futures contract
MaxiMart entered into a futures contract during the year to hedge a forecast sale in the year ended
30 September 20X2. The futures contract was designated and documented as a cash flow hedge. At
30 September 20X1, had the forecast sale occurred, the company would have suffered a loss of £1.9
million and the futures contract was standing at a gain of £2 million. No accounting entries have
been made to record the futures contract, because the Financial Controller is not sure whether or not
it is effective, and would like some advice on how to test for this.
Proposed dividend
The company has a good relationship with its shareholders and employees. It has adopted a strategy
of gradually increasing its dividend payments over the years. On 1 November 20X1, the board
proposed a dividend of 5p per share for the year ended 30 September 20X1. The shareholders will
approve the dividend along with the financial statements at the general meeting on 1 December
20X1 and the dividend will be paid on 14 December 20X1. The directors feel that the dividend
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should be accrued in the financial statements for the year ended 30 September 20X1 as a ‘valid
expectation’ has been created.
7 Robicorp plc
Robicorp plc is a listed company that develops robotic products for the defence industry. You are
Marina Nelitova, an ICAEW Chartered Accountant working within the finance team at Robicorp. You
receive the following email from Alex Murphy, who was appointed finance director of Robicorp in
October 20X4.
To:
Marina Nelitova
From:
Alex Murphy
Date:
3 November 20X4
Subject: Review of financial statements for year ended 30 September 20X4
I am attending a board meeting next week, and have concerns over the way my predecessor has
treated some transactions in the financial statements (Exhibit 1).
I would like you to review these transactions and:
•
recommend any adjustments, with accompanying journal entries, that are required to make the
accounting treatment comply with IFRS, explaining the reasons for your proposed changes;
and
•
revise the draft basic earnings per share figure (Exhibit 2), taking into account your
adjustments, and calculate the diluted earnings per share.
Ignore any tax consequences for now.
Requirement
Reply to Alex Murphy’s email.
Total: 30 marks
Exhibit 1: Transactions requiring further review
(1) On 1 October 20X3 Robicorp started work on the development of a new robotic device, the XL5.
Monthly development costs of £2 million were incurred from that date until 1 January 20X4, when
Robicorp made a breakthrough in relation to this project. On that date the XL5 was deemed
financially and commercially viable and thereafter development costs increased to £2.5 million per
month until development work was completed on 30 June 20X4.
The XL5 went on sale on 1 August 20X4. By 30 September 20X4, Robicorp had received orders for
3,000 units priced at £25,000 per unit, of which it had manufactured and delivered 1,200 units to
customers. The terms of trade required a non-refundable payment in full on receipt of the order.
Robicorp anticipates the XL5 having a commercial life of four to five years, with total sales of 36,000
units over that period. Variable production costs are £11,000 per unit.
In the draft financial statements for the year ended 30 September 20X4, all XL5 development costs
have been capitalised. Cash received in respect of the 3,000 units ordered has been recognised as
revenue because the orders are non-cancellable.
Entries made to reflect the above are:
DEBIT
Intangible assets
CREDIT
Cash
DEBIT
Cash
CREDIT
DEBIT
CREDIT
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£21m
£21m
£75m
Revenue
Cost of sales
Cash
£75m
£33m
£13.2m
Financial reporting 1
15
CREDIT
Accrued variable production costs
£19.8m
On 1 January 20X4, to help fund the XL5 development and production, Robicorp issued a £40
million, 3% convertible bond at par. The bond is redeemable on 1 January 20X7 at par. Interest is
paid annually in arrears on 31 December. Bondholders have the choice on 1 January 20X7 of either
converting the bonds into equity shares at the rate of 10 £1 shares for every £100 of bonds, or
redeeming the bonds at par. Similar non-convertible bonds for a company such as Robicorp pay
interest at 10% per year. Robicorp anticipates that all bondholders will choose to convert the bonds
into shares. Therefore in the draft financial statements the bonds have been treated as equity shares.
In the draft financial statements the following accounting entries have been made in respect of the
bond and interest:
DEBIT
Cash
£40m
CREDIT
Share capital
£4m
CREDIT
Share premium
£36m
DEBIT
CREDIT
Finance costs
£0.9m
Accruals
£0.9m
(2) On 1 October 20X3, Robicorp introduced a share option scheme for 30 senior executives. Each
executive was granted 48,000 share options on that date. Each option gives the right to acquire one
share in Robicorp, for an exercise price of £4 per share, if the executive is still in employment with the
company at 1 October 20X6, and the share price at that date is at least 30% higher than the price at 1
October 20X3. The executives will be able to exercise these options from 1 October 20X7.
The fair value of an option was £3.50 at 1 October 20X3 and £5.30 at 30 September 20X4. By 30
September 20X4, one executive had left her job. Robicorp expects one more executive to leave by 1
October 20X6.
The Robicorp share price at 30 September 20X4 was 32% higher than at the grant date. The average
share price of Robicorp for the year ended 30 September 20X4 was £7.60.
No accounting entries have been made in respect of the share option scheme.
(3) On 1 April 20X3, Robicorp bought 400,000 shares in Lopex Ltd for £6 each. This represents 3% of
the ordinary share capital of Lopex. An irrevocable election was made by Robicorp to treat this as an
equity investment at fair value through other comprehensive income.
At 30 September 20X3, Lopex’s shares had a fair value of £9.20 each and Robicorp measured its
investment at £3.68 million in its financial statements at that date.
A gain of £1.28 million was recognised in other comprehensive income with a corresponding other
component of equity being created at 30 September 20X3.
On 1 August 20X4 Saltor plc, an unrelated company, acquired all the shares in Lopex in a share-forshare exchange. The terms were 2.5 shares in Saltor for each share in Lopex. At 1 August 20X4,
immediately before the takeover by Saltor, the fair value of a Lopex share was £11.20. Saltor’s shares
at 1 August 20X4 were trading at £5.50 each.
No entries have been made in Robicorp’s financial statements for the year to 30 September 20X4 to
reflect the share-for-share exchange. Its investment continues to be recognised at £3.68 million.
Robicorp intends to sell its shareholding in Saltor and to classify the investment as at fair value
through profit or loss. At 30 September 20X4, Saltor’s shares had a bid-offer spread of 480–485
pence. A sales commission of 4 pence per share would be incurred upon disposal.
(4) Robicorp granted interest-free loans to its employees on 1 October 20X3 of £8 million. The loans
will be paid back on 30 September 20X5 as a single payment by the employees. The market rate of
interest for a two-year loan on both of the above dates is 6% per annum.
The loans have been classified as financial assets at amortised cost under IFRS 9, Financial
Instruments. No accounting entries have been made to date in respect of these loans.
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Exhibit 2: Robicorp – Calculation of basic earnings per share for year ended 30 September 20X4
Profit after taxation
£66.27m
Share capital
Number of £1 ordinary shares
At 1 October 20X3
40m
Convertible bond issue 1 January 20X4
4m
At 30 September 20X4
44m
Basic earnings per share = 150.6 pence (£66.27m/44m shares).
8 Flynt plc
You are Miles Goodwin, the newly-appointed financial controller of Flynt plc, a company that
manufactures electronic components for the computer industry. You receive the following email from
Andrea Ward, the CEO of Flynt.
To:
Miles.Goodwin@flynt.co.uk
From:
Andrea.Ward@flynt.co.uk
Subject: Finalisation of consolidated financial statements for year ended 31 May 20X6
Miles, I know you have just joined us, but I would be grateful if you could look at the impact of
some issues that were left unresolved by your predecessor, Shane Ponting (Exhibit 1). I have been
very busy recently and have not had the chance to look at these issues myself.
I would like you to redraft the consolidated statement of profit or loss and other comprehensive
income. I attach a draft for you to work from (Exhibit 2). Please explain the reasoning for any
adjustments you make, as I would like a greater understanding of the impact of these issues on
our post-tax profits. You should also give journal entries.
I have a meeting with the board shortly, and we are concerned about earnings per share (EPS).
I would therefore be grateful if you would also calculate the basic EPS for the year ended 31 May
20X6 and the diluted EPS if applicable.
At this stage do not worry about any adjustments to the current or deferred tax charge; just
assume an effective rate of 23%.
Requirement
Draft a reply to the email from Andrea Ward.
Total: 30 marks
Exhibit 1: Consolidated financial statements for year ended 31 May 20X6: Unresolved issues –
arising from notes prepared by Shane Ponting
On 1 September 20X5 the board approved a share option scheme for 20 senior executives. On that
date each executive was granted options over 10,000 shares at an exercise price of £39 per share,
which was the market price at 1 September 20X5. Each option gives the rights to one share. The
options vest on 1 September 20X9 subject to the following conditions:
(1) Each executive remains in the employment of Flynt until 1 September 20X9.
(2) The share price of Flynt has increased by at least 50% at 1 September 20X9.
The fair value of an option was estimated to be £12.60 at 1 September 20X5 and £19.40 at31 May
20X6.
This is the first time that Flynt has operated such a scheme. As there is no cash cost to the company, I
have not made any adjustments to the financial statements. The share price of Flynt at 31 May 20X6
was £52 and the average share price for the nine months to 31 May 20X6 was £48.
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17
At 31 May 20X6 there were still 19 executives in the scheme, but I anticipate there will only be 16 still
employed by 1 September 20X9.
Lease of surplus machinery
On 1 June 20X5 Flynt leased some surplus machinery to Prior plc, an unrelated company, on the
following terms:
Lease term and remaining useful life of machinery
5 years
Carrying amount and fair value of machinery at 31 May 20X5
£612,100
Annual instalment payable in arrears
£150,000
Interest rate implicit in lease
10% per annum
Residual value guaranteed by Prior plc
£61,100
Expected residual value at 31 May 20Y0
£70,000
Initial direct costs incurred by Flynt
£1,000
I have treated the agreement as an operating lease and recognised lease rental income of £150,000.
I have also charged depreciation of £122,420 and written off the direct costs incurred to profit or
loss.
Acquisition of Dipper plc
On 1 December 20X5 Flynt purchased 100% of the ordinary shares of Dipper plc for a consideration
of £6.4 million when Dipper had net assets with a fair value of £4.9 million including a deficit on a
defined benefit pension scheme of £0.4 million. Goodwill of £1.5 million therefore arose on
acquisition. The consideration given was 150,000 ordinary shares in Flynt. This was the first equity
issue for a number of years. There were 1.4 million ordinary shares in issue on 31 May 20X5.
Flynt operates a defined contribution scheme, and I am unfamiliar with how to deal with Dipper’s
defined benefit scheme.
We obtained the following figures from Dipper’s actuaries at the acquisition date:
Fair value of scheme assets
£2.2m
Present value of pension obligations
£2.6m
Estimated service cost from 1 December 20X5 to 31 May 20X6
£560,000
Interest rate on high quality corporate bonds
5% per annum
The total contributions paid into the scheme by Dipper from the acquisition date to 31 May 20X6
were £480,000, and I have charged this sum to operating costs. I have had a letter from Dipper’s
pension fund advising me that they have paid out £450,000 to pensioners in the same period. I have
not adjusted the deficit in the statement of financial position.
Dipper recognises remeasurement (actuarial) gains and losses immediately in accordance with IAS
19, Employee Benefits. I intend to continue to apply IAS 19 in the group financial statements but I do
not know how to calculate the remeasurement gain or loss.
I have been advised by the scheme actuary that at 31 May 20X6 the fair value of the pension assets
was £2.08 million and the present value of pension obligations was £2.75 million at that date.
We conducted an impairment review of goodwill at the end of our accounting period and estimated
that goodwill arising on the acquisition of Dipper was worth £1.1 million. I have therefore debited
£400,000 to other comprehensive income. No other adjustments were required to goodwill.
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Exhibit 2: Draft consolidated statement of profit or loss and other comprehensive income for year
ended 31 May 20X6
20X6
20X5
£’000
£’000
Revenue
14,725
13,330
Cost of sales
(7,450)
(7,560)
Gross profit
7,275
5,770
(3,296)
(3,007)
Operating costs
Other operating income
Operating profit
Investment income
Finance costs
Profit before tax
Income tax expense
Profit after tax
150
––––––
4,129
2,763
39
32
(452)
(468)
3,716
2,327
(1,003)
(628)
2,713
1,699
(400)
––––––
2,313
1,699
Other comprehensive income
Goodwill impairment
Total comprehensive income for the year
Note: All calculations should be to the nearest £’000.
9 Gustavo plc
You are Anita Hadjivassili, the recently appointed financial controller at Gustavo plc, a manufacturer
of sports equipment. During the year ended 30 September 20X6, Gustavo has sold and purchased
shares respectively in two companies, Taricco Ltd and Arismendi Inc.
You have just received the following email from the CEO, Antonio Bloom.
To:
Anita Hadjivassili
From:
Antonio Bloom
Subject: Draft Financial Statements for the Gustavo group
I attach extracts from the draft financial statements for the year ended 30 September 20X6 (
Exhibit 1). I know you are still unfamiliar with Gustavo’s business, so I have also attached some file
notes prepared by your predecessor (Exhibit 2).
I would like you to prepare the draft consolidated statement of profit or loss and other
comprehensive income for the year ended 30 September 20X6 including other comprehensive
income, as I need to present it at the next board meeting. Please provide briefing notes to explain
the impact of the share transactions (Exhibit 2) on the consolidated statement of profit or loss and
other comprehensive income. Please show separately the profit attributable to the non-controlling
interest.
I would also like you to advise on the impact that any future changes in exchange rates will have
on the consolidated statement of financial position.
Ignore any further income tax or deferred tax adjustments.
Requirement
Respond to Antonio’s email.
Total: 30 marks
ICAEW 2022
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19
Exhibit 1: Extracts from the draft financial statements for year ended 30 September 20X6
Gustavo
Taricco
Arismendi
£’000
£’000
Kr’000
35,660
28,944
48,166
Cost of sales
(21,230)
(22,164)
(30,924)
Gross profit
14,430
6,780
17,242
Operating costs
(5,130)
(4,956)
(9,876)
9,300
1,824
7,366
580
108
–
Revenue
Profit from operations
Investment income
Finance costs
(2,450)
(660)
Profit before taxation
7,430
Income tax expense
(2,458)
(360)
(2,240)
4,972
912
3,670
11,720
4,824
14,846
4,972
912
3,670
Dividends paid (1 July)
(3,000)
(600)
––––––
At 30 September 20X6
13,692
5,136
18,516
10,000
2,000
5,000
Profit for the year
1,272
(1,456)
5,910
Retained earnings
At 1 October 20X5
Profit for the year
Other financial information
Ordinary share capital (shares of £1/Kr1)
Profits arise evenly throughout the year for all three companies.
Exhibit 2: File notes for key issues in year
Taricco
Gustavo bought 1.5 million ordinary shares in Taricco Ltd on 1 January 20X2 for £15 million when
Taricco had retained earnings of £2.4 million. The proportion of net assets method was used to value
the non-controlling interest as the acquisition occurred before IFRS 3 was revised. At the acquisition
date the fair value of Taricco’s net assets was equal to the carrying amount.
Prior to 1 October 20X5 there had been goodwill impairments in relation to Taricco of £2.5 million.
There have been no changes in share capital or other reserves since acquisition.
On 1 April 20X6 Gustavo sold 800,000 shares in Taricco for £19.8 million. Gustavo continues to be
represented by two directors on Taricco’s board to oversee its remaining interest in the company.
(Taricco’s board consists of eight directors.) The only entry in Gustavo’s financial statements
regarding the sale has been to credit a suspense account with the sale proceeds.
It was estimated at 1 April 20X6 that Gustavo’s remaining shares in Taricco had a fair value of £8.2
million.
Arismendi
On 1 January 20X6 Gustavo bought 4 million shares in Arismendi Inc, a company located overseas,
(where the local currency is the Kr) for Kr75.6 million (£12.6 million). Professional fees relating to the
acquisition were £400,000, and these have been added to the cost of the investment.
At 1 January 20X6 Arismendi owned property which had a fair value of Kr14.4 million (£2.4 million) in
excess of its carrying amount. This property had a remaining life of eight years at this date.
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ICAEW 2022
Gustavo would like to adopt the fair value method to measure the non-controlling interest. At 1
January 20X6 the market price of Arismendi’s shares was Kr12 each.
An impairment review of goodwill took place at 30 September 20X6, and no impairment was
deemed necessary.
Exchange rates which may be relevant are:
1 January 20X6
£1:Kr6
Average Jan-Sep
£1:Kr5
30 September 20X6
£1:Kr4
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Financial reporting 2
10 Inca Ltd
Inca Ltd supplies specialist plant and machinery to the oil drilling industry. On 1 May 20X0 Inca
acquired 80% of Excelsior Inc, a company based in Ruritania, where the currency is the CU.
You are Frank Painter, a chartered accountant employed on a temporary contract following the
retirement of the Inca finance director. You have been asked to assist the managing director in
finalising the financial statements of Excelsior and the Inca group for the year ended 30 April 20X1.
Both Inca and Excelsior prepare their financial statements using IFRS. You receive the following email
from the managing director of Inca.
To:
Frank Painter
From:
Inca MD
Date:
25 July 20X1
Subject: Finalising Financial Statements
Acquisition of Excelsior
Excelsior is the first subsidiary that Inca has acquired, and so I would be grateful for some advice
in relation to the consolidated financial statements and also in finalising the financial statements of
Excelsior.
The cost of the investment in Excelsior was CU120 million, and at 1 May 20X0 Excelsior had
retained earnings of CU64 million. There were no fair value adjustments to the net assets of
Excelsior. Inca uses the proportion of net assets method to value non-controlling interest.
Assistance needed
I wish to show your findings to my fellow board members, as they are concerned about Excelsior’s
effect on the consolidated financial statements. I have not told them that I have asked for your
input as I would like to make a favourable impression in terms of my accounting knowledge.
I have provided you with the draft statements of financial position for both companies (Exhibit 1). I
have also provided some exchange rates (Exhibit 2). The accountant at Excelsior is unqualified. He
has identified a number of outstanding financial reporting issues (Exhibit 3).
I have heard that there is an option of valuing non-controlling interests at fair value, rather than
using the proportion of net assets method, as we do. The fair value of the non-controlling interest
in Excelsior is CU20 million. I understand that using this method would change the figures for
goodwill and perhaps the exchange difference relating to goodwill.
Please prepare a working paper for me which comprises:
•
an explanation of the appropriate financial reporting treatment for each of the issues identified
by the Excelsior accountant (Exhibit 3);
•
the consolidated statement of financial position of Inca at 30 April 20X1, assuming there are no
adjustments to the individual company financial statements other than those you have
proposed; and
•
a calculation of goodwill assuming that Inca values the non-controlling interest in Excelsior at
its fair value of CU20 million.
Do not tell anyone else that you are preparing this working paper for me. In return I will ensure
that you are given a permanent contract in the Inca group. In order to save costs I am not
intending to replace the Inca finance director as I can do this role myself with your help.
Requirement
Prepare the working paper requested by the managing director.
In addition to the working paper, explain any ethical concerns that you have, as Frank Painter, in
relation to the managing director’s email, and set out the actions you intend to take.
Note: Ignore any UK current tax implications.
ICAEW 2022
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23
Total: 30 marks
Exhibit 1: Draft statements of financial position at 30 April 20X1
Inca
Excelsior
£m
CUm
Investment in Excelsior
24.0
–
Property, plant and equipment
32.4
64.0
Intangible assets
12.4
7.0
Total non-current assets
68.8
71.0
9.8
16.6
17.4
35.2
1.6
12.8
Total current assets
28.8
64.6
Total assets
97.6
135.6
4.0
10.0
Share premium account
12.0
16.0
Retained earnings
41.6
48.0
12.0
4.4
5.8
48.0
Current liabilities
22.2
9.2
Total equity and liabilities
97.6
135.6
Non-current assets
Current assets
Inventories
Trade receivables
Cash
Equity and liabilities
Share capital £1/CU1
Non-current liabilities
Deferred tax
Loans
Exhibit 2: Exchange rates
£1 = CU
1 May 20X0
5.0
Average for year
4.8
30 April 20X1
4.5
US$1 = CU
1 May 20X0
3.2
Average for year
3.0
30 April 20X1
2.8
Exhibit 3: Excelsior – Outstanding financial reporting issues prepared by Excelsior accountant
Excelsior’s draft statement of profit or loss and other comprehensive income shows an after-tax loss
of CU16 million for the year ended 30 April 20X1. The current tax has been correctly calculated by
our tax advisers.
24
Corporate Reporting
ICAEW 2022
However, I am not familiar with deferred tax and some of the more complex financial reporting rules
and the following matters are outstanding:
(1) At 1 May 20X0 there was a deferred tax liability of CU4.4 million in the statement of financial
position and no adjustments have been made to this figure in the draft financial statements at 30
April 20X1. This deferred tax provision was solely in relation to the differences between the carrying
amount of property, plant and equipment and the tax base.
The carrying amount of property, plant and equipment on 1 May 20X0 was CU60 million, compared
with its tax base of CU38 million. At 30 April 20X1 these figures were CU64 million and CU36 million
respectively.
Companies in Ruritania pay tax at a flat rate of 20%. This rate is not expected to change in future
years.
(2) In the year ended 30 April 20X1 Excelsior capitalised development costs of CU7 million. These
costs are likely to be amortised over four years from 1 May 20X2.
Under Ruritanian tax law such costs are deductible when incurred.
(3) The tax trading loss carried forward in respect of the year ended 30 April 20X1 is CU16 million.
Excelsior has reliable budgets for a taxable profit of CU5 million for each of the next two financial
years, but it has no accurate budgets beyond that date. Tax losses can be carried forward
indefinitely under Ruritanian tax law.
(4) On 1 May 20X0 Excelsior issued a 5% bond to American financial institutions. The bond had a
nominal value of US$16 million and is repayable on 30 April 20X3. The bond was issued at a discount
of US$1 million, and is redeemable at a premium over nominal value of US$1.79 million.
Interest of US$800,000 is paid every 12 months commencing 30 April 20X1. The implicit interest
rate on the bond is approximately 10.91%.
The loan has been translated on 1 May 20X0 and the interest paid in relation to the bond has been
charged to profit or loss. This sum was CU2.24 million (US$800,000 × 2.8) but no other adjustments
have been made.
According to Ruritanian tax law, the only tax deduction in respect of the bond is for nominal interest
which is tax deductible when paid. Debits and credits relating to discounts and premiums are not tax
deductible.
(5) On 1 April 20X1 Excelsior made a loan of CU2 million to one of the directors of the company, who
also happens to be a prominent politician. I do not expect any of this sum to be recoverable, but it
would be politically embarrassing to disclose this in the financial statements. The loan has been
included in trade receivables and no adjustments have been made. On the grounds of materiality,
the board is very keen to exclude any reference to the loan.
11 Aytace plc
Aytace plc is the parent company of a group that operates golf courses in Europe. It has had
investments in a number of 100% owned subsidiaries for many years, as well as owning 40% of the
share capital in Xema Limited since 20X0.
You are Frank Brown, a Chartered Accountant. You have recently taken up temporary employment
with Aytace while the financial controller, Meg Blake, is on maternity leave.
You receive the following email from the finance director, Willem Zhang.
To:
Frank Brown
From:
Willem Zhang
Subject: Draft consolidated statement of profit or loss and other comprehensive income for the
year ended 31 May 20X3
Prior to maternity leave, Meg prepared a first draft consolidated statement of profit or loss and
other comprehensive income and has noted some outstanding matters relating to transactions in
the year (Exhibit).
ICAEW 2022
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25
Please prepare a working paper which comprises:
•
advice, with explanations and relevant calculations, on the appropriate financial reporting
treatment of the outstanding matters highlighted by Meg in the Exhibit; and
•
a revised consolidated statement of profit or loss and other comprehensive income, showing
clearly the financial reporting adjustments you have proposed.
Ignore any tax consequences arising from the outstanding matters, as these will be finalised by
our tax advisers.
Requirement
Prepare the working paper requested by the finance director.
Total: 30 marks
Exhibit: Briefing notes prepared by Meg Blake for year ended 31 May 20X3
Aytace Group – Draft consolidated statement of profit or loss and other comprehensive income for
the year ended 31 May 20X3
£’000
Additional Information
Revenue
14,450
1
Operating costs
(9,830)
Operating profit
4,620
Income from associate
867
Other investment income
310
Finance costs
Profit before tax
Tax
1, 2
4
(1,320)
4,477
(1,220)
Profit for the year
3,257
Additional information on outstanding matters
I have not had sufficient time to look into the following matters because of my personal
circumstances.
(1) Golf tournament
On 1 December 20X2 Aytace won the tender to host an annual international golf tournament for
each of the next four years. The first golf tournament will take place in September 20X3.
The tender process commenced on 5 August 20X2 and the tender was submitted on 8 November
20X2. Internal management time costs of £1.2 million were incurred in relation to the tender
submission. These costs were capitalised and are being amortised from 1 December 20X2 over a
four-year period. Therefore £150,000 (6/48 × £1.2 million) has been recognised in profit or loss as an
operating cost for the year ended 31 May 20X3.
A separate contract was subsequently signed on 1 February 20X3 with a satellite television company
for the exclusive rights to broadcast the tournament. The contract fee is £4.8 million for the whole
four years of the tournament. The broadcaster made an advance payment of £1.0 million to Aytace
on 1 May 20X3. This amount was initially credited to a contract liability. I then decided to recognise
revenue on the satellite television contract evenly over a four-year period from 1 February 20X3. An
amount of £400,000 (£4.8m × 4/48) is therefore recognised as revenue in profit or loss for the year
ended 31 May 20X3.
(2) Defined benefit pension scheme
Aytace operates a defined benefit pension scheme. Employees are not required to make any
contributions into the scheme. Aytace recognises remeasurement (actuarial) gains and losses
immediately through other comprehensive income in accordance with IAS 19, Employee Benefits
(revised 2011).
26
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The scheme assets had a fair value of £12.2 million and £13.5 million at 31 May 20X2 and 31 May
20X3 respectively. Scheme obligations had a present value of £18 million and £19.8 million at 31
May 20X2 and 31 May 20X3 respectively.
At 1 June 20X2 the interest rate on high quality corporate bonds was 6%.
In the year ended 31 May 20X3, employer contributions paid into the scheme were £0.9 million, and
pensions paid by the scheme during the year amounted to £1.1 million. These payments took place
on 31 May 20X3. The service cost for the year ended 31 May 20X3 was £1.2 million.
Aytace decided to improve the pension benefit at 1 June 20X2 for staff who will have worked at least
five years for the company at the date the benefit is claimed. The scheme actuary calculated the
additional benefit obligation in present value terms to be £400,000.
The only entry in the financial statements in respect of the year ended 31 May 20X3 was to recognise
in profit or loss the contributions paid to the scheme by Aytace, with no adjustment to the scheme
obligations in the statement of financial position.
(3) Holiday pay
The salaried employees of Aytace are entitled to 25 days paid leave each year. The entitlement
accrues evenly over the year and unused leave may be carried forward for one year. The holiday year
is the same as the financial year. At 31 May 20X3, Aytace has 900 salaried employees and the
average unused holiday entitlement is three days per employee. 5% of employees leave without
taking their entitlement and there is no cash payment when an employee leaves in respect of holiday
entitlement. There are 255 working days in the year and the total annual salary cost is £19 million. No
adjustment has been made in the financial statements for the above and there was no opening
accrual required for holiday entitlement.
(4) Investment in Xema
On 1 January 20X0, Aytace bought 40% of the issued ordinary share capital of Xema Ltd, a
sportswear company, for £2.3 million. Aytace has had significant influence over Xema since this date
and has used the equity method to account for the investment.
At 1 January 20X0, Xema had an issued ordinary share capital of 1 million £1 ordinary shares and
retained earnings of £3.4 million. There has been no change to Xema’s issued share capital since 1
January 20X0. At 31 May 20X2 retained earnings were £4.8 million. Xema’s statement of profit or loss
for the year ended 31 May 20X3 was as follows:
£’000
Revenue
5,400
Operating costs
(3,600)
Operating profit
1,800
Other investment income
240
Finance costs
Profit before tax
(720)
1,320
Tax
Profit for the year
(300)
1,020
On 1 September 20X2 Aytace bought the remaining 60% of Xema’s ordinary share capital for £12.4
million, at which date its original 40% shareholding was valued at £3.8 million. There were no
material differences between carrying amounts and fair values of the identifiable net assets of Xema
at 1 September 20X2.
I recognised the investment in Xema using the equity method and credited £867,000 to profit or loss
(profit for the year of £1.02m × 3/12 × 40% plus £1.02m × 9/12 × 100%).
(5) Executive and employee incentive schemes
Aytace introduced two incentive schemes on 1 June 20X2. No entries have been made in relation to
either of these schemes in the financial statements for the year ended 31 May 20X3.
The first incentive scheme is for executives. Aytace granted 100,000 share options to each of five
directors. Each option gives the right to buy one ordinary share in Aytace for £6.40 at the vesting
ICAEW 2022
Financial reporting 2
27
date of 31 May 20X5. In order for the options to vest, Aytace’s share price must rise by a minimum of
35% from the market price on 1 June 20X2 of £6.40 per share. In addition, for a director’s options to
vest, he/she must still hold office at 31 May 20X5.
Aytace’s share price was only £5.80 at 31 May 20X3, and I am not confident that we will achieve
the required price increase of 35% by the vesting date. The fair value of a share option at 1 June
20X2 was estimated to be £2.70, but this had fallen to £1.90 by 31 May 20X3.
Most of the board has been with Aytace for a number of years, and none has left in the last 12
months. I would anticipate only one director leaving prior to the vesting date.
The second incentive scheme is an employee scheme in the form of share appreciation rights for
senior managers. The vesting date is 31 May 20X5, and managers must be still in employment at that
date.
There are 60 managers eligible for the scheme, each of whom has appreciation rights over 4,000
shares. Under the scheme each manager will receive a cash amount equal to the fair value of the
rights over each share. I anticipate 50 of the managers being in the scheme at 31 May 20X5. The fair
value of the rights was £2.85 per share at 1 June 20X2 and £2.28 per share at 31 May 20X3.
12 Razak plc
Razak plc is a listed parent company. During the year ended 30 September 20X2 Razak plc increased
its shareholding in its only equity investment, Assulin Ltd.
Razak publishes magazines in the UK. You are Kay Norton, a chartered accountant and a member of
the Razak financial reporting team. You report to the Razak group finance director, Andrew Nezranah,
who is also a chartered accountant.
You receive the following email:
To:
Kay Norton
From:
Andrew Nezranah
Date:
29 October 20X2
I have recently joined the board and I am preparing for our annual update presentation to our
bank.
As part of this update, I have been asked to present the bank with draft consolidated financial
statements for the year ended 30 September 20X2. I appreciate that there will be tax issues to
finalise at a later stage, but the bank has said that it is not interested in these at present.
For a number of years Razak plc held 15% of the ordinary share capital of Assulin, a paper pulp
manufacturer. On 31 March 20X2 this shareholding was increased to 80%, as we wanted to secure
continuity of supply in relation to paper pulp. Further details of this transaction can be found in
Exhibit 1.
Razak plc’s draft financial statements at 30 September 20X2 are summarised in Exhibit 2.
In addition I have some concerns about Razak plc’s purchase of a bond in Imposter plc (Exhibit 3).
The directors are proposing to introduce a pension plan for next year (Exhibit 4) and are perhaps
unclear on how to account for it.
Please would you:
•
provide explanations of how the increase in the stake in Assulin will be treated in Razak’s
consolidated financial statements;
•
explain any adjustments needed to account for the purchase of the Imposter bond in Razak’s
consolidated financial statements and evaluate any ethical issues arising from this matter;
•
prepare Razak’s consolidated statement of financial position at 30 September 20X2 after
making all relevant adjustments; and
•
explain how the proposed pension plan would be accounted for in the financial statements.
28
Corporate Reporting
ICAEW 2022
Requirement
Reply to Andrew’s email.
Total: 30 marks
Exhibit 1: Shareholding in Assulin
In 20W4 (eight years ago), Razak plc bought 75,000 shares in Assulin for £6 each. An irrevocable
election was made on purchase to classify this investment as being at fair value through other
comprehensive income. At 30 September 20X1, the shares had a fair value of £16 each, and a
cumulative increase in fair value of £750,000 had been recognised in other comprehensive income
and was held in equity. In Razak plc’s draft statement of financial position, the increase in the share
valuation has also been included in the investment in Assulin.
On 31 March 20X2 a further 325,000 shares in Assulin were purchased for £25 each. This sum has
been added to the investment in Assulin.
In addition to the cash consideration of £25 per share, Razak plc agreed to pay a further £6 per share
on 31 March 20X4, subject to a condition that Assulin’s management team, each of whom owned
shares in Assulin, remain with the company to that date. It is considered to be highly probable that
this condition will be met. No adjustments for a contingent payment have been included in Razak’s
financial statements. Razak has a cost of capital of 9%.
On 31 March 20X2, the fair value of an Assulin share was estimated to be £20. Razak has decided to
use the fair value (full goodwill) method to measure non-controlling interest.
The statements of financial position of Assulin at 30 September 20X2 and 31 March 20X2 were as
follows:
30 September 20X2
31 March 20X2
£’000
£’000
3,460
3,210
Inventories
610
580
Receivables
400
280
Cash at bank
70
90
4,540
4,160
£1 ordinary shares
500
500
Retained earnings
2,740
2,540
800
800
Trade payables
290
240
Tax payable
210
80
4,540
4,160
Non-current assets
Property, plant and equipment
Current assets
Total assets
Equity
Non-current liabilities
Loan from Razak plc
Current liabilities
Total equity and liabilities
Included in Assulin’s non-current assets is a property which had a carrying amount of £1.2 million at
31 March 20X2. This property was estimated to have a fair value of £2.6 million at this date, and a
remaining useful life of five years.
ICAEW 2022
Financial reporting 2
29
Exhibit 2: Draft statement of financial position for Razak plc at 30 September 20X2
£’000
Non-current assets
Property, plant and equipment
6,000
Investment in Assulin
9,325
Loan to Assulin
800
Other financial assets
1,193
17,318
Current assets
Inventories
1,255
Receivables
960
2,215
Total assets
19,533
Equity
£1 ordinary shares
2,800
Share premium account
7,400
Retained earnings
2,510
Other components of equity
750
13,460
Non-current liabilities
2,788
Current liabilities
Bank overdraft
1,220
Trade payables
865
Tax payable
1,200
3,285
Total equity and liabilities
19,533
Exhibit 3: Imposter bond
Razak plc purchased a 6% bond in Imposter plc on 1 October 20X1 (the issue date) at par for £1.2
million. On recognition, Razak created a separate allowance of £7,000 for 12-month expected credit
losses (present value of lifetime expected credit losses of £100,000 × 7% chance of default within 12
months). The bond has an effective annual rate of interest of 7.5%. No repayments were made in the
year ended 30 September 20X2.
At 30 September 20X2, the credit quality of the bond was considered to have significantly
deteriorated. The present value of lifetime expected credit losses was revised to £600,000.
The discount rate used to calculate the present value of lifetime expected credit losses is 7.5%.
It is currently recognised in ‘other financial assets’ in the draft statement of financial position at
£1,193,000, which is the value on initial recognition net of the 12-month expected credit losses.
The chief executive of Razak plc is also a director of Imposter and has a 5% shareholding in Imposter.
The chief executive authorised the purchase of the bond. There is no record of this matter in the
board minutes.
30
Corporate Reporting
ICAEW 2022
Exhibit 4: Proposed pension plan
The directors of Razak are considering setting up a pension plan in the next accounting period with
the following characteristics:
(1) The pension liabilities would be fully insured and indexation of future liabilities will be limited up
to and including the funds available in a special trust account set up for the plan, which is not at
the disposal of Razak.
(2) The trust account will be built up by the insurance company from the surplus yield on
investments.
(3) The pension plan will be an average pay plan in respect of which the entity pays insurance
premiums to a third party insurance company to fund the plan.
(4) Every year 1% of the pension fund will be built up and employees will pay a contribution of 4%
of their salary, with the employer paying the balance of the contribution.
(5) If an employee leaves Razak and transfers the pension to another fund, Razak will be liable for, or
is refunded the difference between the benefits the employee is entitled to and the insurance
premiums paid.
In the light of the above, the directors believe that the plan will qualify as a defined contribution plan
under IAS 19, Employee Benefits rather than a defined benefit plan, and will be accounted for
accordingly.
13 Melton plc
Melton plc (‘Melton’) owns a number of subsidiaries that operate high quality coffee bars.
You are a recently appointed investment analyst for a major investment bank that owns 6% of the
issued equity of Melton. You have been asked to analyse the profitability, cash flows and investor
ratios of Melton. You need to prepare notes for a meeting with the investment team to determine
whether the investment bank should consider disposing of its investment.
One of your colleagues has left you a note of background information concerning Melton (Exhibit 1)
and some financial information (Exhibit 2).
Your meeting notes should do the following:
(1) Evaluate the investment team member’s comment (Exhibit 1 point (8)), explaining the usefulness
and limitations of diluted earnings per share information to investors.
(2) Analyse the profitability, cash flow and investor ratios of Melton plc, calculating additional
relevant ratios to assist in your analysis. Your notes should identify and justify matters that you
consider require further investigation.
(3) Explain the validity or otherwise of your colleague’s statement that Melton plc is unable to pay a
dividend because of the debit balance on consolidated retained earnings (Exhibit 1, point (7)).
(4) Discuss the reporting implications of the issue raised in the director’s comment in Exhibit 1, point
(9).
Requirement
Prepare the meeting notes for the investment team.
Total: 30 marks
Exhibit 1: Notes on background information for Melton
(1) Melton has a reputation for depreciating its assets more slowly than others in the sector.
(2) The strategy of the group is to fund new outlet capital expenditure from existing operating cash
flows without the need to raise new debt.
(3) Like for like revenue growth in the sector is estimated at 4.1% pa.
(4) Grow ‘outlet profits’ (gross profits) as a percentage of outlet revenue year on year.
(5) Increase promotional and advertising spend on new outlets to encourage strong initial sales.
(6) Management are accused of concentrating on new outlet openings to the detriment of existing
outlets.
ICAEW 2022
Financial reporting 2
31
(7) Melton is unable to pay dividends as the company has a debit balance on its consolidated
retained earnings.
(8) One member of the investment team has questioned the usefulness of diluted earnings per
share, which, he believes, ‘adds in unnecessary complications that may never happen’.
(9)
Melton acquired 8,000 out of the 10,000 shares of R.T. Café Ltd, which operates a chain of cafés
offering simple food and a good but limited range of coffees. Mr Bean, one of the directors of
Melton, has stated the following:
“While R.T. Café Ltd is profitable, long-term it is not a good fit with the image we are trying to
portray. I suggest we dispose 2,000 of our shares in this subsidiary in January 20X8. Preliminary
enquiries suggest that we could make a profit of £500,000, which would be a nice boost to
earnings per share for next year.”
Exhibit 2: Financial information
Melton plc: Consolidated statement of profit or loss for the year ended 30 September
20X7
20X6
£’000
£’000
37,780
29,170
Cost of sales
(28,340)
(22,080)
Gross profit
9,440
7,090
(6,240)
(4,480)
3,200
2,610
Revenue
Administrative expenses
Profit from operations
Finance costs
(410)
Profit before taxation
(420)
2,790
Tax
2,190
(610)
(460)
Profit for the year
2,180
1,730
Earnings per share – basic
26.8p
21.3p
Earnings per share – diluted
21.2p
19.2p
No dividends have been paid or proposed in 20X6 and 20X7.
Melton plc: Consolidated statement of cash flows for the year ended 30 September
20X7
£’000
£’000
20X6
£’000
£’000
Cash flows from operating activities
Cash generated from operations (Note)
6,450
4,950
Interest paid
(410)
(440)
Tax paid
(320)
(260)
5,720
4,250
Net cash from operating activities
Cash flows from investing activities
Purchase of non-current assets
Proceeds on sale of non-current assets
(5,970)
(5,790)
20
Net cash used in investing activities
30
(5,950)
(5,760)
Cash flows from financing activities
Proceeds of share issue
32
Corporate Reporting
240
20
ICAEW 2022
20X7
£’000
Borrowings
Net cash from financing activities
£’000
650
20X6
£’000
£’000
2,000
890
2,020
–––––
–––––
660
510
Cash and cash equivalents brought forward
2,480
1,970
Cash and cash equivalents carried forward
3,140
2,480
Net increase in cash and cash equivalents
Note: Reconciliation of profit before tax to cash generated from operations for the year ended 30
September
Profit before tax
Finance cost
Depreciation and amortisation
Loss on disposal of non-current assets
(Increase)/decrease in inventories
(Increase) in receivables
Increase in trade payables
Cash generated from operations
20X7
20X6
£’000
£’000
2,790
2,190
410
420
3,060
2,210
30
10
(40)
10
(250)
(20)
450
130
6,450
4,950
Analysis of revenue, outlet profits and new outlet openings for the years ended 30 September
20X6 and 20X7
30 new outlets were opened during the year ended 30 September 20X7 to bring the total to 115.
20X7
20X6
£’000
£’000
Outlets open at 30 September 20X6
354
343
Outlets opened in current financial year
258
–
Outlets open at 30 September 20X6
87
83
Outlets opened in current financial year
69
–
Revenue per outlet
Gross profit per outlet
Additional information
20X7
20X6
Gross margin
25.0%
24.3%
Gearing (net debt/equity)
35.2%
44.4%
Current ratio
0.56:1
0.48:1
Trade payables payment period
86 days
103 days
Return on capital employed (ROCE)
20.0%
19.1%
ICAEW 2022
Financial reporting 2
33
20X7
20X6
Cash return on capital employed (CROCE)
40.2%
36.3%
Revenue per employee (£’000)
41.1
37.9
Earnings before interest, tax, depreciation and amortisation
(EBITDA) (£’000)
6,260
4,820
Non-current asset turnover
1.68 times
1.49 times
Share price (at 30 September)
302p
290p
14 Aroma
Jo West owned a highly successful technology business which she sold five years ago for £20 million.
She then set up an investment entity that invests primarily in smaller private businesses in need of
short to medium term funding. Jo sits on the board as a non-executive director of a number of the
entities that her business has invested in and is often able to offer valuable business advice to these
entities, especially in the area of research and development activities. You are Lois Mortimer, a
member of Jo’s investment management team.
Jo has been approached by the managing director of Aroma, a small private entity looking for
investment; she has asked you, as a member of her investment management team, to produce a
report analysing the financial performance of Aroma for the year ended 30 June 20X1 and its
financial position at that date. Your report should contain a recommendation as to whether she
should consider this investment further.
Jo has sent you the following email:
To:
loismortimer@westinvestments.com
From:
jowest@westinvestments.com
Date:
31 August 20X1
Subject: Financial performance of Aroma
Thank you for agreeing to do this report for me. I’ve got hold of some extracts from Aroma’s
financial statements (Exhibit).
Some background detail for you:
Aroma has been trading for more than 10 years manufacturing and selling its own branded
perfumes, lotions and candles to the public in its 15 retail stores and to other larger retailing
entities. Revenue and profits have been steady over the last 10 years. However, 18 months ago,
the newly appointed sales director saw an opportunity to sell the products online. Using longterm funding, she set up an online shop. The online shop has been operating successfully for the
last 14 months. The sales director also used her prior contacts to secure a lucrative deal with a
boutique hotel chain for Aroma to manufacture products for the hotel, which carry the hotel chain
name and logo. The contract was set up on 1 January 20X1.
The managing director of Aroma now believes that the business could take advantage of further
sales opportunities and does not wish to lose the momentum created by the sales director. The
bank that currently provides both the long-term loan and an overdraft facility has rejected Aroma’s
request for additional funds on the basis that there are insufficient assets to offer as security (the
existing funding is secured on Aroma’s property, plant and equipment).
Requirement
Prepare the report required by Jo West.
Total: 30 marks
34
Corporate Reporting
ICAEW 2022
Exhibit: Financial statements extracts
Statement of profit or loss for the year ended 30 June
20X1
20X0
£’000
£’000
6,000
3,700
Cost of sales
(4,083)
(2,590)
Gross profit
1,917
1,110
Revenue
Administrative expenses
(870)
(413)
Distribution costs
(464)
(356)
Finance costs
(43)
(34)
Profit before tax
540
307
(135)
(80)
405
227
Income tax expense
Profit for the year
The revenues and profits of the three business segments for the year ended 30 June 20X1 were:
Retail operations
Online store
Hotel contract
£’000
£’000
£’000
Revenues
4,004
1,096
900
Gross profit
1,200
330
387
320
138
82
Profit before tax
The online store earned a negligible amount of revenue and profit in the year ended 30 June 20X0.
Statement of financial position as at 30 June
20X1
20X0
£’000
£’000
380
400
20
10
400
410
1,260
1,180
455
310
–––––
42
1,715
1,532
2,115
1,942
ASSETS
Non-current assets
Property, plant and equipment
Intangible assets – development costs
Current assets
Inventories
Receivables
Cash and cash equivalents
Total assets
ICAEW 2022
Financial reporting 2
35
20X1
20X0
£’000
£’000
Share capital (£1 equity shares)
550
550
Retained earnings
722
610
1,272
1,160
412
404
363
378
68
–––––
431
378
843
782
2,115
1,942
EQUITY AND LIABILITIES
Equity
Total equity
Non-current liabilities
Long-term borrowings
Current liabilities
Payables
Short-term borrowings (overdraft)
Total liabilities
Total equity and liabilities
15 Kenyon
You work for a team of investment analysts at Inver Bank.
Kenyon plc, a listed entity, operates a number of bottling plants. The entity’s business consists
primarily of contract work for regular customers. Revenue from existing contracts has increased in the
year and in November 20X0 Kenyon plc secured a new contract with a high profile drinks company.
Kenyon plc paid a dividend of £100 million during the year ended 31 October 20X1.
Gary, a client, recently received the latest published financial statements of Kenyon plc and was
impressed by the level of profitability and the dividend paid. He was also impressed with the fact that
the share price had increased from £2.80 per share on 31 October 20X0 to £4.90 on 31 October
20X1. Gary is now considering acquiring some of Kenyon plc’s shares and has asked for your advice
in an email:
“I am interested in your views on whether it is worth investing in Kenyon plc. It would be useful in
making my decision if you could produce a report which:
(1) analyses the financial performance of Kenyon plc for the year to 31 October 20X1 and its
financial position at that date and discusses whether or not it is a good investment at this time;
(2) and, in addition:
(a) shows the best and worst case potential impact of the contingent liability on Kenyon plc’s
profitability and investment potential; and
(b) discusses any further information I may need to access regarding the contingent liability in
advance of making a final investment decision.”
You have obtained the financial statements of Kenyon plc (Exhibit 1), together with some further
information (Exhibit 2).
Requirement
Prepare the report required by Gary Watson.
Total: 30 marks
36
Corporate Reporting
ICAEW 2022
Exhibit 1: Financial statements
Kenyon plc: Statements of financial position as at 31 October
20X1
20X0
£m
£m
381
346
56
–––
437
346
Inventories
86
40
Receivables
72
48
3
60
161
148
598
494
150
150
50
50
Retained reserves
265
223
Total equity
465
423
38
5
95
66
Total liabilities
133
71
Total equity and liabilities
598
494
ASSETS
Non-current assets
Property, plant and equipment
Investment in associate (see Exhibit 2)
Current assets
Cash and cash equivalents
Total assets
EQUITY AND LIABILITIES
Equity
Share capital (50 pence shares)
Share premium
Non-current liabilities
Pension liability (see Exhibit 2)
Current liabilities
Trade and other payables
Kenyon plc: Statements of profit or loss and other comprehensive income for the year ended 31
October
20X1
20X0
£m
£m
663
463
Cost of sales
(395)
(315)
Gross profit
268
148
Distribution costs
(27)
(20)
Administrative expenses
(28)
(17)
Revenue
ICAEW 2022
Financial reporting 2
37
20X1
20X0
£m
£m
Share of profit of associate (see Exhibit 2)
7
–
Investment income
1
6
Profit before tax
221
117
Income tax expense
(45)
(24)
Profit for the year
176
93
(48)
(10)
14
2
Other comprehensive income for the year, net of tax
(34)
(8)
Total comprehensive income
142
85
Other comprehensive income (not re-classified to P/L):
Remeasurement loss on pension assets and liabilities (see Exhibit 2)
Tax effect of other comprehensive income
Exhibit 2: Additional information
Investment in associate
Kenyon plc acquired 40% of AB, its associate on 1 April 20X1 for £49 million.
Pension liability
The actuary has provided the valuations of pension assets and liabilities as at 31 October 20X1 in the
financial statements. However, as yet the actuary has not informed Kenyon plc of the contribution
level required for the year to 31 October 20X2.
Contingent liability
The notes to the financial statements include details of a contingent liability of £10 million. On 5
October 20X1, Kenyon plc suffered a chemical leak at one of the bottling plants and there is currently
an investigation into the potential damage this caused to a nearby river and surrounding area. The
investigation is at an early stage and it is not yet clear whether Kenyon plc was negligent. As stated in
the notes to the financial statements Kenyon plc’s lawyers have intimated that, in their opinion,
Kenyon plc is likely to lose the case. No obligation has been recorded because the amount of
potential damages could not be measured with sufficient reliability at the year end. However, the
lawyers have given a range of possible estimates of between £7 million and £13 million. The case is
due to be decided by 31 October 20X2.
38
Corporate Reporting
ICAEW 2022
Audit and integrated 1
16 Dormro
Note: For formatting reasons it is recommended that this question is done as home study/in a paperbased context.
You are Bernie Eters, an audit assistant manager working for FG, ICAEW Chartered Accountants. The
audit engagement manager in charge of the Dormro Ltd and Dormro group audit gives you the
following briefing:
“This audit is turning into a nightmare and I need your assistance today. The Dormro finance director
has just informed me that Dormro acquired an investment in Klip Inc., an overseas company resident
in Harwan, on 31 January 20X2, which is not included in the consolidation schedules. Klip is audited
by a local Harwanian auditor.
I am also unhappy about the level of detailed testing carried out by our audit senior. I have provided
you with the following relevant work papers:
Exhibit 1
Extract from Dormro audit planning memorandum.
Exhibit 2
Consolidation schedule, notes and outstanding audit procedures.
Exhibit 3
Information concerning the acquisition of Klip provided by Dormro finance
director; statement of financial position for Klip; and audit clearance from Klip
auditors in Harwan.
I have a meeting with the audit partner tomorrow and I need to inform her of any issues relating to
the group financial statements and to provide a detailed summary of the progress of our work.
Please review all the information provided and prepare a work paper which:
(1) identifies and explains any known and potential issues which you believe may give rise to
material audit adjustments or significant audit risks in the group financial statements; and
(2) outlines, for each issue, the additional audit procedures, if any, required to enable us to sign our
audit opinion on the group financial statements.
Also, please include in your work paper a revised consolidated statement of financial position as at
30 April 20X2, which includes the overseas subsidiary, Klip.”
Requirement
Prepare the work paper requested by the audit engagement manager.
Total: 40 marks
Exhibit 1: Extract from Dormro audit planning memorandum for year ended 30 April 20X2
Group planning materiality has been set at £250,000.
Dormro has two wholly-owned UK subsidiaries; Secure Ltd and CAM Ltd.
Secure was set up several years ago and supplies security surveillance systems.
CAM is a specialist supplier of security cameras and was acquired by Dormro on 31 October 20X1.
CAM is a growing business with profitable public sector contracts.
The UK companies have a 30 April year end and FG audits all the UK companies.
ICAEW 2022
Audit and integrated 1
39
Exhibit 2: Dormro: consolidation schedules for the year ended 30 April 20X2
Statement of financial position
Dormro
Secure
CAM
Adjs.
£’000
£’000
£’000
45
2,181
788
–
–
–
Note
Group
£’000
ASSETS
Non-current assets
Property, plant and
equipment
Goodwill
Investments
10,180
–
3,014
9,490
1
(3,239)
2
15
(10,010)
1
3,380
2,947
6,251
185
Current assets
Inventories
–
Trade receivables
Intercompany receivables
Cash and cash equivalents
Total assets
6,327
4,292
4,849
9,141
2,045
–
1,474
567
(706)
382
12,837
9,147
10,455
(7,278)
200
10
510
(520)
1
200
4,523
973
1,758
(1,758)
2
5,496
54
(867)
2,962
(100)
3
568
(1,481)
2
(3,519)
3
––––––
–
243
25,161
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings at 1 May
20X1
Profit/(loss) for the year
Non-current liabilities
Long-term borrowings
8,000
–
–
4
37
5,702
4,513
–
3,329
90
23
–
622
12,837
9,147
10,455
(7,278)
767
23,407
28,097
(14,049)
2
(767)
3
8,000
Current liabilities
Trade and other payables
Intercompany payables
Current tax payable
Total equity and liabilities
10,252
(3,419)
3
–
645
25,161
Statement of profit or loss
Revenue
Cost of sales
Administrative expenses
–
(740)
(19,703)
(4,532)
(19,455)
(4,688)
9,727
2
767
3
(100)
3
2,344
40
Corporate Reporting
37,455
(29,431)
(6,949)
2
ICAEW 2022
Dormro
Secure
CAM
Adjs.
£’000
£’000
£’000
Finance income/(cost)
50
(39)
31
(15)
Profit/(loss) before tax
77
(867)
3,985
(2,093)
(23)
––––––
(1,023)
512
54
(867)
2,962
(1,581)
Income tax expense
Profit/(loss) for the year
Note
Group
£’000
2
27
1,102
2
(534)
568
Notes
(1) This adjustment eliminates investments in the subsidiary companies Secure and CAM. The
equivalent adjustment in the prior year was £10,000 and related to the elimination of share
capital in Secure. The increase in the current year is due to the acquisition of CAM for £10 million
which I have agreed to the bank statement. In addition, £170,000 was paid to acquire the shares
in Klip and there is an investment of £15,000 held by CAM both of which are below the
materiality level.
(2) This adjustment removes from the statement of profit or loss half of CAM’s results as the
subsidiary was acquired on 31 October 20X1. In addition, all pre-acquisition retained earnings
have been eliminated and treated as part of the goodwill calculation.
(3) These adjustments eliminate intragroup balances and management charges from Dormro to its
subsidiaries. The difference of £100,000 between the receivables and payables has been written
off to profit or loss and is concerning a dispute between Secure and CAM.
(4) This loan was taken out by Dormro on 1 May 20X1. I have agreed the balance to the loan
agreement, noting capital repayable over eight years in equal annual instalments commencing 1
May 20X2 and an effective interest rate of 6.68%. An arrangement fee of £200,000 has been
expensed to profit or loss and interest is payable at 6% annually in arrears. An adjustment is
required to accrue for interest of £480,000.
Outstanding audit procedures
I have reconciled all balances from the consolidation schedules to the audit work papers for each
company, noting no exceptions. The following procedures are outstanding:
Secure
Review of the directors’ assessment of the company’s ability to continue as a going concern given
the loss for the year, the overdraft balance and the company’s reliance on loans from other group
companies.
CAM
Final conclusion on the adequacy of the inventory obsolescence provision. CAM has applied the
group accounting policy in determining its provision, but this is based on historical sales. Given the
technical issues with the product range, I am concerned that the calculated provision may be
understated by around £220,000.
Audit procedures on the provision for warranty costs of £205,000 (20X1: £275,000). Management
have failed to supply any supporting documentation for this provision.
Secure and CAM
Receipt of bank confirmation letters and confirmation of balances due to other group companies.
Exhibit 3: Information concerning the acquisition of Klip provided by Dormro finance director
On 31 January 20X2, Dormro paid H$918,000 (£170,000) to acquire 90% of the issued ordinary
share capital of Klip which trades in Harwan where the currency is the Harwan dollar ($H). Klip makes
security cameras and is a supplier company to CAM. There were no adjustments to the fair value of
the net assets acquired except that inventory required a write down of H$1,000,000. None of this
inventory had been sold at the year end.
Dormro measures non-controlling interest using the proportion of net assets method. The rate of
exchange at 30 April 20X2 was H$4.2 = £1 and the average rate for the three months to 30 April
20X2 was H$4.8 = £1.
ICAEW 2022
Audit and integrated 1
41
Klip – Statement of financial position as at 30 April 20X2
H$’000
ASSETS
Non-current assets
Property, plant and equipment
1,940
Current assets
Inventories
2,100
Trade receivables
600
Cash and cash equivalents
Total assets
40
4,680
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings at 1 May 20X1
200
1,200
Profit for the year
500
Non-current liabilities
Long-term borrowings
1,400
Current liabilities
Trade and other payables
1,380
Total equity and liabilities
4,680
Clearance from Harwanian auditors of Klip
To:
Finance director, Dormro, United Kingdom
From:
Mersander Partners, Harwan
Date:
26 July 20X2
Subject: Audit of Klip for the year ended 30 April 20X2
We have performed an audit of the accompanying reporting package of Klip for the year ended
30 April 20X2 in accordance with Harwanian Standards on Auditing and using materiality
specified by you of £250,000. The reporting package has been prepared in accordance with
group accounting policies as notified by Dormro. Where no group policy has been notified, the
reporting package has been prepared using accounting policies consistent with those adopted in
previous years.
The net profit for the year increased by 10% compared to the previous year. This is due to a
decrease in inventory obsolescence provisions when the group accounting policy was applied.
There is no outstanding audit work which would affect our opinion and there are no uncorrected
audit adjustments.
In our opinion, the reporting package of the entity has been prepared in all material respects in
accordance with group accounting policies and presents fairly the results of Klip for the year
ended 30 April 20X2 and its financial position as at that date.
Mersander Partners
42
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17 Johnson Telecom
Johnson Telecom plc (Johnson) is a telecommunications consultancy company delivering telecoms
support to businesses across Europe. Johnson’s treasury department uses financial instruments for
both speculative and hedging purposes. The company has an accounting year end of 31 December.
The company’s financial statements show the following financial instruments:
Extracts from financial statements at 31 December
Draft
20X6
20X7
£’000
£’000
485
321
98
102
143
143
726
566
2,000
2,000
2,000
2,000
Financial assets
Investments in equity
Derivatives
Debt investments
Financial liabilities
Loan note
You are Poppy Posgen, a newly qualified audit senior at Beckett & Co, Chartered Accountants, and
you are assigned to the statutory audit of Johnson for the year ended 31 December 20X7. You have
received the following email from your manager, Annette Douglas.
To:
Poppy Posgen
From:
Annette Douglas
Date:
7 February 20X8
Subject: 20X7 Financial Statements
Poppy,
Following our meeting yesterday, I would like you to review the way Johnson have accounted for a
number of financial instruments. As you know, the Finance Director, who has prepared the
supporting documentation, is on sick leave at the moment and is not expected to return to work
until after the financial statements are published. The Financial Controller has provided all the
information she can find, but lacks the background knowledge on these financial instruments.
I have attached below the notes that the audit junior has taken in relation to the financial
instruments. Bear in mind that planning materiality for the financial statements as a whole is
£80,000, and we have set a lower performance materiality level for investments at 20% of
planning materiality.
Investments in equity
The £485,000 balance at 31 December 20X6 represents two small investments in UK equity
shares. Johnson has held the investment in Cole for a number of years, and sold it on 14 August
20X7 for £242,000. The investment in International Energy plc was acquired on 1 November
20X6. Both Cole plc and International Energy plc are listed companies.
Valuation at 31
Draft at 31
Historical cost December 20X6 December 20X7
Cole plc (50,000 shares)
Routers plc (16,000 shares)
ICAEW 2022
£’000
£’000
£’000
163
230
–
–
–
93
Audit and integrated 1
43
Valuation at 31
Draft at 31
Historical cost December 20X6 December 20X7
International Energy plc (30,000 shares)
£’000
£’000
£’000
270
255
228
433
485
321
On initial recognition of the investments in both Cole plc and International Energy plc an
irrevocable election was made to measure them at fair value through other comprehensive
income, with any fair value gains or losses accumulated in other components of equity.
A new investment of 16,000 shares (out of a total of 50,000 shares) in Routers plc was made on 8
November 20X7. In the Finance Director’s absence, the Financial Controller could not find
supporting documents for the investment.
According to the Financial Times on that date, the bid-offer spread was £5.80–£5.83 at acquisition.
The Directors explained to me that this investment is a short-term investment and is held for
trading, with the aim of generating a profit if the price changes. As a result, it was designated as at
fair value through profit or loss.
The journal entries in respect of the disposal of Cole plc and the acquisition of the new
investment in Routers plc are shown in Exhibit 2.
Derivatives
The balance comprises two derivatives:
(1) Put option
There is a put option to hedge against a fall in the share price of the 30,000 shares in International
Energy. The put was purchased on 1 January 20X7 at £2 per option and is exercisable at £9.00
until 31 December 20X8.
In the absence of the Finance Director, who prepared the documentation to support this hedge,
the documentation cannot be found. The option is accounted for using hedge accounting.
The Directors are unfamiliar with the hedge accounting rules and have asked us to outline the
hedging principles, and explain how fair value hedge accounting changes the way the investment
and option are accounted for.
They have also asked us to provide suitable documentation to support the fair value hedge. As
the original documentation has been lost, the Directors have suggested they may backdate the
documentation as 1 January 20X7.
(2) Interest rate swap
The interest rate swap is a five-year variable-to-fixed interest rate swap to hedge the interest rate
risk of the loan note liability. The swap was entered into on 30 November 20X6. In the financial
statements for the year ended 31 December 20X6, the swap was recorded at a fair value of
£38,000. The swap was designated as a hedge at inception and the hedging documentation was
reviewed by the audit team as part of last year’s statutory audit.
The company applies cash flow hedge accounting to this swap. The Finance Director has
prepared a note on the accounting treatment of the interest rate swap (see Exhibit 5).
The terms of the swap:
•
£2 million notional amount
•
Pay 7% fixed, receive variable at SONIA
•
Semi-annual payments
The fair value of the swap at 31 December 20X7, based on current SONIA rates, is £30,000.
44
Corporate Reporting
ICAEW 2022
Debt investments
The debt investment is a four-year quoted bond in Spence and May plc acquired on 1 January
20X6 and meets the IFRS 9 conditions to be measured at amortised cost (the business model test
and cash flow characteristics test). Half of the holding was sold on the last day of this year for
£83,000.
Terms:
•
Acquired at nominal value of £140,000
•
Redemption at premium of £10,000 on 31 December 20X9
•
Coupon 10% pa, payable six-monthly in arrears (5% per six-month period)
•
Effective interest rate is 11.79% per annum (5.73% per six-month period)
Loan note
The loan note was issued at nominal value on 31 December 20X6 and is a five-year note at SONIA
with semi-annual payments. Issue and redemption of the loan is at the nominal value of £2 million.
The variable interest rate payments are hedged by the interest rate swap referred to in the
Derivatives section above.
Actions
I need you to:
(1) evaluate the accounting treatment adopted in the draft financial statements for the above
financial instruments, showing any journal entries where relevant. Explain any audit
adjustments required;
(2) draft a summary of the hedge accounting rules and hedging principles as requested by the
Directors, along with a sample hedging documentation. Explain separately how we should
approach the Directors’ proposal to use hedging documentation prepared by us to support
the put option;
(3) identify and explain five key risks that arise from the derivatives trading activities, and the
internal controls that should be in place to mitigate these risks; and
(4) identify and explain any additional audit evidence the audit team will need to obtain with
regards to the financial instruments.
Requirement
Prepare a memorandum giving the information required by Annette Douglas.
Total: 40 marks
Exhibit 1: Market information as at 31 December 20X7
Share prices
Day’s close
Mid market
Bid
Offer
£
£
£
£
International Energy plc
7.70
7.62
7.60
7.64
Routers plc
5.84
5.86
5.85
5.88
Put option
Fair value of option (per share)
31 December 20X6
£2
31 December 20X7
£2.40
ICAEW 2022
Audit and integrated 1
45
Exhibit 2: Journal entries in respect of investments
Cole plc
£’000
DEBIT
Cash
£’000
242
CREDIT
Investment
230
CREDIT
Profit or loss
12
Being the disposal of the investment in Cole plc
Routers plc
£’000
DEBIT
Investment
CREDIT
£’000
93.28
Cash
93.28
Being acquisition of investment in Routers plc
Exhibit 3: Bloomberg market data
SONIA
31 December 20X6
7.0%
30 June 20X7
7.5%
31 December 20X7
7.5%
Exhibit 4: Supporting workings for Spence and May bonds
The amortised cost is calculated every six months in line with the frequency of the coupon payments.
Operating
balance
Interest at 5.73%
Cash flow (5% ×
140,000)
Closing balance
£
£
£
£
30 Jun 20X6
140,000
8,022
(7,000)
141,022
31 Dec 20X6
141,022
8,081
(7,000)
142,103
30 Jun 20X7
142,103
8,143
(7,000)
143,246
31 Dec 20X7
143,246
8,208
(7,000)
144,454
Period ended
Journal entries in respect of the bonds
£’000
DEBIT
Debt investment
1.2
DEBIT
Cash
7.0
CREDIT
Interest income
£’000
8.2
Being re-measurement of amortised cost at 31 December 20X7
•
De-recognise 50% of the amortised cost of the investment holding.
•
Resulting gain of £10,773 (83,000 – (144,454/2) is recognised in profit or loss.
£’000
DEBIT
CREDIT
46
Corporate Reporting
Cash
Debt investment
£’000
83
83
ICAEW 2022
Exhibit 5: Accounting note on the loan and interest rate swap
Loan note and interest rate swap
•
The interest rate swap (IRS) provides a cash flow hedge against the interest payments on the loan
note.
•
Hedge accounting is permitted as:
– the hedge is a perfect hedge as all terms match (currency, maturity, nominal amount); and
– documentation has been in place since inception.
•
The amortised cost of the loan will remain at £2 million as the loan issue and redemption are both
at par.
•
The entries through the year are as follows:
– The £150,000 variable rate interest for 12 months to 31 Dec 20X7 is charged to profit or loss
and accrued until payment is made (£2m × 7.5%).
– The net settlement on the interest rate swap is £10,000 ((7.5% – 7%) × £2m). This is received
from the swap bank as a cash settlement and reduces the £150,000 variable rate interest
expense on the loan note to £140,000, being the fixed rate cost.
– The £8,000 change in the fair value of the swap is released from equity (other components of
equity). This represents the settlement of £10,000 less the unwinding of the discounting in the
future swap settlements.
£’000
DEBIT
Profit or loss – Interest expense
CREDIT
Interest accrual
DEBIT
Interest accrual
CREDIT
Cash
DEBIT
Cash
CREDIT
£’000
150
150
150
150
10
Profit or loss – Interest expense
DEBIT
Equity
CREDIT
10
8
Derivative asset
8
18 Biltmore
The Biltmore group, a property business which came into being on 1 January 20X8, owns a number
of investment properties. The parent company, Biltmore plc, and the other members of the group,
had no connection before that date. The directors of Biltmore plc have a reputation for adopting
aggressive accounting practices. At the audit planning meeting, the need for professional scepticism
was highlighted. Materiality for the financial statements as a whole is set at 1% of the group’s total
assets. Total group assets at the year end are £2,423 million.
You are Jane Smith, a senior in James & Co, an accounting firm. David Williams, the audit partner, has
sent you the following email.
To:
Jane Smith
From:
David Williams, Audit Partner
Date:
5 February 20X9
Subject: Investment properties owned by Biltmore group
ICAEW 2022
Audit and integrated 1
47
Following our earlier discussion, I would like you to prepare a report on the investment properties
owned by the various members of the Biltmore Group at 31 December 20X8. Details of the
investments are in an Appendix. As you know, this is a complex area of the audit. The valuation of
investment properties was identified as an area where there is a particular risk of material
misstatement.
All the detailed audit fieldwork has been completed, but the financial statements have yet to be
finalised and agreed by the board of directors, and the auditor’s report is still under consideration.
One thing I’m particularly concerned about is the misclassification of assets. As we have seen
throughout this audit, the directors are very reluctant to make adjustments to reclassify such
assets, arguing that “you’d end up with the same total assets figure anyway”.
Your report should cover the following:
(1) The appropriate treatment of each investment property in the consolidated financial
statements of the Biltmore Group as at 31 December 20X8, with justifications in each case.
(2) A calculation of the adjustments that would have to be made to the figures in the draft
financial statements in order to show the corrected figures relating to investment properties
in the consolidated financial statements.
(3) A summary and explanation of the impact on our auditor’s report if the directors refuse to put
through the reclassification adjustments, setting out the reasons for your conclusion.
Requirement
Prepare the report required by the audit partner.
Total: 40 marks
Exhibit: Appendix: Details of Biltmore investments
The draft financial statements are as follows:
Summarised statements of comprehensive income for the year ended 31 December 20X8
Biltmore plc
Subone plc
Subtoo plc
£m
£m
£m
Rental income
500
–
300
Gains on investment properties
100
80
50
(2)
–
(1)
(12)
(8)
(9)
(140)
(50)
(25)
446
22
315
Biltmore plc
Subone plc
Subtoo plc
£m
£m
£m
38
–
19
Investment properties
1,000
850
510
Investments
2,000
––––
––––
3,038
850
529
3
2
1
Revenues
Operating costs
Depreciation of property
Administration
Finance costs
Net profit
Summarised statements of financial position as at 31 December 20X8
Property, plant and equipment (excluding
investment properties)
Current assets
48
Corporate Reporting
ICAEW 2022
Biltmore plc
Subone plc
Subtoo plc
£m
£m
£m
3,041
852
530
Equity
1,539
351
279
Non-current liabilities
1,500
500
250
2
1
1
3,041
852
530
Current liabilities
All of the property, plant and equipment is in the form of land and buildings. All of these were
professionally revalued as at the date of Biltmore plc’s investment in the group members.
Biltmore plc owns 100% of the share capital of Subone plc and 80% of Subtoo plc.
All companies show all of their investment properties at fair value, unless otherwise stated.
All properties have an estimated useful life of 20 years.
The following information relates to the properties classed as investment properties in the draft
statement of financial position of the group members:
Biltmore plc
Present
carrying
amount
£m
Harmony Tower 3 – a medium-sized office block in London’s Docklands
This property was purchased in February 20X8 for £200 million. The directors have
decided to leave this property valued at cost because they do not believe that they
can measure its fair value reliably.
Harmony Tower 3 is flanked by two identical buildings, neither of which is owned by
any member of the Biltmore Group. The owner of neighbouring Harmony Tower 2
sold the property on the open market in December 20X8 for £150 million. The owner
of Harmony Tower 1 has put the property on the market for £160 million.
200
Grove Place – an office block in Birmingham City Centre
This property had a fair value of £220 million on 1 January 20X8. During the year
Biltmore plc spent £30 million on a major programme of improvement and
refurbishment and capitalised these costs.
The latest valuation report, dated December 20X8, suggests that the property’s fair
value remains at £220 million.
250
Head office – upper floors
Biltmore plc’s head office is a 12-floor office block. The company occupies the bottom
four floors and has left the top eight floors vacant. The directors claim that they intend
to hold these vacant floors for their ‘investment potential’ and are not actively seeking
a tenant or buyer. An architect’s report on the building states that it would be difficult
to remodel the building so as to let or sell the upper floors to a third party.
The upper floors are recognised in the financial statements at £100 million.
The fair value attributed to the upper floors on 1 January 20X8 was £80 million.
100
Northwest Forward – a mixed retail and office complex in Lancaster
This complex had a fair value of £240 million on 1 January 20X8.
Biltmore plc rents out 99% of the floor space in this development, but occupies a
small suite of management offices on the site. The complex cannot be sold separately.
ICAEW 2022
300
Audit and integrated 1
49
Biltmore plc
Present
carrying
amount
£m
Buy-to-let portfolio – Teesside
Biltmore plc owns a large number of flats and houses in the Northeast of England.
These had a fair value of £150 million as at 1 January 20X8.
There was a downturn in house market prices in that region at the end of January
20X9. The portfolio’s value was estimated at £120 million at that time.
150
Essex Mall
Subone plc’s principal asset is the site of Essex Mall, which is presently under
construction. This will be a major shopping development and all of the units in the
mall are under contract to retail chains, with leases commencing from the estimated
completion date of 1 September 20X9. Subone plc intends to sell the development
once it is completed.
The cost of the site and building work as at 1 January 20X8 was £600 million. A further
£170 million was spent on the work done during the year ended 31 December 20X8.
850
The directors of Subone plc believe that the property has a fair value of £850 million
in its present state.
Subone plc’s head office
Subone plc occupies a prestigious London office block which is leased from Subtoo
plc on a five-year lease.
The property had a fair value of £120 million on 1 January 20X8.
150
Coventry building
Subtoo plc owns a building in Coventry.
Subtoo plc commenced development of the Coventry building in March 20X8 with a
view to resale. At that time its fair value was £345 million. The property remains on the
market as at the present date. There have been several expressions of interest, but no
formal offers.
360
19 Hillhire
You are an audit senior with Barber and Kennedy, a firm of ICAEW Chartered Accountants. Peter
Lanning, one of the firm’s audit managers, has just been assigned to the audit of Hillhire plc after the
previous audit manager was signed off sick. Peter has given you some notes made by the previous
manager at the initial audit planning meeting (Exhibit 2), along with some other information, and he
has given you the following instructions:
“I would like you to assist me in the audit planning and first I would like you to prepare a
memorandum which identifies the key audit risks relating to Hillhire’s financial statements using
extracts from the financial statements for 20X7 and 20X8 (Exhibit 1) for the year ended 31 March
20X8. You should also outline the main audit procedures that we should carry out in respect of these
matters and, where appropriate, state (Exhibit 3) the correct financial reporting treatment including
journals for any potential adjustments that you identify at this stage.
It appears that major issues to consider include a discontinued activity, the acquisition of Loucamion
SA, the company’s recent use of financial instruments for hedging purposes and the proposal to
introduce a major new system.
In addition, the company has granted share options to senior employees as an incentive. These have
not been accounted for in the current financial statements.
50
Corporate Reporting
ICAEW 2022
The financial controller has argued that the share options granted are not an expense and therefore
they have not been reflected in the financial statements. He is saying that even if they were to be
accounted for as an expense, they do not yet vest as the vesting period is three years.
You are given relevant information in Exhibit 4.
You should review all of the information to hand and identify any required adjustments and any other
considerations associated with the audit in terms of audit risk, ethics and our own practice
management, that should be addressed before commencing the detailed audit work.”
Requirement
Draft the memorandum requested by the audit manager.
Total: 40 marks
Exhibit 1: Extracts from draft financial statements
Statement of profit or loss and other comprehensive income for the year ended 31 March
20X8 Draft
£’000
Revenue
£’000
20X7 Audited
£’000
£’000
283,670
257,850
Cost of sales
(187,220)
(167,900)
Gross profit
96,450
89,950
Administrative expenses
(excluding amortisation)
Amortisation
(35,020)
(34,610)
(1,960)
(970)
Total administrative expenses
(36,980)
(35,580)
59,470
54,370
(17,750)
(15,910)
41,720
38,460
(10,090)
(9,270)
Profit for the year from continuing
operations
31,630
29,190
Loss for the year from
discontinued operations
(4,390)
––––––––
Profit for the year
27,240
29,190
20X8 Draft
20X7 Audited
Profit from operations
Finance costs
Profit before tax
Taxation
Statement of financial position at 31 March
£’000
£’000
£’000
£’000
ASSETS
Non-current assets
Goodwill
12,000
5,000
Other intangible assets
40,680
28,740
452,130
434,510
10,260
6,130
515,070
474,380
Property, plant and equipment
Financial non-current assets
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51
20X8 Draft
£’000
£’000
20X7 Audited
£’000
£’000
Current assets
Inventories
4,280
3,820
Receivables
86,430
78,160
Cash and cash equivalents
19,540
15,910
110,250
97,890
40,130
–––––––
665,450
572,270
Share capital
10,900
10,900
Share premium
63,250
63,250
Revaluation surplus
30,900
30,900
105,330
85,030
210,380
190,080
Long term borrowings
382,340
313,100
Deferred tax liabilities
22,290
19,740
404,630
332,840
Bank overdraft
11,160
10,270
Trade and other payables
32,810
33,950
6,470
5,130
50,440
49,350
665,450
572,270
Non-current assets held for sale
Total assets
EQUITY AND LIABILITIES
Equity
Reserves
Non-current liabilities
Current liabilities
Tax liabilities
Total equity and liabilities
Exhibit 2: Notes taken by previous audit manager at planning meeting
Hillhire plc is a long-established company that has grown rapidly, both organically and by acquisition
over the last 10 years. It hires out commercial vehicles using a large network of depots throughout
the United Kingdom and also in Europe through a number of wholly owned subsidiaries.
The company’s management has announced that 15 of its less profitable depots are to be sold off.
Each depot is viewed as a cash generating unit in its own right. The depots that are for sale are
clustered in Scotland and the decision to sell them is part of a strategic decision to withdraw from
this area. The results of these depots have been disclosed separately as discontinued operations in
the draft statement of profit or loss and other comprehensive income. The announcement was made
on 1 January 20X8 and management’s intentions were minuted in the board minutes. Marketing of
the depot is not due to start until May or June 20X8 as Hillhire is yet to find alternative storage for the
vehicles currently stored in these depots which it is intending to relocate to other parts of the
business. At 1 January the carrying value of the depots was £44.52 million. They have been classified
as held for sale at a fair value less costs to sell of £40.13 million. At 1 January the depots had a
remaining useful life of 25 years. The loss on the discontinued operations of £4.39 million is only the
loss on the classification of the depots to assets held for sale.
On 1 April 20X7 Hillhire acquired 100% of the share capital of a competitor company, Loucamion SA,
based in France. The functional currency of Loucamion is the euro. The main reason for the
52
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acquisition was the perceived value of the customer relationships built up by Loucamion in its local
market. Assets and liabilities recognised at the date of acquisition included £4 million in respect of
customer lists. Confidentiality agreements prohibit Loucamion from selling or exchanging
information about its customers on the list. At 1 April 20X7 the useful life of the list was estimated to
be 10 years and the intangible asset has been amortised on this basis.
A loan note was issued at nominal value on 1 April 20X7 and is included in the statement of financial
position. It is a five year note at SONIA plus 2%. Issue and redemption of the loan is at nominal value
of £200 million. The variable interest rate payments are hedged by an interest rate swap (see below).
The company has entered into a five year interest rate swap on 1 April 20X7 for a notional amount of
£200 million to hedge the interest rate risk of the loan note liability. A swap agreement has been
signed whereby Hillhire plc will pay a fixed rate of 8% to a counterparty on this amount and the
counterparty will pay SONIA plus 2% to Hillhire plc. Payments are semi-annual. This swap was
designated as a cash flow hedge on 1 May 20X7 and the directors of Hillhire plc believe that it is
effective as such. No adjustment has been made for interest for the six months to 31 March 20X8,
and no entries have yet been made for the change in fair value.
SONIA rates are as follows:
1 April 20X7
7%
30 September 20X7
7.5%
31 March 20X8
7.5%
Exhibit 3: Email from Alison Ritchie, partner responsible for Technology Risk Services in Barber and
Kennedy
To:
Peter Lanning
From:
Alison Ritchie
Date:
10 April 20X8
Subject: Hillhire
I understand that you are now managing the audit of Hillhire plc. You should be aware that my
team has been approached to tender for a one-off assurance assignment for this client. This would
involve a review of risks and advice on controls in Hillhire’s new online booking system, which has
been piloted in 20 of their UK depots since 2 January 20X8, prior to a planned national launch
later in the year.
At present, each depot operates its own bookings. Customers who wish to hire a vehicle must
contact the nearest depot directly and make a booking by telephone. Transactions are logged on
a networked PC system that operates independently within each branch. Every evening, this
information is uploaded to the head office’s computer system. Head office then processes credit
card payments due from personal customers and invoices business customers using information
supplied by the depots.
The new system provides a centralised booking system via the company’s website. Customers can
make a booking online rather than by telephone. If the vehicle type required by the customer is
unavailable at that depot, the system can arrange to have a vehicle transferred from another
depot provided the distance is not too great. All transactions are processed by the new system
immediately, thereby accelerating the billing process.
Now that the system has been piloted, it will be extended to all depots. This will require a central
register to be compiled for all vehicles held at every branch. The standing data for business
customers will also have to be transferred to the new system.
It would be useful to discuss this at the earliest opportunity.
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53
Exhibit 4: Details of share option scheme
On 1 April 20X7, 100 share options have been granted to each of the top senior 50 employees.
The options vest after three years on condition that the employees remain in the employment of
Hillhire; the directors believe that 10% of senior employees will leave during the three-year period.
The scheme is not expected to be available to new employees.
Employing a binomial lattice model gives a fair value for the option on grant date of £10 and a value
of £8 at the year-end.
20 Maykem
You are an ICAEW Chartered Accountant, working as an audit senior in a firm of ICAEW Chartered
Accountants.
You receive the following message from one of the audit managers in your office:
“I know you are unassigned today and I really need your help. Max, the senior on the audit of
Maykem Ltd for the year ended 31 May 20X8, has gone off sick and I would like you to take over his
responsibilities. There are three urgent issues I would like you to address initially:
Current liabilities
An assistant has completed procedures on current liabilities but Max has not yet reviewed her work.
Please examine the assistant’s work attached (Exhibit 1) and prepare a list of review points
explaining, for each of the current liabilities, any key weaknesses in the audit procedures completed
to date and the additional audit procedures necessary.
As part of your review, select and explain the significant financial reporting issues which need to be
addressed prior to the completion of the audit.
Pension
Maykem operates a defined benefit pension plan. The assets of the plan are held separately from
those of the company in funds under the control of trustees. At a recent meeting with the client I was
told that the senior accountant who used to deal with the pension plan left suddenly during the year.
This individual has not been replaced and the directors are proposing that the only amount that they
need to recognise in profit or loss is the cash contribution paid by the company in the year of
£306,000. I need to speak to the directors about this tomorrow.
I would like you to prepare a schedule for me setting out the correct accounting treatment and any
adjustments that need to be made. It would also be helpful if you could set out the key audit issues
we need to consider. I do not require a detailed list of audit procedures at this stage.
Information relating to the plan is attached (Exhibit 2).
Ethical issue
Sophie, the trainee on the audit team, who is originally from France, has sent me an email yesterday
saying that she has an investment which tracks the performance of Euronext (French Stock
Exchange), which includes ParisMet.
I am fairly confident that this is not a problem, but I would like you to confirm whether or not this is
the case with reference to the ICAEW Code of Ethics. Your notes will then provide evidence that we
have considered the issue.
Other information
Maykem Ltd manufactures and distributes refrigeration equipment and is a wholly-owned subsidiary
of a listed French company, ParisMet. ParisMet’s recent results have been disappointing and we
believe that group management is under pressure to announce increased revenues and profit for the
year ended 31 May 20X8.
Our audit approach to Maykem Ltd is wholly substantive and materiality has been set at £250,000.
Thanks for your help on this.”
Requirement
Respond to the audit manager’s message. Ignore the impact of any taxes (including indirect taxes).
Total: 40 marks
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Exhibit 1: Maykem Ltd – Audit – 31 May 20X8
Work performed on current liability balances
Current liabilities are analysed as follows:
20X8
20X7
£’000
£’000
13,342
15,208
Accruals
5,749
4,579
Indirect taxes
2,625
2,302
Payroll taxes
1,214
1,304
15,435
18,167
500
––––––
38,865
41,560
20X8
20X7
£’000
£’000
11,023
12,586
2,319
2,622
13,342
15,208
Trade payables
Contract liabilities
Surplus property provision
Trade payables
This balance is made up as follows:
Trade payables ledger
Goods received not invoiced
From a discussion with Maggie Phillips (financial controller), the balance has decreased compared to
the prior year as fewer goods were purchased in the last month of the year, compared with the last
month of the previous year.
Audit procedures carried out:
•
Agreed trade payables balance to ledger, noting there are no reconciling items.
•
Reviewed trade payables ledger for unusual items. Debit balances totalling £345,601 were noted.
An adjustment has been raised to reclassify these to trade receivables.
•
Reconciled the five largest balances to statements received from the suppliers. The results of this
work are summarised below:
Balance
per ledger
Payments in
transit (note 1)
Invoices in
transit (note
2)
Other
Balance per
statement
£’000
£’000
£’000
£’000
£’000
Metalbits Ltd
2,563
–
239
–
2,802
Hingeit Ltd
2,073
451
34
–
2,558
Metallo Spa
1,491
–
302
62
1,855
Boxit Ltd
1,282
231
459
–
1,972
Bitso Supply Ltd
1,184
104
510
––
1,798
8,593
786
1,544
62
10,985
Supplier
Note
3
Notes
(1) All payments in transit were agreed to the trade payables ledger and to the cash book before
the year end, and to bank statements after the year end. They all appear as reconciling items on
the bank reconciliation.
ICAEW 2022
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55
(2) All invoices in transit were agreed to supplier statements and to invoices posted to the trade
payables ledger after year end.
(3) Metallo Spa invoices Maykem in euro. The supplier statement balance and invoices in transit
balance above have been translated at the year-end rate of €1.45:£1. Per discussion, the balance
per the trade payables ledger has been translated at a rate of €1.51:£1 as this is the rate in a
forward currency contract taken out to hedge purchases from Metallo. The ‘other’ reconciling
item shown above arises from the difference in exchange rates used.
Accruals
Accruals and the audit work performed is analysed as follows:
20X8
20X7
£’000
£’000
Note
235
150
1
Bonus
4,000
2,300
2
General and administration
1,504
1,895
3
10
–
4
––––
234
4
5,749
4,579
Commission
Legal fees
Royalties payable
Notes
(1) The commission accrual represents sales commission payable for May 20X8. This amount was
paid in June 20X8 and has been agreed to the June payroll. The balance is much higher than in
the prior year because of exceptionally high sales in May 20X8.
(2) Staff bonuses will not be paid until September 20X8. The amount accrued is based on an
estimate prepared by the finance director. The accrual is much larger than in the prior year as a
result of a significant increase in the directors’ bonuses which are based on company
performance targets agreed by group management.
(3) An analysis of general and administrative accruals was obtained and all items over £25,000 were
agreed to supporting documentation.
(4) From a discussion with Maggie Phillips, in May 20X7 Maykem received a letter from MegaCo plc,
alleging that Maykem had breached one of MegaCo’s patents and claiming royalties on sales of
all products in which the patented refrigeration technology was used. Although Maykem
disputed MegaCo’s claim, a provision was made in the 20X7 accounts for estimated royalties
payable on sales to date. At that time the Maykem directors considered it more likely than not
that some payment would be made, given MegaCo’s far superior size and resources. Maykem
has now sought independent legal advice and, in April 20X8, wrote to MegaCo plc totally
refuting the breach of patent claim. MegaCo’s directors acknowledged the letter, stating that
they would respond after taking their own legal advice. To date nothing further has been heard
from MegaCo. On this basis, the provision for royalties has been released. The accrual for legal
fees represents the amount payable for legal advice taken to date.
Contract liabilities
Contract liabilities represent service revenues relating to future periods. When customers buy a
refrigeration unit from Maykem, they may choose to buy a three-year maintenance contract in
addition to the normal one-year warranty. Revenue for the maintenance contracts is deferred and
released on a straight line basis over the period to which the contracts relate.
During 20X8, Maykem has reassessed the costs it incurs in providing maintenance services. These
costs have reduced considerably as the reliability of the product has improved. As a result the margin
earned on the maintenance element is far in excess of that earned on the original product sale. An
exercise has therefore been undertaken to recalculate how the total revenue from a product and
maintenance sale should be allocated between the two elements so that the percentage margin
earned on each element is equal. This revised split of revenue has been retrospectively applied to all
maintenance arrangements still in force at 31 May 20X8, resulting in the recognition of nearly £4
million of additional revenue.
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The contract liabilities balance has been agreed to a detailed analysis which has been tested for
accuracy and completeness as part of our procedures on revenue. The revised calculations splitting
the revenue between the two elements have also been tested without exception.
Surplus property provision
This relates to leasehold factory premises which, until January 20X8, were occupied by Maykem’s
domestic refrigeration division. The trade of this division together with all related inventory was sold
to Coolit on 1 January 20X8. The sale excluded the leasehold premises and manufacturing plant as
Coolit did not want these.
From a discussion with Maggie Phillips, Maykem’s directors believe that it will take some time to find
a replacement tenant for the leasehold factory premises, as they are not in good condition. The lease
for the factory expires in May 20Y8 (in 10 years’ time) and the annual rental is £250,000. The
provision of £500,000 is based on the finance director’s view that it will take two years to let the
premises.
Included within profit or loss for the year ended 31 May 20X8 is a net gain on the sale of the
domestic refrigeration business, which has been calculated as follows:
£’000
Proceeds from sale of trade and inventory
1,300
Carrying amount of assets sold
(200)
Provision for surplus property
(500)
Net gain on sale of business
600
Exhibit 2: Pension Plan
The terms of the pension plan have been summarised by Maykem as follows.
•
Employees contribute 6% of their salaries to the plan.
•
Maykem contributes, currently, the same amount as the employees to the plan for the benefit of
the employees.
•
On retirement, employees are guaranteed a pension which is based upon the number of years’
service with the company and their final salary.
The following details relate to the plan in the year to 31 May 20X8:
£’000
Present value of obligation at 1 June 20X7
3,600
Present value of obligation at 31 May 20X8
4,320
Fair value of plan assets at 1 June 20X7
3,420
Fair value of plan assets at 31 May 20X8
4,050
Current service cost
360
Pension benefits paid
342
Total contributions paid to the scheme for year to 31 May 20X8
306
Gains and losses on remeasurement (actuarial gains and losses) are recognised in accordance with
IAS 19, Employee Benefits.
The interest rate on high quality corporate bonds at 1 June 20X7 was 5%.
Assume cash contributions are received and pension payments are made at the year end.
ICAEW 2022
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57
21 Tydaway
You are Gerry Melville, an audit senior in A&B Partners LLP. Today you receive a voicemail message
from your manager, Mary Cunningham:
“Hello Gerry. I’d like you to help me to plan our audit of Tydaway Ltd for the year ending 31 July
20X1. In particular, the inventory section of our audit did not go well last year.
Tydaway is a long-standing audit client of A&B Partners and has for many years manufactured metal
filing cabinets at its factory in South London. On 30 September 20X0, Tydaway acquired a division of
a competitor’s business which produces high-quality wooden office furniture. This business, now
known as Woodtydy, continues to operate from a factory in North London as a division of Tydaway. It
continues to maintain its own separate accounting records and its results have not yet been
incorporated in Tydaway’s monthly management accounts.
I’ve left on your desk extracts from Tydaway’s most recently available management accounts which
are for the 10 months ended 31 May 20X1 (Exhibit 1), notes from last year’s audit file on inventory
valuation (Exhibit 2) and information on Woodtydy’s inventory supplied by the Woodtydy financial
controller (Exhibit 3).
Tydaway’s annual inventory count took place on 30 June 20X1 (a month before the year-end) and it
was attended by audit assistant, Dani Ford. Dani’s inventory count notes are also on your desk (Ex
hibit 4). As Dani is on study leave from next week, it’s important that you raise any questions with her
as soon as possible.
What I need you to do is the following:
(1) Review Dani’s inventory count notes (Exhibit 4) and prepare a list of issues and queries for her to
address before she goes on study leave. Your list should include brief explanations of the points
raised so that Dani understands why any additional information is required.
(2) For each of the relevant financial statement assertions in respect of inventory:
(a) highlight any particular concerns or issues which you have identified from your review of
Exhibits 1, 2 and 3; and
(b) prepare a summary of the key audit procedures we will need to perform to ensure that we
have adequate audit assurance on inventory.
Assume that audit planning materiality is £40,000 as in the prior year.
We have also been asked to give our client some accounting advice. Tydaway is finding the market
for the metals required to make the filing cabinets increasingly competitive. As a result it has been
looking for new suppliers and has identified one in China. Tydaway is to be invoiced by the Chinese
company in US dollars (as this is the functional currency of the Chinese company). On 15 July 20X1
the company intends to enter into a contract with the Chinese company to purchase metals with a
contract price of $500,000. This is a large order but it has been made in the light of the lead time for
transporting the raw materials. The metal will be delivered to Tydaway on 15 December 20X1 and
payment will be made on that date.
The directors are concerned about the impact of foreign exchange risk and are considering whether
to enter into a forward contract on 15 July 20X1 to purchase $500,000 on 15 December 20X1. They
have asked me to meet them next week to discuss their options. I would like you to prepare some
information that I can refer to in my meeting as follows:
(3) Set out, using journal entries, the impact of this contract on the financial statements for the years
ending 31 July 20X1 and 31 July 20X2 under each of the following scenarios:
(a) There is no hedging arrangement put in place.
(b) Tydaway enters into the forward contract, but does not satisfy the conditions for hedge
accounting.
(c) Tydaway enters into the forward contract, satisfies the conditions for hedge accounting and
chooses fair value hedge accounting.
(d) Tydaway enters into the forward contract, satisfies the conditions for hedge accounting and
chooses cash flow hedge accounting.
(4) Explain and compare the financial reporting treatment for the four scenarios above.
I do not require you to consider the tax implications of these issues and I do not require you to list
hedging accounting conditions.
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I have made some additional notes and working assumptions for you to use (Exhibit 5).
We also need to consider the implications for our forthcoming audit. If hedge accounting is used
certain documentation must be kept. Please provide a list of the documentation we would be
expecting to see.
I look forward to reviewing your work later today.”
Requirement
Respond to Mary Cunningham’s instructions.
(Assume that today is 5 July 20X1)
Total: 40 marks
Exhibit 1: Extracts from Tydaway Ltd management accounts for the 10 months to 31 May 20X1
Statement of profit or loss and other comprehensive income
10 months to 31 May
20X1
20X0
£’000
£’000
External customers
4,282
5,912
Sales to Woodtydy
135
–––––
4,417
5,912
2,431
3,197
296
(10)
Other purchase costs, including freight
77
45
Movement in inventory at standard cost
(99)
20
Notes
Revenue generated by South London factory
1
South London factory costs
Raw materials at standard cost
Purchase price variances
Total raw material cost of goods sold
2,705
3,252
–
5
Labour
873
869
Overheads and delivery costs
345
354
3,923
4,480
11%
24%
Movement in inventory provision
Total factory cost of goods sold
Margin as a percentage of total revenue
2
Statement of financial position
31 May
20X1
31 May
20X0
£’000
£’000
Raw materials
340
270
Raw material element of work-in-progress
131
157
55
––––
526
427
(20)
(20)
506
407
Notes
Inventory analysis
Raw material element of finished goods
Inventory provision
ICAEW 2022
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3
4
59
Notes
(1) Represents goods sold to Woodtydy in the period since Tydaway acquired the division on 30
September 20X0.
(2) Purchase price variances are adverse in the period ended 31 May 20X1 as a result of an
unexpected increase in the price of steel. In addition, normal bulk discounts were unavailable on
components bought at short notice to fulfil a major order which was shipped in May 20X1 and
gave rise to a one-off adverse price variance of £25,000.
(3) Raw material inventory has increased as a result of a slow-down in customer orders. During June
20X0, certain components were purchased in bulk in anticipation of orders which have not
materialised. Of these purchases, components costing approximately £60,000 remain in
inventory at 31 May 20X1.
(4) Finished goods held in inventory represent the cost of goods produced for Swishman plc, a
customer which ordered customised products in its corporate colours for a major office
refurbishment. Swishman has recently experienced financial difficulties and has cancelled its
order, leaving Tydaway with a number of finished cabinets already painted in Swishman’s
specified colours. It is possible that these cabinets can be used to fulfil other orders, but they will
need to be stripped and repainted at a total cost of around £10,000. A legal claim for £30,000
has already been made against Swishman for breach of contract. Swishman has offered £6,000
in full and final settlement of the liability.
Exhibit 2: Notes on inventory valuation from prior year audit file for Tydaway
•
Raw materials are valued at standard cost. Standard costs are reviewed and updated on the first
day of each financial year and are then left unchanged throughout the year. Historically, our audit
testing on the valuation of a sample of items has led us to conclude that standard costs generally
represent a reasonable approximation to the actual cost of purchase.
•
Standard costs include an uplift of 1.5% of the material cost to cover freight and other purchase
costs.
•
Inventories of finished goods are typically very low as all goods are shipped to the customer as
soon as they are complete.
•
Work in progress (WIP)* is valued initially at the standard cost of its raw material components. An
adjustment is made at the year end (for statutory accounts purposes only) to include in inventory
an appropriate percentage of labour and factory overhead, calculated as follows:
– ((Units in WIP × 50%) ÷ (Total units produced in the year)) × (Total factory labour + Factory
overhead) *WIP is on average 50% complete
– Provision is made for any obsolete raw materials. No provision is required against finished
goods or WIP as filing cabinets are typically built to order for specific customers.
Exhibit 3: Information on Woodtydy’s inventory supplied by Woodtydy financial controller
(1) At 31 May 20X1, the Woodtydy business had total inventory as analysed below:
£’000
Raw materials
230
Work in progress
120
Finished goods
159
509
Provision
(58)
451
(2) Raw materials are valued at the latest invoice price.
(3) Each customer order is recorded on a separate job card. As materials are allocated to an order,
they are booked out of raw materials and booked on the job card at the latest invoice price. The time
spent on the job is then recorded on the card and a cost of £30 per hour is included in inventory to
reflect the cost of direct labour and factory overhead. At the period end, the job cards are sorted into
complete and incomplete items and recorded as finished goods or work in progress as appropriate.
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(4) Provision is made on a line-by-line basis for any items which are obsolete, slow-moving or can
only be sold for less than cost.
Exhibit 4: Notes on inventory count attendance prepared by Dani Ford
I attended an inventory count at Tydaway’s South London factory on 30 June 20X1. As no inventory
count is planned at 31 July, the inventory quantities from this count will be posted to the book
inventory records and updated for purchases and sales made in the last month of the financial year.
The count was well organised and all counters were briefed beforehand. Counters worked in teams
of two, with one counting and the other recording the quantity counted and comparing it to the
quantity shown on the book inventory system, as supplied on the printed inventory list prepared
beforehand. Where the quantity counted differed by more than 10% from that on the system, a
second count was performed by a team from another area of the warehouse.
I performed independent counts on a sample of 25 types of raw material, noting the following
differences:
•
Quantities of smaller components were estimated by weighing a sample of 10 to 20 items and
comparing their weight to the weight of the total inventory of that item in order to estimate the
overall quantity. When we performed our own tests, we noted differences of up to 5% in quantity
for such items. This does not appear unreasonable given the estimation involved.
•
All tins of paint and chemicals were treated as full tins although some of them were only partly
full. From a discussion with the inventory controller this is unlikely to have resulted in any material
overstatement of inventory.
•
Two differences were noted in samples taken from the mezzanine area of the stores. In both cases,
the counters had recorded a count which agreed with the quantity on the system whereas our
count showed less in one case and more in the other. Our counts were agreed with the counters
and the inventory sheets were updated to record the correct quantities.
I performed counts on a sample of five types of work in progress. All counts were accurate.
I inspected the despatch areas, noting that there were no shipments in progress during the count. In
the goods received area, I noted a large consignment of filing cabinet drawers which had not been
counted. From a discussion with the inventory controller, these drawers had just been returned from
a subcontractor who finishes the premium range to a high standard. They will be booked back into
WIP after the count is complete.
Exhibit 5: Additional notes and assumptions
Proposed contract with China
Hedging
Tydaway is considering two alternatives:
•
Do not hedge and therefore accept any consequent exchange rate risks.
•
Enter into a foreign exchange forward contract on 15 July 20X1 to purchase $500,000 on 15
December 20X1.
At 15 July 20X1, the spot exchange rate is expected to be £1 = $1.6108.
At 15 July 20X1, the five-month forward rate is also expected to be £1 = $1.6108. The forward rate
contract will have a zero fair value at 15 July 20X1.
At 15 July 20X1, the contract with China would be a firm commitment and, if Tydaway decides to
enter into the forward contract at that date, it is unsure whether it would be better to treat it as a fair
value hedge or as a cash flow hedge for financial reporting purposes. However, it may be that
Tydaway cannot satisfy the hedge accounting conditions, although it is hoped it will be able to do so.
Working assumptions
For illustrative purposes I would like you to adopt the following working assumptions as one possible
scenario of future exchange rate movements:
At 31 July 20X1
Spot
£1 = $1.5108
Fair value of forward contract
£20,544 positive (ie, in favour of Tydaway)
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61
At 15 December 20X1
Spot
£1 = $1.4108
Fair value of forward contract
£43,994 positive (ie, in favour of Tydaway)
22 Wadi Investments
The Wadi Investments Group invests in capital markets and real estate primarily in the Indian
subcontinent and Asia. Your firm is responsible for the audit of Wadi Investments and the
consolidated financial statements. The audit has already commenced but you have been asked to
join the team as the manager is concerned that there is not the appropriate level of expertise in the
current team. You have been sent the following email from your manager.
To:
APerdan@ABCAccountants
From:
TFlode@ABCAccountants
Date:
30 July 20X9
Subject: Audit of the financial statements for the year ended 30 June 20X9
Amar,
I am very glad that you are joining the audit as things have not been going well. I have had a fairly
inexperienced team and I am concerned about some of the work which has been prepared to
date. We are responsible for both the parent company audit and the audit of the group. Work has
already started on the audit of the parent company. I have briefly reviewed most of the working
papers produced to date but have not been able to look at them in detail. My review has raised a
number of concerns which I would like you to address in a report which I can use to evaluate how
to approach the remaining audit work. I have listed my concerns below and have attached a
number of other relevant documents including relevant exchange rates (Exhibit 2). I have
confirmed the exchange rates myself so you should use these in any calculations.
Audit of the parent: Wadi Investments
Acquisition of Strobosch
We have been told that Wadi purchased an 80% subsidiary on 1 January 20X9. It is an investment
company based in Ruritania and its functional currency is the Ruritanian rand (RR). Some work has
been done on the investment in the parent’s statement of financial position but from my review of
the audit assistant’s working paper (Exhibit 1) a number of significant issues have not been
addressed. Please identify these including any audit adjustments that may be required. You
should also review the work performed by the junior and list any additional procedures which are
needed.
Investment property
The group carries all land and buildings, including investment property, at fair value. On 15 March
20X9 the head office building in London was vacated and is to be leased out for the next five
years to a company outside the Wadi Group. The building originally cost £90 million back on 3
April 20X6 and as at the next valuation on 30 June 20X7 it was valued at £112 million. Its fair value
at 15 March 20X9 was £124 million and at 30 June 20X9 is £128 million. The depreciation policy
for buildings is straight line over 50 years, measured to the nearest month. Our audit work to date
shows that the asset has been included in property, plant and equipment in the year end
statement of financial position but any further work on this issue is outstanding. Please can you set
out how to account for the change in the use of this asset and outline the audit adjustments
required. You should also list the audit procedures which should be performed.
Audit of Wadi Investments Group
This is still at the planning stage and there are a number of issues which I would like your help
with.
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(1) The Strobosch audit is being conducted by a local firm, Kale & Co. I am familiar with the firm
and its practices and am confident that they will do a professional job. However, I need to
communicate with them and will have to draft a letter of instruction. Please draw up a
checklist of the points which I need to include so that I can ensure that all necessary matters
are covered.
(2) At a recent meeting with the finance director of Wadi, he mentioned that the investment in
Strobosch was financed by a number of Ruritanian Rand loans in order to hedge the foreign
currency exposure and that hedging provisions are to be adopted. Total exchange losses on
the loans for the six months to 30 June 20X9 are £36 million. He also mentioned a loan made
to Strobosch on 1 January 20X9 to assist with expansion plans. Further details regarding the
net investment in Strobosch and the loan to Strobosch are attached (Exhibit 3). Please identify
the audit and financial reporting issues that we will need to consider.
Requirement
Respond to the manager’s instructions.
Total: 40 marks
Exhibit 1: Audit assistant’s working paper for the acquisition of Strobosch
Client: Wadi Investments
Year end: 30 June 20X9
Prepared by: Sam Brown
Investment in Strobosch
£m
Cash paid on 1 January 20X9
675
8% debentures
360
Costs
18
1,053
Analysis of costs
£m
Costs of internal merger and acquisitions team at Wadi Investments
2
Issue costs of debentures
6
Legal costs (RR23m × 0.45)
10
18
Note: I have been told that the IRR on the debentures is 4.42% per six-month period but I am not
sure what the relevance of this is. Interest on the debentures is paid every six months.
Work performed
(1) Agreed cash paid to bank statement.
(2) Agreed £360 million debentures to matching liability in the statement of financial position.
(3) Obtained a schedule of the breakdown of costs.
(4) Cast total and agreed spot rate.
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Exhibit 2: Exchange rates
The following exchange rates should be used for the preparation of the 20X9 financial statements.
Date
RR:£
1 January 20X9
1:0.45
30 June 20X9
1:0.47
Average for six months to 30 June X9
1:0.46
RR = Ruritanian rand
Exhibit 3: Hedge of net investment
Extract from the financial statements of Strobosch as at 30 June 20X9
Draft
RRm
Property, plant and equipment
389
Investment property
1,453
Financial assets
659
Current assets
124
Total assets
2,625
Share capital
300
Retained earnings
1,720
2,020
Non-current liabilities
518
Current liabilities
87
Total liabilities and equity
2,625
•
Retained earnings at acquisition were RR1,440 million and the fair value of net assets at
acquisition was RR1,865 million.
•
The long-term liabilities of Strobosch include RR444 million in respect of a five-year interest free
loan of £200 million made by Wadi on 1 January 20X9.
23 Lyght
The accounting firm for which you work, Budd & Cherry, is a five partner firm of chartered
accountants in general practice. It has 30 staff and it generated fee income last year of £5.2 million.
Budd & Cherry has recently gained a new client, Lyght plc (Lyght), as a result of a competitive tender.
The formalities connected with appointment as auditor, including communication with the previous
auditor, have been completed. The tender was for the audit work, but there is a strong possibility that
Budd & Cherry may also be appointed to carry out the tax work and some advisory work for Lyght.
Gary Orton has been appointed as manager on the Lyght audit for the year to 30 April 20X8 and you
are the senior. Gary calls you into his office and explains the situation:
“Lyght is by far the largest company that our firm has gained as a client so it’s really important that we
do a good job and impress the board – not least because, if we are given the tax and advisory work,
our expected total fees from Lyght will be around £500,000 next year. The previous three auditors
have each lasted only three years before the audit was put out to tender by the Lyght board. I want to
make sure we retain them as a long-term client. They might be looking for an AIM listing in two to
three years’ time and there will be major additional fees for our firm if we are appointed as their
reporting accountants for that process.
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At the moment we are likely to make a low recovery on the audit, as we had to make a low bid to win
the work. We therefore need to carry out the audit efficiently, but also look for opportunities to sell
tax and other services to the client. If I can help gain the tax and other advisory work for a client like
this, I think I could be made a partner in Budd & Cherry and, as the senior, there could also be a big
promotion in it for you.
Harry Roberts, our ethics partner, has some concerns over the fact that this is a large client for a firm
of our size and that the audit fee is so low. He is therefore monitoring the situation. Please provide
me with a memo including some notes explaining any ethical issues that should be drawn to his
attention.
We are commencing the audit in a fortnight, on 25 May 20X8, and I have already been out to the
client for a few days with a junior. I have provided some background notes (see Exhibit 1). I have also
been to see the board and some matters have arisen that I have recorded in my briefing notes (see
Exhibit 2). I would like you to explain the audit and ethical issues arising from the matters raised in
the briefing notes, including the relevant audit procedures we should carry out during the audit.
Where relevant, you should also describe the appropriate financial reporting treatment in each case.
Please include your comments in the memo referred to above.”
Requirement
Respond to the request of Gary Orton, the audit manager.
Total: 40 marks
Exhibit 1: Background notes
Lyght plc is a family-owned company which is controlled and resident in the UK. It purchases public
sector assets from hospitals and from the armed forces within the EU, then sells them to governments
and private sector companies, frequently in developing countries. Sales and purchases are invoiced
either in sterling or in the currency of the foreign customer or supplier. The assets are those which
are no longer required by the public sector bodies, but they are still serviceable. Health equipment
includes expensive machinery for monitoring patients, as well as more basic nursing equipment such
as beds, blankets and appliances. Lyght does not purchase weapons from the armed forces, as it has
no licence to do so, but it acquires a wide variety of small and large items including vehicles,
equipment, boats, tents and clothing.
Draft results for 20X8 show that Lyght plc generated revenue of £107 million from which a profit
before tax of £12 million was generated. The carrying amount of its net assets at 30 April 20X8 is £36
million.
Leslie Moore is the principal shareholder of Lyght plc, with a holding of 55%. He is also Chairman of
the board and the Chief Executive. His daughter, Emma Everton, is finance director and has a 15%
shareholding. VenRisk, a venture capital company, has a 25% shareholding and has significant
influence, with the remaining shares being held by senior management.
Exhibit 2: Manager’s briefing notes
(1) Lyght has grown significantly in the last few years and is in the process of updating its IT systems
with work already completed by an external contractor on the sales and purchase ledger
systems including both hardware and software. The project is ongoing and the next stage is to
install new, more sophisticated IT systems to monitor the flows of goods across the globe and for
management accounting purposes. Lyght directors have asked our firm if we wish to tender for a
small part of this work, including advice on the internal controls to be built into the new system.
The total cost of the new system will be about £9 million, of which £5 million will be the costs of
IT consultants’ time in installation, data transfer and writing new software. Work would
commence in July 20X8 and would take about a year to complete.
(2) Only about £2 million of inventories (out of a total carrying amount of approximately £20 million)
are held in the UK at any time. Inventories are normally shipped shortly after purchase. High
value inventories usually have an identified buyer prior to purchasing them, and goods are
shipped to the buyer within two months of acquisition. Smaller, low value goods are held at
depots in the countries of the intended customers so they are available for prompt sale. Our
appointment as auditors was only formalised after the year end and as a result we were not able
to attend year-end inventory counts. I am therefore worried about how we will audit inventory. I
am also worried about how inventories are going to be valued.
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(3) A large batch of used tyres was acquired by Lyght from an army transport depot for £1,000 in
August 20X7. However, they were sold a few weeks later for £105,000 to a foreign company,
Hott, in which VenRisk has a 30% equity holding giving it significant influence. Leslie Moore
personally arranged the sale with the manager of the depot. An invoice has been found for
£3,487 for personal gifts and entertainment for the depot manager paid for by Lyght. It also
appears from a few enquiries I made that the depot manager is a cousin of Leslie Moore.
(4) At the start of the year Lyght took out a 10-year non-cancellable lease on some offices that were
part of a new city centre development. Lyght has been keen to upgrade its offices for a while in
order to impress customers, particularly representatives of overseas governments. The lease
payments, payable each year in advance, are £150,000. The present value of future lease
payments has been calculated at £950,000 and has been recognised as a right-of-use asset and
a lease liability. The right-of-use asset is being depreciated on a straight-line basis over 10 years,
and the lease liability amortised.
(5) As a result of entering this lease management decided that the existing head office should be
sold. The decision was taken on 1 January 20X8 and the draft financial statements show that the
property was classified as held for sale from this date. On 1 January 20X8 the property which
had been revalued in the past had a carrying amount of £2 million prior to being transferred to
assets held for resale. Its fair value was estimated at £1.6 million and costs to sell of £20,000. The
remaining useful life of the property at the date of reclassification was 20 years. The company is
not planning to market the property until May 20X8.
(6) Included in Lyght’s trade receivables at 30 April 20X8 is an amount due from its customer
Cristina of £2,577,000. This relates to a sale which took place on 1 May 20X7, payable in three
annual instalments of £1,000,000 commencing 30 April 20X8, discounted at a market rate of
interest adjusted to reflect the risks of Cristina of 8%. Based on previous sales where
consideration has been received in annual instalments, the directors of Lyght estimate a lifetime
expected credit loss in relation to this receivable of £1,505,760. The probability of default over
the next 12 months is estimated at 25%. For trade receivables containing a significant financing
component, Lyght chooses to follow the IFRS 9 three-stage approach for impairments (rather
than always measuring the loss allowance at an amount equal to lifetime credit losses). The
£2,577,000 was recorded in receivables and revenue, but no other accounting entries have been
made.
24 Hopper Wholesale
You are an audit senior in a firm of ICAEW Chartered Accountants. You receive the following
voicemail message from one of the audit managers in your office.
“I need some help urgently with one of our clients, Hopper Wholesale Ltd. Hopper is an unquoted
company that supplies retailers with basic goods such as sugar, salt and similar items. It buys goods
in bulk and packages them in its own factory using simple packets bearing the ‘Hopper Value’ label.
Draft financial statements show revenue of £21.4 million, profit before tax of £2.75 million and total
assets of £65 million.
Callum the senior on the audit is unwell and is likely to be off for the rest of the week. The final audit
meeting for the reporting period to 31 December 20X8 is scheduled for the day after tomorrow. I
have reviewed the audit file and have identified a number of areas where audit procedures are
incomplete. I will email you a summary of these including some background information (Exhibit 1). I
have spoken to the junior staff on the audit and they have confirmed that these are areas where they
have little experience and require some guidance. I would like you to prepare a summary of audit
procedures for each of the outstanding matters. I would also like you to explain the key audit issues
which need to be addressed in each case – this will help the juniors to gain a better understanding of
their work.
One more point. The directors of Hopper Wholesale Ltd are interested in sustainability reporting and
are proposing to include social and environmental information in their financial statements. They
would like us to clarify whether they are required to publish this information. Please outline the
current situation so that I can pass on the information to them. If they do include social and
environmental information, they would like us to produce a verification report. I will email you a copy
of the statements they are planning to make (Exhibit 2). We have not been involved in this type of
work before so I would like you to outline the evidence which we should be able to obtain in order to
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verify these statements and any difficulties we may experience in validating the information. You
should also indicate any professional issues that we need to consider if we accept this work.
Thanks for your help on this.”
Requirement
Respond to the audit manager’s voicemail.
Total: 40 marks
Exhibit 1: Hopper Wholesale Ltd – Audit – 31 December 20X8
Manager’s review notes: Summary of outstanding matters
(1) Inventory
In September 20X8 the company took delivery of 30,000 tonnes of flour from a former competitor
who was going out of business. Normally Hopper would not carry this level of inventory of an
individual line, representing a nine-month supply at normal rates of consumption; however, the
competitor was selling at a 10% discount to open market prices. Hopper paid £4.5 million for the
flour. At the time sales budgets suggested that 10,000 tonnes would be sold at a profit by 31
December 20X8, which has proved to be the case and that the remaining 20,000 tonnes would be
sold steadily throughout the first half of 20X9.
The directors were concerned that the market price for flour can be volatile and so they took steps to
protect the company by entering into an agreement with a third party, Sweetcall, a food
manufacturer, under which Hopper has the right to sell 20,000 tonnes at the end of June 20X9 at an
agreed price of £140 per tonne. Hopper paid £250,000 for this option and this amount is recognised
in the statement of financial position within sundry receivables. If the price of flour falls then the
company will be able to retain their competitive advantage by selling the bulk consignment to
Sweetcall and replacing their own inventory with purchases on the open market. The price of flour at
31 December had fallen to substantially less than £140 per tonne and Sweetcall has offered
£400,000 to Hopper to cancel the option.
Audit procedures completed
The quantity of flour inventory has been established by attendance at the inventory count.
Inventory has been valued at the lower of cost and net realisable value. Satisfactory audit procedures
have been carried out in this respect.
(2) Financial assets
The company has made a number of investments in shares in listed companies. These have been
recognised in non-current assets at £3.25 million. They have been classified as at ‘fair value through
other comprehensive income’. A gain has been recognised in other comprehensive income of
£515,000 in respect of these investments.
Audit procedures completed
The only audit procedure performed is reperformance of the calculation of the gain recognised in
the statement of profit or loss and other comprehensive income.
(3) Receivable
The statement of financial position shows a receivable balance of £50,000. This amount is owed to
Hopper Wholesale Ltd by Bourne Ltd, a company which is controlled by Hopper’s managing
director, Jack Maddison. We have been told that it is due to be repaid within the next 12 months. No
information about this transaction is provided in the notes to the financial statements.
Audit procedures completed
A written representation has been obtained confirming the amount and that the company is
controlled by Jack Maddison.
(4) Share option scheme
On 1 January 20X8, Hopper Wholesale Ltd gave 100 employees 500 share options each which vest
on 31 December 20X9. The options are dependent on the employees working for the entity until the
vesting date. During 20X8, five employees left and Hopper Wholesale Ltd anticipates that in total
10% of the current employees will leave over the two-year period, including the five employees who
left during 20X8.
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The fair value of the options has been estimated as follows:
1 January 20X8
£12
31 December 20X8
£14
31 December 20X9
£15
The share options have been recorded in the financial statements as an expense in profit or loss and
a credit to non-current liabilities of £700,000 (100 × 500 × 14).
Audit procedures completed
Agreed number of employees in the scheme to details set out in the contract.
The fair value of the share options has been confirmed with management.
The adjustment required has been recalculated and agreed to the client’s calculation.
Exhibit 2: Social and environmental report – suggested assertions
(1) We do not use suppliers who use child labour.
(2) All our staff are paid at least 10% above the minimum wage.
(3) We have reduced staff sickness to the rate of 2.4% calendar days.
(4) We have reduced the tonnage of waste sent to landfill by 10%.
(5) Through enhanced health and safety procedures, industrial accidents have been reduced by
40%.
25 Button Bathrooms
Button Bathrooms Ltd (BB) is a retailer of bathroom fittings and accessories. You are a senior in Rudd
& Radcliffe LLP, the auditors of BB.
The meeting
You have been called to a meeting with the engagement partner, Carol Ying, in respect of the audit
of BB’s financial statements for the year ended 30 June 20X1. Carol opened the meeting.
“I would like you to act as senior on the BB audit. In the past year there have been some significant
changes in BB’s business model and in its accounting and internal control systems. As a
consequence, I believe there is greater control risk than in previous years. In addition, the company is
seeking an AIM listing in 20X2 and the board is very keen to present the company’s performance as
favourably as possible.
I realise that you are new to this client, so I have provided some background notes about the
company and the changes that have occurred this year (Exhibit 1). Especially note BB’s new, and very
successful, e‑commerce activity and the defined benefit pension scheme. I have also provided you
with the draft management accounts (Exhibit 2).
I have some particular concerns about the revenue recognition procedures that BB has adopted
since installing its new information systems. An audit junior has provided some notes from a
preliminary audit visit (Exhibit 3), but he did not have time to follow up on these matters.
I am due to meet the finance director of BB next week and I would like you to provide briefing notes
for me which:
(1) With respect to each of the matters raised by the audit junior (Exhibit 3):
(a) Explain the financial reporting issues that arise and show any adjustments that will be
required to the draft management accounts.
(b) Describe the key audit risks and the related audit procedures that we should carry out.
(2) Other than the issues raised by the audit junior, set out the audit risks which arise in respect of
the new e-commerce activities of BB, including those relating to SupportTech, and explain how
we should address these in our audit procedures.
(3) Outline the audit issues we will need to consider regarding the outsourcing of the payables
ledger function. Details are provided below. You do not need to refer to any general issues
relating to SupportTech that you have already referred to in (2).
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This morning I received an email from the finance director of BB (Exhibit 4) relating to a
cyber‑security breach at SupportTech. Fortunately as the breach occurred two days ago it does not
have any direct impact on the current year’s audit. However, I do need to respond to his email and
therefore I would like your briefing notes to include a summary of points that can form the basis of
my response.
Please ignore any tax issues.”
Requirement
Respond to the instructions of Carol Ying.
Total: 40 marks
Exhibit 1: Background details and recent changes
History
BB was established 23 years ago as an upmarket retailer of bathroom fittings and accessories. By
20W9 (two years ago) it was operating from 30 showrooms. Of these, 20 large showrooms sold BB’s
full product range and it offered a service to design, supply and install bathrooms in customers’
houses. Products sold included baths, showers, toilets, taps, washbasins and bathroom accessories.
The other 10 smaller showrooms sold only bathroom accessories, a distinctive BB product range
including towels, bathrobes, lighting and decorative items.
Competition and reorganisation
By 20W9 competition from comparable retailers, combined with the recession, forced BB to
reconsider its business model. The board believed that the company’s overheads were too high. As a
consequence, between 1 July 20X0 and 31 December 20X0, BB closed the 10 smaller showrooms
and ceased selling its bathroom accessories range from the other 20 showrooms.
New e-commerce activity
BB decided to adopt an e-commerce business model for sales of all products in its range, including
bathroom accessories, and it commenced the development of a website on 1 July 20X0. The website
was completed and ready for use by 31 December 20X0. It enables customers to design their own
bathrooms online, select the required products and pay in advance, also online. The total cost of
website development in the year ended 30 June 20X1 was £1 million. This was capitalised and is to
be written off over five years.
After initial development, the operation of the website, including collection of payments from
customers, was outsourced to an external service provider, SupportTech plc. BB receives the cash
from SupportTech each month after deduction of a service charge fee.
The selling prices of products have been reduced by approximately 10% for online sales, compared
with the showroom prices.
Inventories of a wide range of products were previously stored in four regional warehouses.
Customer orders for less popular items, not in inventory, needed to be ordered by BB, which
sometimes caused delays of up to four weeks. From 1 January 20X1 the range and the value of
inventories held were significantly reduced.
Goods sold via the website are all ordered from the manufacturer automatically after the information
is input by the customer. Distribution of goods to the customer is outsourced by BB to a third-party
courier.
Costs of reorganisation, including redundancies (but excluding website development costs), in the
year to 30 June 20X1 amounted to £1.5 million. Further costs of £1 million are to be paid in August
20X1 as a result of the reorganisation.
There have been problems with the new business model including high returns of goods from
customers compared with those sold through showrooms. There have also been errors in goods
delivered arising from customers’ misunderstanding of the website.
Outsourcing of payables ledger function
Last year’s audit identified a number of control issues with respect to payables and in the first half of
this year staff turnover in this department was high. Following the success of the outsourcing of
online sales to SupportTech management decided to outsource the payables ledger function too.
Staff were told of the decision including details of redundancies on 1 April 20X1. SupportTech took
over responsibility for the payables ledger from 1 May 20X1.
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Details of the way in which the system works are as follows:
•
Purchase orders are raised by BB and a delivery note is signed on receipt of the goods.
•
SupportTech is sent soft copies of the purchase orders and the signed delivery notes.
•
SupportTech receives invoices from suppliers directly and matches them to the purchase order
and delivery note.
•
The Finance Director of BB receives a schedule detailing all the payments to be made for a given
month one week before SupportTech processes the payments. This must be authorised by the
Finance Director before the payments are processed.
•
A portal has been set up which allows the Finance Director to interrogate purchase ledger
accounts held by SupportTech. The system does not allow the Finance Director to update or
revise the accounts.
Exhibit 2: Draft management accounts: Statement of profit or loss and other comprehensive
income
Years to 30 June
20X1
20X0
£’000
£’000
Showrooms
30,000
60,000
Online sales
33,000
Revenue
Cost of sales
(49,000)
(42,000)
Gross profit
14,000
18,000
Administration expenses
(5,000)
(5,000)
Distribution costs
(5,000)
(6,000)
Marketing costs for website
(1,000)
Less
Website development cost – amortisation
(100)
Reorganisation costs
(1,500)
SupportTech fees
(1,800)
Premises costs
(2,500)
Pension contributions
Profit on sale of eight small showrooms
Profit
(3,000)
(192)
4,000
––––––
908
4,000
All products sold from showrooms make a gross margin of 30% on selling price.
Exhibit 3: Notes on matters arising during interim audit – A. Junior
(1) Customers ordering online pay in full at the time of ordering. BB recognises revenue when the
cash is received from SupportTech. I am concerned about revenue recognition and in particular
cut-off, but I did not have a chance to look at this more closely.
(2) A New Year promotion was held for showroom sales on 1 January 20X1. Any customers placing
an order for a complete bathroom suite were given two years’ interest free credit provided a
10% deposit was paid. Delivery of the suites was guaranteed by the end of March 20X1. The
promotion was very successful, and the total value of sales made to customers under this offer
was £520,000. I have confirmed that this amount has been recorded in sales and have traced a
number of orders through the sales system as part of my sales testing work. No cut-off issues
were identified. I was told by the Finance Director that BB’s own incremental borrowing rate is
7% but that of its customers is 10% but I don’t understand the relevance of this information.
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(3) The 10 small showrooms were closed down between 1 July 20X0 and 31 December 20X0.
However, two of these (Bradford and Leeds) were still not sold by 30 June 20X1. These two
showrooms are disclosed in the BB statement of financial position as property, plant and
equipment at their carrying amounts of £1 million each. The Leeds site was acquired by BB fairly
recently and is stated at cost less depreciation. The Bradford site was revalued on 30 June 20X0
from its carrying amount of £700,000 to £1 million. The original cost of the Bradford site was
£900,000.
A contract was agreed in June 20X1 for the sale of the Bradford showroom for £1.15 million,
with the sale to be completed in September 20X1. The Leeds showroom is being advertised, but
there is currently no buyer identified.
(4) I am unclear about what audit procedures should be carried out with respect to the website
development costs and how these should be treated in the financial statements.
(5) Button Bathrooms started a defined benefit pension scheme on 1 July 20X0. I have obtained the
following information at 30 June 20X1:
£’000
Present value of obligation
249.6
Fair value of plan assets
240.0
Current service cost for the year
211.2
Contributions paid
192.0
Interest cost on obligation for the year
38.4
Interest on plan assets for the year
19.2
The only entry which has been made in respect of this is the recognition of the contributions paid as
an expense in the statement of profit or loss and other comprehensive income. I have agreed these
payments to the cash book and bank statement. However, I am not sure whether the other
information is relevant and whether I should have performed any other audit procedures.
Exhibit 4: Email from finance director of BB
To:
Carol Ying <c.ying@ruddandradcliffe.com>
From:
Andrew Brown <a.brown@buttonbathrooms.com>
Date:
15 July 20X1
Subject: Cyber-attack at SupportTech plc
I have just been informed by our account manager at SupportTech, to whom we outsource the
operation of our website and our payables ledger function, that the company experienced a
significant cyber-attack two days ago which successfully breached its security systems. I have been
assured that the situation has been resolved however I am not clear what the potential
consequences of this for us could be and was hoping you could advise. Surely as it is
SupportTech’s system that has been attacked there can be no direct consequences for us? If there
are, what measures could we take to prevent this situation arising with other suppliers?
26 Jupiter
It is 15 January 20X9. You are the audit senior on the external audit of Jupiter Ltd. The company’s
year end is 31 December 20X8. The audit manager Jane Clarke has asked you to take responsibility
for the audit procedures on development costs. You have a schedule of development costs
produced by the client (Exhibit 1), a summary of the board minutes produced by Jane on a
preliminary visit to the client (Exhibit 2) and some notes of a meeting between the Finance Director
of Jupiter Ltd and Jane Clarke (Exhibit 3).
You receive the following voicemail message from Jane Clarke.
“As you know I would like you to take responsibility for the audit procedures on development costs.
My review of the board minutes and my recent conversation with the finance director of Jupiter Ltd
have given me some cause for concern in this area so we need to get this right. I would like you to
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prepare a memorandum which sets out the audit issues and the audit procedures required to
address these. You should also refer to any financial reporting issues which arise. Please quantify, as
far as you can based on the information currently available, any adjustments required. I would also
like you to consider any potential professional and ethical implications for our firm based on the
discoveries I have made – including matters we should consider in respect of the internal audit
function.
James Brown the audit junior has been doing some work on the audit of trade payables. He has
obtained some information from the client (Exhibit 4) but is unsure how to progress. I would be
grateful if you could review the information he has obtained and make some notes for James
explaining the main audit issues and an outline of the audit procedures required to address these.
See you later!”
Requirement
Prepare the summary and notes requested by Jane Clarke in her voicemail message.
Total: 30 marks
Exhibit 1: Development costs recognised in the year ended 31 December 20X8
£’000
Cost
01.01.X8
10,000
Additions
2,000
At 31.12.X8
12,000
Amortisation
01.01.X8
500
For the period
500
At 31.12.X8
1,000
31.12.X7
9,500
31.12.X8
11,000
Exhibit 2: Jupiter Ltd: Summary of minutes of board meetings
Jupiter manufactures a device which converts vegetable oil into diesel, thereby creating an
inexpensive and sustainable fuel that can be used in conventional diesel-engine cars. This device was
developed over several years. Significant development costs were incurred in the process and these
were capitalised. The device went into full production at the beginning of 20X7.
A total of £4 million was capitalised on the development of this device. The development costs are
amortised on a straight line basis over the device’s estimated useful life of eight years. There is a
balance of £3 million remaining after £1 million was amortised over the last two years. It was
expected that the conversion device would be replaced by more advanced technology at the end of
the eight year period.
Jupiter is in the process of developing a car engine that will run on vegetable oil. This project is the
result of an unexpected breakthrough in a research project that had not been expected to yield
useful results. A major car manufacturer has looked at a prototype engine and has agreed in
principle to offer this engine as an option on its range of compact cars. Jupiter has not applied for a
patent for the vegetable oil engine technology.
Development costs on this engine were capitalised at £6 million on 31 December 20X7. A further £2
million has been capitalised during the year ended 31 December 20X8. None of these costs have
been amortised because development work on the car engine is not yet completed. The car engine
is currently expected to go into full production in the first quarter of 20Y0.
In December 20X8, the internal audit department completed a review on the likely impact of the
launch of the new engine on the sales of Jupiter’s core product, the conversion device. The internal
auditors produced the following cash flow forecast relating to the conversion device business over
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the next six years. The pre-tax discount rate specific to the conversion device is estimated at 15%,
after taking into account the effects of general price inflation.
Year
Future cash flows
1
2
3
4
5
6
£’000
£’000
£’000
£’000
£’000
£’000
770
700
520
350
330
300
Two weeks ago, Jupiter’s management became aware of the fact that the company’s largest
competitor is working on a car engine that will run on vegetable oil and will enter production in the
third quarter of 20X9. The competitor has a contract to supply this engine to a major car
manufacturer and is in the process of completing non-disclosure agreements with several other
manufacturers. Once this formality has been completed the competitor will offer to license their
technology to all major car companies. No formal announcement of this technology will be made
until February 20X9 at the earliest.
Jupiter is extremely concerned because the ability to run cars on vegetable oil may cut short the life
expectancy of the vegetable oil to diesel conversion device. They are also concerned that their
proposed car engine might not come into commercial production unless it is significantly better than
their competitor’s forthcoming model. No details on the competitor’s engine are as yet available.
Jupiter only knows about it because they used a firm of commercial investigators to find out what
progress the rest of the industry was making on alternative fuel sources. As part of this investigation,
a senior design engineer from the competitor was interviewed for a job that did not actually exist. He
was encouraged to talk about projects that he had been involved in during his time with the
competitor. He gave sufficient information about the new engine for Jupiter’s directors to be
extremely concerned. The engineer then became suspicious of the investigator who was conducting
the interview and refused to disclose any further information about the new engine.
The Board has instructed the internal audit department to conduct a detailed risk assessment of this
discovery.
Exhibit 3: Jupiter Ltd: Notes of meeting with Finance Director
The Finance Director stated that Jupiter fully intended to continue to amortise the development
costs of the diesel converter over the remainder of its eight-year estimated useful life and to continue
to capitalise development costs. She said that the internal audit department was working on ways to
complete the preparation of the financial statements as early as possible in January 20X9 and she
asked that the audit work be timetabled so that the audit report could be signed by 31 January at the
very latest. That way, any subsequent announcement by the competitor would not constitute an
event after the reporting period under IAS 10. She said that the matters discussed in the board
minutes were to be treated as confidential. Indeed, the company had effectively obtained this
information through fraudulent misrepresentation and so it would not be appropriate to use it in the
preparation of the annual report.
Jupiter has borrowed heavily in order to fund these two development projects. The bank loan
covenant specifies a maximum gearing ratio. I have done a quick calculation of the effect of an
immediate write-off of the development costs and the company would be in default of this
borrowing condition.
Exhibit 4: Jupiter Ltd: Summary of trade payables
Analysis of trade payables
31.12.X8
31.12.X7
£’000
£’000
Myton Engineering Ltd
2,400
2,400
Overseas suppliers
1,750
900
Other suppliers
995
1,107
GRNI (goods received but not invoiced)
720
288
5,865
4,695
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Notes
(1) Myton Engineering Ltd is the sole supplier of a key component which goes into the fuel
conversion device. In previous years the company has refused to respond to requests to confirm
any year end balance and does not issue statements. In addition this year Myton has introduced
a reservation of title clause on all invoices to Jupiter Ltd.
(2) During the year the clerk responsible for managing overseas suppliers resigned as she had
found a job closer to home. The company has been unable to find a permanent replacement for
her. The overseas suppliers balance at 31 December 20X8 includes £75,000 in respect of goods
which are still in transit but which have been recognised in inventory.
(3) ‘Other suppliers’ relates to around 150–200 small suppliers which produce a range of
components. This balance is net of £125,000 of debit balances.
(4) The company experienced a computer problem in the last week of the reporting period which
meant that no purchase invoices could be processed.
27 Poe, Whitman and Co
You are an audit senior with Poe, Whitman and Co, a firm of chartered accountants. Upon returning
to the office this week from vacation, you find the following email in your inbox from Margaret
Fleming, one of your firm’s audit managers.
To:
Audit Senior <a.senior@poe.whitman>
From:
Margaret Fleming <m.fleming@poe.whitman>
Date:
2 April 20X7
Subject: Commedia Ltd
I hope you had a good holiday. As you may know I have recently been given managerial
responsibility for the firm’s new audit client Commedia Ltd, and I understand that you will be the
senior on the group’s audit for the year ended 28 February 20X7. We have only recently been
appointed auditor following the unexpected resignation of the previous auditor just two weeks
ago.
Please could you consider the practical and ethical issues specifically in connection with our late
appointment and the steps we should take to ensure that these issues do not affect the
performance of our duties as the group’s auditor.
Please also summarise for me the relevant audit procedures and our reporting responsibilities
which arise from the Commedia engagement being a new audit for Poe, Whitman and Co.
I have also attached to this email some notes on the Commedia group (Exhibit 1).
In addition to providing some background information on the group, the notes also include
information on some specific events that occurred within the group during the year. I would like
you to identify the audit risks relating to these events and draft the audit procedures required to
mitigate them.
Finally, I attach an email I received last week from Bob Kerouac (Exhibit 2), requesting advice on
some financial reporting matters. Please draft a response in note form for me to use at the
meeting I have arranged with Bob for next week.
Requirement
Respond to the email from your audit manager.
Total: 30 marks
Exhibit 1: Commedia group background notes
Commedia Ltd (Commedia)
Commedia is an independent television production company with annual revenues last year of
approximately £60 million. The company’s creative team develops ideas for television programmes,
which are then ‘pitched’ to one or more of the television broadcasting companies within the UK. If
the pitch is successful, the programme is commissioned by the broadcaster and then made by
Commedia to an agreed budget.
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During the year, a number of Commedia’s customers changed the terms of some of their
commissions from a ‘funded’ to a ‘licensed’ basis.
Funded commissions
The broadcaster is responsible for funding the entire production budget (which includes an agreed
management fee for Commedia) in monthly instalments as the production progresses. Upon delivery
of the programme to the broadcaster, all future rights to exploit the programme are signed over to
the broadcaster.
Licensed commissions
Under these arrangements, Commedia is paid an agreed amount, in full, upon delivery of the
programme. The broadcaster acquires the rights to broadcast the programme an agreed number of
times, with Commedia retaining all residual rights to future exploitation of the programme. The price
paid by the broadcaster for a licensed commission is 25% to 30% lower than that for the equivalent
funded commission. Where the cost of making the programme exceeds the value of the licensed
commission payment, the difference is carried forward as an intangible asset by Commedia to write
off against future revenues arising from the residual rights held.
At the start of this accounting period, 1 March 20X6, Commedia had two wholly-owned subsidiaries,
Scherzo Ltd and Riso Ltd. The subsidiaries were set up by Commedia Ltd many years ago. All three
companies have the same 28 February year end and they are all audited by your firm.
Scherzo Ltd (Scherzo)
Scherzo is a concert and events promotion company. The company stages major popular and
classical music concerts throughout the year, which are held principally in open-air venues.
Disposal of shareholding
On 30 April 20X6, Commedia disposed of 70% of its shareholding in Scherzo to that company’s
management team for a possible total sum of £20 million. £15 million of this total was paid in cash
on completion of the sale, with the remainder to be paid 15 months later, contingent on the profit of
the company for the year ended 28 February 20X7. Scherzo has also appointed your audit firm as its
auditor. Extracts from the terms of the sale of shares in Scherzo are set out below.
Extracts from contract for sale of shares in Scherzo Ltd
(1) The completion date for the disposal of the shares was 30 April 20X6.
(2) Total possible consideration for the shares is £20 million, split as follows:
(a) £15 million payable on completion.
(b) £5 million payable on 31 July 20X7 if the pre-tax profit of the company for the year ended
28 February 20X7 is at least £5 million.
(c) If the pre-tax profit for the year ended 28 February 20X7 is below £3 million, no further
consideration is payable.
(d) For pre-tax profit between £3 million and £5 million, the further consideration payable is
calculated as follows: Further consideration = £5m × (pre-tax profit less £3m)/£2m
(3) Pre-tax profit for the purpose of this contract is defined as ‘Profit before tax per the company’s
audited financial statements excluding the following items:
(a) Total directors’ emoluments in excess of £350,000.
(b) Exceptional items (ie, items of income and expense of such materiality that IAS 1 requires
their nature and amount to be disclosed separately).
‘Rock in the Park’ concert
Scherzo was responsible again this year for ‘Rock in the Park’, a major outdoor series of popular
music concerts spanning three days in July 20X6. On the evening of the third day, part of the stage
collapsed causing injury to some members of the stage crew and audience. The incident also led to
the cancellation of the rest of the concert, including the performance scheduled for the event’s most
well known performer. Scherzo had sub-contracted the erection and maintenance of the stage to
another company, Highstand Limited.
The directors of Scherzo have included a provision in the year-end financial statements of £2 million.
This is to allow for the cost of refunding all monies received from the sale of tickets to the concerts,
and to recognise the cost of personal injury claims received by the company as at the year end.
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Riso Ltd (Riso)
Riso’s sole activity is the operation of a large television studio which it hires out to customers for the
production of television programmes. The television studio is based in a former glass bottle factory
and is occupied by Riso under a 10-year lease, originally taken out on 1 March 20X3. The studio is
hired out to Commedia (on an arm’s length basis) approximately 30% of the time for the filming of its
own commissions. For the remaining 70% of the time the studio was, until recently, hired out to two
different broadcast companies, each for the production of their own competing daytime television
drama serial.
During the year ended 28 February 20X7, one of these broadcasters announced that, due to poor
viewing figures, it would no longer be making a drama serial. Riso has spent the last three months
looking for an alternative customer, but has so far been unsuccessful. The directors of Riso are aware
that there is currently surplus capacity in UK-based studio facilities, due to a reduction in UKproduced programmes. This reduction has been brought about by an increase in programmes
imported from overseas and reduced TV advertising budgets.
The directors of Riso have produced a forecast of future pre-tax cash-flows for the company as
follows:
Year ending 28 February
£’000 inflow/(outflow)
20X8
(100)
20X9
(50)
20Y0
900
20Y1
1,375
20Y2
1,495
20Y3
1,695
Riso made an initial £8 million investment in the television production equipment required for its
studio on 1 March 20X3. No further capital expenditure is likely to be required for the foreseeable
future. The company expects the equipment to have an expected useful life of 10 years at which
point its disposal value is estimated to be £2 million. Riso depreciates the equipment on a straightline basis. The carrying amount of the company’s other assets and liabilities at 28 February 20X7, was
£250,000.
Exhibit 2: Copy of email from Bob Kerouac
To:
Margaret Fleming <m.fleming@poe.whitman>
From:
Bob Kerouac <bkerouac@commediagroup>
Date:
26 March 20X7
Subject: Year end financial statements
Margaret,
It was good to meet you recently. Further to our scheduled meeting in two weeks’ time, there are
some matters in connection with the current year financial statements that I want to discuss with
you. I hope that when we meet you can provide me with advice on their appropriate treatment in
the financial statements for the year ended 28 February 20X7. The matters are as follows:
(1) Disposal of our majority holding of shares in Scherzo: as you know, we sold the majority of
our shares held in this company during the year. I would be grateful if you could provide me
with some advice on how to account for this disposal in Commedia’s own financial statements
for the year; and also how the remaining investment in Scherzo is now to be treated in the
group’s consolidated financial statements.
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(2) Treatment of the television production equipment in Riso: as you are aware, we have recently
lost a major contract in this company due to cancellation by our customer of their daytime TV
drama serial. This has given rise to a loss in the company this year, and will mean future losses
if an alternative customer cannot be found. I am unsure how, if at all, this affects the value and
presentation of the equipment in the financial statements of Riso. I am particularly concerned
as we recently had the equipment externally valued at a figure of £4 million. Please could you
clarify this issue for me, indicating what adjustments, if any, are required to ensure proper
presentation in the financial statements for the year. I am unsure whether this is of use to you,
but the pre-tax annual rate of return that the market would expect from this type of
investment is 10%.
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Audit and integrated 2
28 Precision Garage Access
Precision Garage Access plc (PGA) is a listed company which manufactures and installs garage doors
for private residences. You are a senior working for PGA’s auditors and are currently supervising the
planning and interim audit work for the year ending 30 September 20X6. You are also carrying out a
review of the interim financial statements for the nine months to 30 June 20X6.
As part of the planning process, an audit junior, Claire Chalker, has completed some initial analytical
procedures on the management accounts for the nine months ended 30 June 20X6. She has
provided some background information (Exhibit 1) and set out some basic financial data and notes (
Exhibit 2). She does not however have the experience to analyse this data in order to identify audit
risks.
The engagement manager, Gary Megg, reviewed Claire’s work and sent you the following email:
To:
A Senior
From:
Gary Megg
Date:
26 July 20X6
Subject: PGA Audit
I have been through the notes prepared by Claire. I think she has highlighted some interesting
points, but she has not really analysed the data in any depth or identified key audit issues. There
appear to be some financial reporting issues arising from her work which may require adjustment
to the management accounts.
Prior to our audit planning meeting next week I would like you to do the following:
(1) Carry out revised analytical procedures using Claire’s data and other information provided.
This work should:
(a) identify any unusual patterns and trends in the data which may require further
investigation. Show supporting calculations (where appropriate assume 360 days in a
year for the purpose of computing any ratios); and
(b) outline the audit risks that arise from the patterns and trends identified in the analytical
procedures and set out the audit procedures you would carry out.
(2) Set out the financial reporting issues that arise from the above audit work with respect to the
interim financial statements for the nine months ended 30 June 20X6 and are expected to
arise for the year ending 30 September 20X6. I do not require any detailed disclosure
requirements. I do not require you to consider tax, or deferred tax, implications at this stage.
There is one further matter which I would like you to look at. I have just received an email from
David May, the finance director of PGA. The board has acknowledged that the company is
experiencing difficulties retaining key staff. This is particularly the case with senior and middle
management. Whilst a bonus scheme has been introduced this year in place of a pay rise (see
Claire’s notes below) the directors realise that they need to encourage individuals to commit to
the company longer-term. David has come up with a proposal for a share based bonus scheme
but is concerned about its effects on future profits. I have attached his email which provides
details of the scheme and the information he requires (Exhibit 3). I would like you to produce the
information he has requested so that I can forward it on to him. Please use his working
assumptions. I think that his predicted share price increases may be optimistic in the current
climate but I can discuss this with him at a later date.
Many thanks,
Gary
Requirement
Respond to the engagement manager’s instructions.
Total: 30 marks
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Audit and integrated 2
79
Exhibit 1: Background information prepared by Claire Chalker
PGA makes and installs two types of garage doors:
•
Manually operated wooden doors – the ‘Monty’. The list price of the Monty was increased by 5%
on 1 October 20X5 to £840 each, including installation.
•
An electrically operated set of metal doors with a motor – the ‘Gold’. The list price of the Gold was
increased by 5% on 1 October 20X5 to £2,520 each, including installation.
Nearly all doors are made to order.
Each of the two types of door is made on a separate production line at PGA’s factory in the south of
England. Production equipment is specialised and highly specific to each of the separate production
processes.
PGA makes about 70% of its sales of both products in Germany and France where it has a network of
sales offices. All selling prices are set at 1 October each year. Prices for overseas markets are fixed in
euro at this time, at the equivalent of pound sterling prices.
The company has had a difficult trading year so far, due to the general economic downturn. The
trading performance in the year ending 30 September 20X6 is thus expected to be weaker than in
the previous year.
In previous years, approximately equal quantities of Gold and Monty doors have been sold.
However, sales of the Gold have suffered particularly badly this year, as customers appear unwilling
to spend large sums on their garage doors in the current economic climate. Sales of Gold doors are
not expected to increase in the foreseeable future.
Customers are either individual householders or small building companies. Discounts may be given
to building companies for large orders but PGA sales staff have stated that door prices to individual
customers are never discounted.
Exhibit 2: Financial data and notes prepared by Claire Chalker
Management accounts – Statements of profit or loss and other comprehensive income
Notes
Revenue:
9 months to 30
June 20X5
Year ended 30
Sept 20X5
£’000
£’000
£’000
7,500
9,600
10,400
14,000
28,800
31,200
(6,700)
(7,800)
(9,200)
(15,500)
(23,400)
(27,600)
(700)
7,200
4,800
(1,200)
(1,200)
(1,600)
(450)
––––––
––––––
(2,350)
6,000
3,200
1
Monty
Gold
Cost of sales:
Draft 9 months to
30 June 20X6
2
Monty
Gold
Gross profit/(loss)
Fixed administrative and
distribution costs
Exceptional item
Staff bonus scheme
Profit/(loss) before tax
Income tax expense
Profit/(loss) for the period
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Corporate Reporting
3
––––––
(2,350)
(1,680)
4,320
(900)
2,300
ICAEW 2022
Management accounts – Extracts from statements of financial position
Notes
At 30 June 20X6
At 30 June 20X5
At 30 Sept 20X5
£’000
£’000
£’000
Current assets
Inventories
4
3,500
3,500
1,200
Trade receivables
4
2,400
4,300
1,000
Notes
(1) Revenue: Inventory records show the number of doors sold as (see below). Sales volumes in the
final quarter of the year ending 30 September 20X6 are expected to be the same as the final
quarter of the year ended 30 September 20X5 for both the Monty and the Gold. Revenue from
garage doors is recognised when they are delivered to a customer’s house. Revenue from
installation is recognised when the contract is completed to the customer’s satisfaction.
(2) Cost of sales: The production process for the Gold is technologically advanced, so annual
budgeted fixed production costs of £12 million are expected. For the Monty, annual budgeted
fixed production costs are £4 million. These fixed costs have not changed for some years and are
incurred evenly over the year, with an equal amount being recognised in each quarter. The
variable cost per unit for each product is budgeted at 50% of selling price.
(3) Staff bonus: As a result of current economic uncertainty, there was a zero general pay increase
for employees. However, a bonus scheme was introduced under which a payment to employees
of £600,000 will be made for the full year if revenue for the year ending 30 September 20X6
exceeds £26 million.
(4) Inventories and receivables: Inventories consist mainly of partly-made doors. There is little
finished inventory as doors are normally made to order. Sales are normally on 30 day credit
terms.
9 months to 30
June 20X6
9 months to 30 Year ended 30 Sept
June 20X5
20X5
Monty
9,000
12,000
13,000
Gold
6,000
12,000
13,000
Exhibit 3: Extract of email from David May: share based bonus scheme
To tie in middle and senior managers to the company, a bonus would be given to existing managers
after three years of continued employment from 1 October 20X6, on which date the scheme would
commence. If these employees leave before 30 September 20X9 they will receive no bonus. Also,
however, I want to link the bonus to company performance – which I think is best achieved by basing
it on share price.
The proposal is to either: (A) issue 600 shares; or (B) pay a bonus equivalent to the value of 600
shares at the date of redemption for each existing manager. The amount would only be given in
either case after three years’ service. Those managers joining after 1 October in any year would not
qualify for the scheme in that year.
The problem is that these managers would probably stay for three years to receive the bonus and
then leave. My idea is – and this is the clever part – to have the same bonus scheme every year so,
whenever managers leave, they would be giving up a large sum in bonuses that have not vested.
Using Proposal A as an example, if we start the scheme on 1 October 20X6, each eligible manager
will receive 600 PGA ordinary shares on 30 September 20X9. There would then be another scheme
on 1 October 20X7 for 600 shares which would vest on 30 September 20Y0 (ie, three years later),
and the same again in each future year. The same rolling system would apply if we decide to go with
Proposal B instead.
My working assumptions are as follows:
•
The PGA share price will be £8 on 1 October 20X6 and increase by 25% in the first year and then
20% per annum thereafter (our future order book looks strong and I believe that there are signs
that the economic outlook is improving).
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81
•
There are 80 eligible managers now. It is assumed that 10 managers (all of whom are currently in
employment) will leave during each year and 10 managers will join.
•
The fair value of the share based cash settled instrument is equal to the share price.
Information required
I would like the following information:
(1) Using my working assumptions, prepare a computation of the effect on profit of this scheme for
each of the years ending 30 September 20X7, 20X8 and 20X9 under the following alternative
assumptions:
(a) Proposal A – the bonus is given in the form of 600 PGA shares per manager each year.
(b) Proposal B – the bonus is paid in cash as an amount equivalent to 600 PGA shares per
manager each year.
(2) An explanation of why the impact on profit may vary:
(a) from year to year for each proposal
(b) between the two proposals
29 Tawkcom
Note: For formatting reasons it is recommended that this question is done as home study/in a paperbased context.
You are the senior responsible for the audit fieldwork at Tawkcom Ltd, the UK trading subsidiary of
Colltawk plc, a major international telecommunications group, listed on the London Stock Exchange.
Tawkcom provides data and communication services to commercial and public organisations. These
services utilise Tawkcom’s UK-wide fibre optic network, a valuable and unique asset built up over
many years.
You are currently completing the final audit of Tawkcom for the year ended 30 September 20X9. The
audit has not gone smoothly and reporting to the group audit team is overdue. The most significant
incomplete area of audit procedures is the work on property, plant and equipment (PPE), which has
been allocated to a junior member of your team, Jo Carter. You are due to meet the audit manager,
Jan Pickering, this evening to discuss progress on this work.
Jan has just left you this voicemail:
“The Colltawk group financial statements are due to be signed off early next week and I’m very
worried about the work we have left to do on Tawkcom. PPE is a key audit area for this business and
Jo is likely to require detailed guidance if she is to complete the procedures satisfactorily. I know
you’ve been very busy but I need you to look today at what she’s done so far (Exhibit 1), both to
identify any unresolved audit or financial reporting issues and to determine what audit procedures
we have left to do.
I’ve sent you some extracts from the group audit instructions (Exhibit 2) so you can take these into
account in determining the required audit procedures.
(1) Notes explaining any financial reporting and audit issues you have identified from your review of
Jo’s work to date (Exhibit 1).
(2) A list of the additional steps we will need to perform to complete our audit procedures on PPE,
both for group reporting and to support our opinion on the statutory financial statements of
Tawkcom.
(3) A summary identifying where the group audit team may provide useful evidence in completing
the audit of PPE.
I am also aware that there have been some changes to the auditing standards relating to auditor’s
reports and in particular the introduction of ISA (UK) 701 on Key Audit Matters. I haven’t had time yet
to look at the new standard in detail so I would be grateful if you could put together a few notes on
this and its relevance if any to Tawkcom and the group.”
Requirement
Prepare the documents Jan has asked you to bring to this evening’s meeting.
Total: 30 marks
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Corporate Reporting
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Exhibit 1: PPE work papers prepared by Jo Carter
Summary of balances
The group reporting pack for Tawkcom at 30 September 20X9 includes the following schedule. All
balances and movements have been agreed to the register of PPE and to the schedules used for
detailed testing.
Freehold
land and
buildings
Leasehold
improv.
Fixtures
Network
and
assets equipment
£’000
£’000
£’000
32,000
4,160
0
Investment
property
Total
£’000
£’000
£’000
162,831
19,255
0
218,246
3,409
34,391
2,406
0
40,206
(102)
0
0
(7,160)
0
0
0
0
3,936
3,936
25,450
7,467
197,222
21,153
3,936
255,228
476
882
38,697
14,577
0
54,632
0
298
2,875
4,051
0
7,224
Disposals
(95)
(98)
Carried forward at
30 September
20X9
381
Carried forward at
30 September
20X9
25,069
Cost/valuation
Brought forward at 1
October 20X8
Additions
Disposals
Transfer from assets
held for sale
Carried forward at
30 September
20X9
(6,550)
(508)
Accumulated
depreciation
Brought forward at 1
October 20X8
Charge for the year
0
(129)
0
(322)
1,082
41,572
18,499
0
61,534
6,385
155,650
2,654
3,936
193,694
Summary of procedures performed
Opening balances
Opening balances have been agreed to prior year signed financial statements with the exception of
the opening cost for Network assets. This is greater than the balance shown in the prior year financial
statements by £1.3 million due to an audit adjustment to remove from non-current asset additions
the cost of certain repairs to and maintenance on the fibre optic network. This was recognised in the
financial statements but not reflected in the register of PPE or in the group reporting pack, as it was
not considered material for group purposes.
Additions
A sample of additions was selected for each category of PPE using group materiality of £4 million to
determine the sample size. Each item in the sample was physically inspected where possible, verified
as a capital item and, where appropriate, agreed to a third party invoice. Further information is
provided below:
Leasehold improvements
Tawkcom has one leasehold property, its head office building. This building is leased under a 20-year
lease, expiring in 20Z5. During the year ended 30 September 20X9, Tawkcom completed a major
refurbishment programme to update and improve all office accommodation.
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83
Network assets
Additions comprise new fibre optic cable laid to extend network coverage or to connect a particular
customer to the network. Tawkcom’s own staff perform much of the work and additions could not
therefore be agreed to third party invoices. Instead they were agreed to project sheets detailing the
material, labour and overhead costs incurred on each stretch of cable.
Additions are higher than in the prior year as group management instructed the local finance
director to increase the day rates used for staff time so they were consistent with the rates used to
compute charges to external customers. A rough calculation indicates that the increase in rates has
increased additions to network assets by around £5 million.
Physical inspection of the network assets was not possible as the fibre optic cabling is laid
underground.
Disposals
There were only three significant disposals in the year ended 30 September 20X9.
(1) In June 20X9, Tawkcom disposed of office equipment with a cost of £332,000 to AR Hughes Ltd.
The accounting assistant informed me that this company is owned by friends of Max Dudley,
Tawkcom’s finance director. The group finance director approved the disposal. The accumulated
depreciation of £62,000 was correctly removed from the register of PPE. There were no
proceeds and a loss of £270,000 was included within the statement of profit or loss and other
comprehensive income.
(2) In September 20X9, the company’s freehold property in Scotland, Glasgow House, was sold to
LJ Finance plc, a finance company owned by the bank for the Colltawk group. The group finance
team arranged this transaction and local management has limited information. Tawkcom is still
occupying the building as it has been leased back from LJ Finance under a 20-year lease, which
can be extended to 50 years at Colltawk’s option. An external valuer revalued Glasgow House at
30 September 20X7, along with the company’s other freehold properties. Its value of £5.8
million was agreed to the prior year audit work papers. The valuation and associated
accumulated depreciation were correctly removed from the register of PPE, cash proceeds of £7
million were vouched to the bank account on 30 September 20X9 and the gain of £1,295,000
was agreed to the statement of profit or loss and other comprehensive income.
(3) Tawkcom disposed of land for £1.5 million recognising a profit on disposal in profit or loss of
£750,000. The contract was entered into on 31 July 20X9 conditional upon detailed planning
approval being granted. By 30 September 20X9 outline planning consent only had been
granted. Full planning consent was received on 20 October and the sale was completed on 30
October 20X9.
Sale proceeds were agreed to the cash book and bank statement. The cost of land was correctly
removed from the register of PPE and the profit on disposal correctly calculated.
Transfer from assets held for sale
In the financial statements for the year ended 30 September 20X8, a freehold property, surplus to
Tawkcom’s requirements, was transferred out of PPE and shown separately as a non-current asset
held for sale. Our prior year audit files concluded that this treatment was correct on the basis that the
property was being actively marketed and a sale at its carrying amount of £3.9 million was
considered imminent.
This sale was not concluded and management has now decided to retain the property for the time
being until the property market has improved. To generate some return from the property,
management intends to divide the property into small office units which it will rent out as office
space under short-term rental agreements. In order to make this more attractive to prospective
tenants, Tawkcom will provide services such as telecommunications, reception, secretarial support
and meeting rooms. As the property is now being held for its investment potential, it has been
transferred back into PPE and designated as an investment property.
Depreciation charge for the year
The Tawkcom financial statements for the year ended 30 September 20X8 disclose the following
depreciation policy.
84
Corporate Reporting
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Depreciation is charged so as to write off the cost or valuation of assets over the following periods:
Freehold buildings
50 years
Leasehold improvements
20 years (the minimum term of the lease)
Network assets
20 years
Fixtures and equipment
3–10 years
For each category of asset, an expectation for the depreciation charge for the year ended was
formed using the above rates and taking into account the timing of additions and disposals.
The following points were noted:
(1) No depreciation has been charged on freehold buildings as these properties are carried at
valuations which the finance director believes reflect their market value at the reporting date and
the buildings are maintained to a high standard.
(2) The depreciation charge for network assets is considerably lower than expected. This is as a
result of a group wide review of useful lives conducted by head office. This review concluded
that the life of network assets is greater than 20 years and a revised useful life of 22 years has
been applied to all such assets. Calculations of the revised carrying amounts for a sample of
assets were reviewed and verified as accurately reflecting for each asset the unexpired portion of
a 22-year life.
Exhibit 2: Extracts from the Group audit instructions for the Colltawk plc group for the year ended
30 September 20X9
Risk of fraud and misstatement
The following key risks have been identified and should be considered by all subsidiary audit teams:
(1) The group has banking covenants on long-term bank loans requiring it to maintain a certain ratio
of non-current assets to net borrowings (defined as bank borrowings and lease creditors less
cash). As a result, management may have an incentive to overstate non-current assets or to
understate net borrowings.
(2) Subsidiary management participates in the group’s bonus scheme. The level of bonus to be paid
depends on the performance both of the individual subsidiary and of the group as a whole.
Management may therefore have an incentive to overstate profit either at a subsidiary or group
level.
Materiality and reporting of misstatements
Pre-tax materiality for the Colltawk group audit is £4 million. All individual misstatements over
£200,000 should be reported to the group audit team.
30 Expando Ltd
You are a supervisor in the audit department of Jones & Co. You are currently in charge of the audit
of Expando Ltd (Expando), a private limited company which imports and retails consumer electronic
equipment. Expando’s year-end is 30 June 20X7. Today you are in the office when you receive the
following email from the audit senior who is working for you on the audit of Expando:
To:
Audit Supervisor
From:
Audit Senior
As you are aware we are nearing the completion of the audit of Expando Ltd, however, there are a
number of outstanding issues which need to be addressed. I have summarised these in an
attachment (Exhibit 1). Unfortunately I am not sure how these should be dealt with in the financial
statements so I have not been able to revise the draft financial statements provided by the client (
Exhibits 2 and 3). The audit partner has specifically requested a set of revised financial statements
as he wants to take them to the meeting with Expando’s finance director tomorrow. I am also
unclear whether these issues have any implications for our remaining audit procedures.
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85
I was hoping that you may be able to help me as follows:
(1) Explain the financial reporting treatment of the outstanding issues.
(2) Complete the draft statement of profit or loss and other comprehensive income, statement of
changes in equity and statement of financial position where indicated and make any
appropriate adjustments and corrections.
(3) List any additional audit procedures which I need to do.
A couple of final points. I have found a list of procedures performed by the auditors of Titch (see
point 5 below). I am not quite sure what to do with these. Shouldn’t we do the audit of Titch?
The client has a member of the accounts department who is due to go on maternity leave in three
months’ time. I have been asked if we can provide temporary help to cover for their absence. Can
we do this?
Requirement
Respond to the audit senior’s email. Assume that the tax figures will be audited by your firm’s tax
audit specialists, so you can ignore tax (including deferred tax) for now.
Total: 30 marks
Exhibit 1: Notes of outstanding issues
(1) With the exception of the property referred to in Note 4, below, all of Expando’s trading
premises are held on short leases (less than 12 months), and are not shown on the statement of
financial position. The land recorded on the statement of financial position refers to the storage
facility in Northern England. This is not depreciated. During the year it was revalued upwards, by
£1 million, to £5 million. The valuation was commissioned in the early summer of 20X6, to
support the company’s fundraising.
(2) New finance was taken out on 1 July 20X6, in the form of an issue of a £2 million debenture loan.
Issue costs were £150,000. The coupon rate on the debenture is 3%. Its terms provide that it was
issued at par but that it will be redeemed at a premium. The overall effective interest rate for
Expando is 7%.
(3) On 1 September 20X6, Expando acquired the business of Minnisculio, a small competitor, for
£250,000. The acquisition was structured as a purchase of trade and assets, with £20,000
allocated to inventories and the balance to goodwill. Expando has not conducted an impairment
review in respect of goodwill as there is no indication of circumstances which would give rise to
an impairment.
(4) Prior to the acquisition by Expando of its trade and assets, Minnisculio had negotiated the
acquisition of new freehold premises, to be acquired on 1 October 20X6 for a consideration of
£125,000. The asset was estimated to have a useful life of 20 years and a policy of straight-line
depreciation was to be adopted. These premises were, however, surplus to requirements after
Minnisculio’s business had been acquired by Expando. On 31 March 20X7 the management
took the decision to sell the premises at which date the fair value less costs to sell amounted to
£115,000.
(5) On 1 October 20X6, Expando acquired 25% of Titch Ltd, for a consideration of £400,000. Titch is
co-owned by three other UK companies, each of which holds 25% of its shares. Unfortunately,
due to unforeseen events which are not expected to be repeated, Titch made a trading loss for
its year ended 30 September 20X7 of £350,000. The results of Titch have not been reflected in
Expando’s draft financial statements with the exception of the tax effect which has been dealt
with by the tax department.
(6) The tax impact of the above is being dealt with by the tax department.
86
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Exhibit 2: Summary draft statement of profit or loss and other comprehensive income and
statement of changes in equity
Year ended
Revenue
Less operating expenses
Operating profit
30 June 20X7
(draft)
30 June 20X6
(audited)
£’000
£’000
4,430
3,660
(3,620)
(2,990)
810
670
(260)
(200)
Profit before tax
550
470
Taxation
(91)
( 141)
Profit for the year
459
329
Gain on property revaluation
1,000
–––––
Total comprehensive income for the year
1,459
329
Retained earnings
Revaluation
surplus
£’000
£’000
Balance at 1 July 20X6
713
–
Total comprehensive income for the year
459
1,000
1,172
1,000
30 June 20X7
(draft)
30 June 20X6
(audited)
£’000
£’000
5,000
4,000
125
–
2
2
650
–
2,155
520
Interest payable – Note 2 above
Other comprehensive income:
Statement of changes in equity 30 June 20X7 (extract)
Balance at 30 June 20X7
Exhibit 3: Summary draft statement of financial position
Period end date
Non-current assets
Land
Premises – Note 4 above
Plant and machinery
Investments – Notes 3, 5 above
Current assets
Current liabilities
Taxation
(91)
(141)
(300)
(149)
6% bank loan
(3,333)
(3,333)
3% debenture – Note 2 above
(1,850)
–
Deferred tax
To be completed
–
Net assets
To be completed
899
Other
Non-current liabilities
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87
30 June 20X7
(draft)
30 June 20X6
(audited)
£’000
£’000
86
86
100
100
Revaluation surplus – Note 1 above
1,000
–
Retained earnings
1,172
713
Equity
2,358
899
Period end date
Share capital
Share premium
31 NetusUK Ltd
You are a senior on a large team which is planning for the audit of NetusUK Ltd, a media company,
for the year ending 30 June 20X9. NetusUK is a wholly owned subsidiary of an Australian parent
company, Netus Oceania (also audited by your firm), and contributes a very substantial proportion of
the revenue and profit reported by the Netus Oceania Group.
Your team is required to report to your firm’s Australian office in Perth on the results of NetusUK and
also to report on NetusUK’s statutory UK accounts. Netus Oceania is planning to raise additional
capital from shareholders and the deadlines for group reporting are very tight.
Your firm is required to provide the final report to the Perth office by 16 September 20X9.
You receive an email from the manager with overall responsibility for the NetusUK audit, Louise
Manning:
To:
A. Senior
From:
L. Manning
Date:
3 July 20X9
Subject: NetusUK audit planning
Welcome to the Netus team. As you know, we have a large team assigned as this is a very
significant client. I’m asking each team member to take responsibility for a particular section of our
work and to prepare a detailed audit plan, setting out the procedures to be performed at our final
audit visit in August.
Materiality for planning purposes has been set at £1.5 million.
You will be responsible for staff costs and the assets and liabilities related to staff costs in the
statement of financial position. NetusUK has around 5,000 permanent employees, 1,000 of whom
are remunerated on an hourly basis. A time sheet system records time for hourly paid staff and
overtime for those salaried staff who are entitled to overtime payments.
The company runs a single computerised payroll system covering both hourly paid and salaried
staff and all staff are paid monthly. Each staff member is allocated to one of the company’s 80
departments, which range in size from three to 400 employees.
Results of our review of controls at the interim audit showed that controls were poor so a
substantive approach is to be adopted. Management’s attitude regarding controls has been a
concern in the past however they are aware of the issues and have told us that they are in the
process of resolving them.
Attached to this email is an extract from NetusUK’s June 20X9 draft accounts (Exhibit 1) showing
the items for which I wish you to take responsibility.
I need you to send me the following planning documentation so that I can complete the overall
planning file for this audit and submit it for manager review. Apart from item (2) below, your
responses should concentrate solely on the audit of staff costs and related assets and liabilities in
the statement of financial position.
You do not need to consider any corporation tax or deferred tax balances.
88
Corporate Reporting
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Planning documentation required
(1) The following documents are required:
(a) Briefing notes for Harry Thomas the Finance Director (see Exhibit 2) so he understands
what entries he needs to make to account correctly for pension costs and where he can
obtain any additional information necessary.
(b) A schedule summarising the audit procedures you believe we should complete at our
final visit in August. For the substantive procedures, please be specific about the
procedures you plan to perform on each relevant balance.
(2) Your comments on any other matters, including ethical issues, you think we should take into
account in planning our audit procedures more generally or any concerns you have as a result
of the information you have been given.
I look forward to receiving your audit planning.
In addition to this I would like your assistance with a special project. Our firm is looking into the
possibility of using data analytics in future as a means of making our audit process more efficient.
At the interim audit our IT specialists were given permission by NetusUK to use our newly devised
data analytics tool as part of a pilot scheme. A journals dashboard was produced as a result (
Exhibit 3).
I have not been part of the working party involved in the data analytics project and am unclear as
to what this is all about and its relevance to our audit work. Please produce some notes for me
explaining what data analytics is. Then I would like you to look at the information produced and
set out how this could assist in our risk assessment process.
You should also indicate any further analysis which we could perform using the data analytics tool.
Louise
Requirement
Respond to Louise Manning’s email.
Total: 30 marks
Exhibit 1: Extract from NetusUK’s draft accounts for the year ended 30 June 20X9
Summary of staff costs reflected in the statement of profit or loss and other comprehensive income
for the year to 30 June 20X9
Cost of
sales
Distribution Administrative
costs
expenses
Total year to
30 June 20X9
Total year to
30 June 20X8
£’000
£’000
£’000
£’000
£’000
Payroll
78,301
40,815
33,974
153,090
141,496
Pension cost
10,487
5,466
4,550
20,503
12,634
5,690
0
2,451
8,141
1,065
341
287
2,074
2,702
2,396
94,819
46,568
43,049
184,436
157,591
Temporary staff
Employee expenses
Total staff costs
Summary of staff cost related balances in the statement of financial position at 30 June 20X9
30 June 20X9
30 June 20X8
£’000
£’000
Employment taxes
6,903
6,287
Employer’s pension contributions payable
2,397
1,484
Current liabilities
ICAEW 2022
Audit and integrated 2
89
30 June 20X9
30 June 20X8
£’000
£’000
Temporary staff
204
119
Commission payable on June sales
454
429
Accruals
Note: For the purposes of the draft accounts pension costs comprise only employer contributions
payable to NetusUK’s defined benefit pension scheme. The rate of employer contribution increased
from 10% of pensionable salary to 15% of pensionable salary with effect from 1 July 20X8 following
an actuarial valuation which showed a significant deficit.
Exhibit 2: Briefing notes
To:
L. Manning
From:
H.Thomas@Netus
Date:
1 July 20X9
Subject: Audit planning
Hi Louise
You already have our draft accounts for the period ended 30 June 20X9 which have been
prepared on the same basis as last year’s group reporting. As you know, the group head office has
never required us to include adjustments for the pension scheme deficit.
I’ve just received instructions from head office which state that, for this year’s group reporting, they
want full compliance with IFRS and will not be making central adjustments for our pension
scheme. I’m going to need your help in calculating the necessary entries as I have no real
experience of accounting for pension schemes and you’ve always helped me with the entries for
our statutory accounts.
As you know, we have one UK defined benefit pension scheme open to all employees. Head
office has told me that I should recognise the actuarial gains and losses immediately.
I look forward to receiving your advice on these matters and to discussing your detailed audit
plan.
Regards
Harry
90
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Exhibit 3: Journals dashboard
COMPANY: NETUSUK 01.07.X8 – 30.06.X9
Journals
Dashboard
Automated vs Manual
440
Total no. of journals
Value
25%
£3,874,000
Total value of journals
75%
£8,805
Average value of journals
Volume
10
Number of users
60%
40%
Automated
ICAEW 2022
Volume
×
×
×
×
×
×
×
£12k
£8k
£5k
£18k
as
W
on
g
£15k
38
36
34
32
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
Th
om
ng
h
dl
ey
do
n
y
le
£13k
Ly
n
n
w
ar
ds
Ed
to
£53k
Si
£17k
ay
×
Ri
Average
Value
×
D
al
Finance
Finance
Sales
Finance
Finance
Finance
Sales
Volume
×
s
Finance
Finance
Finance
900
850
800
750
700
650
600
550
500
450
400
350
300
250
200
150
100
50
C
on
w
Andrews
Conway
Dalton
(financial
controller)
Edwards
Farley
Lyndon
Ridley
Singh
Thomas
Wong
×
Value £000
dr
ew
Department
An
Creator ID
Fa
r
Top 10 users
Manual
£18k
£2k
Audit and integrated 2
91
32 Verloc Group
You, Ruth Smith, are a newly-promoted audit manager at Marlow & Co, a firm of ICAEW Chartered
Accountants. You arrive at the office on a Monday morning and find the following email from
Leonard Kurtz, the audit engagement partner for Verloc Group.
To:
Ruth Smith
From:
Leonard Kurtz
Date:
4 October 20X9
Subject: Verloc Group audit
Ruth,
I know that you have not been involved in the Verloc Group audit before, but as you probably
know, the audit manager on this account has just resigned and I need you to step in. I’m looking
for someone who can pick things up quickly and run with it, and you look like the right person for
the job.
I attach the following information, which I have just received from Verloc Group’s Finance Director:
•
Individual statements of profit or loss and other comprehensive income for the companies in
the group (Exhibit 1).
•
Notes on the main transactions during the year ended 30 September 20X9 (Exhibit 2).
•
Draft consolidated statements of profit or loss and other comprehensive income with
supporting workings (Exhibit 3).
The Finance Director has not yet sent me the statements of changes to equity and statements of
financial position but he promises to have them ready for us at the audit planning meeting this
afternoon.
I have also forwarded to you some handover notes prepared by your predecessor (Exhibit 4),
which may help us in planning the audit this year.
Ahead of the audit planning meeting, please review the information provided and:
(1) explain any financial reporting and auditing issues that arise, and describe the actions that we
should take in response to each issue, including matters to be discussed with the Finance
Director; and
(2) draft the revised consolidated statement of profit or loss and other comprehensive income
that you would expect to see after adjusting for the financial reporting issues.
Come and see me at 1pm so we can go through the main points before we head off to the
meeting with Verloc Group.
Thanks,
Leonard Kurtz
Requirement
Respond to the audit partner’s email. Assume that the tax figures will be audited by your firm’s tax
audit specialists, so you can ignore tax for now.
Total: 30 marks
Exhibit 1: Statements of profit or loss and other comprehensive income for three entities for the
year ended 30 September 20X9
Verloc
Winnie
Stevie
£’000
£’000
£’000
6,720
6,240
5,280
Cost of sales
(3,600)
(3,360)
(2,880)
Gross profit
3,120
2,880
2,400
Revenue
92
Corporate Reporting
ICAEW 2022
Verloc
Winnie
Stevie
£’000
£’000
£’000
Administrative expenses
(760)
(740)
(650)
Distribution costs
(800)
(700)
(550)
Investment income
Finance costs
Profit before tax
Income tax expense
80
–
(360)
(240)
1,280
1,200
–
(216)
984
(400)
(360)
(300)
880
840
684
Remeasurement gains on defined benefit pension plan
110
–
40
Tax effect of other comprehensive income
(30)
–––––
(15)
80
–––––
25
960
840
709
Profit for the year
Other comprehensive income (not reclassified to P/L):
Other comprehensive income for the year, net of tax
Total comprehensive income for the year
Exhibit 2: Notes on the main transactions during the year ended 30 September 20X9
(1) Verloc acquired 160,000 of the 200,000 £1 issued ordinary shares of Winnie on 1 May 20X9 for
£2,800,000. The reserves of Winnie at 1 May 20X9 were £2,050,000. A year end impairment
review indicated that goodwill on acquisition of Winnie was impaired by 10%. The group policy
is to charge impairment losses to administrative expenses. The group policy is to value the noncontrolling interest at the proportionate share of the fair value of the net assets at the date of
acquisition. The fair value of the net assets acquired was the same as the book value with the
exception of an investment property, which had been valued at the time of acquisition to be
£960,000 above its book value. The property has an estimated total useful life of 50 years, and
has been depreciated on the cost model. At the date of acquisition Winnie had owned this
property for 10 years.
(2) The group policy is to charge depreciation on buildings to administrative expenses on a monthly
basis from the date of acquisition to the date of disposal.
(3) Verloc disposed of 40,000 £1 ordinary shares of Stevie on 1 July 20X9 for £960,000. Verloc had
acquired 75,000 of the 100,000 £1 issued ordinary shares of Stevie for £980,000 on 1 November
20X6, when the balance on reserves was £1,020,000. The fair value of the shareholding retained
at 1 July 20X9 was £792,000. There was no evidence of goodwill having been impaired since the
date of acquisition. The reserves of Stevie at 1 October 20X8 were £1,300,000.
(4) Winnie paid a dividend of £100,000 on 1 September 20X9 and Verloc has recorded its share in
investment income.
(5) Verloc holds several investments in equity instruments, including some unquoted shares, and
accounts for these in accordance with IFRS 9, Financial Instruments. Gains on subsequent
measurement of £46,000 occurred in the year. The financial controller, however, is unsure how
this should be presented within the statement of profit or loss and other comprehensive income
and so has yet to include it.
(6) The previous year Verloc had obtained a loan of £800,000 from Inver Bank to invest in a retail
outlet. However, due to a recession the outlet did not produce the expected income, and Verloc
had difficulty servicing the debt. During the year ended 30 September 20X9, Verloc negotiated
with Inver Bank to transfer the ownership of the retail outlet to the bank in settlement of the
outstanding debt. The market value of the retail outlet is £770,000. Its carrying amount was also
£770,000 as it was measured at fair value.
ICAEW 2022
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93
Exhibit 3: Draft consolidated statements of profit or loss and other comprehensive income with
supported workings
Verloc Group
Consolidated statement of profit or loss and other comprehensive income for the year ended 30
September 20X9
£’000
£’000
Revenue (6,720 + (6,240 × 5/12) + 5,280)
14,600
Cost of sales (3,600 + (3,360 × 5/12) + 2,880)
(7,880)
Gross profit
6,720
Administrative expenses (760 + (740 × 5/12) + 650 + 119 (W2))
(1,837)
Distribution costs (800 + (700 × 5/12) + 550)
(1,642)
Finance costs (360 + (240 × 5/12) + 216)
(676)
Profit before tax
2,565
Income tax expense (400 + (360 × 5/12) + 300)
(850)
Profit for the year
1,715
Other comprehensive income:
Items that will not be reclassified to profit or loss
Remeasurement gains on defined benefit pension plan (110 + 40)
150
Tax effect of other comprehensive income (30 + 15)
(45)
Other comprehensive income for the year, net of tax
105
Total comprehensive income for the year
1,820
Profit for the year attributable to:
Owners of the parent
1,202
Non-controlling interest (W1)
513
1,715
Total comprehensive income for the year attributable to:
Owners of the parent
1,291
Non-controlling interest (W1)
529
1,820
WORKINGS
(1) Non-controlling interests
PFY
TCI
£’000
£’000
Winnie
As stated in Attachment 1 (840 × 5/12)
350
Additional depreciation on fair value adjustment
(10)
340
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NCI share (NCI in TCI is the same as Winnie has no OCI)
PFY
TCI
£’000
£’000
× 20%
= 68
= 68
684
709
× 65%
× 65%
= 445
= 461
513
529
£’000
£’000
Stevie
As stated in Attachment 1
Total NCI
(2) Goodwill (Winnie) (to calculate impairment loss for year)
Consideration transferred
2,800
NCI at proportionate share of fair value (20% × 3,210)
642
Less net assets at acquisition:
Share capital
Reserves
200
2,050
(2,250)
Goodwill
1,192
Impairment (10%)
119
(3) Goodwill (Stevie)
£’000
£’000
Consideration transferred
980
NCI at proportionate share of fair value (25% × 1,120)
280
Less net assets acquired:
Share capital
Reserves
100
1,020
(1,120)
140
(4) Adjustment to equity on part disposal of Stevie
£’000
Fair value of consideration received
960
Increase in NCI in net assets at disposal (483 (W5) × 35%/75%)
(225)
Adjustment to parent’s equity
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735
Audit and integrated 2
95
(5) Non-controlling interests (SOFP)
£’000
NCI at acquisition (W3)
280
NCI share of post acquisition reserves to disposal
(25% × [(1,300 + 709 × 9/12) – 1,020])
203
NCI at part disposal
483
Movement in NCI (483 × 35%/75%))
(225)
258
(6) Intragroup dividend
Intragroup dividend income from Winnie = £100,000 × 80% group share = £80,000
Eliminate from ‘investment income’ bringing balance to zero.
Exhibit 4: Handover notes – Verloc Group
Verloc is a family-owned retail business which had grown organically. In recent years, it has sought to
expand in the domestic market by acquiring other synergistic businesses: Stevie in 20X6 and Winnie
in 20X9.
We are auditors for Verloc, and have been auditing the individual financial statements of Stevie as
well, although I am unsure whether this arrangement will continue.
The Verloc Group audit has always been extremely time-pressured. In the three years when I have
worked on this audit, the Board has insisted each time that the audit must be completed by 1
November. This deadline is completely artificial of course, but that’s what the Group policy is.
Fortunately, this audit is very straightforward compared to most of the firm’s other audit
engagements and presents low audit risk. Therefore, audit procedures can be simplified as much as
possible. For example, related party transactions and share capital are of low risk, so audit
procedures can be minimised on these two accounts.
Also, the timescale is such that there is insufficient time to apply the firm’s statistical sampling
methods in selecting trade receivables balances for testing. It is more efficient to pick the sample
based on the audit team members’ own judgement.
Materiality for the financial statements as a whole was £200,000, based on £12.8 million of revenue,
£2.1 million of profit before tax and £11.1 million of gross assets. I expect similar materiality levels
can be used on the 20X9 audit.
Last year, I gave two audit juniors the tasks of auditing trade payables and going concern. They
reviewed each other’s work. This worked very well all round: reducing my review time and providing
good training for the audit juniors.
On a separate matter, I spoke with the Finance Director at a networking function two months ago,
and he mentioned that the Board is preparing for a listing on the London Stock Exchange in a bid to
raise long-term finance. I don’t know where they are now on their listing plans.
33 KK
Kemsler Kessinger Ltd (KK) is a manufacturer of industrial cutting equipment.
You are a senior who has recently been assigned to the audit of KK. You work for Wight and Jones
LLP (WJ), a firm of ICAEW Chartered Accountants. WJ has recently been appointed as auditor for the
KK consolidated financial statements for the year ended 30 June 20X4. WJ is also the auditor of all
KK group companies and associates. The engagement partner, Emma Happ, invited you to a
meeting with her to plan some aspects of the KK audit.
Emma opened the meeting:
“KK is a new client of WJ and we are still trying to understand fully its management processes and
corporate governance. My particular concern is that the interim audit discovered transactions with
directors and other related parties during the year which I suspect may not be at arm’s length.
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We need to make sure that the financial reporting treatment is appropriate in the KK consolidated
financial statements for the year ended 30 June 20X4 and that all necessary disclosures are made in
each of the individual company financial statements.
I have met with the KK chief executive, Mike Coppel. As a result of this discussion, I have prepared
some background information (Exhibit 1). In addition, the audit senior on the KK interim audit,
Russell Reed (who no longer works for WJ), raised some matters of concern (Exhibit 2).
One further issue is that Mike is unhappy with the due diligence work which was performed by the
accountants Trebant & Edsel LLP (TE) for KK’s purchase of the shares in Crag Ltd (Exhibit 1). Mike is
considering asking WJ to review their work so the KK board can decide whether to undertake
litigation against TE. However, Mike emphasised that, while he is happy with the work of WJ so far, he
would like the audit for the year ended 30 June 20X4 to be completed to his satisfaction before he
would consider awarding this new review work to WJ, or indeed reappointing WJ for the audit
engagement next year.
Please prepare notes for me as follows.
(1) For each of the issues in Exhibit 2:
(a) describe the appropriate financial reporting treatment in the KK consolidated financial
statements for the year ended 30 June 20X4. Explain and justify whether or not disclosure of
any related party transactions needs to be made in the individual financial statements of the
companies concerned for the year ended 30 June 20X4, setting out any required
disclosures; and
(b) explain the key audit issues and the audit procedures to be performed.
(2) Identify and explain the key audit issues which arise from the acquisition by KK of shares and
options in Crag.
(3) Explain the ethical implications for WJ of Mike’s suggestion that WJ carry out review work in
respect of the due diligence assignment performed by TE.
Please ignore tax and deferred tax for now.”
Requirement
Respond to the instructions of Emma Happ, the engagement partner.
Total: 30 marks
Exhibit 1: Background information
KK manufactures industrial cutting equipment at its factory in the UK. In the year ended 30 June
20X4, the KK group had revenue of £126 million, made a profit before tax of £13 million and had net
assets of £88 million at that date.
Share ownership and the board
The ordinary share ownership and directors of KK at 30 June 20X4 were as follows:
Director role
Shareholding in KK
Mike Coppel
Chief executive
15%
Holly Reaney
Finance director
5%
Janet Coppel
Production director
10%
Dans Venture Capital Co (DVC)
–
40%
Harry Harker
Non-executive director
(appointed by DVC)
Yissan plc
–
Monica Orchard
Non-executive director
(appointed by Yissan plc)
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–
30%
–
Audit and integrated 2
97
No directors joined or left the KK board during the year ended 30 June 20X4. Mike and Janet
Coppel are married to each other.
Group structure, other investments and transactions
Most of the component parts used by KK in its manufacturing process are imported. One supplier,
Yissan, supplies 32% of KK’s components. Yissan acquired its 30% shareholding in KK in 20X1 and
actively exercises its votes. Yissan has the right to appoint a director to the board.
KK owns 40% of the ordinary shares in Seal Ltd and exercises significant influence.
KK owns 35% of the ordinary shares in Moose Ltd and appoints two of its five board members. The
remaining 65% shareholding is owned by Finkle Inc, a US registered company. KK owns 30% of the
ordinary shares in Finkle Inc. The remaining 70% of the shares are held by a single unrelated
individual.
On 1 August 20X3, KK acquired 45% of the ordinary shares in Crag Ltd, a competitor company. The
remaining 55% of the ordinary shares continue to be held by Woodland plc. Crag had previously
been a wholly-owned subsidiary of Woodland which is an unrelated company. Under the terms of
the share purchase, KK has an option, exercisable up to three years from the date of the share
purchase, which allows it to buy an additional 15% holding of Crag ordinary shares from Woodland
at an exercise price per share which is 10% higher than the actual price per share paid to purchase
the 45% shareholding. KK has been exercising its votes as a shareholder of Crag. Since 1 August
20X3, the fair value per ordinary share of Crag is estimated to have risen by 13%. Crag’s marketing
director, who was appointed by KK, has implemented a new successful marketing strategy which has
been a key factor in increasing the fair value per share.
The ordinary shares of all companies are voting shares. All companies have a 30 June accounting
year end.
Exhibit 2: Interim audit notes – prepared by Russell Reed
(1) Seal sold £12 million of goods to Crag, spread evenly over the year ended 30 June 20X4. I am
not clear how this should be treated and whether there should be separate disclosure of these
transactions and, if so, what needs to be disclosed.
(2) On 6 June 20X4, Seal sold goods to Moose at a price of £2 million. At 30 June 20X4, none of
these goods remained in inventories held by Moose. There were no other transactions between
Seal and Moose during the year ended 30 June 20X4.
(3) On 15 December 20X3, Mike Coppel purchased a cutting machine from KK for £300,000. At the
date of sale, the carrying amount of the machine was £240,000 and its fair value was estimated
to be £380,000.
(4) On 2 October 20X3, KK repaid a £9 million interest-free loan from Yissan. The loan was originally
raised on 12 March 20X1.
(5) On 20 January 20X4, Crag sold goods which had cost £1 million, to KK for £1.5 million. One
quarter of these goods remain unsold by KK at the end of the year. There were no other
transactions between Crag and KK during the year ended 30 June 20X4.
34 UHN (July 2014) (amended)
You work for Hartner as an audit senior. Hartner is a firm of ICAEW Chartered Accountants. You have
recently been asked to act as an audit senior on the audit of UHN plc, an AIM-listed company.
UHN manufactures electronic navigation systems for the aircraft industry. It has survived periods of
economic uncertainty and order levels have started to recover. In addition, low interest rates and the
ability to keep costs controlled have improved the company’s financial performance in recent years.
The audit engagement partner, Petra Chainey, gives you the following briefing:
“We have been very short-staffed on the UHN audit and Greg Jones, the audit senior, has been
acting as the audit manager on this assignment. Greg has just gone on study leave and I would like
you to take on his role for the remainder of the audit. Before he left, Greg prepared a handover note (
Exhibit 1) which includes information on UHN’s covenants and its draft summary financial statements
for the year ended 31 March 20X4. The handover note also includes Greg’s summary of the key
financial reporting issues. These issues are either unresolved or, in Greg’s opinion, issues where the
directors have exercised judgement in the application of accounting policies and estimates in the
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preparation of the financial statements for UHN. The planning materiality is £100,000. The audit
closure meeting is scheduled for this Friday.
I have also forwarded you an email from the UHN finance director, Melvyn Hansi, requesting Hartner
to accept a one-off assignment (Exhibit 2). I need to respond quickly to this email as the matter is
urgent. I am concerned that if we do not do as UHN requests, they may engage with another
assurance firm, not just for this one-off engagement, but also for future audits.
We may not have the expertise in-house to complete this one-off assignment as the nature of UHN’s
industry is specialised, but I am sure we can put together a convincing report.
I would like you to prepare a working paper in which you:
(1) Set out and explain the implications of the financial reporting issues in Greg’s handover note
(Exhibit 1). For each issue, recommend the appropriate financial reporting treatment, showing
any adjustments that you would need to make to the draft summary financial statements.
(2) Using your recommendations above, evaluate and explain the overall impact of your
adjustments on the gearing ratio and the interest cover ratio at 31 March 20X4 in accordance
with the bank’s loan covenants.
(3) Explain the key audit risks that we need to address before signing our audit report on the
financial statements. I do not need the detailed audit procedures; just concentrate on the key
risks.
(4) Explain the responsibility and accountability of the UHN board for cyber security and make
appropriate recommendations.
I will ask the tax department to review any further deferred tax and current tax adjustments.
I would also like you to prepare a file note explaining the ethical implications for our firm if we decide
to accept the one-off assignment (Exhibit 2).”
Requirement
Prepare the working paper and the file note requested by the audit engagement partner.
Total: 45 marks
Exhibit 1: Handover note prepared by Greg Jones
Loan covenants
UHN is financed by equity and debt. In 20X0, UHN was rescued from insolvency by its bank, which
provided a £20 million loan, repayable in 20X8. The loan contract with the bank stipulates two
covenants which are based on the year-end audited financial statements. Failure to meet either
covenant could result in the loan facility being withdrawn.
The covenants are as follows:
(1) The gearing ratio is to be less than 130%. The ratio is defined as:
((Non-current liabilities (excluding provisions and deferred tax liability)) ÷ (Equity (Share capital and
reserves))) × 100%
(2) The interest cover is to be greater than 3. The ratio is defined as:
Profit before finance costs (including exceptional items) ÷ Finance costs
Covenants are determined at each 31 March year end.
As part of the loan agreement, audited financial statements must be presented to the bank within
four months of the accounting year end.
UHN – Draft summary financial statements for the year ended 31 March 20X4
Statement of profit or loss for the year ended 31 March 20X4
£’000
Revenue
Operating costs
Exceptional item (Issue 1)
Operating profit
ICAEW 2022
56,900
(49,893)
5,040
12,047
Audit and integrated 2
99
£’000
Finance costs
Profit before tax
(2,200)
9,847
Statement of financial position at 31 March 20X4
£’000
ASSETS
Non-current assets
Property, plant and equipment (Issue 2)
20,040
Current assets
Inventories (Issue 3)
21,960
Trade receivables
15,982
Cash and cash equivalents
2,128
40,070
Total assets
60,110
EQUITY AND LIABILITIES
Equity
Share capital – ordinary £1 shares
Share premium
Retained earnings
Total equity
1,000
15,000
1,500
17,500
Non-current liabilities
Loans
20,000
Long-term provision (Issue 4)
8,520
Deferred tax liability
1,000
Total non-current liabilities
29,520
Current liabilities
Trade and other payables (Issue 3)
Short-term provision (Issue 4)
Total current liabilities
12,350
740
13,090
––––––
Total equity and liabilities
100
Corporate Reporting
60,110
ICAEW 2022
Financial reporting issues identified by Greg Jones
Issue 1 – Sale and leaseback of factory
On 31 March 20X4, UHN entered into a sale and leaseback agreement for its freehold factory in
Swindon. The factory was originally acquired by UHN on 31 March 20W4 (10 years ago), at which
point it had a useful life of 30 years and a zero residual value. The sale proceeds from the sale and
leaseback agreement were £8 million, which is equal to the fair value of the freehold factory. The
property was leased back on a 20-year lease from 31 March 20X4 at an annual rental of £611,120 to
be paid annually in arrears. The first lease rental will be payable on 31 March 20X5 and the directors
have decided to charge it to the statement of profit or loss in the year ending 31 March 20X5.
The profit on the disposal of the factory and land has been included as an exceptional item as
follows:
Factory
£’000
Disposal proceeds
Less carrying amount at 31 March 20X4
8,000
(2,960)
Profit recognised as an ‘exceptional item’
5,040
The IFRS 15 criteria for a genuine sale have been met.
Although we have vouched this transaction to the lease agreement and other documents (and there
is plenty of evidence on the audit file relating to this transaction), as it is such a material amount I
thought I would draw it to your attention.
I have calculated the interest rate implicit in the lease to be 8% per annum.
Issue 2 – Service centre in Russia
On 1 April 20X3, UHN set up a service centre in Russia at a cost of RUB266 million. The service centre
is situated at Moscow airport and operates as a repair depot for flights in and out of Moscow airport.
The service centre had an estimated useful life of six years at 1 April 20X3, with a zero residual value.
In March 20X4, new regulations were introduced in Russia which prevented extended stays at
Moscow airport for a number of major airlines. Therefore, significantly fewer aircraft could be
serviced at UHN’s Moscow service centre. The UHN finance director recognised this regulatory
change as an impairment indicator and carried out an impairment test exercise at 31 March 20X4 on
the service centre.
As a consequence of this exercise, the service centre was determined to have a value in use of
RUB180 million and a fair value less cost to sell of RUB204 million at 31 March 20X4.
The finance director therefore calculated an impairment charge of RUB18 million. He translated this
at RUB48 = £1 to give an impairment charge of £375,000 in operating costs.
I haven’t studied this area of financial reporting at college yet, so I thought I should bring it to your
attention. I have checked the exchange rates which are as follows:
At 1 April 20X3: RUB53 = £1
At 31 March 20X4: RUB48 = £1
Issue 3 – Hedge against increase in price of titanium
UHN uses titanium in its production process and holds titanium inventory of around 680,000
kilograms to ensure a constant supply for production. UHN’s selling price of its products is linked to
the price of titanium. On 1 January 20X4, UHN had 680,000 kilograms of titanium at a total cost of
£8.2 million in inventory. At that date, UHN signed a futures contract to deliver 680,000 kilograms of
titanium at £14 per kilogram on 30 September 20X4 to hedge against a possible price fluctuation of
titanium. At 31 March 20X4, the market price of titanium was £15 per kilogram and the futures price
for delivery on 30 September 20X4 was £16.60 per kilogram.
The arrangement was clearly designated as hedge accounting for financial reporting purposes in the
documentation prepared on 1 January 20X4, and it meets the criteria for hedge accounting set out in
IFRS 9, Financial Instruments. However, no adjustment has been made in the financial statements to
31 March 20X4 to use hedge accounting or to adjust the fair value of the inventory. I was informed
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101
that, as UHN had met the interest cover requirement for its bank covenant for the year ended 31
March 20X4, the directors want to hold back profit in order to recognise it in the year ending 31
March 20X5. The loss on the futures contract of £1.768 million is included in operating costs and in
trade and other payables.
Issue 4 – Provision for claim for damages
In 20X0, a cargo plane, fitted with a navigation system installed by UHN, crashed in the Saharan
desert. There was no loss of life, but the owner of the plane blames the crash on a failure of the UHN
navigation system. It is alleged that UHN’s computer system had been hacked and the information
used to attempt to hi-jack the plane. UHN has strenuously denied this and contested the legal case.
However, as the UHN directors believed that it was probable that there would be a settlement, but
were uncertain as to the amount, a provision was made on 31 March 20X2 for the most likely
outcome of £10 million to be settled in approximately three years. The provision was discounted at
8% per annum.
In March 20X4, to avoid further bad publicity, UHN settled out of court with the owner of the plane
and agreed to pay £9.1 million. The payment terms have been agreed as 25% payable in April 20X4
and 75% payable in April 20X5. No adjustments have been made to the financial statements as a
result of the settlement because the directors believe that the existing provision should cover the
payments they will be required to make.
Exhibit 2: Email from finance director of UHN
To:
Petra Chainey
From:
M Hansi
Date:
21 July 20X4
Subject: One-off assignment
The UHN board is in disagreement about UHN’s approach to cyber security.
The operations director believes that a cyber incident would be so rare that despite the fact that
the effects would be potentially significant it is not worth spending large amounts on attempting
to mitigate risks. He pointed out that the responsibility for cyber security lies with the IT senior
manager who is not a board director but is responsible for the IT and security budget.
The finance director believes that the amount UHN pays for cyber insurance premiums could be
reduced if it could demonstrate good cyber security practices. Other directors complain that
there is a lack of information regarding security breaches. The HR director complained that she
first heard about the hacking allegations and the attempted hijacking of the cargo plane in the
press.
I would like Hartner to report to the board of directors about whether our spending on cyber
security matters is providing value for money.
I would like Hartner to accept this one-off assignment. I expect that Hartner will be able to charge
a low fee for this work as I am sure you will be able to use some of this report as part of your audit
work.
35 Couvert (November 2014)
You are Anton Lee, a recently-qualified ICAEW Chartered Accountant working for Pryce Gibbs LLP
(PG), a firm of ICAEW Chartered Accountants. You are currently assigned as audit senior to the audit
of Couvert plc for the year ended 31 August 20X4. Couvert is a listed company.
Couvert sells high-quality carpets. It has struggled during the recession as demand for its products
has fallen. However, the company’s directors are now confident that it will benefit from the expected
recovery in the carpet industry.
Couvert has several subsidiaries, most of them carpet retailers. In 20X3, Couvert’s directors decided
to implement a strategy of vertical integration in order to protect the company’s sources of supply.
On 1 September 20X3, as part of this strategy, Couvert acquired 55% of the ordinary share capital of
Ectal, a carpet manufacturer based in Celonia. Background information on the investment in Ectal is
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provided (Exhibit 1). On 1 March 20X4, Couvert also acquired 100% of the shares of Bexway Ltd, a
UK carpet manufacturer.
Mary, the audit manager assigned to the Couvert audit for the year ended 31 August 20X4, left PG
last week to start a new job in Australia.
The audit partner, Lucille Jones, has sent you the following email:
To:
Anton Lee, audit senior
From:
Lucille Jones, audit partner
Date:
3 November 20X4
Subject: Couvert audit
I have assigned a new audit manager to the Couvert audit, but he is currently concluding another
engagement, and will not be able to join you until next week. In the meantime, there are several
urgent tasks outstanding on the Couvert audit. Our deadline for completion of the audit work is
12 November 20X4. Couvert is due to release its preliminary results to the stock market one week
later.
I am concerned that Couvert has only today received year-end financial information from its
subsidiary Ectal (Exhibit 2) for consolidation into the Couvert group financial statements. I am also
perturbed by the apparent lack of involvement by Couvert’s management in Ectal’s affairs. Ectal
has not prepared regular management accounting reports during the year.
Another concern is the conduct of the audit of Ectal by the local Celonian auditor, Stepalia LLP;
they have not communicated the results of their audit to us. We originally assessed audit risk for
Ectal as moderate, but given the lack of information received we may need to look at this
assessment again. Ectal is material to Couvert’s consolidated financial statements.
Also, I’ve just received a request for advice regarding two financial reporting issues from Couvert’s
finance director. His email is attached (Exhibit 3).
I would like you to prepare a working paper in which you do the following:
(1) Analyse and explain, using analytical procedures, the financial performance and position of
Ectal for the year ended 31 August 20X4 (Exhibit 2). Include enquiries that will need to be
made of Ectal’s management and its auditor Stepalia arising from these analytical procedures.
(2) Identify and explain your concerns about the corporate governance arrangements at Ectal
and the impact of these on the financial reporting of the investment in Ectal in Couvert’s
consolidated financial statements for the year ended 31 August 20X4.
(3) Explain, in respect of the audit of Ectal by Stepalia:
(a) the actions to be taken by PG; and
(b) the potential implications for the group auditor’s report.
(4) Explain the appropriate financial reporting treatment for the two issues identified by Couvert’s
finance director (Exhibit 3).
Requirement
Respond to the audit partner’s email.
Total: 40 marks
Exhibit 1: Background information on Couvert’s investment in Ectal
Ectal was incorporated 20 years ago in Celonia, a country well known in the carpet industry for the
high quality of its wool products and its skilled labour force. The currency of Celonia is the Celonian
dollar (C$).
Ectal was founded by Ygor Vitanie, who held a majority shareholding until, on 1 September 20X3,
Couvert purchased 55% of Ectal’s ordinary share capital from him, at a substantial premium. The
remaining 45% of the shares are now held as follows:
Ygor Vitanie
35%
Other members of the Vitanie family
10%
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103
Corporate governance arrangements
Ygor is Ectal’s managing director, and his daughter, Ruth, is the manufacturing director. There are
three other directors nominated by Couvert. These are Couvert’s marketing director, finance director
and operations director. Ygor has the casting vote in cases where voting is tied. Since 1 September
20X3, Couvert’s operations director has attended four of Ectal’s monthly board meetings, Couvert’s
finance director has attended one board meeting in November 20X3 and Couvert’s marketing
director has been unable to attend any of the meetings because of other commitments.
External audit arrangements
PG does not have a correspondent or branch office in Celonia. The audit of Ectal continues to be
conducted by a local Celonian audit firm, Stepalia, which was first appointed to the Ectal audit
several years ago. PG issued group audit instructions to Stepalia several months ago, but has
received very little information from Stepalia. Component materiality for the Ectal audit was set at the
planning stage at C$20 million.
Due diligence
Due diligence in respect of Couvert’s acquisition of Ectal was carried out jointly by PG and Stepalia.
The principal member of PG’s staff involved in the due diligence exercise was Mary, the PG audit
manager who has just left the firm.
Exhibit 2: Year-end financial information received from Ectal
The Ectal financial statements have been prepared in compliance with IFRS.
Ectal: Statement of profit or loss for the year ended 31 August 20X4
20X4
Actual
20X4
Budget
20X3
Actual
C$m
C$m
C$m
305.4
358.6
350.4
4.8
––––––
––––––
310.2
358.6
350.4
5.9
(8.3)
(18.6)
(192.8)
(205.7)
(194.1)
Employee expenses
(26.3)
(25.8)
(21.0)
Depreciation expense
(52.4)
(60.8)
(59.4)
Impairment of property, plant and equipment
(60.0)
–
Other expenses
(29.7)
(21.0)
(21.2)
(5.1)
(5.0)
(5.0)
(50.2)
32.0
31.1
––––––
(10.0)
(9.3)
(50.2)
22.0
1.8
Revenue
Other income
Change in finished goods and WIP
Raw materials and consumables used
Finance costs
(Loss)/profit before tax
Tax
(Loss)/profit after tax
104
Corporate Reporting
–
ICAEW 2022
Ectal: Statement of financial position at 31 August 20X4
20X4
Actual
20X4
Budget
20X3
Actual
C$m
C$m
C$m
551.3
622.5
603.7
Inventories
98.0
90.0
92.1
Trade receivables
50.7
55.0
57.0
1.5
15.0
10.1
Current assets
150.2
160.0
159.2
Total assets
701.5
782.5
762.9
5.0
5.0
5.0
Retained earnings
529.0
621.5
599.2
Loan from director
50.0
50.0
50.0
Provisions
16.0
––––––
––––––
Non-current liabilities
66.0
50.0
50.0
Trade and other payables
98.7
96.0
99.4
2.8
–
–
––––––
10.0
9.3
Current liabilities
101.5
106.0
108.7
Total equity and liabilities
701.5
782.5
762.9
Property, plant and equipment
Cash
Ordinary share capital
Short-term borrowings
Current tax payable
Exhibit 3: Email to Lucille Jones from Couvert’s finance director
Lucille
I would appreciate your advice on the following two financial reporting issues that affect Couvert’s
consolidated financial statements for the year ended 31 August 20X4.
Issue 1 – Accounting for retirement benefits
As you know, the Group’s pension plan is a defined contribution plan, which is open to employees in
most, but not all, of our subsidiaries. However, as part of our vertical expansion strategy we
purchased 100% of the shares of Bexway Ltd halfway through the financial year, on 1 March 20X4.
Bexway has a defined benefit scheme for senior staff. Bexway’s accountant retired shortly after the
takeover and there is now no one at the company who understands the accounting for a defined
benefit scheme. The only accounting entry that has been made since recognising the net pension
liability on acquisition is in respect of employer contributions paid. This amount has been debited to
staff costs.
I have the following information about the pension plan between 1 March 20X4 and 31 August 20X4:
£’000
Current service cost for six months (estimated by actuary)
Fair value of plan assets at 1 March 20X4
ICAEW 2022
604
8,062
Audit and integrated 2
105
£’000
Present value of plan liabilities at 1 March 20X4
8,667
Contributions paid into plan by Bexway on 31 August 20X4
842
Retirement benefits paid out by plan
662
Fair value of plan assets at 31 August 20X4 (estimated by actuary)
8,630
Present value of plan liabilities at 31 August 20X4 (estimated by actuary), not including
amendment to plan (see below)
8,557
On 14 April 20X4, Bexway’s directors decided to amend the pension plan by increasing the benefits
payable to members with effect from 1 September 20X4. From this date benefits will increase, as will
the contributions payable by Bexway. I am informed by the actuary that the present value of plan
liabilities should be increased by £500,000 at 31 August 20X4 in this respect.
The applicable six-month discount rate is 3%.
I am unfamiliar with current practice in respect of accounting for defined benefit plans.
Please advise me of the correct accounting treatment for the plan for the six months ended 31
August 20X4 and provide me with the appropriate journal entries for Bexway.
Issue 2 – Financial asset
On 1 April 20X4 Couvert’s board bought a put option contract over 500,000 shares in an Australian
wool-producing company, The Brattle Company. The exercise price of the option is £6.00 per share
and it will expire on 31 March 20X5. The bank has supplied me with the following information about
the put option:
Market price of one share in Brattle
Value of put option contract
1 April 20X4
31 August 20X4
£6.00
£5.90
£63,000
£95,000
I recorded the initial investment of £63,000 as an investment in equity instruments, but I have made
no other accounting entries in respect of this asset and I am not sure whether any adjustment is
necessary. Please explain the appropriate financial reporting treatment for this item, and set out the
appropriate journal entries.
I look forward to your response to my queries.
36 ERE (November 2014)
ERE Ltd (ERE) designs, manufactures and installs medical equipment for healthcare providers. ERE is
currently unlisted but its shareholders are considering an AIM listing within the next three years. The
chief executive, Frank Mann, owns 30% of the shares in ERE and the remaining 70% are owned by
private equity investors. ERE has a 31 July accounting year end.
You are Tom Tolly, an audit senior with Ham and Heven LLP (HH), a firm of ICAEW Chartered
Accountants. HH has audited ERE for a number of years. You have just returned to work after study
leave and you have received the following email from your audit manager setting out your
assignment for today.
To:
Tom Tolly
From:
Audit manager
Date:
3 November 20X4
Subject: ERE – audit of payables and deferred tax for the year ended 31 July 20X4
ERE’s financial controller, Josi Young, is a former employee of HH. She left HH in August 20X4
before completing her training contract and shortly afterwards secured a job with ERE. Josi had
been a member of the ERE audit team for a number of years before leaving HH.
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I assigned Chris King, a junior audit assistant, to the payables and deferred tax sections of the ERE
audit as I felt confident that Josi would be able to provide him with some assistance. However, I
now have some concerns with the work that he has produced.
I have attached a working paper that I asked Chris to prepare summarising the audit procedures
he has performed on payables and deferred tax (Exhibit).
I would like you to review this working paper and prepare a report for me in which you:
(1) explain the key weaknesses in the audit procedures performed by Chris. Identify the audit
risks arising in respect of ERE’s payables and deferred tax and the audit procedures that
should be completed in order to address each risk;
(2) identify and explain the financial reporting issues and recommend appropriate adjustments;
(3) summarise on a schedule of uncorrected misstatements the adjustments that you have
recommended. Explain the further action that we should take in respect of the uncorrected
misstatements; and
(4) identify and explain any ethical issues for HH, and recommend any actions for HH arising from
these issues.
Requirement
Prepare the report requested by your audit manager.
Total: 34 marks
Exhibit: Working paper: prepared by Chris King
ERE: Audit procedures for payables and deferred tax for the year ended 31 July 20X4
The planning materiality is £120,000.
Payables and deferred tax per the statement of financial position are as follows:
Reference to audit procedures
20X4
20X3
£’000
£’000
Trade payables
(1)
13,709
14,628
Other payables
(2)
2,620
550
Deferred tax
(3)
440
950
20X4
20X3
£’000
£’000
11,820
12,036
345
52
1,544
2,540
13,709
14,628
(1) Audit procedures for trade payables
Trade payables comprise:
Trade payables ledger balances
Add: Debit balances
Add: Goods received not invoiced
Total trade payables
Trade payables ledger balances
I reviewed a sample of 10 supplier statement reconciliations selected for me by Josi, who has
performed reconciliations for all the major suppliers.
ICAEW 2022
Audit and integrated 2
107
I re-performed the reconciliations for the three largest suppliers, which represented 89.8% of the
total trade payables balances at 31 July 20X4, as follows:
Mesmet plc
KH GmbH
Medex
£’000
£’000
£’000
Balance per ledger
2,563
1,739
1,962
Payments in transit
950
–
250
Invoices in transit
525
–
540
Mesmet invoices ‘on hold’
1,230
–
–
Disputed Medex invoices
––––
–––––––––
850
Balance per supplier statement
5,268
see below
3,602
44.6
14.7
30.5
% of trade payable ledger balances
I agreed payments in transit to the cash book and to the bank reconciliation. All payments were
presented within 30 days of the year end.
All invoices in transit were agreed to invoices posted in August 20X4.
Mesmet invoices ‘on hold’
I queried the invoices ‘on hold’ on Mesmet’s supplier statement. Josi was unsure about these
invoices, but said that they have now ‘disappeared’ from Mesmet’s most recent supplier statement.
ERE’s finance director has told her not to contact Mesmet to query these invoices as he deals
personally with the Mesmet finance department.
KH
KH is a new supplier and invoices ERE in euro. The supplier statement shows a balance of €2 million
at 31 July 20X4. On 1 October 20X3, ERE purchased a large consignment of monitors from KH for €4
million and recorded this transaction at the exchange rate on that date. ERE paid €2 million to KH on
1 April 20X4 and made a final payment of €2 million on 1 November 20X4 at the exchange rate on
that date of €1.28:£1. The year-end ledger balance has been adjusted for an exchange gain. I have
checked the calculation of the exchange gain using the following exchange rates:
€/£
€’000
£’000
1 October 20X3
1.15
4,000
3,478
1 April 20X4
1.20
(2,000)
(1,667)
Exchange gain
Year-end balance
(72)
1,739
The €/£ exchange rate at 31 July 20X4 was €1.27:£1.
Disputed Medex invoices
I queried the £850,000 of disputed Medex invoices with Josi and have noted below her explanation:
Medex supplies components to ERE. ERE used these components to manufacture its oxygen units,
which are installed for hospital customers in operating theatres. On 10 August 20X4, legal
proceedings were commenced against ERE by a hospital which claims that failure of the oxygen units
installed by ERE during the year ended 31 July 20X4 caused delays to the performance of
operations. The hospital is claiming £1.2 million compensation for loss of income.
On 14 September 20X4, ERE appointed legal advisers who suggested that it is possible, but not
likely, that the claim will succeed. However, the legal advisers estimate that, if the case is settled, it
would be in July 20X6. Also, they have advised that legal costs will be £100,000, which will also be
settled at that date. Josi has included an accrual for the legal fees as part of ‘other payables’ (see
below). The ERE board does not want to disclose any information regarding the legal case as the
directors believe that it will cause reputational damage for ERE.
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ERE believes that the Medex components were faulty. Therefore Josi has requested credit notes from
Medex in respect of invoices for these components and has credited purchases with £850,000 and
debited the Medex payable ledger account.
Debit balances
This is an adjustment to reclassify debit balances as receivables. I have checked that the debit entry
of this adjustment is included in receivables.
Goods received not invoiced
I reviewed the list of goods received not invoiced and noted several items dating from January 20X4.
Josi informed me that she is still chasing invoices from the suppliers for these goods but as the
amount involved is only £115,000, and therefore less than materiality, I have not carried out any
further audit procedures.
(2) Audit procedures for other payables
Other payables comprises:
Legal fees (see above)
20X4
20X3
£’000
£’000
100
–
Provision for restructuring:
Redundancy payments
One-off payments to employees for relocation costs
Costs of removing plant and machinery
270
50
400
720
–
1,100
–
Payroll and other current taxes
200
200
Other accruals
500
350
2,620
550
Lease cost of factory
Total
Provision for restructuring
On 1 October 20X4, ERE closed down a manufacturing division which operated from a factory in the
North of England. I have agreed the provision for restructuring to the budget and also to the board
minutes which stated that negotiations with employee representatives and the factory landlord were
completed on 30 July 20X4 and a formal announcement was made to all employees on 31 July
20X4.
Lease cost of factory
ERE signed a 10-year lease for the factory on 1 August 20X0 at an annual rental of £240,000, payable
annually in arrears. At that date, the present value of the future lease payments was £1,853,280,
based on the interest rate implicit in the lease of 5%. A right-of-use asset had been set up for
£1,853,280, and was being depreciated over the period of the lease term. It was noted in the board
minutes that, following the closure of the division on 1 October 20X4, ERE has the choice of
subleasing the factory to another company for the remaining six years at an annual rental of £60,000
payable annually in arrears; or paying £1.1 million as compensation to the factory landlord to
terminate the lease. The directors asked Josi to obtain more information and to prepare calculations
using an annual discount rate of 5%. Until this information is made available, a provision of £1.1
million has been made in the draft financial statements.
ICAEW 2022
Audit and integrated 2
109
(3) Audit procedures for deferred tax
Josi has provided the following deferred tax computation and notes:
Deferred tax computation
£’000
Taxable temporary difference:
Carrying amount of plant and equipment at 31 July 20X4
12,800
Tax base of plant and equipment at 31 July 20X4
(8,600)
Taxable temporary difference on plant and equipment
4,200
Deferred tax liability on taxable temporary difference at 20%
840
Deferred tax asset in respect of carried forward trading losses
(400)
Deferred tax balance
440
Notes
(1) Accounting profits equal taxable profits except in respect of depreciation.
(2) ERE made a tax loss of £2 million in the year ended 31 July 20X4. Under current tax legislation
this loss can be carried forward indefinitely. ERE has prepared a budget for 20X5 and 20X6
which shows taxable profits of £500,000 and £750,000. No projections are available after this
date due to the uncertainty of tax law.
(3) ERE revalued its head office building on 31 July 20X4. The revalued carrying amount at 31 July
20X4 was £5 million and its tax base was £4 million. Gains on property are charged to tax at 20%
on disposal. However, ERE has no intention of selling its head office therefore no deferred tax
liability has been recognised.
(4) I have agreed the carrying amount of plant and machinery to the financial statements and the tax
base to the company tax return.
110
Corporate Reporting
ICAEW 2022
Real exam (July 2015)
37 Congloma
Congloma plc is a UK listed company and it is the parent of a group of manufacturing companies
located across the UK. Your firm, A&M LLP, a firm of ICAEW Chartered Accountants, has audited
Congloma and its subsidiaries for three years.
You are assigned to the group audit team for Congloma for the year ending 31 August 20X4. Your
manager, Harri Merr has asked for your help to finalise audit planning. Other audit teams from your
firm are responsible for the individual audits of Congloma’s subsidiaries.
You meet with Harri, who gives you the following instructions:
“I’ve provided some background information (Exhibit 1). The Congloma finance director, Jazz
Goring, has asked A&M to assist her in determining how a number of significant transactions should
be treated in the Congloma consolidated financial statements for the year ending 31 August 20X4.
She also wants to understand the overall impact of these transactions on the consolidated profit
before taxation.
I’ve forwarded her email to you (Exhibit 2), together with an attachment comprising briefing notes
from the Congloma corporate finance team which provides some further details of the transactions (
Exhibit 3). These briefing notes were presented at the Congloma board meeting in May 20X4 before
the significant transactions were completed. Jazz has assured me that none of the details changed
when the deals were finalised, so we can use this information for audit planning purposes.
I would like you to:
(1) draft a response to Jazz’s email (Exhibit 2) and its attachment (Exhibit 3). In your response you
should:
(a) set out and explain, for each of the transactions she identifies, the correct financial reporting
treatment in Congloma’s consolidated financial statements for the year ending 31 August
20X4. Recommend and include appropriate adjustments and calculations; and
(b) calculate the consolidated profit before taxation for the year ending 31 August 20X4, taking
into account the adjustments you have identified; and
(2) set out, in a working paper, the additional audit procedures that we will need to perform as a
result of the transactions Jazz has identified. Include an explanation of the impact that the
transactions will have on the scope of our audit procedures and the identification of components
that we consider to be significant.
The additional audit procedures that you identify should include those we will perform both at the
significant component subsidiaries and head office. These procedures should only be those of
relevance to our opinion on the Congloma consolidated financial statements for the year ending 31
August 20X4. At this stage, I am not interested in the procedures we will need to perform in order to
sign an audit opinion on each individual group company.”
Requirement
Respond to Harri’s instructions.
Total: 40 marks
Exhibit 1: Background information provided by the audit manager, Harri Merr
Our experience of the Congloma audit is that the group is generally well managed and maintains
reliable accounting records. We have noted, however, that the finance team’s experience of more
complex transactions is limited and they do not always make the correct accounting entries or
appreciate fully the financial reporting implications of such transactions.
The scope of the work to be performed by the group audit team in respect of the group financial
statements is as follows:
•
Audit procedures on the group financial statements and consolidation
•
Direction and review of the audit procedures performed by other teams from our firm at all
significant components
•
Review procedures on the results of components which are not significant
ICAEW 2022
Real exam (July 2015)
111
Based on the group’s latest financial projections, I have determined planning materiality for the
group audit at £350,000.
Exhibit 2: Email from Congloma Finance Director, Jazz Goring
To:
Harri Merr
From:
Jazz Goring
Date:
17 July 20X4
Subject: Significant transactions
After a period of over a year with no acquisitions or disposals, June 20X4 was a busy month for
our corporate finance team. In addition to the information provided below, you will find further
details in the attached briefing notes from the Congloma corporate finance team which were
presented at our board meeting in May 20X4 (Exhibit 3).
The board is pressing me for a forecast of the consolidated profit before tax for the year ending
31 August 20X4. Therefore, it would be helpful to have your advice on the financial reporting
treatment of the transactions set out below. Before accounting for the effect of any adjustments
arising from these transactions, our latest forecasts show a consolidated profit before tax of £7
million for the year ending 31 August 20X4.
Further investment in Oldone Ltd
In 20W4, 10 years ago, Congloma subscribed £9.6 million for an 80% shareholding in Oldone on
the incorporation of the company. At that date, Anthony Myers, the Oldone chief executive
subscribed for the remaining 20% of Oldone shares.
On 1 June 20X4, Anthony retired and sold his shares in Oldone to Congloma for £4 million.
Oldone is expected to make a profit before taxation of £500,000 in the year ending 31 August
20X4. As for all our group companies, Oldone’s profits are not seasonal, but accrue evenly
throughout the year.
The identifiable net assets of Oldone at 31 May 20X4 were £14 million and, in our interim financial
statements at that date, we recognised a non-controlling interest of £2.8 million, using the
proportion of net assets method always adopted by Congloma. I will instruct an expert valuer to
determine the fair value of Oldone’s assets so that I can calculate the goodwill to be included in
the consolidated financial statements for the year ending 31 August 20X4. However, I need your
advice on how to eliminate the non-controlling interest balance of £2.8 million from the
consolidated statement of financial position at 31 August 20X4.
Issue of convertible bonds
On 1 June 20X4, Congloma raised £10 million through an issue of convertible bonds to third
party investors. Further details are included in the attached briefing notes (Exhibit 3). For the time
being, I have recognised the £10 million as a liability.
Investment in Neida Ltd
On 1 June 20X4, Congloma acquired 45% of Neida’s issued ordinary share capital and voting
rights for £3 million. Neida’s remaining ordinary shares and voting rights are currently held equally
by the two individuals who founded the company. Congloma has an option to acquire a further
20% of Neida’s ordinary share capital in the future.
Neida is engaged in developing practical applications for Lastlo, an innovative new material. We
expect that the use of Lastlo will improve the durability and performance of a number of
Congloma’s products.
I believe that Congloma’s holding of 45% of Neida’s ordinary share capital and voting rights gives
it significant influence and so propose to account for Congloma’s investment in Neida as an
associate. As you will see from the attached briefing notes (Exhibit 3), Neida has very few assets or
liabilities, so the key impact on the group financial statements will be the recognition of the
investment of £3 million.
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Disposal of 75% interest in Tabtop
On 30 June 20X4, 75% of the ordinary shares and voting rights in Tabtop Ltd, which was wholly
owned by Congloma, were sold to a third party for £6 million. The carrying amount of the net
assets (excluding goodwill) of Tabtop on 30 June 20X4 was £5.6 million and the carrying amount
of goodwill relating to Tabtop in Congloma’s consolidated statement of financial position at that
date was £1.5 million. Therefore I have calculated, and propose to include, a group profit on the
sale of £0.3 million (£0.3 million = £6.0 million – (75% of £5.6 million) – £1.5 million).
Further details of this transaction are included in the attached briefing note (Exhibit 3).
I propose to equity account for our non-controlling interest following the share sale. The disposal
should save you some time on the audit compared to last year, as now you will not need to
perform group audit procedures on Tabtop.
Impairment of investment in Shinwork Ltd
Congloma has an 80% holding of the ordinary share capital of Shinwork Ltd.
Demand for Shinwork’s products has fallen and cash flow projections show that its business will
have a value in use of £9.2 million at 31 August 20X4. We will therefore need to record an
impairment in our group financial statements for the year ending 31 August 20X4.
I am not quite sure how to calculate this impairment charge from the information I have and would
welcome your advice. It would be helpful if you could highlight any other financial reporting
points that I should consider.
At 31 August 20X4, key financial data for Shinwork is projected to be as follows:
£m
Carrying amount of net separable assets
8.0
Carrying amount of goodwill relating to Shinwork in Congloma consolidated
statement of financial position
4.0
Non-controlling interest (determined using the proportion of net assets method)
1.06
Exhibit 3: Briefing notes from the Congloma corporate finance team, presented to the Congloma
board meeting on 21 May 20X4
Issue of convertible bond
Proposed terms for the convertible bond issue have now been agreed. On 1 June 20X4, Congloma
will raise £10 million by issuing 100,000 5% convertible bonds, each with a par value of £100. Each
bond can be converted on or before its maturity date of 31 May 20X7 into 10 shares in Congloma
plc. Interest will be payable annually in arrears.
By issuing a convertible bond, we not only obtain longer-term finance for the group, but also secure
a lower interest rate. The annual interest rate for similar debt without the conversion rights would be
8%.
Investment in Neida
We propose to proceed with the acquisition of 45% of the issued share capital of Neida for £3 million
on 1 June 20X4. We will also have a call option to acquire, from the two founding shareholders, a
further 20% of Neida’s ordinary share capital and voting rights for £1.5 million. Neida expects to
exercise this option before 1 June 20X9.
The draft shareholder agreement states that the board of Neida will comprise the two founding
shareholders and two individuals nominated by Congloma. Most decisions will be made by a
majority of the directors, but decisions about major research and development projects cannot be
made without the agreement of both of the Congloma-nominated directors.
ICAEW 2022
Real exam (July 2015)
113
Neida is expected to make a loss of £300,000 in the year ending 31 August 20X4 and the projected
carrying amounts of its net assets at the date of acquisition (1 June 20X4) are as follows.
£’000
Property, plant and equipment
150
Net current assets
50
Net assets
200
Given the nature of these assets and liabilities, their fair values are equal to their carrying amounts.
Disposal of 75% interest in Tabtop
Tabtop has been making losses for a number of years and is also incurring net cash outflows to an
extent that the Congloma group no longer wishes to fund. Its projected loss for the year ending 31
August 20X4 is £3 million. We have received an offer of £6 million for 75% of the Tabtop ordinary
shares which we believe we should accept. In addition, Congloma will retain a holding of 25%
Tabtop’s ordinary share capital, which experts tell us would have a fair value of £1 million. Congloma
would continue to exercise some influence on the business through a seat on the board.
38 Heston
Heston plc is a listed company which manufactures engines. It has four autonomous divisions, which
operate from separate factories. Heston has no subsidiaries.
You recently joined Heston as deputy to the finance director, Edmund Rice. Edmund sent you the
following email.
To:
Deputy finance director
From:
Edmund Rice, finance director
Date:
20 July 20X5
Subject: Finalisation of the annual report – year ended 30 June 20X5
The past few years have been difficult for Heston, but a new chief executive, Franz Zinkler, was
appointed in 20X4 and he is beginning to change things. Despite this, the year ended 30 June
20X5 was again a challenging year. I have provided you with a document giving some
background information about Heston and its recent history (Exhibit 1).
We need to publish our financial statements shortly. Draft financial statement information has
been prepared (Exhibit 2), but there are a number of issues which will require adjustment (Exhibit
3).
I need to provide an explanation of Heston’s financial performance for the year ended 30 June
20X5 and its position at that date. This is for the finance director’s section of the management
commentary in the annual report. I also need to make a presentation to financial analysts about
Heston’s financial performance and position following publication of the annual report. This will
include some tough questions about the financial statements and the company’s underlying
performance.
I need your assistance with the following:
(1) I would like you to:
(a) set out and explain the financial reporting adjustments required in respect of the issues in
Exhibit 3; and
(b) prepare an adjusted statement of profit or loss for the year ended 30 June 20X5 and an
adjusted statement of financial position at that date in a form suitable for publication
(including comparative figures for the year ended 30 June 20X4, in the form that they
would appear in the financial statements for year ended 30 June 20X5). Do not worry
about the tax or deferred tax effects of your adjustments at this stage.
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(2) To help me to prepare my section of the management commentary and to help me answer
questions, please analyse Heston’s performance and position for the year ended 30 June
20X5. Include calculations and use the adjusted financial statements. Outline any further
information needed, so I can ask somebody to investigate.
Requirement
Respond to the instructions of the finance director.
Total: 30 marks
Exhibit 1: Company background – prepared by the finance director
Heston produces engines. Heston has four divisions which are not separate subsidiaries and are part
of the Heston plc legal entity; they are autonomous and operationally independent of each other.
Each of its four separate divisions produces a different type of engine for: cars, motor bikes, boats
and lawn mowers.
Trading has been difficult for all the divisions in recent years, but particularly for the Lawn Mower
Division, because there was a major new entrant into this industry in August 20X4. The chief
executive, Franz, therefore decided that Heston should sell off the Lawn Mower Division (Exhibit 3).
For the other three divisions, the key risk was a potential fall in future sales volumes. Such a fall would
affect Heston significantly because about 70% of cost of sales comprises fixed manufacturing costs,
which need to be incurred irrespective of sales volumes. To counter the risk of falling volumes, Franz
decided to reduce all selling prices in these three divisions by 10% from 1 July 20X4.
Financial analysts have responded favourably to these decisions, but have been enquiring about
their impact on profit.
Exhibit 2: Draft financial information for the year ended 30 June 20X5 – prepared by the finance
director
Draft financial information for the statement of financial position at 30 June
20X5
20X4
£’000
£’000
113,660
120,400
Development costs
10,380
10,380
Inventories
32,300
23,200
Trade and other receivables
36,100
30,400
(Overdraft) / Cash
(8,400)
5,600
ASSETS
Property, plant and equipment
184,040
189,980
Share capital
37,000
37,000
Retained earnings
85,220
68,520
Long-term borrowings
22,000
39,000
Trade and other payables
31,600
39,400
Current tax payable
4,420
6,060
Provision for redundancy costs
3,800
–––––––
184,040
189,980
EQUITY AND LIABILITIES
ICAEW 2022
Real exam (July 2015)
115
Draft financial information for the statement of profit or loss for the year ended 30 June
20X5
20X4
£’000
£’000
436,000
451,700
Cost of sales
(306,180)
(318,500)
Distribution costs and administrative expenses
(107,200)
(101,400)
Finance costs
(1,500)
(1,500)
Income tax expense
(4,420)
(6,060)
16,700
24,240
Revenue
Profit for the year
Exhibit 3: Issues requiring adjustment in the financial statements – prepared by the finance director
Disposal of the Lawn Mower Division
Impact on results
On 1 January 20X5, Franz decided to dispose of the Lawn Mower Division, which had recently
started making losses. The Heston board formally approved the decision on 1 March 20X5 and the
division’s assets were advertised for sale at their fair value from 1 April 20X5.
Heston intends to sell only the division’s non-current assets (including its brand name, GrassGrind). It
is expected that these assets will be sold to a range of different buyers.
The land and buildings are expected to be sold at their fair value of £13 million and plant at its fair
value of £7 million. Selling costs are expected to be 4% of the fair value for these assets.
The Lawn Mower Division brand name, GrassGrind, including the legal right to trade under that
name, is expected to realise only £800,000. The brand was internally generated by Heston and so is
not recognised in the financial statements.
Draft financial information for the year ended 30 June 20X5 (Exhibit 2) includes the following
amounts in respect of the Lawn Mower Division:
20X5
20X4
£’000
£’000
92,000
119,300
Cost of sales
(72,084)
(77,400)
Distribution costs and administrative expenses (Note)
(33,800)
(34,700)
(13,884)
7,200
2,600
(1,400)
(11,284)
5,800
Revenue
Income tax credit/(charge)
(Loss)/profit after tax
Note: Staff working in the Lawn Mower Division will be made redundant when the division is sold
and a provision for redundancy costs of £3.8 million has been recognised in distribution costs and
administrative expenses for the year ended 30 June 20X5.
Impact on property, plant and equipment
Heston uses the cost model for property, plant and equipment.
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ICAEW 2022
An analysis of the property, plant and equipment figure in the draft financial statements is as follows:
Land
Buildings
Plant and
equipment
Total
£’000
£’000
£’000
£’000
5,600
6,000
12,000
23,600
–
(960)
(3,400)
(4,360)
–––––
(120)
(860)
(980)
5,600
4,920
7,740
18,260
Carrying amount at 30 June 20X5
32,200
34,700
28,500
95,400
Total carrying amount at 30 June 20X5
37,800
39,620
36,240
113,660
Lawn Mower Division:
Cost at 30 June 20X4 and 30 June 20X5
Accumulated depreciation at 1 July 20X4
Depreciation charge for the year ended
30 June 20X5
Carrying amount at 30 June 20X5
Continuing activities:
(ie, the other three divisions)
The buildings are being depreciated over a 50-year life to a zero residual value. The plant and
equipment is being depreciated on a 10% reducing balance basis. The company’s policy is to
recognise all depreciation charges in cost of sales.
There were no acquisitions or disposals of property, plant and equipment during the year ended 30
June 20X5.
Cash flow hedge
On 1 May 20X5, Heston entered into a contract to purchase 6,000 tonnes of steel. The contract is for
delivery in September 20X5 at a price of £165 per tonne. Heston uses steel to make most of its
engines and makes regular purchases of steel.
At 30 June 20X5, an equivalent new contract, for delivery of 6,000 tonnes of steel in September
20X5, could be entered into at £158 per tonne.
Heston does not intend to take physical delivery of the 6,000 tonnes of steel, but intends to settle the
contract net in cash, then purchase the actual required quantity of steel as regular production needs
arise.
The contract is designated as a cash flow hedge of the highly probable forecast purchase of steel. All
necessary documentation was prepared to qualify the contract as a cash flow hedge, and the
arrangement meets the criteria in IFRS 9, Financial Instruments to qualify for hedge accounting and
the hedge effectiveness tests. No accounting entries have been made in the draft financial
statements.
ICAEW 2022
Real exam (July 2015)
117
118
Corporate Reporting
ICAEW 2022
Real exam (November 2015)
39 Larousse
You are Alex Chen, an ICAEW Chartered Accountant. You have just started work as financial
controller at Larousse plc, an unlisted company, which is the parent company of the Larousse Group.
The Larousse Group is a successful business, supplying fashion clothing to supermarkets and
department stores both in the UK and internationally.
Larousse plc designs clothes, but does not manufacture them. However, about 18 months ago the
board decided on a new business policy of vertical integration with its key suppliers. On 1 October
20X4, Larousse plc acquired 100% of the ordinary share capital of two separate companies, HXP Ltd
and Softex Ltd. HXP and Softex are manufacturers of clothing and both companies supply to
Larousse plc.
Currently, Larousse’s finance director, Dennis Speed, who is an ICAEW Chartered Accountant, is out
of the country negotiating new contracts with some of the company’s significant customers. The
accounting assistant, Marie Ellis, has just started a two-week period of study leave.
Larousse’s managing director, Hal Benny, sends you the following email:
To:
Alex Chen
From:
Hal Benny
Date:
2 November 20X5
Subject: Draft consolidated financial statements for the year ended 30 September 20X5
Welcome to Larousse. It is unfortunate that both Dennis and Marie are away as there is a lot of
urgent accounting work to complete.
Consolidated financial statements
Marie started to draft consolidated financial statements for the year ended 30 September 20X5,
but she did not have time to complete the task before going on study leave. Her draft
consolidation schedule (Exhibit 1) is unfinished and she has prepared some notes that will help
you to complete it (Exhibit 2). I need you to check Marie’s work carefully as she has told me that
she is not very knowledgeable about advanced aspects of financial statement preparation.
Performance analysis
Following the acquisition of HXP and Softex on 1 October 20X4, I would like to understand the
difference in the post-acquisition performance of the two subsidiaries, particularly as there is
significant intra-group trading between them (Exhibit 2, Note 3).
Social responsibility reporting and assurance
The board would like to discuss some proposals for social responsibility reporting and assurance
for the Larousse Group. I have prepared a brief summary of these proposals and related
performance targets (Exhibit 3). Also, it has been suggested to me by one of my fellow directors
that our auditors could be asked to provide an additional assurance report which could be
published in our annual report.
Instructions
In summary, I would like you to:
(1) prepare the consolidated statement of profit or loss for the Larousse group for the year
ended 30 September 20X5 and the consolidated statement of financial position at that date,
correcting any errors. Provide explanations and journal entries for any adjustments you make.
You may assume for now that tax and deferred tax will remain unchanged as a result of your
adjustments;
(2) prepare notes for the board analysing and comparing the performance and profitability of
the two subsidiaries for the year ended 30 September 20X5; and
ICAEW 2022
Real exam (November 2015)
119
(3) respond to the proposals from the board about social responsibility reporting by:
(a) explaining the responsibilities of the Larousse Group’s external auditors in respect of the
proposed social responsibility reporting (Exhibit 3); and
(b) determining the scope of an additional assurance report by the external auditors and
describing the type of work that might be involved in providing verification of progress
on the four key targets (Exhibit 3).
Requirements
39.1 Respond to the instructions in Hal Benny’s email.
39.2 Identify any potential ethical issues arising for you and for Dennis Speed from the
circumstances set out in the file note in Exhibit 4. Describe the actions that you should take.
Note: Work to the nearest £100,000.
Total: 40 marks
Exhibit 1: Larousse Group – draft consolidation schedule for the year ended 30 September 20X5 –
prepared by Marie Ellis
Larousse
plc
HXP
Softex
Adjs.
£m
£m
£m
£m
56.5
12.0
16.0
84.5
(33.3)
(7.5)
(12.5)
(53.3)
Administrative expenses
(8.3)
(1.5)
(1.5)
Selling and distribution costs
(4.7)
(0.7)
(1.4)
Finance costs
(1.6)
––––
–––––
8.6
2.3
0.6
(1.7)
(0.5)
(0.2)
6.9
1.8
0.4
38.0
10.8
16.0
Goodwill – HXP
–
–
–
Goodwill – Softex
–
–
–
Investment in HXP
12.0
–
–
(12.0)
1
–
Investment in Softex
22.0
–
–
(22.0)
2
–
9.2
1.9
1.7
12.8
10.8
2.0
2.1
14.9
–
0.6
2.0
2.6
–––––
––––
–––––
92.0
15.3
21.8
Note
Group
£m
Statement of profit or loss
Revenue
Cost of sales
Profit before tax
Income tax expense
Profit for the year
(1.0)
4
(12.3)
(6.8)
–––––
(1.6)
(1.0)
10.5
–––––
(2.4)
(1.0)
8.1
Statement of financial position
Non-current assets
PPE
64.8
2.6
1
5.6
2
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Total assets
120
Corporate Reporting
–––––
(28.4)
–––––
100.7
ICAEW 2022
Share capital
Larousse
plc
HXP
Softex
Adjs.
£m
£m
£m
£m
10.0
4.0
5.0
(4.0)
1
–
(5.0)
2
–
Share options
Retained earnings at 1 October
20X4
Profit for the year
Note
Group
£m
10.0
–
–
–
1.0
4
1.0
35.8
7.4
14.0
(7.4)
1
35.8
(14.0)
2
6.9
1.8
0.4
(1.0)
4
8.1
28.4
–
–
2.0
1
30.4
Trade and other payables
8.2
1.6
2.2
12.0
Current tax payable
1.7
0.5
0.2
2.4
Short-term borrowings
1.0
–
–
1.0
–––––
––––
–––––
92.0
15.3
21.8
Non-current liabilities
Current liabilities
Total equity and liabilities
–––––
(28.4)
–––––
100.7
Exhibit 2: Notes for completion of draft consolidated financial statements for the year ended 30
September 20X5 – prepared by Marie Ellis
(1) Acquisition of HXP
On 1 October 20X4, Larousse plc acquired 100% of the ordinary share capital of HXP for £12 million
in cash. The fair values of the recognised net assets at the date of acquisition were equivalent to their
carrying amounts. Additional deferred consideration of £6 million will be payable in cash on 30
September 20X7. Dennis told me to use an annual discount rate of 5%. However, I was not sure what
to do with this information, so have ignored it. I have added one-third of the deferred consideration
into the goodwill calculation, as follows:
£m
Consideration in cash
12.0
Deferred consideration
2.0
14.0
Less: share capital and retained earnings at date of acquisition
(11.4)
Goodwill on consolidation
2.6
(2) Acquisition of Softex
On 1 October 20X4, Larousse plc acquired 100% of the ordinary share capital of Softex for £22
million in cash. The fair values of the recognised net assets at the date of acquisition were equivalent
to their carrying amounts. Dennis left a note on the file saying that Softex also had an unrecognised
internally-generated research asset valued at £2 million at the date of acquisition. This asset relates to
the development of a waterproof fabric coating developed by Softex’s manufacturing team.
ICAEW 2022
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121
As it is an intangible asset, I felt that it was prudent to ignore this in my goodwill calculation, shown
below:
£m
Consideration in cash
22.0
Less: share capital and retained earnings at date of acquisition
(19.0)
Goodwill on consolidation
3.0
(3) Intra-group trading
I know that some adjustments will be required for intra-group trading, but I have not had time to do
them. I have set out information about intra-group trading in the following table:
HXP
Softex
Percentage of revenue from sales to Larousse plc
50%
50%
Percentage of revenue from sales outside the group
50%
50%
Gross profit margin on intra-group sales
40%
20%
Percentage of intra-group purchases for the year remaining in
Larousse plc’s inventories at 30 September 20X5
20%
25%
Intra-group receivable from Larousse plc at 30 September 20X5
£1.2 million
£1.4 million
Following a review of inventories at 30 September 20X5, the board decided that the inventories in
Softex were impaired and should be written down by £1.2 million. I have therefore adjusted Softex’s
cost of sales and inventories by £1.2 million, producing revised figures of £12.5 million for cost of
sales and £1.7 million for inventories.
(4) Share options
On 1 October 20X4, Larousse plc introduced a share option scheme for senior staff. Each share
option entitles the holder to subscribe for one Larousse plc share. On 1 October 20X4, 1,000 share
options were granted to each of 50 employees and directors. The share options will vest on 30
September 20X8 to those employees who are still in employment with Larousse plc at that date. In
the year ended 30 September 20X5, four of the 50 employees left the company and it is expected
that a further two employees will leave in each of the remaining years until the shares vest. The fair
value of each option was £20.00 at 1 October 20X4, and £21.74 at 30 September 20X5.
I have calculated the cost of the share option scheme in the financial statements for the year ended
30 September 20X5 as follows:
1,000 × (50 – 4) × £21.74 = £1m (to nearest £100,000)
This expense is included in administrative expenses and is credited to equity.
Exhibit 3: Proposals for social responsibility reporting and assurance – prepared by Hal Benny
In recent years, the fashion industry has been subject to criticism. This criticism results from the
fashion industry’s perceived indifference to issues such as the wellbeing of staff in developing
countries, the use of child labour and the environmental impact of its activities in cotton production
and dyeing. Now that the Larousse Group has direct interests in production and supply through our
new shareholdings in HXP and Softex, it is timely to reconsider our social responsibility policies and
reporting.
Both HXP and Softex produce a significant proportion of their fashion range in countries with low
economic standards of living. We know that staff in their factories are paid very low wages and that
working conditions are challenging.
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I have provisionally set four key performance targets for achievement by HXP and Softex:
•
A clean water initiative is to be undertaken to mitigate the environmental effects of fabric dyeing
and cotton production. Scientists will monitor water quality regularly.
•
An effective health and safety programme is to be launched in the factories.
•
The use of child labour (children under 16 years of age) is to be eliminated within three years.
•
Training and development programmes are to be carried out to improve the skills of all factory
workers.
Progress towards achievement of these targets will be disclosed as part of sustainability reporting to
stakeholders in the social responsibility section of the Larousse Group’s annual report for the year
ending 30 September 20X6.
Exhibit 4: Ethics file note prepared by Alex Chen
On my first day at Larousse, I was sitting in the staff coffee bar where I overheard a conversation
between two of the office administrators. They were gossiping about Dennis Speed, the Larousse
finance director.
According to their conversation, Dennis Speed may have been involved in unethical activities in
respect of Larousse plc’s takeover of HXP. Dennis is married to Lola Gonzalez, a director of HXP. Prior
to the takeover, Lola owned 30% of the shares in HXP. It was suggested that Larousse overpaid
substantially for HXP, and that Dennis facilitated the overpayment in order to benefit his wife. He did
this, allegedly, by colluding with his wife to falsify records submitted to the accountants who
undertook due diligence in respect of the takeover. Dennis is apparently not well liked; the
administrative staff regard him as intimidating and it seems they would be pleased if he lost his job.
40 Telo
You are Sophie Blake, an ICAEW Chartered Accountant. You have been appointed as the financial
accountant of Telo plc, an unlisted company engaged in running marketing campaigns for its clients.
Telo was established five years ago and its ordinary share capital is held equally by its three founder
shareholders. All three remain directors, and are actively involved in running the business. The
directors’ intention is to achieve an AIM listing within the next three years.
Your predecessor was John Birch, a part-qualified accountant who left Telo last month. Before he left,
John prepared a draft trial balance as at 31 August 20X5, the company’s year end, together with
some notes (Exhibit).
Telo’s auditors are TCC Associates who were appointed three years ago. TCC completed a brief
interim audit in May 20X5, and is due to start work on the final audit next week.
Telo’s operations director has given you the following instructions:
“Sophie, I have discussed with TCC the information that they will require next week. I would like you
to review John’s draft trial balance and related notes (Exhibit) and prepare a working paper in which
you:
(1) explain the appropriate financial reporting treatment of the four matters highlighted in John’s
notes, setting out any necessary adjustments; and
(2) prepare, including your adjustments, a draft statement of profit or loss and other comprehensive
income for the year ended 31 August 20X5, and a statement of financial position at that date.
The current tax charge in the trial balance of £350,000 was estimated by John, and you can assume
for the purpose of preparing the draft financial statements that it is correct. Adjustments in respect of
deferred tax may, however, be required.”
Requirement
Respond to the instructions of the operations director.
Work to the nearest £1,000.
Total: 30 marks
ICAEW 2022
Real exam (November 2015)
123
Exhibit: Draft trial balance at 31 August 20X5 − prepared by John Birch
Additional
information
Debit
Credit
£’000
£’000
Operating costs
1
11,353
–
Inventories and work-in-progress at 1
September 20X4
1
4,355
–
Sales
2
–
15,680
Selling costs
1,162
–
Administrative expenses
2,340
–
–
70
350
–
–
60
3,281
–
Trade payables
–
3,965
Current tax payable
–
350
82
–
–
5,051
Other income: property letting
Current tax charge
Ordinary share capital
Trade receivables
2
Cash
Retained earnings at 1 September 20X4
Revaluation surplus at 1 September 20X4
3
–
971
Property at 53 Prospect Street
3
3,335
–
242
–
–
110
–
243
–––––
–––––
26,500
26,500
Computer and office equipment – at cost
Computer and office equipment – depreciation
at 31 August 20X5
Deferred tax at 1 September 20X4
4
Additional information
(1) Cost of sales
The cost of sales is calculated by adjusting operating costs for opening and closing inventories and
work-in-progress. Inventories and work-in-progress are estimated at each year end in respect of all of
Telo’s current marketing campaigns. Unfortunately, I have recently found that an addition error was
made in the calculation of inventories and work-in-progress at 31 August 20X4 and brought forward
on 1 September 20X4. Inventories and work-in-progress at that date should actually have been
recognised at £3,742,000.
On 31 August 20X5, inventories and work-in-progress are valued at £4,437,000.
(2) Invoices
In September 20X4, Telo won the contract to provide marketing services to a client, Sourise, which is
based in Nemisland. The contract specified that services should be invoiced twice a year, and that
invoices should be denominated in Nemisland dollars (N$). Telo sent an invoice for N$220,000 on 31
December 20X4, and another invoice for N$180,000 on 30 June 20X5. Sourise experienced financial
difficulties during the year, but following refinancing was able to pay Telo N$250,000 on 31 August
20X5.
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Corporate Reporting
ICAEW 2022
I recorded the invoices using the relevant exchange rates on the invoice dates, as follows:
Date
Rate
Invoice amount
(to nearest £’000)
31 December 20X4
£1 = N$1.06
£208,000
30 June 20X5
£1 = N$1.16
£155,000
On 31 August 20X5, I translated the cash receipt of N$250,000 at the exchange rate at that date of
£1 = N$1.12. I set the cash receipt first against the 31 December 20X4 invoice, which settled it in full,
then set the balance against the 30 June 20X5 invoice. Following further correspondence with
Sourise, Telo’s directors have decided to make a specific allowance of 50% against the outstanding
receivable at 31 August 20X5. I have not had time to make this adjustment.
(3) 53 Prospect Street
The property at 53 Prospect Street was bought by Telo on 1 September 20X2 for £2 million (land
£300,000 and buildings £1.7 million). The directors decided to measure the property under the
revaluation model, and to apply an annual depreciation rate to the buildings of 1%, assuming no
residual value.
The first revaluation of the 53 Prospect Street property took place on 31 August 20X4. A chartered
surveyor valued the property at £3,180,000 (of which land comprised £600,000). No change was
made to the expected useful life of the property at that date.
It was clear by late 20X4 that the property was too small for Telo’s rapidly-increasing scale of
operations, and the business moved to offices at 15 Selwyn Road on 1 January 20X5. The 15 Selwyn
Road offices are occupied under a lease of nine months. Telo has elected to take advantage of IFRS
16’s recognition exemptions in respect of the 15 Selwyn Road offices.
The Telo directors decided to retain ownership of 53 Prospect Street, and to let it out as an
investment property. A five-year lease was agreed with an unrelated party, which moved into the
property on 1 January 20X5.
The carrying amount of 53 Prospect Street in the trial balance is £3,335,000 and comprises:
£’000
Property at valuation at 31 August 20X4
3,180
Installation of air conditioning system (March 20X5)
100
Professional fees in respect of leasing 53 Prospect Street
25
Costs of relocation to 15 Selwyn Road
30
3,335
As commercial property prices in the area are rising rapidly, the same chartered surveyor who
conducted the valuation at 31 August 20X4 was asked to revalue the property again at 1 January
20X5 and at 31 August 20X5. She produced the following valuations:
Date
Land
Buildings
£’000
£’000
1 January 20X5
620
2,600
31 August 20X5
650
2,850
On 1 January 20X5, the Telo directors decided to measure 53 Prospect Street using the fair value
model.
(4) Deferred tax balance
The deferred tax balance of £243,000 brought forward at 1 September 20X4 arose in respect of the
property at 53 Prospect Street. It was calculated at a tax rate of 20% which continues to be the
applicable rate at 31 August 20X5. Gains on property, plant and equipment are taxed when the asset
is sold. However, the tax rules for calculating gains on investment properties follow the accounting
ICAEW 2022
Real exam (November 2015)
125
rules: gains are taxed when they are recognised in the statement of profit or loss. No other
temporary differences arose, including on computer and office equipment, either at 31 August 20X4
or 31 August 20X5.
41 Newpenny (amended)
You are Cary Lewis, an ICAEW Chartered Accountant working for a firm of accountants and auditors,
Linton LLP. You are the senior assigned to the audit of Newpenny plc, a UK company which
manufactures and distributes a range of vacuum cleaners. You are currently planning the Newpenny
audit for the year ending 31 December 20X5.
Your audit manager calls you into his office and briefs you:
“I have received an email (Exhibit 1) from Rosa Evans, the Newpenny finance director. She needs our
advice on some financial reporting matters and has also provided information about the purchasing
procedures Newpenny now has in place (Exhibit 2). She would like us to take these updated
procedures into account when planning our audit approach, so that we can place more reliance on
internal controls in our audit of trade payables and accruals.
Our audit of Newpenny’s trade payables and accruals for the year ended 31 December 20X4 relied
wholly on substantive audit procedures. The results of these audit procedures are summarised in a
memorandum (Exhibit 3).
I need you to prepare the following:
(1) An email replying to Rosa Evans in which you provide, with explanations, the financial reporting
advice she has requested (Exhibit 1).
(2) A memorandum to me in which you respond to Rosa’s suggestion that we should place more
reliance on internal controls in our audit of Newpenny’s trade payables and accruals for the year
ending 31 December 20X5. I have set out in a note (Exhibit 4) how you should structure this
memorandum and the information you should include. (Ignore the results of the data analytics
noted below.)
(3) I have some concerns about Newpenny’s purchase order and receipt of materials systems. I have
therefore taken the opportunity to analyse the purchase data using Linton’s new data analytics
system, DAACA. I have provided a ‘dashboard’ showing the results of this analysis (Exhibit 5).
Using this data, set out and explain any further concerns (in addition to those identified in (2)
above) regarding Newpenny’s internal control system for purchase orders.”
Requirement
Prepare the documents requested by your audit manager.
Total: 40 marks
Exhibit 1: Email from Rosa Evans
Jones Engineering Ltd (JE) supplies Newpenny with vacuum cleaner motors.
Historically we have agreed with JE annually in advance the price per motor and JE has invoiced
Newpenny at the agreed price on delivery. In the year ended 31 December 20X4, Newpenny
purchased 75,000 JE motors and the budget, prepared at 1 January 20X5, for the year ending 31
December 20X5 showed that Newpenny would require 100,000 JE motors. The price agreed on 1
January 20X5 was £20 per motor.
When our new purchasing manager joined Newpenny in May 20X5, he renegotiated the contract
with JE, resulting in a revised contract for the year ending 31 July 20X6. The renegotiated contract
has the following terms:
•
The price per JE motor is reduced to £19 for all motors delivered to Newpenny on or after 1
August 20X5 and this is invoiced by JE to Newpenny on delivery.
•
If the total number of motors ordered in the year ending 31 July 20X6 is less than 100,000 then
Newpenny will pay an additional £1 for each motor purchased in the year ending 31 July 20X6
(resulting in a price per motor of £20).
•
If the total number of motors ordered in the year ending 31 July 20X6 exceeds 110,000, then JE
will give Newpenny a refund which will reduce to £18.50 the price per motor supplied in the year
ending 31 July 20X6.
126
Corporate Reporting
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At the moment, we are recording the liability to pay JE as invoices are received. Please explain to me
any further accounting entries or disclosures I should make in Newpenny’s financial statements for
the year ending 31 December 20X5.
In the last month, Newpenny had an issue with a few of its Model2000 industrial vacuum cleaners.
Customers complained that the vacuum cleaners overheat and one customer alleged that their
vacuum cleaner was the cause of a serious fire. Under its one-year warranty, Newpenny provides free
replacement cleaners to those who complain within the warranty period. To date, eight vacuum
cleaners at a total cost of £1,200 have been replaced and Newpenny made an offer of £5,000 in
compensation to the customer who reported a fire. Newpenny sells around 10,000 Model2000
vacuum cleaners each year.
The costs to date have been covered by the warranty provision made each year on the basis of past
claims. Please advise me of the approach I should take when assessing the need for any additional
provision in the financial statements for the year ending 31 December 20X5.
Your audit approach
I understand that in last year’s audit of trade payables and accruals you relied wholly on evidence
obtained from substantive testing and did not test the operating effectiveness of our controls. We
have introduced updated purchasing internal control procedures and I would like you to rely as
much as possible on the controls we now have in place. Please give this some consideration as you
perform your detailed audit planning.
I attach a copy of our updated purchasing internal control procedures (Exhibit 2) to assist you.
Rosa
Exhibit 2: Newpenny’s updated purchasing internal control procedures – prepared by Newpenny
purchasing manager in July 20X5
Background
Newpenny’s purchases can be categorised as follows:
(1) Materials (including components) used in the manufacture of vacuum cleaners
(2) Services such as utilities and agency staff
Purchase orders
Purchase orders for materials are prepared by the manufacturing department and sent to the
relevant supplier. The orders are authorised by a manufacturing manager in accordance with the
authorisation limits set by the finance department and are entered in the purchasing IT system by an
assistant in the purchasing department. Manufacturing managers each have a limit of £5,000 for a
single order and have a maximum total order value of £100,000 per month. Authorisation by a senior
manufacturing manager is required for orders above these limits.
Purchase orders for services are prepared and authorised by the relevant departments.
Receipt of materials
When materials are received at the factory, staff in the goods received department match the
quantity and type of materials received to a purchase order on the system. If matched, the delivery is
accepted and the purchasing IT system is updated. This entry automatically generates a ‘goods
received not invoiced’ (GRNI) accrual at standard cost and the printing of a ‘received’ sticker which is
attached to the goods. The store’s manager checks for the presence of this sticker before moving the
goods into the store area.
Goods are moved out of the store area when requested for use in production. The goods are then
deducted from stores records (inventory) and transferred to production costs.
Standard costs for each material or component are set at 1 January each year.
The goods received department staff are instructed that if there is no matching purchase order on
the system, materials should not be accepted.
Receipt and posting of invoice
Invoices are received by various departments and forwarded to the finance department. If the
invoice is for materials, it is matched to the goods received entry (thus removing the GRNI accrual)
and posted to the purchase ledger.
ICAEW 2022
Real exam (November 2015)
127
If the invoice is for services for which there is an authorised purchase order, it is posted to the
purchase ledger immediately without further authorisation. If there is no authorised purchase order,
the invoice is sent to the relevant department for approval and only posted to the purchase ledger
once that approval has been obtained.
Month end accruals process
At the end of each month, an assistant in the finance department reviews open purchase orders (ie,
those orders which have not been matched to goods received or invoice) on the system and
determines whether the ordered materials or services were supplied before the month end. Accruals
are made for all items supplied before the month end. The accruals listing is reviewed by the
financial controller, who requests supporting information for a sample of items selected at random.
Where a supplier provides a monthly statement, this is reconciled to the balance on the purchase
ledger and GRNI accrual for that supplier by a member of staff in the finance department.
Cash payments
Every two weeks, all items due for payment are selected from the purchase ledger and added to the
automated payment run. The payment run is reviewed and authorised by the financial controller and
one of the other bank signatories before being notified to the bank. The payment is posted to both
the cash book and the purchase ledger. Bank and purchase ledger control account reconciliations
are performed at each month end by the financial controller.
Exhibit 3: Memorandum on trade payables and accruals from the audit working papers for the year
ended 31 December 20X4
We performed the planned audit procedures on trade payables and accruals. The following findings
were noted:
•
Our audit procedures on post year-end invoices identified omitted accruals of £103,000 relating
to invoices for agency staff work performed before the year end, but invoiced a month later.
•
A review of the GRNI accrual listing revealed old items amounting to £50,000. Newpenny staff
were unable to explain why invoices had not been received and matched to these receipts of
materials.
Exhibit 4: Audit manager’s note − memorandum on Newpenny’s controls over purchasing
Your memorandum should first explain any general points about Newpenny’s control environment
for payables and accruals.
You should then consider the audit assertions relevant to payables and accruals balances, setting out
the following for each assertion:
•
An explanation of the assertion as it relates to trade payables and accruals
•
The key control activities you have identified from the information provided
•
Your initial assessment as to whether the controls you have identified individually or in
combination with other controls are capable of ensuring that the audit assertion is met
•
An explanation of any potential internal control deficiencies identifying:
– any gaps you have identified in the control activities;
– matters on which you require additional information; and
– areas where you are concerned that the controls may not be designed effectively to meet the
relevant assertion.
Exhibit 5: Dashboard of results from the application of DAACA data analytics
Newpenny management has made available to Linton all its data files with respect to its purchases,
stores and payables system. Linton’s Data Analytics and Controls Assessment system (DAACA) has
been applied to this data.
The DAACA system tested 100% of items for all types of product ordered and received, in the year
ended 31 December 20X4. It analysed data and identified outliers in respect of each of the
following:
Test 1: Size and timing of individual orders and monthly totals for each manufacturing manager.
Test 2: Matching of all orders with goods received notes (GRNs).
128
Corporate Reporting
ICAEW 2022
Based on the above analytics, the following results have been obtained in the form of the standard
output of the DAACA system, which is the data dashboard.
Test 1: DAACA system – data dashboard
Outliers
Frequency of value of individual
orders for John Fuller for the year
Outcome
Average value per individual order
£3,246
Average value of monthly totals of
orders
£64,379
% of individual orders exceeding £4,000
35%
% of individual orders in last three days
of the month
27%
Frequency of John exceeding £90,000
of orders in a month
7
35%
30%
25%
20%
15%
10%
5%
0%
£0
-£
10
£1
00
00
1£2
00
£2
0
00
1£3
00
£3
0
00
1£4
00
£4
0
00
1£5
00
0
Test
One manufacturing manager, John Fuller, was identified as an outlier showing the following data:
Test
Outcome
Frequency of value of
individual orders for the year
30
Average value per individual order
£2,343
Average value of monthly total orders
per manager
£45,864
Frequency of managers exceeding
£90,000 in any one month
16
Frequency of managers exceeding
£100,000 in any one month (requiring
approval from senior manager)
2500
2000
1500
1000
500
0
£0
-£
10
£1
00
00
1£2
00
£2
0
00
1£3
00
£3
0
00
1£4
00
£4
0
00
1£5
00
0
Number of manufacturing managers
zero
Test 2: DAACA system – data dashboard
Test
Number of orders matched
with GRN
Top 4 suppliers
Average no of days
delivery terms exceeded
Outcome
13,546
Number of unmatched orders
1,175
Number of unmatched orders
over 2 months old
22
Number of unmatched GRNs
17
Wilson
Man Inc
UUP Ltd
Jones plc
-5
ICAEW 2022
0
5
10
Real exam (November 2015)
129
130
Corporate Reporting
ICAEW 2022
Real exam (July 2016)
42 Earthstor
Earthstor plc is listed on the AIM of the London Stock Exchange. It is a retailer of clothing and
footwear and sells products to customers in the UK.
You are a newly-qualified ICAEW Chartered Accountant working for the auditors of Earthstor. Your
firm is currently undertaking the audit of Earthstor for the year ended 30 June 20X6 and you have
replaced Greg Troy, the audit senior who has recently been reassigned to another client. You report
to Tom Chang, the audit manager.
Tom Chang gives you the following briefing:
“I have provided you with a draft statement of financial position at 30 June 20X6, prepared by
Earthstor’s finance department (Exhibit 1).
Greg reviewed the minutes of the directors’ quarterly board meetings and prepared a file note in
respect of some financial transactions undertaken by Earthstor during the year ended 30 June 20X6 (
Exhibit 2). Greg has set out Earthstor’s draft financial reporting treatment and some additional
information for these transactions, but Greg had concerns about whether the financial reporting
treatment is correct (Exhibit 3).
Planning materiality is £2.4 million, which represents 5% of profit before tax. We agreed with the
audit committee that we will report to them each misstatement above £120,000 identified during our
audit.
Please prepare a working paper in which you:
(1) explain the financial reporting implications of each of the transactions noted by Greg from the
board minutes (Exhibits 2 and 3). Recommend appropriate accounting adjustments. Please
ignore any tax or deferred tax implications of these adjustments;
(2) identify the key audit risks arising from each of the transactions (Exhibits 2 and 3) and
recommend the audit procedures that we will need to complete in order to address each risk;
(3) prepare a revised draft statement of financial position at 30 June 20X6 (Exhibit 1). This should
include any adjustments identified in (1) above; and
(4) explain any corporate governance issues for Earthstor that you identify from Greg’s file note
(Exhibit 2). Also, identify any ethical issues for our audit firm and recommend the actions that our
firm should take.”
Requirement
Prepare the working paper requested by Tom Chang.
Total: 40 marks
Exhibit 1: Earthstor − Draft statement of financial position at 30 June 20X6 – prepared by Earthstor
finance department
£’000
ASSETS
Non-current assets
Intangible assets – website development costs
Financial asset – investment in TraynerCo
Property, plant and equipment
31,300
8,000
56,309
Current assets
Inventories
144,380
Trade and other receivables
22,420
Cash and cash equivalents
71,139
ICAEW 2022
Real exam (July 2016)
131
£’000
Total assets
333,548
EQUITY AND LIABILITIES
Equity
Ordinary share capital (£1 shares)
Retained earnings
Translation reserve (TraynerCo)
10,000
163,362
(1,500)
171,862
Non-current liabilities
12,175
Current liabilities
149,511
Total equity and liabilities
333,548
Exhibit 2: File note – Transactions noted from review of the minutes of the directors’ quarterly board
meetings – prepared by Greg Troy
I have summarised the key points from the minutes of the board meetings which relate to complex
financial transactions during the year. I have also set out in a separate file note (Exhibit 3) Earthstor’s
draft financial reporting treatment for the year ended 30 June 20X6, for each transaction. I am not
sure that the draft financial reporting treatment is always correct.
Meeting on 10 September 20X5
TraynerCo is an unquoted Malaysian company which supplies Earthstor with footwear, a core product
for Earthstor. An interruption in supply from TraynerCo would affect Earthstor’s ability to trade
successfully in the footwear market.
TraynerCo suffered a serious cash flow problem in June 20X5 and Earthstor’s CEO, Dominic Roberts,
reports that, on 1 July 20X5, he instructed the finance director to provide emergency finance to
TraynerCo. This is an interest-free loan of MYR20 million, repayable at par on 30 June 20X7. (MYR is
the currency of Malaysia.) Loans of equivalent risk in the marketplace have an annual effective
interest rate of 6%. In order to secure footwear supplies, the directors retrospectively approve the
loan.
Dominic proposes a long-term investment in TraynerCo. Henry Min, an entrepreneur, owns 100% of
the share capital in TraynerCo. Dominic states that Henry Min has agreed to sell 10% of his
shareholding in TraynerCo to Earthstor for MYR45 million. The date of the transaction will be 1
October 20X5.
Although the board approves the purchase of the 10% shareholding in TraynerCo, there is a
dissenting vote from the finance director, who believes that the price to be paid for the shares is
above the market price. The finance director states that he will provide further evidence of the
market price valuation.
Meeting on 10 January 20X6
The board records the resignation of the finance director on 1 January 20X6. In his resignation letter
to the board, the finance director states that he can no longer work with Dominic, who is dominating
the board and allowing a close friendship with Henry Min to compromise his judgement.
The HR director presents a short report on the process for recruiting a new finance director. Dominic
joins the meeting via teleconference from Singapore. Dominic tells the board that, in the interim
period, the finance department will have to cope until a replacement finance director is appointed.
Dominic is negotiating the purchase of an office building in Singapore for Earthstor, which will be
rented out entirely to third parties. He asks the board to approve this transaction in advance.
Although details of the purchase are not available, Dominic considers that it is a good investment
opportunity for Earthstor.
After the Singapore office building has been purchased by Earthstor, TraynerCo will relocate its
administration function on 1 August 20X6 to Singapore for tax reasons and has agreed to occupy
one floor of this Singapore office building. Dominic states that no rent will be charged to TraynerCo
as he recently agreed a very low price for Earthstor’s purchases of footwear from TraynerCo.
132
Corporate Reporting
ICAEW 2022
Meeting on 10 March 20X6
Dominic decided to cancel this board meeting.
Meeting on 30 June 20X6
Dominic reports that the purchase of the Singapore office building has been successful and presents
details of the deal. Earthstor paid SG$10 million on 1 February 20X6 when the exchange rate was £1
= SG$2.1. (SG$ is the currency in Singapore.) Dominic states that this is a good price as a similar
property was sold for SG$11 million in June 20X6.
Dominic announces the launch on 1 May 20X6 of the new Earthstor website which fully integrates
with Earthstor’s inventory and order processing systems. The website now enables goods to be
despatched to the customer within four hours of the order being placed. The website will provide
future benefits to the business for seven years.
Exhibit 3: Draft financial reporting treatment for the year ended 30 June 20X6
Set out below are Earthstor’s draft financial reporting treatment and some additional information for
the financial transactions during the year noted from my review of the minutes of the directors’
quarterly board meetings (Exhibit 2).
MYR20 million interest-free loan to TraynerCo
This loan is recognised in trade and other receivables, translated at the exchange rate on 1 July 20X5
of £1 = MYR5. No other entries have been made in respect of this loan. The average exchange rate
for the year ended 30 June 20X6 was £1 = MYR5.5 and the exchange rate at 30 June 20X6 was £1 =
MYR6.
Investment in 10% of TraynerCo’s shares
The investment in TraynerCo is recognised as a financial asset at its cost on 1 October 20X5 of £9.5
million (MYR45 million at £1 = MYR5, plus legal fees of £0.5 million). It is translated at the year-end
exchange rate at 30 June 20X6 of £1 = MYR6. A loss of £1.5 million is presented through other
comprehensive income in a translation reserve in the statement of financial position. On initial
recognition, an irrevocable election was made to recognise valuation gains and losses in other
comprehensive income.
In July 20X6, Henry Min sold a further 10% holding of his shares in TraynerCo to a Malaysian entity for
MYR36 million. This valuation reflects a fall in the value of TraynerCo’s shares since 1 October 20X5
caused by poor trading results since 1 October 20X5. This fall is due to market conditions.
Purchase of Singapore office building
The Singapore office building is held at cost in property, plant and equipment. It is translated at the
date of acquisition. No depreciation has been charged and the accounting policy for investment
properties states that they should be recognised at fair value. The exchange rate at 30 June 20X6 was
£1 = SG$2.7.
New Earthstor website
The following website development costs have been included in non-current assets:
£’000
Planning costs
3,000
Professional fees for photography and other graphic design
1,300
Fee paid to Tanay (Note)
5,000
Internal software development costs
22,000
31,300
Note: £5 million was paid to Tanay, an internationally-famous singer, who is the ‘name behind the
Earthstor brand’.
The above costs have not been amortised in the financial statements.
ICAEW 2022
Real exam (July 2016)
133
43 EyeOP
You are Greta Hao, an ICAEW Chartered Accountant working in the finance department at HiDef plc,
an AIM-listed company which manufactures medical equipment. HiDef has several wholly-owned
subsidiaries and prepares consolidated financial statements. Its year end is 30 November.
On 1 December 20X4, HiDef bought 50,000 of the 1 million issued ordinary shares in EyeOP Ltd, for
£700,000. EyeOP makes medical imaging cameras. On initial recognition, HiDef made an irrevocable
election to recognise valuation gains and losses on its investment in 50,000 EyeOP shares in other
comprehensive income. On 30 November 20X5, the fair value of the 50,000 shares was £2.5 million
and the increase in fair value of £1.8 million was recognised in HiDef’s consolidated other
comprehensive income for the year ended 30 November 20X5.
HiDef intends to buy a further 650,000 of EyeOP’s ordinary shares on 1 August 20X6 for £85 million.
The fair value of EyeOP’s net assets at 1 August 20X6 is expected to be £63 million. EyeOP has a 31
December year end.
The fair value of HiDef’s original shareholding of 50,000 shares is expected to be £6.2 million on 1
August 20X6. HiDef intends to use the proportion of net assets method to value non-controlling
interests.
You receive the following briefing from the HiDef CEO:
“A finance assistant has provided some financial information, which comprises:
•
a draft forecast statement of profit or loss and other comprehensive income for EyeOP for the
year ending 31 December 20X6; and
•
some notes on outstanding financial reporting issues and assumptions for 20X7 (Exhibit 1).
The HiDef directors want to understand the impact of buying a further 650,000 shares in EyeOP on
the group’s ability to achieve the key group performance targets. I have provided you with the
forecast consolidated statement of profit or loss and other comprehensive income for the HiDef
group (excluding the impact of the proposed purchase of 650,000 EyeOP shares) for the year ending
30 November 20X6, together with other information and key group performance targets (Exhibit 2).”
The CEO’s instructions
“I would like you to prepare a report for me in which you:
(1) calculate the goodwill relating to the proposed purchase of 650,000 ordinary shares in EyeOP
on 1 August 20X6, which would be included in HiDef’s consolidated statement of financial
position as at the year ending 30 November 20X6. For this purpose, use the expected fair value
of EyeOP’s net assets at 1 August 20X6 of £63 million;
(2) explain the impact of each of the outstanding financial reporting issues (Exhibit 1) on EyeOP’s
forecast financial statements for the year ending 31 December 20X6. Recommend appropriate
adjustments using journal entries;
(3) prepare a revised forecast consolidated statement of profit or loss and other comprehensive
income for HiDef for the year ending 30 November 20X6. Assume that HiDef buys 650,000
shares in EyeOP on 1 August 20X6 and include any adjustments you recommend in respect of
the outstanding financial reporting issues (Exhibit 1); and
(4) analyse the impact of the purchase of 650,000 shares in EyeOP on HiDef’s key performance
targets (Exhibit 2) for the year ending 30 November 20X6 and, where possible, for the year
ending 30 November 20X7.
Please ignore any tax or deferred tax consequences.”
Requirement
Respond to the CEO’s instructions.
Total: 30 marks
Exhibit 1: Financial information provided by the EyeOP finance assistant
£m
Revenue (Note 2)
178.9
Cost of sales (Note 2)
(92.6)
134
Corporate Reporting
ICAEW 2022
£m
Gross profit
86.3
Administrative expenses (Note 1)
(36.3)
Non-recurring item – development costs (Note 2)
(14.0)
Profit from operations
36.0
Finance costs
(12.2)
Profit before tax
23.8
Income tax
(4.8)
Profit for the year
19.0
–––––
Other comprehensive income for the year
Total comprehensive income for the year
19.0
Depreciation of £4.1 million and lease rentals of £5.5 million are included in cost of sales. The leases
are for less than 12 months, and EyeOP has taken advantage of the IFRS 16 recognition exemptions
for short-term leases.
Outstanding financial reporting issues
(1) Pension schemes
EyeOP contributes to two pension schemes on behalf of its employees: Scheme A and Scheme B.
The total contribution paid to the company’s pension schemes of £9.2 million is recognised in
administrative expenses. The breakdown of the contribution and details of the schemes are as
follows:
Details
A
EyeOP will make a contribution of £6.4 million to scheme A in the year ending 31
December 20X6.
This scheme is for directors and employees who have worked for more than five years for
the company. EyeOP has a contractual obligation to ensure that its contributions are
sufficient to provide a pension to the scheme members at retirement. The pension is
based on an average of the member’s final three years’ salary. Scheme A is separately
constituted from Scheme B (see below). Scheme A is now closed to new members.
B
EyeOP will make a contribution of £2.8 million to Scheme B in the year ending 31
December 20X6.
This scheme is for employees who are not eligible for Scheme A.
Contributions create, for an employee, a right to a portion of the scheme assets, which can
be used to buy an annuity on retirement. Contributions are fixed at 7% of the annual salary
for the employer and 3% for the employee.
The following information relates to Scheme A as reported in the financial statements for the year
ended 31 December 20X5:
£m
Pension scheme assets
22.0
Present value of the obligation
(60.0)
Post-employment net benefit obligation
(38.0)
ICAEW 2022
Real exam (July 2016)
135
The scheme actuary provided the following information:
•
During the year ending 31 December 20X6, 15 senior employees will be made redundant and as
a consequence, EyeOP will commit to pay additional pensions to these employees under the
terms of their redundancy. This contributes an additional £4.2 million to the present value of the
pension obligation.
•
The valuation of the pension scheme assets and the present value of the pension obligation at 31
December 20X6 are now expected to be £32.6 million and £74.5 million respectively.
•
Other information estimated for the year ending 31 December 20X6:
Yield on high-quality corporate bonds
5% pa
£m
Current service cost
5.9
Benefits paid to former employees
2.1
Actual return on scheme assets
6.3
Except for the recognition of the pension contributions of £9.2 million in administrative expenses, no
adjustments have been made to the draft forecast statement of profit or loss for the year ending 31
December 20X6.
(2) Medical imaging camera – Medsee
On 1 October 20X4, EyeOP started to develop a new medical imaging camera, the Medsee. Monthly
development costs of £4 million were incurred from that date until 1 January 20X6, when EyeOP
made a technical breakthrough in relation to this project. On 1 January 20X6, the Medsee was
deemed financially and commercially viable and thereafter development costs decreased to £3.5
million per month until development work was completed on 30 April 20X6.
Marketing and production of the Medsee began on 1 May 20X6. EyeOP expects to receive orders for
600 cameras priced at £60,000 each in the year ending 31 December 20X6. The terms of trade
require a non-refundable payment of 25% of the selling price on receipt of the order. The order is
non-cancellable. There will be 50 cameras manufactured and delivered to customers in the year
ended 31 December 20X6 who will pay EyeOP the remaining 75% of the selling price in January
20X7.
EyeOP anticipates the Medsee having a commercial life of four years, with total sales of 3,500
cameras over that period. It is anticipated that 875 cameras will be delivered in the year ending 31
December 20X7.
Variable production costs are £22,000 per camera.
In the forecast statement of profit or loss for the year ending 31 December 20X6, EyeOP intends to
expense all Medsee development costs. Because the orders are non-cancellable, EyeOP intends to
recognise revenue in respect of the 600 cameras which customers will order by 31 December 20X6.
Entries made in the forecast financial statements for the year ending 31 December 20X6 to reflect
the above are:
£m
DEBIT
Cash
9.0
DEBIT
Receivables
27.0
CREDIT
DEBIT
CREDIT
Revenue
Cost of sales
Inventories
£m
36.0
13.2
13.2
Assumptions for year ending 31 December 20X7
It is expected that the variable production cost per Medsee camera, and its selling price, will remain
unchanged in the year ending 31 December 20X7. Other revenue and costs are also expected to
remain constant.
136
Corporate Reporting
ICAEW 2022
Exhibit 2: HiDef consolidated forecast statement of profit or loss and other comprehensive income
for the year ending 30 November 20X6 (excluding the impact of the proposed purchase of
650,000 EyeOP shares)
20X6
£m
Revenue
383.0
Cost of sales
(264.2)
Gross profit
118.8
Administrative expenses
(102.0)
Profit from operations
16.8
Finance costs
(5.5)
Profit before tax
11.3
Income tax
(2.3)
Profit for the year
9.0
––––––
Other comprehensive income for the year
Total comprehensive income for the year
9.0
Other information
Depreciation of £28.1 million and lease rentals of £35.5 million are included in cost of sales. The
leases are for less than 12 months, and HiDef has taken advantage of the IFRS 16 recognition
exemptions for short-term leases.
HiDef’s consolidated revenue and costs are expected to remain constant for the foreseeable future.
Revenue for the year ended 30 November 20X5 was £400 million.
Key group performance targets for HiDef
Revenue growth
Increase of 7% each year
Gross profit percentage
Greater than 35%
EBITDAR*/Interest
Greater than 12
*EBITDAR = Earnings before interest, tax, depreciation, amortisation and rentals.
44 Topclass Teach
You are Mo Ranza, an ICAEW Chartered Accountant who recently joined Jones, Smith & Wilson LLP
(JSW) as an audit senior. You receive the following briefing from Sue Jessop, the JSW engagement
partner:
Welcome to JSW. I need your help on the audit of Topclass Teach plc (TT) for the year ending 31
August 20X6. TT provides education and training, and it operates from an extensive campus. TT has
been an audit client of JSW for a number of years.
Our interim audit visit at TT starts next week and I am concerned that we have not yet planned our
audit approach on property, plant and equipment (PPE). The TT financial controller has sent me the
PPE note from the management accounts for the nine months ended 31 May 20X6. This gives you an
idea of the significance of the PPE balances (Exhibit 1). Planning materiality for the TT audit is £2
million and we will report each proposed misstatement over £40,000 to the audit committee.
The only documentation regarding PPE on our audit file is a planning memorandum prepared in
June 20X6 (Exhibit 2) by an audit assistant, Naomi Wills. This was not reviewed by the audit senior or
manager and, while it includes some useful information, it does not specifically identify or comment
on the audit risks.
ICAEW 2022
Real exam (July 2016)
137
I’ve received an email from the TT finance director, Karel Kovic, which requests advice on the financial
reporting implications of a proposed agreement and updates us on some recent developments at TT
(Exhibit 3).”
Partner’s instructions
“What I need you to do is to use the information I have provided to do the following:
(1) Draft a response to Karel’s request for advice on the financial reporting implications of the
proposed agreement with Beddezy on the TT financial statements for the year ending 31 August
20X6 (Exhibit 3). You can ignore any tax or deferred tax consequences.
(2) Identify and explain the inherent, control and detection audit risks associated with the audit of
PPE in TT’s financial statements for the year ending 31 August 20X6.
(3) Prepare an outline audit approach for TT’s PPE balance at 31 August 20X6 which explains those
aspects of our audit of PPE where:
(a) we are able to test and place reliance on the operating effectiveness of controls;
(b) we will need expert input;
(c) audit software can be used to achieve a more efficient audit;
(d) substantive analytical procedures will provide us with adequate audit assurance; and
(e) tests of details should be performed during our interim audit visit.
We can discuss detailed audit procedures once we have agreed on the audit approach.”
Requirement
Respond to the instructions of Sue Jessop, the JSW engagement partner.
Total: 30 marks
Exhibit 1: PPE note from TT management accounts for the 9 months ended 31 May 20X6 –
prepared by TT financial controller
Freehold land
and buildings
Assets under
construction
Fixtures, fittings
and equipment
Total
£m
£m
£m
£m
129.5
2.8
29.5
161.8
–
21.8
4.1
25.9
13.5
(13.5)
–
–
––––––
–––––
(1.5)
143.0
11.1
32.1
186.2
At 1 September 20X5
6.1
–
15.4
21.5
Charge for the period
2.4
–
2.8
5.2
––––––
–––––
(0.9)
(0.9)
8.5
–––––
17.3
25.8
At 1 September 20X5
123.4
2.8
14.1
140.3
At 31 May 20X6
134.5
11.1
14.8
160.4
Cost or valuation
At 1 September 20X5
Additions
Assets coming into use
Disposals
At 31 May 20X6
(1.5)
Depreciation
Disposals
At 31 May 20X6
Carrying amount
138
Corporate Reporting
ICAEW 2022
The forecast for the three months ending 31 August 20X6 includes movements in PPE as follows:
Freehold land
and buildings
Assets under
construction
Fixtures, fittings
and equipment
Total
£m
£m
£m
£m
134.5
11.1
14.8
160.4
–
8.0
0.5
8.5
Depreciation charge for the
period
(0.8)
–
(1.0)
(1.8)
Revaluation gain
40.0
––––
––––
40.0
173.7
19.1
14.3
207.1
Cost or valuation
At 31 May 20X6
Additions
At 31 August 20X6
The revaluation gain shown above is an estimate as the valuation will not be completed until early
September 20X6.
Exhibit 2: Interim audit memorandum on PPE – prepared by Naomi Wills in June 20X6
This memorandum summarises relevant information from our prior-year audit file and discussions
with TT management to date to assist us in determining the risks associated with our audit of the PPE
balance at 31 August 20X6. Points noted are as follows:
•
TT’s freehold land and buildings comprise teaching facilities, including lecture theatres,
classrooms and specialised laboratories. TT also has surplus land on its campus.
•
No audit adjustments were raised in relation to PPE balances during our audit of TT for the year
ended 31 August 20X5.
•
Prior-year audit work concluded that controls over the TT purchasing function (including the
purchase and classification of PPE) were appropriately designed and operating effectively.
•
The TT register of PPE is maintained on a system which is separate from the main accounting
ledger. This system was developed by the TT finance department and uses spreadsheets run on a
laptop to calculate month-end journals and prepare year-end reports.
•
Freehold land and buildings are recognised at fair value in the financial statements. The most
recent valuation was performed by a professional valuer on 31 August 20X3. TT is planning to use
its own estate’s department to determine the value of freehold land and buildings at 31 August
20X6. A significant increase in value is expected as property values in the area have increased by
an average of 25%.
•
During August 20X6, the TT finance department plans to conduct a physical verification exercise
focussing on small equipment and IT assets, as these are considered the categories of PPE most
susceptible to theft or other loss.
•
TT has a number of major capital projects in progress during the financial year ending 31 August
20X6. The construction of a new business school was completed in May 20X6 at a total cost of
£13.5 million. Assets under construction include the refurbishment of two science laboratories
and the replacement of the IT system for recording attendance and marks.
Exhibit 3: Email from Karel Kovic to Sue Jessop – Request for advice and update
I need your advice on the financial reporting implications of a proposed agreement with Beddezy
plc, a UK company which runs an international chain of hotels. Under this agreement, which we plan
to finalise before 31 August 20X6, Beddezy will build both a hotel and a management training centre
using surplus land on our campus. An outline of the key terms of the proposed agreement is as
follows:
•
TT will sell land with a carrying amount of £3 million to Beddezy for £5 million.
•
Beddezy will build two separate buildings on that land: a hotel and a management training
centre. Each building will occupy half of the land bought by Beddezy.
ICAEW 2022
Real exam (July 2016)
139
•
The hotel will be operated by Beddezy. TT expects to use approximately half of the hotel capacity
for its visitors, but it has no commitment to do so. The prices of hotel rooms will be determined by
Beddezy based on market conditions and are expected to vary over time. TT has no rights to
acquire the hotel, or the land occupied by the hotel, at any stage in the future.
•
The management training centre will comprise lecture theatres and teaching facilities, with a wide
variety of uses. It will be built by Beddezy and is expected to cost £4 million to build, excluding
the cost of the land. It will be completed by 31 August 20X7. For 15 years from that date, TT will
have exclusive use of the management training centre to run training courses and conferences.
In return, TT will pay to Beddezy (on 1 September each year) £300,000 to cover both the rental of
the management training centre and the supply of Beddezy staff to clean and maintain the
building, provide security and run the main reception. These staff will work under the direction of
a building manager employed by TT. If TT employed the staff it would cost approximately
£100,000 per annum.
Update on other matters
Here is an update on some other matters before you begin your interim audit visit.
Harry George, our PPE accountant, is on long-term sick leave so his role is being covered by one of
the surveyors within the estates department. Key aspects of Harry’s role include maintaining our PPE
register and reviewing all accounting for major building projects.
Work on the two science laboratories refurbishment is progressing. Work on Laboratory 1 was
completed on 1 July 20X6 and the laboratory is now back in use.
Work on Laboratory 2 is also well advanced, but progress has slowed as new regulatory
requirements for some of our advanced engineering courses mean that TT needs to make changes
to the plans. The changes we need to make include additional building work to demolish and
reposition a number of dividing walls, which is expected to add approximately £100,000 to the total
cost
140
Corporate Reporting
ICAEW 2022
Real exam (November 2016)
45 Zego
You are Andy Parker, an audit senior working for Terry & Jonas LLP (TJ), a firm of ICAEW Chartered
Accountants. You have just been assigned to the audit of Zego Ltd, a 100% subsidiary of Lomax plc, a
listed company. Lomax and its subsidiaries operate in the aerospace sector. You have received the
following email from Grace Wu, the audit manager with overall responsibility for the Lomax Group
audit.
To:
Andy Parker
From:
Grace Wu
Date:
7 November 20X6
Subject: Zego audit for the year ended 31 October 20X6
As you are new to this audit, I have provided some background information about Zego and the
Lomax Group (Exhibit 1). The final audit starts next week.
Zego’s finance director, Carla Burton, went on maternity leave in September 20X6. Before she left,
Carla prepared a schedule of information relating to Zego’s non-current assets (Exhibit 2).
Our contact in Zego’s finance department is now Julia Brookes, a part-qualified accountant who
was appointed as the financial controller earlier this year. Julia has prepared draft financial
statements for the year ended 31 October 20X6 (Exhibit 3).
Two days ago, I met with Grahame Boyle, the Lomax Group finance director, and I attach notes
relating to Zego from that meeting (Exhibit 4).
Yesterday I had a meeting with Zego’s chief executive, Jurgen Miles, where we discussed some
important issues arising from the draft financial statements and the current risks and difficulties
that Zego is facing. I attach notes of that meeting (Exhibit 5).
Prepare the following documents.
(1) Notes explaining and, where possible, calculating adjustments that are required to Zego’s
draft financial statements for the year ended 31 October 20X6 (Exhibit 3).
Do not prepare revised financial statements, but you should clearly identify areas where more
information is required to make appropriate adjustments.
(2) A working paper setting out the results of preliminary analytical procedures. Include relevant
calculations and explain any issues arising for the audit from the analytical procedures. Your
calculations should take into account any adjustments that you have proposed to the financial
statements.
(3) A memorandum explaining the key audit risks for Zego. Set out the implications of these risks
for the financial statements for the year ended 31 October 20X6 of:
(a) Zego
(b) Lomax plc
(c) The Lomax Group
Requirement
Prepare the documents requested by Grace Wu, the audit manager.
Total: 40 marks
Exhibit 1: Background information about Zego and the Lomax Group – prepared by Grace Wu,
audit manager
The Lomax Group supplies communication products to the aerospace industry. The Lomax Group’s
strategy in recent years has involved the development of new markets and products, partly through
its own research and development activities and partly through acquisitions of related businesses.
ICAEW 2022
Real exam (November 2016)
141
Zego Ltd specialises in fibre-optic aerospace products. During 20X3 and 20X4 Zego’s research and
development team developed a product called Ph244. By 31 October 20X5, orders were received
for this product and the criteria had been fulfilled for recognition of a significant amount of
development expenditure as an intangible asset.
During November and December 20X5, Ph244 achieved expected sales targets. However, in January
20X6, Zego’s largest competitor announced the launch of a rival product which has proved superior
to Ph244. Zego’s sales of Ph244 since January 20X6 have fallen.
Planning materiality for Zego has been estimated at £250,000 and for the Lomax Group at £5 million.
We consider all adjustments under £10,000 to be clearly trivial.
The Lomax Group has committed to make a preliminary announcement of its earnings on 5 January
20X7.
Exhibit 2: Schedule of information relating to Zego’s non-current assets – prepared in September
20X6 by Carla Burton, Zego’s finance director
Analysis of forecast non-current assets between Ph244 related assets and other assets for the year
ending 31 October 20X6
Property, plant and equipment (PPE)
20X6
20X6
20X5
20X5
Forecast
Ph244
Forecast
Other PPE
Ph244
Other PPE
£m
£m
£m
£m
Balance at 1 November
5.8
10.0
0.3
8.9
Additions
1.8
2.2
6.0
1.5
(0.5)
(0.7)
(0.5)
(0.4)
7.1
11.5
5.8
10.0
20X6
20X6
20X5
20X5
Forecast
Ph244
Forecast Other
R&D
Ph244
Other R&D
£m
£m
£m
£m
7.2
8.2
–
7.9
–
1.6
7.2
2.3
(1.2)
(1.8)
–––
(2.0)
6.0
8.0
7.2
8.2
Depreciation
Balance at 31 October
Intangible asset: research and development (R&D)
Balance at 1 November
Additions
Amortisation
Balance at 31 October
In the above analysis R&D comprises capitalised development costs.
Recoverable amounts
(1) I believe it is unlikely that impairment losses will arise in respect of ‘Other PPE’ or ‘Other R&D’.
(2) Included in the £7.1 million forecast for Ph244 PPE at 31 October 20X6 is £6.2 million for a
specially-constructed building for the production of Ph244. It is likely that this building could be
sold for £8 million if it were adapted for more general use. Adaptation costs are currently
estimated at £1.5 million. This building could continue to be used in Zego’s business if future
research and development projects are undertaken.
142
Corporate Reporting
ICAEW 2022
(3) A market is likely to continue to exist for Ph244, although at a much reduced level of activity.
Estimated net cash inflows are:
Year ending 31 October 20X7: £1.4 million
Year ending 31 October 20X8: £1.0 million
Year ending 31 October 20X9: £0.5 million
We would need to discount these at around 8% per annum. No significant cash flows are expected to
arise after 31 October 20X9.
Exhibit 3: Zego Ltd – Draft financial statements for the year ended 31 October 20X6 – prepared by
Julia Brookes, Zego’s financial controller
Zego Ltd: Statement of profit or loss for the year ended 31 October 20X6
20X6
20X5
£m
£m
24.8
31.4
Cost of sales
(15.2)
(18.8)
Gross profit
9.6
12.6
(7.2)
(8.8)
2.4
3.8
(1.8)
(1.4)
0.6
2.4
Revenue
Operating expenses
Operating profit
Finance costs
Profit before tax
Income tax
Profit for the year
–––––
(0.6)
0.6
1.8
20X6
20X5
£m
£m
Property, plant and equipment
18.6
15.8
Intangible asset: R&D
14.0
15.4
32.6
31.2
12.0
7.8
4.6
5.8
–––––
3.6
16.6
17.2
49.2
48.4
4.0
4.0
17.0
16.4
21.0
20.4
Zego Ltd: Statement of financial position at 31 October 20X6
ASSETS
Non-current assets
Current assets
Inventories
Trade receivables
Cash and cash equivalents
Total assets
EQUITY AND LIABILITIES
Ordinary share capital
Retained earnings
ICAEW 2022
Real exam (November 2016)
143
Long-term liabilities: borrowings
20X6
20X5
£m
£m
20.6
22.4
0.6
0.6
21.2
23.0
3.8
4.4
–
0.6
3.2
––––
7.0
5.0
49.2
48.4
Deferred tax
Current liabilities
Trade payables
Tax payable
Overdraft
Total equity and liabilities
Zego Ltd: Statement of cash flows for the year ended 31 October 20X6
20X6
20X6
20X5
20X5
£m
£m
£m
£m
Cash flows from operating activities
Profit before tax
0.6
2.4
Depreciation
1.2
0.9
Amortisation
3.0
2.0
Finance costs
1.8
1.4
6.6
6.7
(4.2)
0.4
1.2
(0.7)
(0.6)
0.9
3.0
7.3
Interest paid
(1.8)
(1.4)
Tax paid
(0.6)
(0.7)
Adjustments for:
Change in inventories
Change in trade receivables
Change in trade payables
Cash generated from operations
Net cash from operating activities
0.6
5.2
Cash flows from investing activities
Purchase of property, plant and equipment
(4.0)
(7.5)
Investment in development assets
(1.6)
(9.5)
Net cash used in investing activities
(5.6)
(17.0)
Loan (repayment)/financing
(1.8)
13.0
Net change in cash and cash equivalents
(6.8)
1.2
3.6
2.4
(3.2)
3.6
Cash flows from financing activities
Opening cash and cash equivalents
Closing cash and cash equivalents
144
Corporate Reporting
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Exhibit 4: Notes of a meeting with Grahame Boyle, the Lomax Group Finance Director – prepared
by Grace Wu, audit manager
(1) Lomax paid £18 million for 100% of the shares in Zego on 1 August 20X3, resulting in £3.75
million of goodwill on consolidation. Zego’s performance until the year ended 31 October 20X5
was slightly worse than expected. In particular, the investment in Ph244 was a big
disappointment.
(2) Lomax made loans of around £10 million to Zego and Lomax’s main board directors have stated
that no more cash will be forthcoming to support Zego. From now on, Zego’s directors must raise
all of its finance from sources external to the Lomax Group.
(3) Lomax has no plans to sell its investment in Zego in the near future, but it is likely to take more
steps to exercise control.
Exhibit 5: Notes of a meeting with Jurgen Miles, Zego’s Chief Executive – prepared by Grace Wu,
audit manager
(1) The development of Ph244 has been expensive and a disappointment. At 31 October 20X6,
Zego had a balance of capitalised development costs of £6 million in respect of the Ph244
product technology (Exhibit 2). How much of this investment can be recovered is now uncertain.
Zego recently received an offer of £2.4 million for the Ph244 product technology from a non-UK
competitor. This offer includes the rights to use this intangible development asset and related
plant and equipment, but not the existing inventories or the specially-constructed production
building for Ph244.
The Zego board is considering the offer. It is likely that Zego would incur around £200,000 in
legal and related fees if it accepts the offer.
(2) Zego needs to renegotiate its bank finance. Of the long-term borrowings of £20.6 million in the
statement of financial position at 31 October 20X6, £11 million is owed to the company’s bank.
The remainder is owed to Lomax plc. Zego met a required repayment of £1 million to the bank
on 1 June 20X6. A further repayment of £1 million is due on 1 December 20X6.
The bank holds fixed and floating charges over Zego’s assets, and agreed covenants requiring
an interest cover ratio of at least 1.2 and the gearing ratio to be no higher than 130% (calculated
as net debt/equity). Although these covenants were not breached at 31 October 20X6, based on
the draft financial statements, the bank has called for a meeting which will take place next week.
It seems likely that further conditions will be imposed by the bank in order to continue the
existing level of financing. Jurgen thinks that additional financial support will be provided by
Lomax, and is hopeful that finance will be provided for a new project which will require
development investment of around £7 million. Jurgen knows that Lomax has stated that there
will no more finance available for Zego. However, he is confident that finance will, ultimately, be
provided by Lomax if it becomes really necessary.
(3) Of the inventories of £12 million at 31 October 20X6, £3.6 million relates to Ph244 products.
Production of Ph244 ceased in June 20X6. Sales of £1.4 million of Ph244 at a gross profit margin
of 40% are expected in the year ending 31 October 20X7.
46 Trinkup
Trinkup plc operates a chain of coffee shops which sell coffee, tea and cakes. Its accounting year end
is 30 September.
On 1 October 20X5, Trinkup acquired 80% of the ordinary share capital of The Zland Coffee
Company (ZCC), a coffee producer and distributor. Trinkup has no other subsidiaries.
You have recently started a new job as the financial accountant at Trinkup. The financial controller
gives you the following briefing:
“I need your help in preparing the consolidated financial statements for the Trinkup group now that
we have acquired ZCC.
ZCC operates in Zland, a country where the currency is the krone (K). Trinkup paid K350 million for its
investment in ZCC. As ZCC is not a listed company, Trinkup intends to use the proportion of net asset
method to value the non-controlling interest.
ICAEW 2022
Real exam (November 2016)
145
ZCC prepares its financial statements using Zland GAAP. Although there are similarities between
Zland GAAP and IFRS, there are differences in pension accounting and deferred tax is not
recognised under Zland GAAP. I have provided you with a working paper which contains the draft
financial statements for Trinkup and ZCC for the year ended 30 September 20X6, and notes on the
outstanding financial reporting issues (Exhibit).
I would like you to do the following.
(1) Set out and explain the appropriate adjustments for the outstanding financial reporting issues
(Exhibit) for the year ended 30 September 20X6 for:
(a) the individual company financial statements of Trinkup and ZCC; and
(b) the consolidated financial statements.
You should assume that the current tax charges are correct, but you should include any
deferred tax adjustments.
(2) Prepare Trinkup’s consolidated statement of comprehensive income for the year ended 30
September 20X6. Please use the adjusted individual company financial statements.
(3) Calculate Trinkup’s consolidated goodwill and consolidated foreign exchange reserve at 30
September 20X6. Show your workings.”
Requirement
Respond to the financial controller’s instructions.
Total: 32 marks
Exhibit: Working paper prepared by the financial controller
Draft statements of comprehensive income for the year ended 30 September 20X6
Notes
Trinkup
ZCC
£m
Km
Revenue
1
189.2
494.6
Cost of sales
1
(124.0)
(354.2)
65.2
140.4
–
Gross profit
Other operating income
2
15.7
Operating expenses
2
(35.0)
(188.8)
45.9
(48.4)
Profit/(loss) before tax
Tax
3
Profit/(loss) for the year
Other comprehensive loss
4
Total comprehensive income/(loss) for the year
(9.0)
––––––
36.9
(48.4)
––––––
(56.6)
36.9
(105.0)
Draft statements of financial position at 30 September 20X6
Notes
Trinkup
ZCC
£m
Km
127.3
244.5
64.8
–
Non-current assets
Property, plant and equipment
6
Financial asset – investment in ZCC
Amount owed by ZCC
5
36.4
–
Net current assets
1
30.8
101.0
259.3
345.5
146
Corporate Reporting
ICAEW 2022
Notes
Trinkup
ZCC
£m
Km
150.0
50.0
Retained earnings at 1 October 20X5
52.8
240.5
Profit/(loss) for the year
36.9
(48.4)
–––––
(56.6)
239.7
185.5
19.6
–
–––––
160.0
259.3
345.5
Equity
Share capital
Pension reserve
4
Non-current liabilities
Deferred tax
Long-term loan owed to Trinkup
5
Outstanding financial reporting issues
Notes
(1) In the year ended 30 September 20X6, Trinkup bought coffee from ZCC for K294 million. Trinkup
paid for the coffee on delivery and there are no trading amounts owing to ZCC at the year end.
At 30 September 20X6, Trinkup’s inventory includes £18 million of coffee bought from ZCC. ZCC
charges a mark-up of 30% on cost of goods sold.
(2) Trinkup’s ‘other operating income’ comprises a management charge to ZCC of K75.3 million for
management support given to ZCC. This charge was paid by ZCC on 30 September 20X6 and is
included in ZCC’s operating expenses. In future years there will be no management charge as it
is expected that ZCC will not require Trinkup’s management support.
(3) ZCC has a K100 million tax trading loss arising in the year ended 30 September 20X6. Zland tax
law allows tax trading losses to be carried forward only against future taxable trading profits.
ZCC expects to make a taxable trading profit next year. ZCC’s accountant has suggested that the
Zland tax authorities could investigate the K75.3 million management charge made by Trinkup
to ZCC and challenge the recovery of ZCC’s tax loss. The tax rate for Trinkup and ZCC is 20%.
(4) In October 20X5, ZCC set up a defined contribution pension scheme for its directors and has
accrued a contribution of K56.6 million for the year ended 30 September 20X6. This contribution
was paid to the pension fund on 15 October 20X6. Under Zland GAAP, pension contributions
are recognised directly in reserves through other comprehensive income. Tax relief for pension
contributions is claimed in the accounting year in which the cash is paid to the pension
company.
(5) On 1 April 20X6, Trinkup made an additional investment in ZCC when it provided a loan of K160
million to ZCC with interest payable at 5.25% annually in arrears. Trinkup does not require
repayment of this loan in the near future. No adjustments have been made for this loan other
than to include it in Trinkup’s non-current assets at the rate of exchange at 1 April 20X6. ZCC has
recognised the loan in non-current liabilities. No entries have been made in either company in
respect of the interest on the loan. Interest is taxed on an accruals basis.
(6) At 1 October 20X5, there were no differences between the fair value of ZCC’s net assets and the
carrying amounts, except for the valuation of land owned by ZCC. PPE included land, at cost, of
K156 million which had a fair value at 1 October 20X5 of K232 million. The directors do not
intend to sell the land. Zland GAAP does not allow revaluations. The following tax rules apply to
PPE in Zland: no tax is charged on disposals of PPE; and depreciation is an allowable expense
for tax purposes.
ICAEW 2022
Real exam (November 2016)
147
Other information
£1/K exchange rates were as follows:
1 October 20X5
£1 = K5.4
1 April 20X6
£1 = K4.4
30 September 20X6
£1 = K4.2
Average for the year to 30 September 20X6
£1 = K4.8
47 Key4Link
You are an audit manager, working for ICAEW Chartered Accountants, HJM LLP. You have just been
assigned to finalise the audit procedures for Key4Link Ltd for the year ended 30 September 20X6.
Key4Link installs media systems.
You receive the following briefing note from the engagement partner:
“Carey Knight, the senior manager working on the Key4Link audit, has had a cycling accident and will
be off work for two weeks. Our audit procedures on Key4Link need to be finalised this week as I have
a meeting with the finance director, Max Evans. I therefore need to understand the current position
regarding our audit work. I have provided you with background information on Key4Link (Exhibit 1).
Most of our audit procedures are complete and have been reviewed by Carey. Carey’s file note (
Exhibit 2), prepared a week ago, lists a number of matters which were at that time unresolved.
Updated information
I asked Kevin Jones, the audit assistant, to find out more information about the unresolved matters in
Carey’s file note (Exhibit 2). I have now received a memorandum (Exhibit 3) from Kevin.
I have also received an email from Max, the Key4Link finance director (Exhibit 4) responding to some
of the unresolved matters in Carey’s file note and asking for advice. I have not had time to review
Max’s email in detail, but I did note that he is keen for HJM to bid for Key4Link’s tax work.
Instructions
I would like you to review all of the documentation provided and complete the following tasks:
(1) The difference of £57,230 relates to a missed accrual for inventory delivered on 28 September
20X6 direct to a customer’s premises rather than to Key4Link. As the amount is not material, no
adjustment has been proposed.
(2) Farnell’s statement is dated 5 October 20X6. It includes an invoice for £160,000 dated 1 October
20X6 for engineering services. I discussed this invoice with Max Evans who referred me to Jan
Furby (CEO), as Farnell is owned by Jan and his brother. Jan told me that Farnell had performed
these engineering services in September 20X6. As this amount relates to services performed
before the year end and is material, I have proposed an audit adjustment to increase trade
payables and cost of sales.
(3) For each of the matters identified in Carey’s file note (Exhibit 2), taking into account the
procedures already undertaken by Kevin (Exhibit 3) and the observations in Max’s email (Exhibit
4), identify and explain:
(a) any additional financial reporting adjustments required, including journals; and
(b) any auditing issues and the additional audit procedures required in order to complete our
audit and reach a reasoned conclusion on the unresolved matters. Identify any further
information required from Key4Link. You do not need to consider any current tax or
deferred tax adjustments.
(4) Explain any ethical issues for HJM arising from Max’s request for HJM to bid for Key4Link’s tax
advisory work (Exhibit 4). Set out any actions that HJM should take.”
Requirement
Respond to the financial controller’s instructions.
Total: 28 marks
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Corporate Reporting
ICAEW 2022
Exhibit 1: Background information on Key4Link – provided by the engagement partner
At 30 September 20X6, the three directors of Key4Link had the following shareholdings:
Name
Position
% shareholding in
Key4Link
Number of £1
ordinary shares held
Jan Furby
CEO
50%
50,000
Max Evans
Finance director
25%
25,000
Carol Furby (wife of Jan)
Marketing director
25%
25,000
Key4Link’s draft financial statements for the year ended 30 September 20X6 recognise revenue of
£25 million and a profit before taxation of £3.2 million.
Planning materiality for the financial statements as a whole has been set at £150,000. Performance
materiality is £100,000. Each potential audit adjustment of £5,000 or over should be recorded for
further consideration.
From the audit procedures completed and reviewed to date, we have identified only one
uncorrected misstatement – an understatement of accruals by £50,000 due to an error in the
calculation of the sales commission payable for the quarter ended 30 September 20X6.
Key4Link uses the revaluation model for freehold land and buildings and the cost model for all other
non-current assets.
Exhibit 2: File note – prepared by Carey Knight, HJM senior manager
Set out below is the status of the Key4Link audit as at 28 October 20X6. Our audit procedures are
almost complete, but I have identified the following unresolved matters:
(1) The audit procedures on trade payables are largely complete but the supplier statements for
two key suppliers still need to be obtained and reconciled.
(2) Our audit procedures on the valuation of the company’s freehold premises are substantially
complete, but we are awaiting a final signed copy of the report from the external valuer, Mason
Froome. Our audit procedures to date have been based on a draft report which we understand
is unlikely to change. We concluded that specialist input from an auditor’s expert was not
required as a third party valuer with appropriate qualifications had performed the valuation.
(3) Max called me yesterday to say that he has adjusted the financial statements to include a
provision of £175,000 for restructuring costs. I have asked him to provide Kevin, the audit
assistant, with more details.
(4) A Key4Link staff member mentioned to me that some of the senior staff are expecting to
exercise share options as soon as the financial statements for the year ended 30 September
20X6 are signed off. This worried me as no accounting entries or disclosures have been made in
respect of any share option scheme. Therefore, I have asked Max to provide me with information
about the share options.
(5) I have reviewed the Key4Link draft annual report and I believe that the related party disclosures
may be incomplete. The only related party transaction identified is the remuneration paid to
Key4Link’s directors, which we have already audited. However, I know that the Key4Link CEO, Jan
Furby, has other business interests and I am therefore concerned that there may be other
transactions to disclose.
Exhibit 3: Update memorandum – prepared by Kevin Jones, HJM audit assistant
This memorandum records the audit procedures I performed during my visit to Key4Link on 4
November 20X6.
Supplier statements
I obtained supplier statements for the remaining two key suppliers, Barnes Communications (Barnes)
and Farnell Engineering (Farnell). I have summarised below how the statements reconcile to the
purchase ledger balance for each supplier at 30 September 20X6.
ICAEW 2022
Real exam (November 2016)
149
Supplier
Note
Balance per
purchase ledger
Included in
accruals
Difference
Balance per
supplier statement
£
£
£
£
Barnes
1
231,650
21,560
57,230
310,440
Farnell
2
148,000
–
160,000
308,000
Notes
(1) The difference of £57,230 relates to a missed accrual for inventory delivered on 28 September
20X6 direct to a customer’s premises rather than to Key4Link. As the amount is not material, no
adjustment has been proposed.
(2) Farnell’s statement is dated 5 October 20X6. It includes an invoice for £160,000 dated 1 October
20X6 for engineering services. I discussed this invoice with Max Evans who referred me to Jan
Furby (CEO), as Farnell is owned by Jan and his brother. Jan told me that Farnell had performed
these engineering services in September 20X6. As this amount relates to services performed
before the year end and is material, I have proposed an audit adjustment to increase trade
payables and cost of sales.
Restructuring costs
I obtained from Max details of the provision for restructuring costs. The board has decided to
outsource its delivery function, which will result in redundancy payments to its drivers and the
disposal of its fleet of trucks. The provision comprises:
£
Carrying amount of trucks at 30 September 20X6
Anticipated redundancy costs
100,000
75,000
175,000
I agreed the carrying amount of the trucks to the non-current asset register at 30 September 20X6,
which was tested by our audit procedures on non-current assets. I obtained calculations for the
anticipated redundancy costs; agreed the basis of the calculations to documented advice obtained
from Key4Link’s employment lawyer; and agreed all details for each affected employee to the
relevant employment records. I also ensured that all the drivers were included in the calculation.
Exhibit 4: Email from Max Evans, Key4Link finance director
To:
Engagement partner
From:
Max Evans
Date:
7 November 20X6
Subject: Audit of Key4Link for the year ended 30 September 20X6
Valuation of freehold premises
Carey asked me to contact our valuer, Mason Froome, for a final copy of his valuation report. I now
have a copy of this.
Jan told me that he had a conversation with Mason at the golf club last week and Mason has now
revised some of the assumptions in his draft report. The final valuation is now £1.2 million,
£200,000 higher than in the draft version of the report which you have audited. We will need to
adjust the financial statements for this.
150
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ICAEW 2022
Share option scheme
Carey also asked me about the company’s share option scheme. On 1 December 20X2, five key
members of staff, including me, were each granted options over 500 £1 ordinary shares. Each
option grants the right to acquire one share at an exercise price of £5 per share. These options
vest on 30 November 20X6, provided that the company makes a profit before tax of £2.6 million
or more for the year ended 30 September 20X6. As you know, this profit level is expected to be
achieved and all five of us are planning to exercise our options. I should have mentioned this
scheme to you before but forgot to do so, as there have been no cash entries to account for.
When the options were granted I calculated that each option had a fair value of £45.
Key4Link’s tax work
There is also one other matter I would like to discuss at our meeting. Our current tax advisors,
Blethinsock Priory, have told me that they intend to resubmit the company tax return for last year
as they have identified an error, leading to an underpayment of Key4Link’s tax. This seems
ridiculous to me – I cannot see why we need to draw attention to this error and I am not happy at
the prospect of paying more tax. I am considering changing advisors and would like HJM to bid
for this work. We are likely to need tax advice in the next few years, so there would be lots of work
for HJM.
ICAEW 2022
Real exam (November 2016)
151
152
Corporate Reporting
ICAEW 2022
Real exam (July 2017)
48 Konext
You work for Noland, a firm of ICAEW Chartered Accountants. Your firm is the auditor of Konext plc
and its subsidiaries. Konext is AIM-listed and is in the business communications sector. It sells mobile
devices to businesses and provides related software and repair services.
Noland has been asked to provide an assurance report on Konext’s interim financial statements for
the six months ended 30 June 20X4. You have been assigned to act as audit senior.
The recently-appointed Konext financial controller, Menzie Mees, has provided the following:
•
Extracts from the draft consolidated interim financial statements for the six months ended 30 June
20X4 (Exhibit 1)
•
An extract from the proposed management commentary drafted by the finance director, Jacky
Jones, who is an ICAEW Chartered Accountant (Exhibit 2)
•
A summary of financial reporting issues on which Menzie needs advice (Exhibit 3)
The engagement partner gives you the following briefing:
“I had a meeting with Jacky last week and she mentioned that there had been an information security
issue. She has made some disclosure about this in her proposed management commentary (Exhibit
2). I have asked her to send more details to you (Exhibit 4).”
Partner’s instructions
“I would like you to:
(1) explain the appropriate financial reporting treatment of the issues in the summary provided by
Menzie (Exhibit 3). Recommend appropriate adjustments, including journals, to the draft
consolidated interim financial statements for the six months ended 30 June 20X4;
(2) prepare a revised consolidated statement of profit or loss for the six months ended 30 June
20X4. Set out analytical procedures on the revenue and gross profit in the revised statement of
profit or loss. Identify potential risks of material misstatement arising from these analytical
procedures; and
(3) set out briefly the key audit procedures required to address each of the risks of misstatement
relating to revenue that you have identified. For these risks, set out separately the audit
procedures for:
(a) the interim financial statements; and
(b) the financial statements for the year ending 31 December 20X4.
(4) In respect of the details you receive from Jacky about the information security issue (Exhibit 4):
(a) evaluate the adequacy of the management commentary disclosure in relation to the
information security issue (Exhibit 2); and
(b) explain any ethical issues for Noland and set out the actions Noland should take.”
Requirement
Respond to the engagement partner’s instructions.
Total: 40 marks
Exhibit 1: Extracts from the draft consolidated interim financial statements for Konext for the six
months ended 30 June 20X4 prepared by Menzie Mees, financial controller
Consolidated statement of profit or loss for the six months ended 30 June 20X4
Six months ended 30 June
Revenue
Customised mobile
devices
ICAEW 2022
Notes
1
Year ended 31 Dec
20X4
20X3
20X3
£’000
£’000
£’000
30,300
20,700
51,700
Real exam (July 2017)
153
Six months ended 30 June
Revenue
Software services
Notes
1
Year ended 31 Dec
20X4
20X3
20X3
£’000
£’000
£’000
18,010
10,800
25,900
48,310
31,500
77,600
Other mobile devices
2
15,700
6,100
20,500
Mobile device repairs
3
2,100
5,200
7,800
Total revenue
66,110
42,800
105,900
Gross profit
39,541
21,625
54,025
Distribution costs
(3,823)
(3,122)
(8,547)
Administrative expenses
(6,563)
(6,054)
(13,755)
Operating profit
29,155
12,449
31,723
Finance costs
(1,280)
(1,550)
(4,125)
Profit before tax
27,875
10,899
27,598
Taxation
(2,000)
(2,180)
(5,520)
Profit for the period
25,875
8,719
22,078
Notes on operating segments
The type of mobile devices Konext sells are tablet computers. The following are the operating
segments used by the board to make strategic decisions:
(1) Konext develops a software service specific for each client which enables the clients’ employees
to access the clients’ business processes. In each case, the software service contract includes
data security and storage services. Konext buys mobile devices to which it uploads software
specific to the client business. It then sells the customised mobile devices to the client together
with a software service contract.
(2) Konext also sells other mobile devices to customers without customised software services.
(3) Mobile device repairs for Konext clients and other customers are undertaken by a division of
Konext called ‘Refone’ (Exhibit 3).
Exhibit 2: Draft management commentary for the six months ended 30 June 20X4 prepared by
Jacky Jones, finance director
Financial performance
The Konext group had a good financial performance across all operating segments in the first half of
20X4.
Total revenue increased by 54.5% to £66.11 million in comparison with the equivalent six-month
period ended 30 June 20X3. Konext’s sales of all mobile devices are seasonal, with 40% of mobile
devices delivered in the first six months of 20X4.
The directors forecast that total revenue for the year ending 31 December 20X4 will grow by 20% in
comparison with the year ended 31 December 20X3.
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The directors estimate that the number of devices to be delivered in the year ending 31 December
20X4 will be as follows:
20X4
20X3
Number of devices
Number of devices
Customised mobile devices
650,000
636,000
Other mobile devices
392,000
205,000
The combined gross profit margin on sales of customised mobile devices and software services has
increased from the 60% margin achieved in 20X3. The gross profit margins on sales of other mobile
devices and mobile device repairs have remained at 25% and 30% respectively.
Future prospects − New product, the Denwa+
Konext has signed a contract with JUI, a Japanese manufacturer of mobile devices. JUI will sell a new
device called the Denwa+ to Konext. This device will be sold exclusively by Konext to its customers
together with specific software and services where relevant. From August 20X4, sales of the Denwa+
will gradually replace sales by Konext of its current mobile device.
All the Denwa+ devices will be sold with a guarantee of a replacement device if the original is
damaged. This guarantee will apply regardless of the reason for the damage.
An advertising campaign for the launch of the new Denwa+ device began in May 20X4 in
anticipation of the sales starting in August 20X4.
Information security issue
An information security issue in a Konext subsidiary is under investigation. There is no evidence that
client accounts have been compromised.
Exhibit 3: Summary of financial reporting issues – prepared by Menzie Mees
I have set out below some financial reporting issues. I am not sure that the transactions are correctly
treated in the draft consolidated interim financial statements.
Revenue
In June 20X4, Konext received deposits totalling £2 million from clients for the new Denwa+ device.
The clients will make final payments totalling £13 million on delivery of the devices on 1 August
20X4. These clients will also receive a software service contract for two years and a free guarantee for
replacement should the device be damaged or faulty. Revenue in relation to these sales has been
recognised in full and presented in the interim financial statements as follows:
£’000
Customised mobile devices
10,000
Software services
5,000
15,000
An estimate of the cost of sales for these devices has been recognised in the interim financial
statements, assuming a gross profit margin of 60%.
Jacky, the finance director, said that we should recognise the Denwa+ sales in full because the
contracts were signed before 30 June 20X4 and are legally binding. Jacky added that, because the
devices will be delivered before 31 December 20X4, it does not make much difference whether we
recognise the revenue in the first or second half of the year.
Impairment of Refone
In January 20X2, Konext bought the trade and net assets of Refone, a mobile device repair business.
Refone’s cash flow is independent of other group cash flows and it is regarded as a separate cash
generating unit. At 30 June 20X4, the carrying amounts of the net assets of Refone were:
£’000
Property, plant and equipment
ICAEW 2022
7,550
Real exam (July 2017)
155
£’000
Brand name
4,175
Goodwill
1,975
Inventory
225
Receivables
1,950
15,875
Payables and other liabilities
(3,425)
Net assets
12,450
Recently Konext received an offer of £8 million after selling costs for the Refone trade and net assets.
Jacky told me that there is currently no plan to sell the business as the budget shows that it can
generate pre-tax cash flows of £1,200,000 per annum for the five years to 30 June 20X9. With a pretax annual discount rate of 5%, Jacky believes this business can be a success. However, I wonder if
there should be an adjustment to reflect the fall in value of the assets.
Deferred advertising costs
In March 20X4, Nika, an advertising company, was engaged to market the new mobile device,
Denwa+. On 30 June 20X4, Konext recorded invoices totalling £1 million from Nika for marketing
services delivered by that date by debiting the statement of profit or loss and crediting the Nika
payable account. Konext has agreed to issue 100,000 of its £1 ordinary shares to Nika, in full
settlement of the £1 million owed to Nika. The date of the share issue is expected to be 1 September
20X4.
However, Jacky has accounted for the £1 million as a prepayment in the interim financial statements
for the six months ended 30 June 20X4 by debiting prepayments and crediting the statement of
profit or loss. She explained to me that the final cost for the marketing services will depend on the
share price on 1 September 20X4 and it should, in any case, be matched against the deliveries of the
Denwa+, which start in August 20X4. I am concerned that this treatment is not correct.
Defined benefit scheme
Konext operates a defined benefit pension scheme for its senior executives and a defined
contribution scheme for other employees. Konext’s employer contributions to the schemes for the six
months to 30 June 20X4 have been charged to the interim statement of profit or loss as follows:
£’000
Defined benefit scheme
Defined contribution scheme
900
3,600
4,500
The service cost for the defined benefit scheme for the year ending 31 December 20X4 is expected
to be £2.8 million. The six-month interest rate to 30 June 20X4 on a selection of corporate bonds is
3.25%. The net benefit pension obligation of £2.3 million reported at 31 December 20X3 comprised
assets at fair value of £12.2 million and the present value of the obligations of £14.5 million. To date
the scheme has not paid out pensions or other benefits to beneficiaries of the scheme.
Jacky did not want to incur the cost of asking the scheme actuary to provide measurements of the
scheme’s assets and liabilities at 30 June 20X4 as there have been no significant changes since the
actuarial valuation at 31 December 20X3. For simplicity, Jacky told me to charge the employer
contributions to the interim statement of profit or loss and leave the net pension obligation
unchanged.
Exhibit 4: Confidential details about information security issue – prepared by Jacky Jones, finance
director
Last week the Konext IT department emailed me with details of a cyber attack on a Konext data
server in Poland. The data server held clients’ business details and bank accounts. It is possible that
data from 500 client accounts could have been accessed during the attack.
156
Corporate Reporting
ICAEW 2022
There is no evidence so far that client accounts were accessed, so we have not informed the clients.
However, there is some risk that clients could suffer a financial loss.
I have included a statement disclosing the security issue in my management commentary in the
interim financial statements. As this is still being investigated, I don’t want to say too much publicly
about it at the moment. Further details will be announced in the year-end consolidated financial
statements.
49 Elac
Elac plc is listed on the London Stock Exchange and supplies metal-framed windows for use in
industrial buildings. Elac has investments in several wholly-owned subsidiaries.
You are Elac’s financial accountant and you report to Elac’s finance director. You have just returned to
work after a holiday. Your assistant, Daniel, an unqualified accountant, has prepared the first draft of
the consolidated financial statements for the year ended 31 May 20X7 using briefing papers
prepared by Elac’s finance director. These briefing papers include details of the following significant
matters:
•
The increase in Elac’s investment in Fenner Ltd and transactions with Fenner Ltd (Exhibit 1)
•
Trading outside the UK (Exhibit 2)
The first draft of Elac’s consolidated statement of profit or loss for the year ended 31 May 20X7 and
its consolidated statement of financial position at that date (Exhibit 3) exclude the results and
balances of Fenner Ltd. Fenner has prepared draft financial statements for the year ended 30 June
20X7. These are shown in a separate column in Exhibit 3.
Exhibit 3 also includes Daniel’s notes showing the adjustments that he has made to Elac’s draft
consolidated financial statements. The notes explain areas where he is uncertain about the
appropriate financial reporting treatment.
Elac’s finance director has asked you to draft a working paper in which you:
(1) explain the financial reporting adjustments required in respect of the matters described in the
briefing papers (Exhibits 1 and 2) and in Daniel’s notes (Exhibit 3). Include relevant journal
entries. Identify any further information required. Ignore the effects of accounting adjustments
on taxation; and
(2) prepare Elac’s revised consolidated statement of profit or loss for the year ended 31 May 20X7
and consolidated statement of financial position at that date. These should include the
adjustments identified in (1) above.
Requirement
Prepare the working paper requested by Elac’s finance director.
Work to the nearest £0.1 million.
Total: 30 marks
Exhibit 1: Elac’s investment in Fenner Ltd – briefing paper prepared by Elac’s finance director
Fenner, an important supplier to Elac, manufactures toughened glass. In 20X4, Elac bought 5% of the
ordinary share capital of Fenner for £50 million. This investment is recognised at cost (which
approximates to its fair value) in Elac’s draft consolidated statement of financial position at 31 May
20X7 (Exhibit 3).
On 1 February 20X7, Elac bought an additional 20% of the ordinary share capital of Fenner for £350
million in cash from one of Fenner’s principal shareholders. This payment was debited to a suspense
account. The additional investment entitles Elac to appoint a director to Fenner’s board. The
remaining 75% of Fenner’s shares are held equally by three institutional investors, each of which is
entitled to appoint a director to the Fenner board.
Fenner has made losses during its financial years ended 30 June 20X6 and 30 June 20X7 but it has
continued to pay dividends throughout this period. Fenner paid a dividend of 20p per share on 1
October 20X6 and a dividend of 40p per share on 30 April 20X7.
ICAEW 2022
Real exam (July 2017)
157
Trading with Fenner
Fenner sells goods to Elac at cost plus a mark-up of 20%. During Elac’s financial year ended 31 May
20X7, Fenner supplied goods to Elac at a price of £145.2 million. Trade takes place evenly
throughout the year. At 31 May 20X7, Elac’s inventories included goods supplied by Fenner at a price
of £35.0 million and Elac’s trade payables included an amount of £37.6 million due to Fenner.
Exhibit 2: Trading outside the UK – briefing paper prepared by Elac’s finance director
Until recently, all Elac’s sales were to the UK construction industry. During the financial year ended 31
May 20X7, the group started trading with construction companies in Otherland.
Otherland contract
The currency of Otherland is the Otherland dollar (O$).
In September 20X6, an agent for several construction companies in Otherland agreed a one-year
contract with Elac to supply a single type of office window at a price of O$5,000 per window. The
contract started on 1 January 20X7 and Elac expects to make a gross profit margin of approximately
30%, which is a much larger margin than UK sales.
The contract includes a commitment by Elac to pay the agent a commission of 5% of sales value in
O$, provided that total sales for the calendar year 20X7 exceed 16,000 windows. If total sales for
20X7 are below 16,000 windows the rate of commission is reduced to 3%. The commission is
payable annually in arrears.
Average monthly sales for the five-month period from 1 January 20X7 to 31 May 20X7 were 1,600
windows and this level of sales is expected to continue for the rest of the 20X7 calendar year.
Exchange rates:
Spot rate at 1 January 20X7
£1 = O$2.2
Spot rate at 31 May 20X7
£1 = O$2.4
Forward rate (at 1 June 20X7) for 31 December 20X7
£1 = O$2.8
Exhibit 3: Draft financial statements
Draft statements of profit or loss for the year
Elac: consolidated
Additional (excluding Fenner) to 31
information
May 20X7
Fenner to 30
June 20X7
£m
£m
1,855.4
382.4
(1,482.9)
(272.0)
Revenue
Cost of sales
1
Gross profit
Operating expenses
Investment income
2
372.5
110.4
(270.8)
(91.2)
3.6
–
Finance costs
(9.4)
(77.7)
Profit/(loss) before tax
95.9
(58.5)
(19.1)
12.0
76.8
(46.5)
Income tax
Profit/(loss) for the year
158
Corporate Reporting
ICAEW 2022
Draft statements of financial position
Elac: consolidated
Additional (excluding Fenner) to 31
information
May 20X7
Fenner to 30
June 20X7
£m
£m
1,799.7
1,180.0
Investments
456.0
–
Suspense account
350.0
–
243.8
43.2
238.9
88.8
16.4
––––––
3,104.8
1,312.0
150.0
10.0
2,255.4
208.4
388.3
1,003.2
305.6
65.6
5.5
24.8
3,104.8
1,312.0
Non-current assets
Tangible assets
Current assets
Inventories
Trade receivables
1
Cash
Total assets
Equity
Ordinary share capital (£1 shares)
Reserves
Long-term liabilities
Current liabilities
Trade payables and accruals
Provisions and borrowings
Total equity and liabilities
1
Additional information for Elac’s draft consolidated financial statements for the year ended 31 May
20X7 – prepared by Daniel
(1) Cost of sales
Cost of sales includes a provision relating to the Otherland contract. I have classified this as an
onerous contract because of the exchange losses I expect to occur between 31 May and 31
December 20X7. I have calculated expected sales over this period as O$56 million (7 months ×
1,600 × O$5,000). Using the 1 January 20X7 exchange rate, £ equivalent sales would have been
£25.5 million, but at the 31 December 20X7 forward rate, the £ equivalent sales will be only £20
million. I have recognised a provision of £5.5 million under current liabilities.
Elac’s trade receivables at 31 May 20X7 include £4.8 million due from Otherland customers. This is
the equivalent of O$10.1 million translated at O$2.1 = £1, which was the average exchange rate
during the period 1 January 20X7 to 31 May 20X7.
I have not recognised any accrual for agent’s commission as this is a contingent liability depending
on performance, and should therefore be disclosed only as a note to the financial statements.
(2) Investment income
Investment income includes the dividends received from Fenner on 1 October 20X6 (£100,000) and
on 30 April 20X7 (£1 million). I have made no adjustments in respect of trading with Fenner.
50 Recruit1
You are an audit manager working for Hind LLP, a firm of ICAEW Chartered Accountants with offices
in several countries. You have been assigned to the group audit of Recruit1 plc for the year ended 30
April 20X7. Recruit1 is the parent of an international group of companies engaged in executive
ICAEW 2022
Real exam (July 2017)
159
recruitment and training. You receive a briefing from the engagement partner on the Recruit1 group
audit:
“Our scoping and materiality planning summary (Exhibit 1) provides an overview of the audit
procedures planned at each entity within the Recruit1 group.
Our audit is nearly complete but I need your help with outstanding matters relating to Recruit1’s
subsidiaries in the countries Arca and Elysia. These subsidiaries are R1-Arca Inc and R1-Elysia Ltd.
The local currency in Arca is the Arcan dollar (A$) and in Elysia is the Elysian dollar (E$).
Last week I received a reporting memorandum from the Hind audit team in Arca (Exhibit 2) which I
need you to review. I was relieved to receive their report as the team has not replied to any of our
other requests for information.
During audit planning, R1-Elysia was assessed as an immaterial subsidiary. However, our review
procedures, completed last week, identified that the company bought a property during the year,
resulting in material property and loan balances at 30 April 20X7. I asked the audit senior to find out
more about this property transaction and she has provided additional information (Exhibit 3).
Partner’s instructions
(1) I would like you to review the reporting memorandum from the Hind audit team in Arca (Exhibit
2) and for each account identified:
(a) describe any weaknesses in the audit procedures;
(b) explain any potential financial reporting and audit issues; and
(c) set out further audit procedures that either the UK group audit team or the Hind team in
Arca should perform, and identify any additional information needed for these procedures.
(2) In respect of R1-Elysia’s property transaction and loan, review the further information provided
(Exhibit 3) and:
(a) explain the financial reporting implications for the consolidated financial statements of
Recruit1 for the year ended 30 April 20X7. Recommend appropriate accounting
adjustments; and
(b) set out any additional audit procedures that should be performed.”
Requirement
Respond to the partner’s instructions.
Total: 30 marks
Exhibit 1: Scoping and materiality planning summary for the Recruit1 group audit for the year
ending 30 April 20X7 (Prepared by Hind UK group audit team in January 20X7)
Recruit1 has trading subsidiaries, located in many countries around the world. All subsidiaries are
wholly owned by Recruit1. All subsidiaries report under IFRS.
The Hind UK audit team is responsible for the audit of the parent company, Recruit1 plc, the Recruit1
UK subsidiaries and the audit of the consolidated financial statements. The audits of Recruit1 plc’s
non-UK subsidiaries are performed by Hind audit teams in the countries where the subsidiaries are
located.
Group planning materiality has been determined at £1.2 million. Scoping and component materiality
are shown below:
Entity
Level of component materiality
Audit procedures to be
performed by Hind
Recruit1 plc – the parent
company
£850,000
UK audit team
UK subsidiaries
Materiality will be determined
separately for each.
UK audit team
R1-Arca
This entity is not required to issue
audited financial statements and so
work will be performed using
component materiality of £300,000
Hind audit team in Arca to
perform audit procedures
Results are expected to be
material to the Recruit1
160
Corporate Reporting
ICAEW 2022
Entity
Level of component materiality
group.
(A$600,000 as at 31 December
20X6).
Other non-UK subsidiaries
(including R1-Elysia)
£500,000
Results are not expected to be
material to the Recruit1
group.
Audit procedures to be
performed by Hind
UK audit team to perform
review procedures for
unexpected fluctuations
or material balances
Exhibit 2: Reporting memorandum received from the Hind audit team in Arca on 14 July 20X7
The table below sets out the audit procedures we have performed on the financial statements of R1Arca for the year ended 30 April 20X7 and highlights matters arising. All accounts have been agreed
to the consolidation schedules provided to Recruit1. These are reported in A$. At 30 April 20X7, the
exchange rate was £1 = A$1.8.
Account
A$’000
Notes on audit procedures and matters arising
Revenue
11,172
Selected a sample of items recorded within revenue
and agreed them to invoices and either to the
receivables ledger as at 30 April 20X7 or to a cash
receipt. No exceptions were noted.
Staff costs
(4,924)
Agreed the total staff costs to payroll schedules
provided by the service company which processes the
payroll for R1-Arca.
Other operating expenses
(2,652)
Agreed a sample of items to supporting
documentation, ensuring that each item is a valid
business expense, recorded in the correct period and
correctly classified within operating expenses. No
exceptions were noted.
Interest income
350
No audit procedures carried out as below materiality
of A$600,000.
Profit before taxation
3,946
Taxation
(1,715)
Profit for the year
2,231
Retained earnings at 1 May
20X6
4,238
Agreed to draft tax computation prepared by R1Arca’s tax advisors. Checked that current tax payable is
correctly calculated as taxable profit of A$4.9 million
at the Arcan corporate tax rate of 35%.
Reconciled to prior-year financial statements. Retained
earnings as reported to Recruit1 as at 30 April 20X6
were A$6,488,000.
The difference of A$2,250,000 is due to the reversal of
revenue which was incorrectly included in the
reporting pack for the year ended 30 April 20X6 as it
relates to recruitment services provided in May and
June 20X6.
This error was discovered during the preparation of
the financial statements for the year ended 30 April
20X7.
Retained earnings at 30 April
20X7
ICAEW 2022
6,469
Real exam (July 2017)
161
Account
A$’000
Notes on audit procedures and matters arising
Property, plant and
equipment
1,065
In accordance with group policy, property, plant and
equipment is measured at cost and depreciated over
its useful life.
Movements in this account during the year ended 30
April 20X7 relate to immaterial additions and
depreciation.
As all movements are below component materiality of
A$600,000, no further audit procedures have been
performed.
Trade receivables
2,987
This balance was agreed to a detailed list of
receivables which was reviewed for any related party
or unusual balances. No such items were noted.
A sample of balances with a total of A$453,000 was
selected to be tested for agreement to cash received
after the year end.
Of the sample, A$198,000 has been received to date.
As the unpaid element is below component
materiality of A$600,000, no further audit procedures
have been performed.
Other receivables and
prepayments
592
No audit procedures carried out as below component
materiality of A$600,000.
Cash and short- term
investments
4,143
Agreed to bank statements or investment
confirmations.
Total assets
8,787
Trade payables and accruals
2,218
The only material balance within this account is
A$1,715,000 relating to tax payable – this is discussed
above.
Share capital
100
No audit procedures carried out as below component
materiality of A$600,000.
Retained earnings at 30 April
20X7
6,469
Total equity and liabilities
8,787
Exhibit 3: Further information on property transaction and loan in R1-Elysia – prepared by audit
senior
I discussed the increase in property and loan balances in R1-Elysia with the group finance director as
I was concerned that the carrying amounts are incorrect.
On 30 September 20X6, R1-Elysia bought a property for E$6 million with a bank loan of E$6 million
taken out on the same date. The loan is repayable in full after five years and interest is payable
annually in arrears at a fixed rate of 6% per annum. In Elysia, a tax deduction for interest is available
only when the interest is paid.
After buying the property, R1-Elysia converted it into a training facility. The conversion took six
months and was completed on 1 April 20X7 when the property was ready for use.
From 1 April 20X7, R1-Elysia has used the property to run training courses for its clients. Also, training
rooms are rented to third parties on a daily or weekly basis. The rental income includes the use of all
facilities, together with some administrative support. Catering is provided as an optional service. As
the property generates rental and other income, it has been classified as an investment property in
the consolidation reporting pack submitted by R1-Elysia. The property is expected to have a useful
life of 25 years.
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The carrying amounts of the property and the loan in the consolidation reporting pack at 30 April
20X7 are as follows:
Property
E$’000
Loan
E$’000
6,000
6,000
Initial purchase transaction on 30 September 20X6
Conversion and start-up costs incurred (funded from cash)
External contractor costs
4,200
Allocated salary costs of R1-Elysia employees
850
Marketing costs
900
Security, insurance and other running costs incurred while the
building was empty
750
Interest for 7 months to 30 April 20X7
210
Fair value gain on property due to increase in Elysian property
prices in the 7 months to 30 April 20X7
Carrying amounts in the consolidation reporting pack at 30 April
20X7
500
–––––
13,200
6,210
Under Elysian tax rules, capital allowances of 50% of the cost of buying business property, including
all conversion and marketing costs, are given in the year of purchase. Therefore capital allowances of
E$6.35 million, based on a total cost before fair value changes of E$12.7 million, have been taken
correctly into account in calculating the Elysian current tax charge. No tax deduction is given for
depreciation.
No other accounting entries have been made in respect of the current or deferred tax on the
property or the loan. The tax base does not change if the property is subsequently revalued for
accounting purposes. The Elysian corporate tax rate is 35%.
Spot exchange rates are as follows:
30 September 20X6 £1 = E$4.0
30 April 20X7 £1 = E$3.6
Average for seven months from 1 October 20X6 to 30 April 20X7 £1 = E$3.8
ICAEW 2022
Real exam (July 2017)
163
164
Corporate Reporting
ICAEW 2022
Real exam (November 2017)
51 EF
You are an audit senior working for a firm of ICAEW Chartered Accountants, MKM LLP. You have been
assigned to the audit of EF Ltd, a UK company which sells home furnishings.
In July 20X7, your team completed audit planning and interim audit procedures on EF for its year
ending 31 December 20X7. You prepared a file note (Exhibit 1) outlining the key elements of your
planned audit approach.
The MKM audit manager for the EF audit engagement gives you the following briefing:
“On 31 August 20X7, EF was acquired by a listed multinational company, MegaB plc. I have received
an email from the EF chief financial officer (CFO) (Exhibit 2) which provides information that may
affect our audit plan. MegaB has told the CFO to make some adjustments to EF’s financial statements
for four matters. These matters are included in an attachment to the email.
MegaB is a client of MKM’s consulting division and we know its finance team well. We have not done
much work for the MegaB group in the last 12 months but MKM is currently tendering for a large
consultancy contract with MegaB which MKM is keen to win. It is therefore important that we perform
well on the EF audit this year.
MegaB is audited by Lewis-Morson LLP and today I received a telephone call from the Lewis-Morson
group audit partner. The telephone call raises issues for our audit approach and I have summarised it
in a brief note (Exhibit 3).
Instructions from the MKM audit manager
“I need to respond to the CFO’s email (Exhibit 2) and consider its implications for the EF audit. To
help me, please prepare a briefing note in which you:
(1) Explain, for each of the four matters in the email attachment (Exhibit 2), the appropriate financial
reporting treatment in the financial statements of EF for the year ending 31 December 20X7.
Identify any additional information you need to finalise the accounting entries required. Ignore
any adjustments for current and deferred taxation.
(2) Identify and explain the changes that we need to make to each element of the planned audit
approach summarised in the file note (Exhibit 1). You should also consider any additional key
areas of audit focus and risk using all the information available.
(3) Explain any ethical matters which MKM now needs to consider in respect of the 20X7 EF audit
and any actions that MKM should take.”
Requirement
Respond to the MKM audit manager’s instructions.
Total: 40 marks
Exhibit 1: File note – planned approach for EF audit – prepared by audit senior in July 20X7
The key elements of our planned audit approach for EF for the year ending 31 December 20X7 are
set out below.
We have done the following:
•
Agreed engagement terms and an audit fee of £60,000, giving us an inflationary increase from
the prior year.
•
Established planning materiality at £800,000 based on a forecast profit after tax of £16 million for
the year ending 31 December 20X7.
•
Considered factors affecting the inherent risk associated with the client, noting:
– no new business risks;
– no unusual pressures on management; and
– no factors which cause us to question the effectiveness of the general control environment.
ICAEW 2022
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165
•
Assessed the risk of material misstatement, identifying the following balances and assertions as
key areas of audit focus:
– The accuracy and cut-off of revenue recognition
– The valuation of future obligations for the defined benefit pension scheme
•
Evaluated the design of the controls over revenue and trade receivables. We also performed
testing to ensure that these controls had been implemented and we also tested their operating
effectiveness for the six months ended 30 June 20X7. No exceptions were identified from this
work so we plan to rely on the operating effectiveness of controls over revenue and trade
receivables.
•
Scheduled our final audit visit for March 20X8 in line with the timing of our audit procedures in
previous years. During this final visit, we plan to update our testing of operating effectiveness to
cover the operation of controls in the six months ending 31 December 20X7.
Exhibit 2: Email from EF CFO
To:
MKM audit manager
From:
EF CFO
Date:
6 November 20X7
Subject: Information and attachment including adjustments required by MegaB
Change in ownership of EF
EF was acquired by MegaB on 31 August 20X7. As a result, there have been some changes in EF’s
staff, systems and procedures. With effect from 1 November 20X7, responsibility for routine
accounting was transferred to the MegaB shared service centre. This now processes all our
accounting transactions. As EF CFO, I still have overall responsibility for the EF financial
statements. I am responsible for reviewing the draft financial statements and for processing
journal entries for judgemental, complex or one-off items.
MegaB does not get involved in detailed operational matters but expects the EF board to achieve
the forecast results. MegaB has made it clear that EF will face cuts in staff if we fail to do so.
In the future, it may make sense to appoint the MegaB group auditor as the EF auditor. However,
the board has decided that it would like MKM to complete the audit of EF for the year ending 31
December 20X7. Cost control is very tight under our new owners so I am unlikely to be able to
approve any increase in the £60,000 audit fee already agreed.
Pension scheme
MegaB asked its actuary to provide a valuation of the EF defined benefit pension scheme at 31
August 20X7, as it questioned the assumptions that EF’s actuary used last year. Because of
changes in the actuarial assumptions used, the revised valuation resulted in a reduction of £10.5
million in the net pension obligation recognised at 31 August 20X7. The MegaB auditor has
reviewed the actuarial calculations and is happy with them.
The MegaB actuary has confirmed that he expects his actuarial assumptions to be very similar at
31 December 20X7 and he plans to use the same assumptions at that date.
Re-organisation and bonus costs
Because of MegaB’s acquisition of EF, there are several employees whose services will not be
required. A redundancy programme was announced on 1 October 20X7 and 12 members of the
finance and administration staff have already left the company, together with three directors and
six other members of senior management. They received redundancy payments totalling £1.25
million, which will be recognised in our October 20X7 management accounts.
A further 50 members of staff are due to leave on 28 February 20X8, by which time we hope to
have signed off our financial statements. They will receive redundancy payments totalling
£635,000.
There is a new executive bonus scheme for me and the two other remaining directors of EF. If the
company exceeds its forecast operating profit of £34 million, we will each receive a bonus
payment of £100,000. I have not accrued for this cost, as the bonus will be payable in 20X8.
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Financial performance
I summarise below key financial data from EF’s management accounts for the nine months ended
30 September 20X7. The results for October 20X7 are not yet available. I hope to provide these in
early December 20X7.
9 months ended
30 September 20X7
Actual
Year ending
31 December 20X7
Updated forecast
Year ended
31 December 20X6
Actual
£m
£m
£m
175.0
274.3
214.0
Gross profit
51.0
76.2
64.2
Operating profit
18.9
34.0
21.4
Profit after tax
14.7
26.0
16.1
Net assets
53.1
74.9
38.4
Revenue
Performance for the eight months to 31 August 20X7 was in line with the forecast and the
previous year.
In September 20X7, revenue increased by around £15 million because of sales of EF products to
MegaB subsidiaries outside of the UK. These sales represent our first international revenue and
are expected to continue at the same level for the rest of the year. The gross margin is lower than
on EF’s other sales, as the prices charged to group companies are lower than those charged to
third parties. I have updated the whole forecast to reflect these sales.
There have been no changes to costs and revenue other than the additional international sales.
Attachment to CFO’s email – adjustments required by MegaB
Bob Wright (the MegaB group financial controller) has reviewed EF’s accounting policies and
estimates at the acquisition date, 31 August 20X7. He has told me to adjust EF’s financial
statements for the year ending 31 December 20X7 for the four matters set out below.
Brand
At 31 August 20X7, an expert valued the EF brand at £20 million and Bob expects to see this asset
in the EF statement of financial position. We have not previously recognised any value for the
brand and I am unsure as to what costs were incurred to acquire or develop it.
Goodwill
MegaB has recognised goodwill of £11.2 million relating to the EF business and Bob wants me to
recognise this in the EF statement of financial position.
Investment property
MegaB has a policy of measuring both its investment properties and all other land and buildings
at fair value and it requires EF to adopt the same policy, although we have historically used the
cost model for all property, plant and equipment (PPE).
MegaB valued EF’s PPE as at 31 August 20X7. There was no difference between the carrying
amount and fair value of PPE, except for EF’s head office property. The carrying amount of the
property at 31 August 20X7 was £1.3 million, including land at £0.7 million. The property had a
remaining useful life of 30 years at that date.
Because there are plans for EF to vacate the head office property and to rent it to tenants, MegaB
wants us to treat it as an investment property. At 31 August 20X7, MegaB valued the head office
property at £3.7 million, including land at £0.7 million, based on anticipated rental income.
The head office property has three identical floors and each floor can be rented to tenants
separately. Until 1 September 20X7, EF occupied the whole building. At that date, it signed a 10year lease with a tenant for the third floor, at an annual rental of £40,000. EF continues to occupy
the other two floors.
ICAEW 2022
Real exam (November 2017)
167
Trade receivables allowance
Historically, EF has taken the IFRS 9 simplified approach for trade receivables, measuring the loss
allowance at the lifetime expected credit losses from initial recognition, which typically gave a
small total allowance. Bob has now also asked us to apply the three stage approach that, at 31
August 20X7, would give us an impairment allowance of £1.35 million. An impairment allowance
calculated on the same basis as at 31 December 20X6 would have amounted to £800,000. The
trade receivables do not contain a significant financing component.
I would welcome your advice as to what, if anything, we should adjust. I am not sure Bob has really
considered the effect on EF’s single company financial statements. The above four matters are not
recognised in EF’s management accounts.
Exhibit 3: Note of my telephone call with Petra Newton – prepared by MKM audit manager
I received a telephone call today from Petra Newton, the group audit partner from Lewis-Morson,
MegaB’s auditor.
Lewis-Morson LLP expects to sign off the group audit opinion by 28 February 20X8.
EF is a significant component of the MegaB group. By 15 February 20X8, Lewis-Morson needs us to
do a full audit of EF’s financial statements for the year ending 31 December 20X7, based on the
component materiality of £3 million, and to prepare a reporting memorandum to Lewis-Morson.
The partner confirmed that Lewis-Morson has completed audit procedures on the defined benefit
pension scheme obligations at 31 August 20X7, so we may not need to perform separate procedures
on these. He will send an email confirming the work done and that no issues were noted.
It is likely that, during 20X8, the EF business will be transferred into an existing MegaB subsidiary. As
a result, the audit this year may be MKM’s last for EF. The MegaB board is interested only in ensuring
that there is no material misstatement at group level. Therefore, it expects MKM to adopt component
materiality of £3 million for the single company EF audit. The MegaB board sees no great value in the
single company audit and just wants it to be completed as quickly and efficiently as possible.
52 Wayte
You are Damian Field, an ICAEW Chartered Accountant and the financial controller at Wayte Ltd, a
manufacturer of industrial weighing machines. The ordinary shares in Wayte are held equally by four
members of the Benson family, who are also the directors of the company. You have just returned to
work after a period of sick leave. During your absence, Wayte employed an unqualified accountant,
Jenny Smith, on an interim contract.
On your return to work, you received the following note from Gerard Benson, the production director
who is your line manager.
Wayte needs to expand production facilities and requires a loan of £10 million from the bank to
invest in plant and machinery. The bank has asked for information to support Wayte’s application
for this loan.
Jenny has prepared a draft information schedule as requested by the bank (Exhibit 1). She has
also prepared a draft statement of cash flows for the year ended 30 September 20X7 (Exhibit 2).
Jenny told me that her work is incomplete and adjustments are still required. She has left some
handover notes for you (Exhibit 3).
I believe that Wayte will have no problem obtaining bank finance because profitability is high and
increasing, liquidity is generally good and there is ample security for the loan.
Instructions
I would like you to do the following:
(1) Explain the financial reporting adjustments required for the year ended 30 September 20X7
in respect of the issues identified in Jenny’s handover notes (Exhibit 3). Include journal entries
for each adjustment.
(2) Prepare a revised information schedule for the bank (Exhibit 1) including your financial
reporting adjustments to both the figures and the key ratios.
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(3) Prepare a report for the board in which you analyse and interpret the financial position and
performance of Wayte using your revised information schedule and the draft statement of
cashflows (Exhibit 2). Provide a reasoned conclusion on whether the bank is likely to advance
the £10 million loan.
Requirement
Respond to Gerard Benson’s instructions.
Total: 30 marks
Exhibit 1: Wayte draft information schedule requested by the bank – prepared by Jenny
Performance information for the year ended 30 September
20X7
20X6
£’000
£’000
Revenue
35,400
34,500
Gross profit
10,020
9,660
6,320
3,990
20X7
20X6
£’000
£’000
35,670
33,560
8,490
8,730
27,180
24,830
Cash generated from operations
Extracts from statement of financial position at 30 September
Total assets
Total liabilities
Equity
Net debt
450
Non-current assets available as security at 30 September 20X7
20X7
£’000
Land
1,000
Buildings
18,200
Financial assets: fair value through OCI
430
Financial assets: fair value through profit or loss
192
Plant and equipment
8,678
28,500
Key ratios
20X7
Gearing (Net debt/equity) × 100
1.7%
Gross profit margin
28.3%
Return on capital employed (Operating profit/net debt + equity) × 100
16.0%
ICAEW 2022
Real exam (November 2017)
169
Exhibit 2: Wayte draft statement of cash flows for year ended 30 September 20X7 – prepared by
Jenny
Cash generated from operations (Note)
20X7
20X6
£’000
£’000
6,320
3,990
(810)
(790)
5,510
3,200
Tax paid
Net cash from operating activities
Cash flows from investing activities
Dividends received
Purchase of PPE
30
(2,408)
(2,656)
(192)
(430)
(2,570)
(3,086)
Dividends paid
(3,000)
–
Directors’ interest-free loan accounts repaid
(1,000)
––––––
(4,000)
––––––
(1,060)
114
Cash and cash equivalents brought forward
610
496
Cash and cash equivalents carried forward
(450)
610
4,440
4,040
(30)
–
1,100
690
Purchase of financial asset
Cash flows from financing activities
Net change in cash and cash equivalents
Note: Reconciliation of profit before tax to cash generated from operations
Profit before tax
Investment income
Depreciation charge
Decrease (increase) in inventories
250
(400)
Decrease (increase) in trade receivables
330
(360)
Increase in trade payables
230
20
6,320
3,990
Cash generated from operations
Exhibit 3: Handover notes for Damian, financial controller – prepared by Jenny
Financial instruments
I have accounted for the foreign exchange implications of all trading transactions, and I am satisfied
that these are correctly recognised. However, I was unsure about the correct treatment of the two
financial assets and have made no year-end adjustments in respect of them.
•
On 30 September 20X6, Wayte invested in 2% of the issued ordinary share capital of PSN, a
company based in Ausland, where the currency is the Auslandian dollar (AS$). The investment
comprised 2,000 shares and was recognised as a financial asset at fair value through other
comprehensive income with a value of £430,000. Wayte had made an irrevocable election to treat
it in this way. On 30 September 20X7, the shares in PSN were quoted in an active market at
AS$310 per share.
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•
On 1 January 20X7, Wayte invested in 1% of the issued ordinary share capital of another
Auslandian company, LXP. Wayte bought 50,000 shares at AS$5 each, and the investment was
recognised by Wayte at £192,000. Wayte correctly classified this investment as fair value through
profit or loss. On 30 September 20X7, the shares in LXP were quoted in an active market at AS$7
per share.
The exchange rates for the Auslandian dollar were:
At 30 September 20X6
£1 = AS$1.4
At 1 January 20X7
£1 = AS$1.3
At 30 September 20X7
£1 = AS$1.6
Revenue
Until recently, Wayte sold weighing machines without service contracts. On 31 July 20X7, Wayte
signed a new contract with a large customer, JM Ltd, to supply weighing machines together with a
two-year fixed-term service contract. For two years after delivery of the machines, Wayte’s engineers
will make quarterly visits to JM to service them.
Sales made under this contract in August and September 20X7 were £4,500,000, comprising
machine sales of £3,750,000 and services valued at £750,000. No service visits are due until
December 20X7 at the earliest, so no service costs were incurred under this contract before 30
September 20X7.
I have left the full amount of £4,500,000 in revenue, but I am not sure if this is correct under IFRS 15,
Revenue from Contracts with Customers.
Deferred tax
A deferred tax balance of £1,200,000 was brought forward on 1 October 20X6. This relates entirely
to temporary differences in respect of the revaluation of land and buildings. I have made no
adjustment to the balance of £1,200,000, but I think it is likely that adjustments will be required in
respect of the following:
•
Land and buildings are carried at revalued amounts. I have adjusted for the revaluation on 30
September 20X7, which increased the value to £19,200,000. The original cost of the land and
buildings was £11,400,000. In Wayte’s tax jurisdiction no tax allowances are given for depreciation
charged on land and buildings. A taxable capital gain will arise in future on the sale of land and
buildings. This capital gain is calculated as the difference between the sale proceeds and the
original cost. A tax on capital gains of 20% will apply when the land and buildings are sold.
•
Any temporary differences arising in respect of adjustments you make from note (1) above. The
tax treatment for financial instruments follows the accounting treatment in respect of gains and
losses recognised through profit or loss.
Current tax
Adjustments from notes (1) and (2) above may require adjustments to the current tax charge. Tax is
charged at 20%.
53 SettleBlue
SettleBlue plc (SB) is a UK AIM-listed company, operating in the outdoor retail sector. SB owns
several subsidiaries and has an investment in CeeGreen Ltd (CG). Owen-Grey LLP, a firm of ICAEW
Chartered Accountants, is the auditor of SB and its subsidiaries. It also audits CG.
You are an audit senior working on the SB group audit and SB parent company audit for the year
ended 30 September 20X7. Other audit teams from Owen-Grey are responsible for the individual
audits of SB’s subsidiaries and CG.
ICAEW 2022
Real exam (November 2017)
171
The group audit engagement manager left you the following briefing note including instructions:
Briefing note
The draft consolidated financial statements for SB for the year ended 30 September 20X7 show
profit after tax of £5.3 million. SB uses the proportion of net asset method to value non-controlling
interests when preparing consolidated financial statements.
Our audit procedures are nearly complete and I need your help in respect of the following:
Investment in CG
The SB financial controller, Geri Hawes, has sent me a note with information about two key matters
concerning SB’s investment in CG (Exhibit 1).
Audit of parent company’s trade and other payables
SB’s purchases and its trade and other payables balances have been identified as high audit risk
balances. Ann Zhang, the Owen-Grey audit associate responsible for this area of our work, has just
gone on leave. She has left a file note summarising two issues arising from her audit procedures
for the year ended 30 September 20X7 (Exhibit 2). Ann asked Owen-Grey’s data analytics team to
analyse SB’s purchase data using our new data analytics system, Titan. This analysis was delayed
and has only just been provided. It includes a dashboard summarising the results (Exhibit 3).
Instructions
(1) Explain, for each of the two matters identified in Geri’s note (Exhibit 1), the appropriate
financial reporting treatment in SB’s consolidated financial statements for the year ended 30
September 20X7. Set out appropriate adjustments. Ignore any potential adjustments for
current and deferred taxation.
(2) Review the file note prepared by Ann (Exhibit 2) and the dashboard (Exhibit 3) and:
(a) identify and explain any weaknesses in the audit procedures completed by Ann on the
two issues;
(b) analyse the information provided in the dashboard to identify the audit risks; and
(c) set out any additional audit procedures that we will need to perform.
Requirement
Respond to the audit engagement manager’s instructions.
Total: 30 marks
Exhibit 1: Note prepared by Geri Hawes, SB’s financial controller
There are two key matters concerning SB’s investment in CG which have arisen during the year
ended 30 September 20X7.
(1) Additional investment in CG
CG was set up by the Troon family 10 years ago to manufacture tents. CG is one of SB’s key suppliers.
On 1 June 20X5, CG issued 100,000 new ordinary £1 shares to SB for cash at £20 per share. At 30
September 20X5 and 20X6, the issued ordinary share capital was held as follows:
Shareholder
Number of £1 ordinary shares
John Troon
600,000
Ken Troon – John’s son
200,000
Sharon Troon – Ken’s wife
100,000
SB
100,000
1,000,000
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John, Ken and Sharon were the only directors of CG until 1 January 20X7. At 30 September 20X5, SB
recognised its investment in CG as a financial asset at fair value through other comprehensive
income at its fair value of £2 million, making an irrevocable election to recognise it as such. At 30
September 20X6, the SB board estimated the fair value of the investment to be £2.5 million and an
increase of £0.5 million was recognised in other comprehensive income.
On 1 January 20X7, John offered to sell his 600,000 shares to SB for £15 million. SB bought 40% of
John’s shares on 1 January 20X7 for a consideration of £6 million. SB also holds a call option to buy
the remaining 60% of John’s shares on 1 January 20X8 for £9 million.
On 1 January 20X7, John resigned as a director of CG. SB appointed two representatives to the CG
board as marketing and production directors. Since they joined the board, CG’s performance has
improved significantly and this trend is expected to continue.
In SB’s consolidated financial statements for the year ended 30 September 20X7, the investment in
CG is recognised at £8.5 million, as a simple investment in equity instruments, since SB does not own
the majority of the shares in CG.
(2) Share options
On 1 January 20X7, as an incentive to work more closely with SB, Ken and Sharon were appointed as
directors of SB. The service agreement includes the following key terms:
•
Ken and Sharon are not paid cash salaries.
•
On 1 January 20X9, Ken and Sharon have the right to receive (provided that they are still directors
of SB at 1 January 20X9) either 32,000 SB shares or cash to the equivalent value of 28,000 SB
shares.
•
At 1 January 20X7, the fair value of the share route has been calculated at £20 for the right to
receive one SB share on 1 January 20X9.
•
The market value of SB’s shares at 1 January 20X7 was £22 per share and at 30 September 20X7,
it was £24 per share. I have not made any adjustment for this service agreement in the
consolidated financial statements as no cash has been paid.
Exhibit 2: File note: Key issues arising from audit procedures on purchases, trade and other
payables – prepared by Ann Zhang, Owen-Grey audit associate on SB audit
Issue 1: Goods received not invoiced (GRNI) accrual of £610,000
When goods are received in SB’s factory, they are matched to a purchase order on SB’s computer
system and a goods received note (GRN) is produced and recorded on a list of goods received not
invoiced (GRNI). When the purchase invoice is received from the supplier, it is matched to the GRN,
which is removed from the GRNI list on SB’s computer system. The purchase invoice is then
authorised for payment and recorded in the purchases and payables accounts.
At 30 September 20X7, SB has calculated an accrual of £610,000 from the list of GRNI and made the
following adjustment:
DEBIT
CREDIT
Cost of sales
£610,000
Trade and other payables
£610,000
My controls testing of the matching of GRNs to purchase invoices showed that the controls did not
operate effectively during the year ended 30 September 20X7. This was due to inexperienced SB
staff members not matching purchase invoices to the correct GRNs. Therefore, I tested a sample of
10 GRNs included on the GRNI list at 30 September 20X7 to make sure that the goods were received
before the year-end. I also tested completeness by agreeing large payments made to suppliers after
30 September 20X7 to the payables account for the appropriate supplier.
Issue 2: Accrual for a debit balance of £290,000 on MAK Ltd payables account
At 30 September 20X7, the payable account of MAK Ltd, a large supplier of goods to SB, shows a
debit balance of £290,000. This balance arose because SB did not receive purchase invoices from
MAK for goods received in June and July 20X7 when MAK’s accountant was on sick leave.
ICAEW 2022
Real exam (November 2017)
173
To authorise payments to MAK without purchase invoices, SB’s accounts staff used GRNs prepared
by SB’s warehouse and recorded on the GRNI list as evidence that the goods had been received
from MAK. SB accounted for the payments to MAK for these goods by crediting the cash account
and debiting MAK’s payables account. No adjustment has been made to the GRNI list for these
payments.
SB has corrected the transaction by recording the following journal entry:
DEBIT
Cost of sales
CREDIT
£290,000
Trade and other payables
£290,000
I agreed payments of £290,000 made to MAK before 30 September 20X7 to SB’s bank statements. I
confirmed that SB did not receive the invoices from MAK by agreeing the amounts to GRN on the
GRNI list at 30 September 20X7. Invoices relating to these goods have been received by SB and
recorded after 30 September 20X7. I have asked SB to provide a supplier statement from MAK but
have not yet received a response.
Exhibit 3: Dashboard of results from the application of the Titan analytics system
SB provided Owen-Grey with its purchases data files for the year ended 30 September 20X7. OwenGrey’s Titan analytics system has been applied to this data. The system analysed 100% of purchase
orders and goods received notes raised in the year ended 30 September 20X7. The following results
have been obtained:
Test for all data (including MAK Ltd)
Outcome
Number of purchase orders raised
7,246
Number of GRNs raised and matched to purchase orders
6,884
Average number of days from GRN to receipt of purchase invoice
10 days
Number of GRNs not invoiced at 30 September 20X7 (GRNI)
311
Number of GRNs over 2 months old not invoiced at 30 September 20X7
156
Average order value
£1,900
Largest 4 suppliers:
Average number of days
from GRN to receipt of
purchase invoice
MAK Ltd
CG Ltd
UMD Ltd
Pegs Ltd
0
174
10
20
Corporate Reporting
30
ICAEW 2022
One supplier, MAK Ltd was identified as an outlier showing the following data:
Test for MAK Ltd
Outcome
Number of purchase orders raised
771
Number of GRNs raised and matched to purchase orders
732
Average number of days from GRN to receipt of purchase invoice
21 days
Number of GRNs not invoiced at 30 September 20X7 (GRNI)
142
Number of GRNs over 2 months old not invoiced at 30 September 20X7
122
Average order value
£2,040
Frequency of order value
for MAK Ltd
40%
35%
30%
25%
20%
15%
10%
5%
ICAEW 2022
3,
£2
,8
01
-£
-£
01
,1
£2
50
80
2,
2,
-£
01
,4
£1
0
0
0
10
40
1,
-£
01
£7
£0
-£
70
0
0
0%
Real exam (November 2017)
175
176
Corporate Reporting
ICAEW 2022
Real exam (July 2018)
54 EC
EC Ltd is the UK parent company of a diversified manufacturing group. EC Ltd supplies water
irrigation systems.
You are Jess Rowe, and you work for Myner LLP, a firm of ICAEW Chartered Accountants. Myner LLP
has been responsible for the audit of EC Ltd and the companies in the EC group for several years.
You are assigned to the audit of the EC group for the year ended 31 May 20X8. You report to Gaynor
Fodes, the EC audit engagement partner. The individual company audits of EC Ltd and its
subsidiaries for the year ended 31 May 20X8 are in progress. Gaynor gives you the following briefing
and instructions:
“The EC Ltd audit team has identified three audit issues for my attention (Exhibit 1). These issues
involve judgements made by the EC Ltd directors which increase audit risk and therefore require
extra audit time. I will be discussing these issues with the EC Ltd directors at a meeting next week.
I have provided you with the EC group draft summary consolidated statement of profit or loss and
notes (Exhibit 2). This statement of profit or loss does not include any adjustments arising from the
three audit issues identified by the EC Ltd audit team.”
Instructions
Gaynor provides the following instructions.
(1) For each of the three audit issues:
(a) Explain and set out the correct financial reporting treatment in the EC group financial
statements and EC Ltd individual financial statements. Ignore the tax impact arising from any
adjustments.
(b) Set out the key audit risks and the relevant audit procedures that we should perform.
(2) Prepare a revised summary consolidated statement of profit or loss including, where
appropriate, your adjustments for the three audit issues.
(3) Explain briefly, without calculations, the impact of your adjustments on the income tax expense.
Requirement
Respond to Gaynor’s instructions.
Total: 40 marks
Exhibit 1: Audit issues identified by EC Ltd audit team
Issue 1: Disposal of shares in Luka Ltd
Ten years ago, EC Ltd paid £10.5 million for 75,000 shares in Luka Ltd, which represented 75% of
Luka’s 100,000 issued ordinary shares. An unconnected Japanese company owns 25% of Luka’s
issued ordinary shares.
Luka Ltd manufactures water pumps.
On 1 December 20X7, EC Ltd sold 60,000 of its shares in Luka for £7.9 million to Walter Brown,
Luka’s CEO. The fair value of EC Ltd’s remaining 15% investment in Luka was estimated to be £1
million at that date.
The directors have made a judgement that EC Ltd no longer has control over Luka and it should not
consolidate Luka as a subsidiary. They also judged that EC Ltd does not have significant influence
over Luka. EC Ltd’s financial statements and the EC draft consolidated financial statements for the
year ended 31 May 20X8 show an investment in 15,000 shares in Luka at cost of £2.1 million.
In the draft consolidated financial statements for the year ended 31 May 20X8, the directors have
treated Luka as a discontinued operation as they believe that Luka represents a major line of
business from which EC has now withdrawn. Luka’s loss for the six-month period to 1 December
20X7 has been presented as one figure in the consolidated statement of profit or loss. A loss of
£500,000 on disposal of the shares in Luka is also included. This is calculated as proceeds of £7.9
million less cost of £8.4 million, being £10.5 million × 60,000/75,000 shares (Exhibit 2, note 2).
We believe that the financial reporting treatment of the sale of Luka shares may not be correct.
ICAEW 2022
Real exam (July 2018)
177
The following information was noted during our audit procedures:
•
Two of the four members of Luka’s board are also EC Ltd board directors. The Japanese company
is represented by one director on the Luka board.
•
Luka buys filter systems from WFT Ltd, a 100%-owned subsidiary of EC Ltd. The filter system is
designed specifically for Luka’s water pumps.
•
Luka continues to use the EC group’s shared service centre, which provides Luka with marketing
and accounting services for a monthly fee.
Issue 2: Contingent liability
EC Ltd competes internationally for large contracts to supply irrigation systems for farms. The
contracts are with governments and local contractors. Local law often requires EC Ltd to use
commercial intermediaries and, in some countries, the tender process is open to corruption. EC Ltd
has control procedures to ensure that all contracts are compliant with UK and local law. Breaches of
laws can lead to fines and restrictions on future business.
In January 20X8, a fraud investigation commenced into bribery and corruption, in a country in which
EC Ltd operates. EC Ltd is being investigated and is cooperating with the authorities.
We reviewed minutes of EC Ltd directors’ meetings which show that the fraud investigation was
discussed on 12 January 20X8. The directors are satisfied that EC Ltd’s control procedures have
mostly been complied with, but that there could be isolated occurrences where intermediaries were
paid sums of money by EC Ltd personnel to secure contracts. Advice from EC Ltd’s internal legal
department was presented to the directors as follows:
•
Similar investigations in other countries have taken five years to be resolved.
•
Estimates of the likelihood of EC Ltd being found liable for fines are as follows:
Estimate of fines
Probability
No fines payable
52%
£1.0 million
38%
£1.5 million
10%
The directors have made a judgement that because the investigation is ongoing and it is difficult to
identify if, or when, any fines will be payable, only a contingent liability note should be included in
the financial statements for the year ended 31 May 20X8.
The board minutes also record that future operating losses caused by the restriction of trade during
the anticipated five-year investigation are expected to be £100,000 each year, regardless of the
outcome of the fraud investigation. Therefore, a provision of £433,000 (using a 5% pa interest rate for
the time value of money) is included in operating expenses in the financial statements for the year
ended 31 May 20X8.
Issue 3: Sale of manufacturing division in Spain
EC Ltd owns a manufacturing division in Spain which consists of a factory, an office building and
plant and equipment. The division makes water pumps which EC Ltd uses for its irrigation systems.
Because of wage increases in Spain, it is now cheaper for EC Ltd to buy a similar pump from a UK
supplier. Therefore, on 1 March 20X8, the EC Ltd board decided to sell some of the Spanish
division’s assets. The carrying amounts of the division’s property, plant and equipment are as follows:
Cost at 31 May 20X7 and 31 May 20X8
Factory
(including
land)
Office
(including
land)
Plant and
equipment
£’000
£’000
£’000
4,385
4,640
4,850
Accumulated depreciation at 1 June 20X7
(685)
(800)
(1,986)
Depreciation for the year ended 31 May 20X8
(137)
(160)
(286)
3,563
3,680
Carrying amount at 31 May 20X8
178
Corporate Reporting
2,578
ICAEW 2022
The factory and office buildings are depreciated over 25 years with zero residual values and plant
and equipment is depreciated at 10% pa on a reducing balance basis.
On 1 March 20X8, a surveyor in Spain valued the factory (including land) and office (including land),
in euro, as follows:
€’000
Notes on valuation method
Factory
5,040
The valuation is based on the price per square metre achieved in the
sale of a similar property in February 20X8.
Office
5,570
As no similar properties have recently been sold, the valuation is
based on forecast rental income per square metre and occupancy
rates.
EC Ltd advertised the factory for sale in March 20X8 and expects to sell it within six months.
EC Ltd decided that it would achieve a higher return by renting out the office building. On 1 March
20X8, EC Ltd signed a three-year agreement to lease the office building to an unconnected
company. EC Ltd’s accounting policy is to recognise investment properties at fair value.
On 30 June 20X8, EC Ltd received an offer from a Spanish company to buy the plant and equipment
for €2,519,000.
Exchange rates for the € are:
1 March 20X8
£1 = €1.20
31 May 20X8
£1 = €1.10
30 June 20X8
£1 = €1.12
The directors told the audit team that, because of the uncertainty regarding the recoverable amount
of the manufacturing division’s assets, no adjustments have been made to EC Ltd’s non-current
assets in the draft consolidated financial statements at 31 May 20X8.
Exhibit 2: EC group − draft summary consolidated statement of profit or loss for the year ended 31
May 20X8
£’000
Continuing operations
Revenue
Profit before tax
31,170
1,896
Income tax expense (Note 1)
Profit from continuing operations
(380)
1,516
Discontinued operations
Loss from discontinued operations (Note 2)
(1,250)
Profit for the year
266
Additional information
(1) Income tax expense
The income tax expense includes adjustments for current tax and deferred tax at 20%. Income tax is
calculated for each group company based on 20% of the accounting profit, except for the following
tax rules relating to non-current assets:
•
No tax implications arise from a profit or loss on disposal of shares.
ICAEW 2022
Real exam (July 2018)
179
•
No tax relief is given for a depreciation expense or an impairment charge for buildings or plant
and equipment.
•
Tax depreciation is available for purchases of plant and equipment. No tax depreciation is
available for buildings.
•
Tax is payable on gains when a building is sold and is calculated based on the difference between
the disposal proceeds and the original cost.
(2) Loss from discontinued operations of Luka
On 1 December 20X7, EC Ltd sold 60,000 of its shares in Luka. Luka’s loss for the six-month period
from 1 June 20X7 to 1 December 20X7, together with the loss on the disposal of these shares, are
presented as a single line in the statement of profit or loss as discontinued operations. This
comprises:
£’000
Loss before taxation
(890)
Income tax
140
Loss after taxation
(750)
Loss on disposal of shares in Luka
(500)
Loss from discontinued operations
(1,250)
Luka’s net assets at 31 May 20X8 were £9.25 million. Luka’s revenue for the year ended 31 May 20X8
was £15 million. It made a loss of £1.5 million after tax for the year ended 31 May 20X8. Luka’s
revenue and loss arise evenly throughout the year. Goodwill arising on the consolidation of Luka was
fully impaired at 1 June 20X7. EC Ltd measures non-controlling interests using the proportion of net
assets method.
55 Raven plc
Raven plc is an unlisted company which manufactures electrical products.
You are an ICAEW Chartered Accountant. You have just been appointed as financial controller at
Raven. The previous financial controller left in July 20X7 and, since then, Raven’s accounting has
been under the temporary control of Simon, a part-qualified accountant.
Simon has prepared draft financial statements for the year ended 30 April 20X8 with extracts
provided in Exhibit 1. Simon has been unable to deal with some complex financial reporting matters
and has left you notes on the issues that require further work (Exhibit 2).
The candidate is an ICAEW Chartered Accountant who has just been appointed as financial
controller of Raven plc, an unlisted business that produces electrical products.
The candidate is supplied with information extracted from the draft financial statements of the
company for the year ended 30 April 20X8. This information has been prepared by an unqualified
accountant, who has also supplied a list of outstanding matters.
The candidate is required to explain the appropriate financial reporting treatment for five financial
reporting matters: a cash flow hedge, the issue of ordinary shares to a supplier in exchange for
goods, an impairment of a previously revalued asset, a sale and leaseback and transactions in
relation to a defined benefit pension scheme. The candidate is also required to prepare revised draft
extracts of the financial statements.
Requirements
55.1 Explain the appropriate financial reporting treatment for each of the items in Simon’s notes
(Exhibit 2) and set out the adjusting journal entries required.
55.2 Prepare revised financial statement extracts which include your adjustments.
Note: Ignore current tax and deferred tax
Total: 30 marks
180
Corporate Reporting
ICAEW 2022
Exhibit 1: Raven plc: Extracts from draft financial statements – prepared by Simon
Extracts from statement of comprehensive income for the year ended 30 April 20X8
£’000
Profit before tax
2,300
Other comprehensive income
−
Extracts from statement of financial position at 30 April 20X8
Additional information
(see Exhibit 2)
£’000
3 and 4
53,860
Suspense account − one
1
6,757
Financial asset
1
706
Non-current assets
Property, plant and equipment
61,323
Current assets
20,859
Total assets
82,182
Equity
Share capital (£1 ordinary shares)
200
Retained earnings
Revaluation reserve
Cash flow hedge reserve
25,920
3 and 4
6,200
1
706
Other reserves
600
33,626
Non-current liabilities
Loans
18,650
Pension – net defined benefit liability
5
136
Suspense account − two
4
10,000
28,786
Current liabilities
2
Total equity and liabilities
19,770
82,182
Exhibit 2: Additional information on financial reporting issues – prepared by Simon
(1) Cash flow hedge
On 1 March 20X7, Raven signed an agreement to purchase a new machine from a supplier in
Ruritania, where the currency is the Ruritanian dollar (R$). The machine, costing R$50 million, was
delivered and paid for on 31 July 20X7. On 1 March 20X7, to provide a hedge against exchange rate
movements, Raven entered into a forward contract to buy R$50 million on 31 July 20X7 at a rate of
£1 = R$7.4. All necessary documentation was prepared for hedge accounting and the contract was
designated as a cash flow hedge.
ICAEW 2022
Real exam (July 2018)
181
In respect of the forward contract, a financial asset of £705,930 was recognised in the statement of
financial position at 30 April 20X7. An equal amount was recognised, through other comprehensive
income, in a cash flow hedge reserve.
This was the first time that Raven had designated a hedging arrangement. The arrangement meets
the requirements for hedge accounting specified in IFRS 9, Financial Instruments, including the
hedge effectiveness criteria.
On 31 July 20X7, the machine was purchased as planned and the forward contract settled. On that
date, the following journal entries were made:
£
DEBIT
Suspense account − one (R$50,000,000/5.7)
CREDIT
Cash
DEBIT
Cash
CREDIT
£
8,771,930
8,771,930
2,015,173
Suspense account − one
2,015,173
The net debit to suspense account − one was £6,756,757. No further entries have been made in
respect of the machine purchase or the cash flow hedge. The machine is to be depreciated on a
straight-line basis over five years, assuming zero residual value.
Spot and forward exchange rates were as follows:
Spot
Forward
(for delivery on 31 July 20X7)
1 March 20X7
£1= R$7.3
£1= R$7.4
30 April 20X7
£1= R$6.5
£1= R$6.7
31 July 20X7
£1= R$5.7
£1= R$5.7
(2) Issue of ordinary shares
On 1 May 20X7, Raven had 200,000 £1 ordinary shares in issue.
On 1 November 20X7, Ester Ltd, one of Raven’s suppliers, agreed that each month it would supply
goods at a fair value of £2,000 in exchange for 50 new £1 shares in Raven. This agreement is for a
period of two years until 31 October 20X9.
As a result, in the year ended 30 April 20X8, 300 £1 ordinary shares were issued to Ester. No
accounting entry has yet been made in respect of the share issue, but the following entry has been
made in respect of goods purchased from Ester between 1 November 20X7 and 30 April 20X8:
£
DEBIT
CREDIT
Cost of sales
Trade payables
£
12,000
12,000
(3) Non-current assets: fixed production line
Raven has a fixed production line. It has a policy of revaluing this production line because of its
specialist nature. No annual transfer for depreciation is made from revaluation reserve to retained
earnings.
This production line cost £8 million on 1 May 20X2. It was to be depreciated on a straight-line basis
over 10 years, with an estimated nil residual value. The asset was revalued on 30 April 20X5 to £6.3
million. The asset’s estimated useful life and residual value were unchanged.
An impairment review of the asset took place on 30 April 20X8, at which date the production line had
an estimated fair value less costs to sell of £2.6 million and a value in use of £2.8 million. No
impairment has been recognised in respect of this fixed production line in the draft financial
statements.
182
Corporate Reporting
ICAEW 2022
Depreciation on the production line has been correctly calculated for the year ended 30 April 20X8
before taking into account any revaluation or impairments.
(4) Leased asset: administration building
Because of a shortage of cash in the business, Raven’s directors decided to sell the company’s
administration building for £10 million, its fair value, on 1 May 20X7, leasing it back immediately from
the building’s new owners for a period of 10 years. Raven does not have an option to buy back the
building.
The carrying amount of the building immediately before the sale was £7 million. The transaction
qualifies as a sale in accordance with IFRS 15, Revenue from Contracts with Customers.
The receipt of cash of £10 million on 1 May 20X7 was debited to cash and credited to Suspense
account − two. No other accounting entries have been made in respect of the disposal of the
building.
The building’s lease requires an annual rental payment of £540,000, payable in arrears every 30
April. The first payment was made on 30 April 20X8 and was debited to rental expenses in profit or
loss. The payment of £540,000 represents an annual market rate for the lease of the building. Raven
expects to continue to occupy the building, which has a remaining useful life of 50 years, for the next
10 years.
The interest rate implicit in the lease is 5%.
(5) Pension scheme
Raven operates a defined benefit pension scheme for its directors.
On 1 May 20X7, the fair value of the pension scheme assets was £2,830,000 and the present value of
the pension scheme obligations was £2,966,000, resulting in a net defined benefit liability in the
statement of financial position at that date of £136,000.
During the year ended 30 April 20X8, the scheme received contributions of £575,000 from Raven.
This amount has been debited to staff costs.
According to Raven’s actuary, the current service cost for the year ended 30 April 20X8 was
£390,000. Benefits were improved during the year resulting in past service costs of £120,000. The
amount of benefits paid in the year by the pension scheme was £330,000.
Raven’s actuary estimates the fair value of the pension scheme assets at 30 April 20X8 to be
£3,248,000 and the present value of the pension scheme obligations at that date to be £3,457,600.
An annual discount rate of 5% is to be applied to the pension scheme assets and liabilities.
56 MRL
You are an audit senior working for Cromer Bell LLP, a firm of ICAEW Chartered Accountants. You
have been assigned to the audit of Miles Recruitment Ltd (MRL) for the year ending 31 August 20X8.
MRL provides recruitment services to the financial services, transport and technology sectors. It earns
revenue by charging business customers a fee for identifying appropriate employees to fill job
vacancies.
MRL is a wholly-owned subsidiary of Milcomba, a listed company incorporated in Elysia. Cromer
Bell’s Elysian office is responsible for the group audit of Milcomba.
You receive a briefing note and instructions from the Cromer Bell audit manager responsible for the
MRL audit:
Briefing note from MRL audit manager
We need to complete our planning for the MRL audit for the year ending 31 August 20X8. I want
you to plan substantive audit procedures to test operating expenses.
Last year, we relied wholly on substantive analytical procedures to test all operating expenses, but
that approach was criticised in a recent external cold review of our audit. The reviewer’s
comments stated that some of the expectations developed by the audit team in their substantive
analytical procedures were imprecise. In addition, the reviewer considered that some of the
expenses should have been tested using tests of details. As a result, I would expect us to use
analytical procedures in a more selective and focused way for this year’s audit.
ICAEW 2022
Real exam (July 2018)
183
Although the group audit team in Elysia has performed interim review procedures on the
Milcomba consolidated financial statements for the six months ended 28 February 20X8, it did not
require us to perform any interim review procedures locally on MRL.
Planning materiality for MRL has been determined at £50,000, based on 5% of forecast profit
before tax for the year ending 31 August 20X8.
MRL’s finance director, Gil Moore, was appointed on 1 March 20X8. We know Gil well, as he was,
until February 20X8, a senior audit manager with Cromer Bell. Gil was the manager responsible
for the audit of MRL for the year ended 31 August 20X7, which we completed in December 20X7.
Gil has provided details of MRL’s operating expenses for the 10 months to 30 June 20X8.
I asked the Cromer Bell specialist data analytics team to analyse these. The team has provided a
report (Exhibit 1).
I met with Gil last week and have summarised our discussion in a note for the file (Exhibit 2).
Instructions from MRL audit manager
Please consider all the information I have provided and:
(1) Identify and explain the key audit risks for our audit of MRL for the year ending 31 August
20X8. Where appropriate, set out and explain any related financial reporting issues, including
relevant calculations;
(2) For each of the operating expenses (Exhibit 1) explain whether substantive analytical
procedures and/or tests of detail would be the more appropriate audit approach. Identify the
key substantive audit procedures that we should perform to test each operating expense; and
(3) Explain any potential ethical issues in respect of Gil Moore’s behaviour and summarise the
actions that Cromer Bell should take to address them.
Requirement
Respond to the audit manager’s instructions.
Total: 30 marks
Exhibit 1: Report from Cromer Bell specialist data analytics team on MRL’s operating expenses for
the 10 months ended 30 June 20X8
MRL’s financial statements for the 10 months ended 30 June 20X8 include total operating expenses
as shown below.
Wages and salaries for administrative staff
Other staff expenses
Insurance, electricity, gas and other utilities
Depreciation of office equipment
Movement in allowance for receivables
Profit on sale of branch office
Legal and professional fees
Movement in provision for claims and other legal matters
Start-up costs for MP Ltd
Other administrative expenses
Total operating expenses
184
Corporate Reporting
10 months to
30 June 20X8
10 months to
30 June 20X7
£’000
£’000
2,324
2,159
495
540
1,140
1,275
180
200
80
200
(300)
–
210
50
40
180
230
–
76
63
4,475
4,667
ICAEW 2022
MRL’s operating expenses have fluctuated over the 10 months to 30 June 20X8, as shown in the chart
below:
Operating
expenses
£’000
Operating expenses by month
800
700
600
500
400
300
200
100
0
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Month
Data analytics − potentially unusual or one-off items
Our analysis of the underlying data on operating expenses identified the following potentially
unusual or one-off items:
•
In February 20X8, a credit entry of £100,000 was made to the impairment allowance for
receivables.
•
In June 20X8, a credit entry of £300,000 was made in respect of the profit on the sale of the
branch office.
•
December 20X7 expenses include a one-off legal fee of £150,000.
•
October 20X7 expenses include start-up costs of £230,000.
•
Movements in the provision for claims and other legal matters were:
– a credit entry of £40,000 in February 20X8
– a debit entry of £80,000 in March 20X8.
Analysis of journal entries
You also asked us to identify any unusual journal entries posted to operating expenses. Our analysis
identified two entries posted by Gil Moore, the MRL finance director:
(1) In April 20X8:
DEBIT
Wages and salaries for administrative staff
CREDIT
£50,000
Accruals
£50,000
Half-year bonus for MRL executive team.
(2) In May 20X8:
DEBIT
CREDIT
Other staff expenses
Cash
£9,000
£9,000
New tablet computers for finance team.
ICAEW 2022
Real exam (July 2018)
185
Exhibit 2: File note summarising meeting last week with Gil Moore, MRL finance director – prepared
by Cromer Bell audit manager
Key points noted from my discussion with Gil were as follows.
Group performance
The Milcomba group is facing challenges in the financial year ending 31 August 20X8, with falling
profits at several international subsidiaries. While MRL’s trading is reasonably good, a weakening of
the £ has meant that MRL’s profit is lower than in the year ending 31 August 20X7 when translated
into Elysian $, the presentation currency for the group.
Strong financial management and cost control at group level ensured that the group’s reported
results for the six months ended 28 February 20X8 were in line with market expectations. The
Milcomba board has made it clear that it expects MRL to deliver profit above budget for the six
months to 31 August 20X8.
Review of receivables
The first monthly report provided for Gil, after his appointment, was for February 20X8 and he spent
the limited time available reviewing provisions and other judgemental areas. A significant adjustment
he made was to reduce the impairment allowance for receivables by £100,000, based on 12 months’
expected credit losses. His decision to do this was based on a review of receivables written off as
irrecoverable in the six months ended 28 February 20X8, which showed that write-offs were lower
than anticipated.
Revenue
MRL’s revenue for the 10 months ended 30 June 20X8 was in line with budget but its customer base
has changed. MRL recruited fewer candidates for its traditional financial services customers but
attracted new customers in the transport and technology sectors. This resulted in a greater number
of candidates but a lower average recruitment fee per job vacancy filled.
The terms of business for the new customers are similar to those for existing customers. Recruitment
fees are invoiced when a job applicant identified by MRL accepts employment with an MRL customer.
The customer can claim a refund of 75% of the recruitment fee if the new employee leaves within
one month of starting employment and a refund of 50% of the fee if the employee leaves within
three months.
Start-up of MP Ltd
Recruiting a large number of candidates has put pressure on MRL’s staff resources. To relieve some of
this pressure, MRL has entered into an arrangement with another recruitment company, Peerless Ltd.
In October 20X7, MRL and Peerless each invested initial capital of £230,000 in a newly-formed
company, MP Ltd. The shares of MP are held equally by MRL and Peerless. MRL’s investment is
included in operating expenses as start-up costs.
MP was created to provide administration and research services to MRL and Peerless. It focuses on
lower-salaried positions and utilises advanced technology to obtain efficiencies. MP recharges its
costs, plus a margin of 5%, to Peerless and MRL in proportion to the time its staff spend working for
each investor.
MP did not start trading until May 20X8, because of delays in the installation of its computer system.
This computer system and other non-current assets cost £400,000 in total. MP has 30 staff and is
performing well, relieving the pressure on MRL’s consultants and allowing them to focus on
recruitment of higher-salaried positions. MP is expected to make a profit of £50,000 in the period
ending 31 August 20X8.
Sale and leaseback of branch office
On 30 June 20X8, MRL sold its branch office building for £1,000,000, its market value. The carrying
amount at that date was £700,000. The company immediately leased back the office from the new
owners for a period of 8 years at £120,000 per year, payable in arrears. The interest rate implicit in
the lease is 3%, for which the eight-year cumulative discount factor is 7.020, and the transaction
qualifies as a sale under IFRS 15. The only entry Gil made in respect of this transaction was to credit
the profit on the sale of £300,000 to profit or loss.
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Cold review
Gil enquired about our planned audit approach for operating expenses. He had heard about the
comments made by the external reviewer who conducted the cold review of the MRL audit file for
the year ended 31 August 20X7. Gil hoped that we would not pay too much attention to these
comments as they were, in his view, not valid.
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Real exam (July 2018)
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188
Corporate Reporting
ICAEW 2022
Real exam (November 2018)
57 Zmant plc
You are Trina Briggs, an ICAEW Chartered Accountant, working for Dealy and Brant (DB), a firm of
ICAEW Chartered Accountants. DB has audited Zmant plc and its subsidiaries for some years and
you are the audit manager for the Zmant group audit.
Zmant plc supplies specialist audio equipment and has several 100%-owned subsidiaries. Zmant and
its subsidiaries have a 30 September year end. During the year ended 30 September 20X7, Zmant
made the following acquisition:
Investment in KJL
Zmant made an investment in KJL, a company that produces and sells audio equipment to Zmant.
KJL is based in Otherland where the currency is the Otherland $ (O$).
On 1 January 20X7, Zmant bought 60% of the issued ordinary share capital of KJL for O$52,800,000.
On acquisition, there were no fair value adjustments needed to the carrying amounts of the assets
and liabilities of KJL.
On 1 January 20X7, Zmant made a loan of O$21,000,000 to KJL, at an annual interest rate of 6%,
repayable at par on 30 September 20X9.
KJL prepares its financial statements under IFRS and has a 30 September year end. DB is not the
auditor for KJL.
DB’s individual audits of Zmant and its subsidiaries are almost finished and the audit of the
consolidation is now in progress. The DB audit partner responsible for the Zmant group audit has
given you the following briefing:
Briefing from audit partner
“KJL was identified as a significant component in the group audit plan. KJL is audited by Welzun, an
audit firm based in Otherland. The audit plan included an assessment of Welzun’s professional
qualifications and independence and no issues were noted. We performed a review of KJL’s financial
statements for the year ended 30 September 20X7 and identified two matters of potential
significance to the group audit:
•
Research and development (R&D) expenditure of O$10,700,000
•
Income tax receivable balance of O$8,025,000
We asked Welzun to prepare a report explaining these two matters and the audit procedures that it
performed. I have provided you with Welzun’s report (Exhibit 1).
Zmant has a new finance director, Janet Gray, who is an ICAEW Chartered Accountant. She has asked
for help in finalising Zmant’s consolidated financial statements and has sent some extracts and
queries to me (Exhibit 2). She has also sent me a newspaper article published in the Otherland News
(Exhibit 3) which I find very concerning.
I need you to prepare a working paper which addresses the following:
(1) For each matter in Exhibit 1:
(a) set out and explain the appropriate financial reporting treatment for KJL’s financial
statements for the year ended 30 September 20X7;
(b) identify and explain any weaknesses in the audit procedures completed by Welzun; and
(c) set out any additional audit procedures that should be performed by DB and by Welzun to
provide assurance for the group audit opinion.
(2) Set out and explain the appropriate adjustments for the financial reporting queries raised by
Janet (Exhibit 2) for the year ended 30 September 20X7 for:
(a) the individual financial statements of Zmant
(b) the consolidated financial statements of Zmant
(3) Calculate goodwill to be recognised for KJL in Zmant’s consolidated financial statements for the
year ended 30 September 20X7. Assume Zmant uses the proportion of net assets method to
value the non-controlling interest in KJL.
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(4) Explain the ethical issues for DB arising from the newspaper article (Exhibit 3) and any related
matters. Set out and explain how DB should respond. Advise Janet on any actions she should
take.”
Requirement
Prepare the working paper requested by the audit partner.
Total: 42 marks
Exhibit 1: Report on matters of significance to the group audit – prepared by Welzun, KJL’s auditor
We set out below our report on the matters of significance identified by DB in its review of KJL’s
financial statements for the year ended 30 September 20X7.
Audit procedures have been performed in accordance with component materiality determined by
DB at O$1,800,000.
Research and development (R&D) expenditure of O$10,700,000
The government in Otherland gives generous tax relief for R&D costs provided that the costs are
expensed in the statement of profit or loss. O$10,700,000 has been expensed in the year ended 30
September 20X7, comprising the costs of the following two R&D projects:
Project Sound: O$7,900,000
Project Sound commenced on 1 January 20X7. The project’s objective was to adapt an existing
speaker produced by KJL for the car industry. The project started after L-Motors, a customer of KJL,
requested a customised speaker for its cars. On 1 April 20X7, L-Motors placed a large order for the
speaker. Costs of this project, which have been expensed to the statement of profit or loss, are:
O$’000
Materials for prototype model
1,725
New computer equipment – bought on 1 January 20X7
1,700
Salary costs of development staff
incurred after 1 April 20X7
1,270
incurred before 1 April 20X7
790
Registration fees for design
910
Car used for speaker testing – bought on 1 January 20X7
555
Allocated general overheads
950
7,900
As each cost was less than component materiality, no detailed audit procedures were performed.
We asked KJL whether the computer equipment and the car should have been included in PPE
rather than expensed.
•
KJL informed us that the cost of the computer equipment was expensed because it was being
used for this project. If capitalised, this computer equipment would have been written off over
two years under KJL’s depreciation policy.
•
KJL informed us that, since completion of the project, the CEO of KJL has driven the car. Including
the cost of the car in PPE would result in a personal tax liability for the CEO under Otherland tax
rules.
Project Entertain: O$2,800,000
The project’s objective is to determine the success of product events. KJL obtains new business by
arranging product events for existing and potential customers. A product event involves sales staff
and other KJL personnel entertaining customers with food and drink and at the same time
demonstrating and selling KJL’s products. KJL paid O$2,800,000 to a public relations company,
GetGo, which made all the arrangements for the product events and carried out analysis of the new
business generated.
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We agreed the cost of O$2,800,000 to invoices from GetGo, authorised by KJL’s CEO, and also to the
bank statements. We requested a copy of GetGo’s report showing the analysis of the new business
generated and we were told by KJL that GetGo will provide the report in 20X8.
Income tax receivable balance of O$8,025,000
The income tax receivable balance is in respect of a tax refund for R&D expenditure. Welzun’s tax
department confirmed that a tax refund will be received based on the following formula:
250% × R&D expenditure included in the statement of profit or loss × 30% tax rate.
Welzun’s tax department confirmed that KJL pays tax at 30% and that the receivable balance of
O$8,025,000 has been correctly calculated. As the R&D tax claim was prepared by Welzun’s own tax
department, no audit procedures were performed.
Exhibit 2: Financial statement extracts and queries from Janet Gray
Extracts from financial statements for the year ended 30 September 20X7
Zmant group
KJL
£’000
O$’000
10,000
25,000
Retained earnings at 1 October 20X6
9,200
45,000
Profit for the year
2,200
15,000
21,400
85,000
Equity
Share capital
Janet Gray’s queries
Before I complete the consolidation of KJL with Zmant, I would like your advice on the correct
financial reporting treatment of the following:
Loan to KJL £3,500,000
In Zmant’s statement of financial position, there is a receivable balance of £3,500,000 which
represents the O$21,000,000 loan made to KJL on 1 January 20X7.
My predecessor translated the O$21,000,000 loan using the exchange rate at 1 January 20X7, which
was £1 = O$6.0. The exchange rate at 30 September 20X7 was £1 = O$4.8.
I do not know whether I need to include any adjustments for exchange differences because, under
Zmant’s and KJL’s tax jurisdictions, there is no tax payable on exchange differences recognised in the
statement of profit or loss. Instead, gains and losses are taxed at 20% when the loan is repaid. In any
case, I understand that the balances will cancel on consolidation.
Inventory
In the year ended 30 September 20X7, Zmant bought goods from KJL for £5,500,000. KJL charges
Zmant a mark-up of 35% on cost. There are no intra-group trading balances outstanding at the year
end between KJL and Zmant.
Zmant’s inventory at 30 September 20X7 includes £2,500,000 of goods which were bought from KJL.
I believe I need to adjust for the intra-group profit. I have calculated the adjustment as follows, but I
am not sure that it is correct:
Profit on goods bought by Zmant from KJL = £5,500,000 × 35%
£1,925,000
Profit on goods bought by Zmant from KJL for 9 months from 1 January 20X7
to 30 September 20X7 = £1,925,000 × 9/12
£1,443,750
£1,443,750 translated at the average rate for the period from 1 January 20X7
to 30 September 20X7 of £1 = O$5.7
O$8,229,375
ICAEW 2022
Real exam (November 2018)
191
The journal is:
DEBIT
KJL Retained earnings
CREDIT
Inventory
O$8,229,375
O$8,229,375
Exhibit 3: Article from the Otherland News – sent by Janet Gray
Otherland News: 31 October 20X7
An Otherland government official has resigned after accusations of corruption were made
following his attendance at a ‘product event’ paid for by KJL. The official, who is the husband of a
KJL board member, attended the five-day event at a luxury spa hotel. An undercover journalist
reported that the guest list for the event comprised KJL’s directors and their families and a
representative from L-Motors, a long-standing customer of KJL.
A former KJL finance assistant told the Otherland News that KJL is manipulating its financial
statements to claim large refunds of tax. The Otherland tax authority stated that it investigates any
incidence of tax fraud.
58 Chelle plc
You are Aiden Clark, an ICAEW Chartered Accountant. You have recently been appointed as financial
controller at Chelle plc, a company listed on the London Stock Exchange. Chelle was incorporated
15 years ago to import delicatessen products, such as olive oil and luxury tinned goods, to the UK.
Suppliers deliver goods to Chelle’s distribution centre near London and Chelle’s own vans transport
goods to the company’s customers (supermarket chains and smaller retailers). The company’s year
end is 31 October.
During the seven years ended 31 October 20X5, Chelle experienced steady growth in revenue and
profits. However, the company has become less profitable in the years ended 31 October 20X6 and
31 October 20X7 and its share price has fallen.
Chelle’s directors own 20% of the company’s ordinary shares. The remaining shares are owned 40%
by several institutional investors and 40% by individual investors. Each investor owns no more than
5% of the company’s ordinary shares. A significant source of finance for Chelle is long-term
convertible bonds. The bonds will mature at the end of October 20X9.
Chelle’s finance director is on long-term sick leave. The financial controller, Joe Bold, left Chelle in
early November 20X7. Before he left, he prepared draft financial statements for the year ended 31
October 20X7 (Exhibit 1) and notes on outstanding matters (Exhibit 2).
Jen West, Chelle’s managing director, emails you:
Chelle has not been doing well. The depreciation of £ sterling since June 20X5 has increased
costs. Profits have suffered as a result. Revenues have been adversely affected by increased
competition. The board is concerned about the company’s cash flows over the next year or two.
As you are new to the company, you can help us by providing a fresh interpretation of the draft
financial information (Exhibit 1).
The company’s shareholders are not happy because of the falling share price. Chelle did not
declare a dividend for the year ended 31 October 20X7. This was the first time in many years that
a dividend was not declared and some of the directors think we should recommence paying
dividends as soon as possible. The board wants to know when Chelle can start paying dividends
again.
Please:
(1) Set out and explain any adjustments required to the draft financial statements for the year
ended 31 October 20X7, in respect of the outstanding matters (Exhibit 2). Provide supporting
journal entries.
(2) Prepare a revised statement of profit or loss for the year ended 31 October 20X7 and a
revised statement of financial position at that date. Include calculations of earnings per share
and diluted earnings per share.
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(3) Prepare a report to the board, analysing the key elements of the financial position,
performance and cash flow for the year ended 31 October 20X7, in comparison with the two
previous financial years. Use your revised financial statements and other information
provided.
(4) Calculate the amount of Chelle’s legally distributable reserves at 31 October 20X7, providing
explanations to support your calculations.
Requirement
Respond to Jen West’s email.
Note: Ignore deferred tax
Total: 30 marks
Exhibit 1: Chelle plc draft financial information for the year to 31 October 20X7 prepared by Joe
Bold
Draft statement of profit or loss and other comprehensive income
20X7
20X6
20X5
Draft
Final
Final
£’000
£’000
£’000
30,600
31,800
35,700
Cost of sales
(22,803)
(23,044)
(25,444)
Gross profit
7,797
8,756
10,256
(8,235)
(7,904)
(6,996)
Finance costs
(500)
(617)
(609)
(Loss)/profit before tax
(938)
235
178
(47)
(530)
(760)
188
2,121
(273)
46
Revenue
Operating costs
Tax
(Loss)/profit for the year
Other comprehensive income
––––––
2,651
Additional information
Earnings per share
Dividend per ordinary share
Chelle share price at 31 October
20X7
20X6
20X5
To be calculated
1.9p
21.2p
Nil
1p
2p
980p
1139p
1711p
20X7
20X6
20X5
Draft
Final
Final
£’000
£’000
£’000
53,675
51,497
48,574
1,503
1,503
1,776
55,178
53,000
50,350
£1 = 100 pence (p)
Draft statement of financial position
Non-current assets
Property, plant and equipment
Financial asset
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20X7
20X6
20X5
Draft
Final
Final
£’000
£’000
£’000
Inventories
2,770
2,910
3,307
Trade receivables
7,710
7,503
7,997
178
–
–
–––––
525
2,273
10,658
10,938
13,577
65,836
63,938
63,927
10,000
10,000
10,000
1,416
1,416
1,689
37,294
38,054
37,966
48,710
49,470
49,655
9,603
9,603
9,486
6,304
4,818
4,256
–
47
530
1,219
–––––
–––––
7,523
4,865
4,786
65,836
63,938
63,927
20X7
20X6
20X5
Draft
Final
Final
£’000
£’000
£’000
11,316
11,173
10,516
Net cash (outflows) from investing activities
(13,060)
(12,821)
(8,462)
Net cash (outflows) from financing activities
––––––
(100)
(200)
(1,744)
(1,748)
1,854
525
2,273
419
(1,219)
525
2,273
Current assets
Tax asset
Cash
Total assets
Equity
Share capital (£1 shares)
Other components of equity
Retained earnings
Long-term liabilities (5% convertible bonds)
Current liabilities
Trade payables
Tax payable
Bank overdraft (limit £5 million)
Total equity and liabilities
Extracts from draft statement of cash flows
Net cash inflows from operating activities
Change in cash
Cash brought forward
Cash carried forward
Exhibit 2: Notes on outstanding matters in respect of the financial statements for the year to 31
October 20X7 – prepared by Joe Bold
(1) Convertible bond instrument
On 31 October 20X1, Chelle issued a £10 million 5% convertible bond for proceeds of £10 million.
The bond is repayable at par on 31 October 20X9, but can instead be converted at that date, at the
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choice of the bondholders, into one new ordinary share for every £10 unit held. At the date of issue,
the market interest rate for similar debt without conversion rights was 6.5%. Interest was paid on 31
October 20X7 and recorded in finance costs, but I have not made any other accounting entries in
respect of the convertible bond in the year ended 31 October 20X7.
(2) Investment in equity instruments
Several years ago, Chelle paid £1 million for 100,000 of the 1,500,000 £1 ordinary shares of Spence
plc, its main supplier of refrigeration equipment. On initial recognition, an irrevocable election was
made to record gains and losses in other comprehensive income. Of the other components of
equity, amounts relating to the accumulated gains and losses on this investment were £776,000 in
20X5 and £503,000 in 20X6. I have not recorded any entry in respect of the financial asset since the
31 October 20X6 year end. The price of one ordinary share in Spence plc at 31 October 20X7 was
£18.50.
(3) Tax
The applicable corporation tax rate during the financial year ended 31 October 20X7 can be
assumed to be 19%, chargeable on accounting profits before tax. A current tax credit, calculated at
19%, can be recognised in respect of accounting losses.
59 Solvit plc
Solvit plc is a listed company supplying accounting software and related services to education and
public-sector customers. Some of Solvit’s customers purchase only software but others enter into
multiple element contracts, purchasing software together with customisation, integration and
maintenance services.
Kanes LLP, a firm of ICAEW Chartered Accountants, recently won the audit of Solvit from Fenn Yo LLP,
following a competitive tender. You are a senior working for Kanes LLP and have been assigned to
the audit of Solvit for its financial year ending 31 March 20X8. The audit manager calls you into her
office:
“I need you to help plan the audit of Solvit for the year ending 31 March 20X8. The Audit Committee
Chair has requested that we present our audit plan at next week’s Audit Committee meeting and has
asked that this plan sets out our initial assessment of the key audit matters we expect to include in
our audit report.
I have provided you with an extract from last year’s audit report (Exhibit 1) so that you can see the
key audit matter that Solvit’s previous auditor, Fenn Yo LLP, identified. This is a good starting point for
us, but we will need to update last year’s key audit matter and identify additional key audit matters.
It’s important that where we identify a key audit matter (KAM), we are precise about the audit
objectives and where the greatest audit risk arises.
I have also provided notes from my meeting with the Fenn Yo LLP audit partner and manager (Exhibit
2) and a summary of points from my initial audit planning meeting with the Solvit Finance Director,
Sam Browne (Exhibit 3). I need you to do the following:
(1) In respect of the key audit matters to be included in our plan for the Solvit audit for the year
ending 31 March 20X8:
(a) Explain why the key audit matter identified by Fenn Yo LLP (Exhibit 1) continues to be
relevant and explain how this matter has changed this year.
(b) Identify additional key audit matters for this year’s audit and explain the factors which have
led you to select each of them as a key audit matter.
(2) For each of the key audit matters identified in (1) above:
(a) Identify the relevant financial reporting standard and explain how it should be applied to the
key audit matter in Solvit’s financial statements for the year ending 31 March 20X8.
(b) Explain the specific audit objectives and set out the audit procedures to provide assurance
in respect of the key audit matter.”
Requirement
Respond to the audit manager’s instructions.
Total: 28 marks
ICAEW 2022
Real exam (November 2018)
195
Exhibit 1: Extract from last year’s audit report on the financial statements of Solvit plc for the year
ended 31 March 20X7 – prepared by Fenn Yo LLP
Key audit matter
Revenue recognition
We identified revenue recognition as a key audit matter because the allocation of revenue to each
component of a sale (software, services and maintenance), when sold together in a bundle, requires
the application of judgement. We assessed this risk to be greatest in larger, more complex
transactions, where there is increased likelihood of multiple components or the delivery of
customised software.
Our audit procedures focused on the larger, more complex revenue transactions with the objective
of checking that the allocation of revenue between components was consistent with the terms of the
sale contracts and in line with Solvit plc’s accounting policy. In particular, we audited the basis upon
which management had calculated the fair value attributable to the components of revenue. Our
audit procedures identified one contract where, because of a calculation error, too much revenue
was allocated to the initial software supplied rather than deferred to cover future maintenance. An
adjustment of £1.3 million was recorded to correct this error.
Exhibit 2: Kanes LLP audit manager’s notes from handover meeting with Fenn Yo LLP audit partner
and manager
These notes summarise key points from my meeting with the Fenn Yo LLP audit partner and manager
responsible for the Solvit audit for the financial years ended 31 March 20X5, 20X6 and 20X7. They
clearly knew the client well and could provide helpful insights into the work they performed and their
audit report.
In addition to meeting with the engagement partner and manager, we performed a detailed review
of the Fenn Yo LLP audit working papers. This review identified no issues with the audit procedures
performed or the conclusions reached.
Key points from meeting with the Fenn Yo audit team
•
Materiality for the year ended 31 March 20X7 was set at 5% of profit before taxation, giving a
materiality figure of £1 million.
•
The error noted in revenue recognition was a calculation error and arose in March 20X7 when a
new revenue accountant was appointed. He lacked the experience of his predecessor and made
an error in determining the separate prices of the component parts.
•
In addition to the revenue error identified, there was one other item on the schedule of
misstatements. This was in relation to the allowance for aged receivables where a judgemental
excess allowance of £700,000 was identified. This was not adjusted in the financial statements.
•
In addition to the key audit matter included in the audit report for the year ended 31 March 20X7,
Fenn Yo also considered the presumed risk of material misstatement arising from management
override of controls. Management was judged to have a relatively low incentive to overstate
results for the year, as Solvit had far exceeded the target performance required for the maximum
management bonus to be paid. Therefore, Fenn Yo did not identify this as a key audit matter.
Exhibit 3: Summary of meeting with Solvit Finance Director, Sam Browne – prepared by Kanes LLP
audit manager
Revenue
A typical customer relationship for Solvit starts with a contract for the supply of software. In most
cases this is standard software for which the customer pays a one-off, up-front licence fee.
However, there are also complex contracts under which Solvit supplies standard software together
with other elements such as customisation, integration and maintenance services. At the end of the
contract period, customers can renew the maintenance agreement at the standard price quoted in
Solvit’s price list.
Customisation and integration services are also sold separately at standard day rates.
Sam commented that IFRS 15 is a relatively new standard, and applying it was challenging and he
has relied heavily on Solvit’s revenue accountant.
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Revenue for the six months ended 30 September 20X7 is at the same level as the same period last
year but is £5 million lower than forecast. This is largely because sales of new software for the
education market have grown more slowly than expected because of issues with the software. The
education market has proved to be very price-competitive and Solvit has incentivised customers to
purchase its software by giving large discounts on maintenance agreements for up to three years.
Management bonus
Lower than budgeted revenues for the six months ended 30 September 20X7 have resulted in lower
than expected profit and Solvit will need to perform exceptionally well in the second half of the year
to meet its profit target. Sam is confident that it will do so and has therefore accrued half of the
maximum management bonus for the year in the results for the six months ended 30 September
20X7.
Receivables
The new education clients have been slow to settle their debts and receivables days have increased
from 45 days at 31 March 20X7 to 75 days at 30 September 20X7. On initial recognition of all
receivables, Solvit created an allowance equal to 12 months’ expected credit losses in accordance
with IFRS 9, Financial Instruments. Sam intends to keep the allowance for receivables at the same
level as at 31 March 20X7, as he is confident that most receivables will be paid once the issues with
the software are sorted out. The trade receivables do not contain a significant financing component.
Sale and leaseback
On 1 April 20X7, Solvit sold its northern office property to a property company for £15 million, its fair
value, and leased it back. The lease has a term of 10 years and rentals of £600,000 per annum paid
annually in arrears. Immediately prior to the transaction with the property company, the office
property had a carrying amount of £11 million. It has an estimated remaining useful life of 20 years.
The interest rate implicit in the lease is 3% and the 10-year cumulative discount factor at 3% is 8.530.
The Finance Director believes that this transaction constitutes a sale in accordance with IFRS 15,
Revenue from Contracts with Customers but he is unsure of the correct accounting for this transaction
under IFRS 16, Leases.
ICAEW 2022
Real exam (November 2018)
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198
Corporate Reporting
ICAEW 2022
Real exam (July 2019)
60 Vacance plc
Vacance plc is a listed company which operates a chain of hotels. You are Georgie Smith and you
work for Atar LLP, an international firm of ICAEW Chartered Accountants. Atar has audited Vacance
for many years.
You have been assigned to work for Simon Lane, a partner in Atar’s quality assurance division. Simon
carries out second partner reviews of audits performed on listed audit clients. Simon gives you the
following briefing:
“I need your help with my second partner review of the Vacance audit for the year ended 31 May
20X1. The audit report is due to be signed in two weeks’ time and I am concerned about the audit
team’s work. I will need you to get involved in some of the detail.
As property is a material figure in the statement of financial position, I have provided you with
extracts from the property section of the audit file. These extracts were prepared by the audit senior,
Jim Green (Exhibit 1). Last Friday, I had a conversation with Jim about the Vacance audit. What he
told me has caused me some concern. I have summarised our conversation in a note (Exhibit 2),
which I would like you to keep confidential.
I have a meeting next week with Harriet Meening, the Vacance audit engagement partner, to discuss
the outcome of my second partner review on the Vacance audit. Harriet is due to retire later this year.
This morning I received a file note from Jim (Exhibit 3) with outstanding financial reporting matters
concerning the financing of Vacance’s Malaysian operations.
I need you to prepare a draft email to the Vacance audit team in which you:
(1) Explain the appropriate financial reporting treatment for the £24.55 million recognised by
Vacance as investment properties (Exhibit 1) and for each of the financial reporting matters set
out in Jim’s file note (Exhibit 3). Include journals.
(2) Prepare a revised extract from the financial statements for property for the year ended 31 May
20X1 (Exhibit 1). Assume that Vacance selects the fair value model for investment properties.
(3) Identify and explain the weaknesses in the audit procedures performed by Jim (Exhibit 1).
(4) Identify and explain the key audit risks for the separate plot of land and the shopping complex
and land. Set out any additional audit procedures that should be performed.
I will need to provide feedback on the quality management and ethical issues relating to the Vacance
audit.
Please prepare a briefing note for me in which you:
(5) Explain the key factors that have affected the overall quality of the Vacance audit and set out
appropriate recommendations.
(6) Identify the ethical issues for Atar and for me. Set out the actions Atar and I should take.”
Requirement
Prepare the draft email and the briefing note requested by Simon. Ignore any adjustments for tax or
deferred tax
Total: 40 marks
Exhibit 1: Extract from the property section of the audit file prepared by audit senior, Jim Green
The accounting policy note for property disclosed in last year’s financial statements for the year
ended 31 May 20X0 was:
Property comprises land and hotel buildings. It is stated at cost less depreciation and any
impairment. Land is not depreciated. Buildings are depreciated over 50 years on a straight-line basis.
Residual values are reassessed annually. Repairs and maintenance costs are expensed as incurred.
Property is tested for impairment when events or changes in circumstances indicate that the carrying
amount may not be recoverable. Each hotel is regarded as a separate cash generating unit for
impairment purposes.
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Extract from the financial statements for the year ended 31 May 20X1
Land and hotel
buildings
Investment
properties
£’000
£’000
At 1 June 20X0
100,500
–
Additions
––––––
24,550
At 31 May 20X1
100,500
24,550
Land and hotel
buildings
Investment
properties
£’000
£’000
2,585
–
80
–
2,665
–
Property
Cost
Depreciation
At 1 June 20X0
Provided in the year
At 31 May 20X1
Planning materiality was established at £4 million. Performance materiality for ‘Property’ has been set
at £2 million.
Summary of audit procedures performed
•
Land and hotel buildings
Tests of details have been performed on the cost of land and hotel buildings to ensure existence
and valuation by agreeing a sample of hotel properties to the balance on last year’s audit file.
There are no additions or disposals of land and hotel buildings and the depreciation charge is
below materiality. Therefore, no audit procedures have been performed.
•
Investment properties
There were no investment properties in previous years.
On 1 March 20X1, Vacance bought land and some properties next to a small airport in Malaysia.
An analysis of the cost of these assets which are recognised in investment properties is as follows:
MYR million
Separate plot of land
50
Office building and land
45
Shopping complex and land
40
135
Exchange rate on 1 March 20X1 £1 = MYR 5.5
Recognised in investment properties £24.55 million
The MYR is the currency of Malaysia.
I agreed the cost of MYR 135 million to a bank transfer from Vacance to the seller and agreed the
exchange rate at 1 March 20X1 to a reliable source. The spot exchange rate at 31 May 20X1 was £1 =
MYR 6.0.
This is the first time Vacance has purchased property outside the UK. Vacance has set up operations
in Malaysia to rent out the properties. This rental business represents a departure from Vacance’s
core hotel business.
The finance director told me that the properties have significant investment potential as the airport
authorities have applied to the government for planning permission to expand the airport. A
decision is expected within the next 12 months.
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The finance director said that Vacance has an accounting policy choice in respect of investment
property which can be recognised at cost or fair value. The Vacance board would like to show the
highest possible amounts for investment properties and believes that the fair value model would
achieve this. The finance director would like to discuss the accounting policy choice with Harriet
Meening, the engagement partner, and has provided the following additional information:
Separate plot of land – MYR 50 million
Vacance is uncertain about the future use of this land. If planning permission for the airport
expansion is granted, Vacance will develop the land for commercial use. If permission for the airport
expansion is not granted, Vacance will sell the land. The finance director told me that the market
value of the land at the year ended 31 May 20X1 has increased to MYR 60 million and the Vacance
board wants to recognise this asset at its fair value.
Office building and land – MYR 45 million
Vacance lets out the office building to tenants on short-term rental agreements. The average rental
period is two days but can be as short as an afternoon. Vacance provides lunch and office support
services to the tenants. Because a similar office building was sold in June 20X1 for MYR 50 million,
the directors believe that MYR 50 million represents the fair value of Vacance’s office building and
should be reflected in the financial statements.
Shopping complex and land – MYR 40 million
The shopping complex comprises retail units of different sizes. Vacance lets the units to retailers. It
provides cleaning and security services for the common areas only. As this is the only shopping
complex in the area, the Vacance finance director is uncertain of its fair value.
He has suggested that a valuation could be determined using forecast rental income and budgeted
occupancy rates. Vacance intends to sell the shopping complex on 31 May 20X4 for MYR 50 million.
Occupancy rates will increase if the airport receives planning permission for expansion.
The finance director provided the following estimates:
Year ending 31 May
Forecast rental income with full occupancy
20X2
20X3
20X4
MYR million
MYR million
MYR million
4.0
4.0
4.5
Disposal proceeds
50.0
20X2
20X3
20X4
No airport expansion
32%
20%
20%
With airport expansion
55%
80%
85%
Expected occupancy rates:
Vacance uses a 10% annual discount rate.
I have emailed Harriet for advice, but she told me she is too busy and will speak to the finance
director on her return next week.
Exhibit 2: Note of conversation between Simon Lane (second partner) and Jim Green (audit senior
Jim told me that there have been changes to the Vacance audit team during the audit. The audit plan
was prepared by an audit manager who has now left the firm. Harriet Meening, the engagement
partner, has not signed off the audit plan and she has not been available during the audit because
she is visiting and staying in various Vacance hotels in the UK. Jim is friendly with one of the
accountants at Vacance who told Jim that Harriet is being accompanied by her husband and that all
their expenses are being paid by Vacance.
A new audit manager joined the team last week. He struggles to explain to the team what to do and
appears not to understand some of the complex transactions that Vacance has undertaken during
the year.
Also, Jim and the rest of the audit team were invited to have drinks after work by the Vacance
accountant. Jim overheard one of the audit juniors telling the accountant that his audit work is
ICAEW 2022
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201
‘boring and repetitive’ and involves agreeing ‘one number from a spreadsheet to another
spreadsheet’ and that he ‘has no idea what he is doing’.
Exhibit 3: File note of outstanding financial reporting matters concerning the financing of Vacance’s
Malaysian operations prepared by Jim Green
The purchase of the land and properties in Malaysia was financed by issuing £20 million 4.2%
debentures and taking out a MYR 25 million loan with a Malaysian bank.
Issue of 4.2% debentures
On 1 March 20X1, Vacance issued £20 million fixed rate 4.2% debentures at par. Interest on the
debentures is due at the end of each quarter. The debentures will be repayable in 20X7. Vacance
entered into a receive-fixed, pay-variable interest rate swap agreement of £20 million to hedge the
fair value of the debentures.
The terms of the swap are for Vacance to pay the agreed variable rate at the end of each quarter and
receive 4% per annum fixed rate in return. The swap matures on the same date as the debentures.
The variable interest rate agreed for the swap for the three months to 31 May 20X1 was 3.7% per
annum. The fair value of the swap at 31 May 20X1 was £302,000.
The fair value of the debentures fell to £19.7 million at 31 May 20X1 because of a rise in market
interest rates. The debentures have been recognised in the statement of financial position as follows:
£’000
DEBIT
CREDIT
Cash
Non-current liabilities
£’000
20,000
20,000
The interest on the debentures and the swap was paid and received after the year end and no
accounting entries have been recorded in the year ended 31 May 20X1.
MYR 25 million loan from a bank in Malaysia
On 1 March 20X1, Vacance received a MYR 25 million loan from a Malaysian bank. This loan is
repayable on 1 March 20X2 and is recognised in the statement of financial position at 31 May 20X1
as a current liability. It is translated at the spot exchange rate at 1 March 20X1 as follows:
MYR 25 million @ £1 = MYR 5.5 = £4.55 million
On 1 March 20X1, Vacance entered into a forward contract to purchase MYR 25 million at a forward
exchange rate of £1 = MYR 6.0 for delivery on 1 March 20X2. At 31 May 20X1, a similar contract was
available at a forward exchange rate of £1 = MYR 6.5. The spot rate on 31 May 20X1 was £1 = MYR
6.0
61 JKL plc
JKL plc is an AIM-listed food processing company. It has investments in several wholly-owned
subsidiaries and owns 90% of the ordinary share capital of MiTek Ltd, a company which produces
animal feed. All group companies have a 30 September year end. JKL has decided to sell some of its
shares in MiTek to raise cash for other business ventures.
Background information on JKL’s investment in MiTek
MiTek was established 40 years ago and has a stable workforce. It has 20 million £1 ordinary shares
in issue.
On 1 July 20X1, JKL bought 18 million of MiTek’s £1 ordinary shares for £50 million, when MiTek’s
retained earnings were £16 million. At acquisition, MiTek’s only other reserve was a £7 million share
premium account. No fair value adjustments were required at the date of acquisition. JKL recognised
the non-controlling interest using the proportion of net assets method.
On 30 June 20X4, following MiTek’s poor trading results, JKL impaired goodwill arising on
consolidation of MiTek by £6 million. MiTek has made no changes to its share capital since 1 July
20X1. Its retained earnings at 1 October 20X6 were £23 million.
You are Darren Anker, JKL’s newly appointed accountant, and you report to JKL’s finance director,
Kylie Schmidt. Kylie gives you the following briefing:
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“On 1 January 20X7, Fym plc, a company unrelated to JKL, made an offer to buy 15 million ordinary
shares in MiTek from JKL for £58 million. The JKL board believed that this offer was too low and
rejected it.
Fym was concerned that MiTek’s statement of financial position showed a large defined benefit
pension liability and said that it would revise its offer only if this liability were reduced.
In January 20X7, MiTek’s board asked the MiTek pension scheme trustees to carry out a review to
consider how MiTek’s pension liability might be reduced. The outcome of this review was to make an
offer to the scheme’s pensioners to exchange future pension increases for a higher current pension
that will remain constant. Most pensioners in the MiTek scheme accepted this offer.
On 1 July 20X7, before he left the company, your predecessor, Kevan Riley, prepared a handover
note. This note includes JKL’s draft forecast consolidated statement of comprehensive income for the
year ending 30 September 20X7, excluding the results of MiTek. Kevan has also set out MiTek’s
forecast statement of comprehensive income for the year ending 30 September 20X7 and a note
about MiTek’s net defined benefit pension liability (Exhibit 1).
Since this financial information was prepared, I have received a report from MiTek’s pension scheme
actuary (Exhibit 2) and information regarding a revised offer from Fym (Exhibit 3).
JKL’s board would like to understand the impact that the potential sale of its 15 million MiTek shares
will have on JKL’s consolidated statement of comprehensive income for the year ending 30
September 20X7.
I would like you to prepare a working paper for the JKL board in which you:
(1) Explain the impact on MiTek’s financial statements for the year ending 30 September 20X7
arising from the information provided by MiTek’s pension scheme actuary (Exhibit 2).
(2) Prepare a revised forecast statement of comprehensive income for MiTek for the year ending 30
September 20X7.
(3) Explain the effect on JKL’s forecast consolidated statement of profit or loss and statement of
financial position for the year ending 30 September 20X7 of JKL’s sale of 15 million MiTek shares
to Fym. Include a calculation of the group gain or loss on this sale. Assume that JKL’s board
accepts Fym’s revised offer (Exhibit 3).
(4) Prepare a revised forecast consolidated statement of comprehensive income for JKL, including
MiTek, for the year ending 30 September 20X7. Include the adjustments required from (1) and
(3) above.”
Requirement
Prepare the working paper requested by Kylie.
Work to the nearest £0.1 million.
Total: 30 marks
Exhibit 1: Handover note prepared by Kevan Riley on 1 July 20X7
I have prepared a draft forecast consolidated statement of comprehensive income for JKL and its
subsidiaries for the year ending 30 September 20X7. This does not include the results provided by
MiTek’s accountant, which are shown below in a separate column.
Forecast statements of comprehensive income for the year ending 30 September 20X7
JKL: consolidated
(excluding MiTek)
MiTek
£m
£m
200.1
60.9
Cost of sales
(128.7)
(31.7)
Gross profit
71.4
29.2
(53.0)
(20.8)
Finance costs
(1.4)
(1.2)
Profit before tax
17.0
7.2
Revenue
Operating expenses
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203
JKL: consolidated
(excluding MiTek)
MiTek
£m
£m
Income tax
(2.9)
(1.2)
Profit for the year
14.1
6.0
––––––
–––––
14.1
6.0
Other comprehensive income for the year
Total comprehensive income
Attributable to:
Equity holders of the parent
Non-controlling interest
14.1
––––––
14.1
MiTek: Net defined benefit pension liability
MiTek operates a defined benefit pension scheme for its employees.
Because of uncertainty regarding the outcome of the review by MiTek’s pension scheme trustees, no
adjustments have been made to MiTek’s net pension liability at 1 October 20X6 in the forecast
above. A report has been requested from the pension scheme actuary.
On 1 October 20X6, the fair value of the pension scheme assets was £36 million, and the present
value of the pension scheme obligations was £47 million.
A tax deduction is available to MiTek for contributions made to the scheme. The tax rate is 20%.
A deferred tax asset of £2.2 million was recognised in the statement of financial position at 30
September 20X6 in respect of the net defined benefit pension liability. There has been no
adjustment to this asset in the draft forecast financial statements.
On 30 September 20X7, MiTek will pay a contribution of £800,000 to the scheme. This cost is
included in cost of sales in MiTek’s forecast statement of comprehensive income for the year ending
30 September 20X7.
Tax relief for this contribution has been allowed for in calculating the forecast current tax charge for
the year ending 30 September 20X7.
Exhibit 2: Report from MiTek’s pension scheme actuary, received on 10 July 20X7
On 1 February 20X7, the trustees of the MiTek defined benefit pension scheme made an offer to its
pensioners to exchange future pension increases for a higher current pension which would then
remain constant.
On 1 June 20X7, this offer was accepted by most pensioners and this resulted in a past service gain
of £3.5 million.
The present value of the scheme liabilities at 30 September 20X7 is estimated to be £42.1 million,
which includes the impact of the offer and its acceptance. The fair value of the scheme assets at the
same date is estimated to be £39.5 million.
Relevant projections for the year ending 30 September 20X7 are set out below:
£’000
Current service cost
Benefits paid to pensioners
200
1,200
The yield on high-quality corporate bonds is expected to be 6% pa.
Exhibit 3: Fym plc’s revised offer
Last week, following confirmation of the successful reduction in MiTek’s defined benefit pension
liability, Fym made a revised offer of £65 million to buy 15 million MiTek shares from JKL.
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This revised offer is likely to be accepted by the JKL board. The proposed date of sale is 1
September 20X7. JKL intends to sell its remaining 3 million MiTek shares in 20X9 as it believes that
their current fair value of £6 million is likely to increase by that date.
62 Roada Ltd
You are an audit senior working for DWE LLP, a firm of ICAEW Chartered Accountants. You have just
been assigned to the audit of Roada Ltd for the year ended 31 May 20X9. You receive the following
briefing from the Roada audit manager:
“Roada builds new roads and supplies related raw materials, such as cement and gravel, to other
road-builders. Planning materiality has been set at £1.8 million.
You will be working on revenue. Roada implemented IFRS 15 for the first time in the year ended 31
May 20X9. I have provided a copy of a memorandum prepared during our interim audit which
documents Roada’s two key revenue streams and its revenue recognition policies (Exhibit 1). Your
predecessor was ill during the interim audit and did not have time to document our assessment of
Roada’s accounting policies, nor to plan detailed audit procedures.
An audit assistant, Janice Yow, has provided her preliminary analysis of revenue for the year ended
31 May 20X9, based on analytics carried out by the DWE data analytics team (Exhibit 2).
I have also provided an email that I received from the Roada finance director (Exhibit 3). This
addresses some queries raised by Janice concerning the Pott road-building contract and the sale of
the Brightfield quarry.
In respect of our audit of Roada’s financial statements for the year ended 31 May 20X9, please
prepare a file note in which you:
(1) explain how Roada should recognise revenue for the two revenue streams identified in our
interim memorandum (Exhibit 1) and also for the sale of the Brightfield quarry (Exhibit 3).
Identify any additional information you require to reach a conclusion;
(2) identify and justify the elements of revenue which have a high risk of material misstatement. Use
Janice’s file note (Exhibit 2) together with the other information provided; and
(3) set out the audit procedures we should perform on the Pott road-building contract (Exhibits 2
and 3).”
Requirement
Prepare the file note requested by the audit manager.
Total: 30 marks
Exhibit 1: Memorandum on Roada’s revenue recognition - prepared by audit senior in March 20X9
during interim audit
For the year ended 31 May 20X9, Roada has two significant revenue streams:
Revenue stream 1 – Road-building
Revenue from contracts for building new roads. Contracts may cover a single road or multiple roads
and can extend for up to two years. An initial fixed price is agreed in advance and payable in
instalments as the work is carried out and certified by the customer’s surveyor. Certification means
that the customer’s surveyor has agreed the stage of completion. If a customer has certified work,
then the customer has agreed both that the work has been performed and that the value of the work
shown in the certificate is the amount they are due to pay.
Additional amounts can be charged to the customer in the form of variations to the initial fixed price
if:
•
the customer changes the specification;
•
there are significant changes in the prices of externally-sourced road-building materials; and/or
•
there are significant unforeseen issues with the site on which the road is being built.
The basis for charging for variations is set out in the contract but, in practice, there is often
negotiation with the customer before a revised price is agreed.
ICAEW 2022
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205
Revenue stream 2 – Cement and gravel
Revenue from supplying cement and gravel to other road-builders both within the UK and
internationally.
Customers based in the UK send their own drivers to collect cement or gravel from Roada’s
premises.
For international deliveries, Roada’s drivers deliver the cement or gravel to the docks, where it is
loaded into ships owned or hired by the customers.
Cement and gravel are weighed as they leave Roada’s quarries or manufacturing sites and a
despatch note is signed both by the driver and by Roada’s despatch team, which confirms the
product type and the weight despatched. The despatch note is then matched to a customer order
and an invoice is generated.
Revenue recognition policy
Roada’s accounting policies are unchanged from the previous year and do not take account of any
new accounting standards.
Its revenue recognition policies are as follows:
Road-building:
•
Revenue from contracts to build one or more new roads is recognised monthly based on the
value of work certified by the customer’s surveyor in that month.
•
Revenue from agreed variations to the initial fixed price of the contract is recognised when the
work has been completed.
•
Revenue from work performed but as yet uncertified is recognised as the higher of the costs
incurred by Roada and the value offered by the customer as part of ongoing negotiations.
Supplying of cement and gravel:
•
Revenue is recognised when the cement and gravel are collected from Roada’s quarries or
manufacturing sites.
Where there is a risk that a customer may not be able to pay, a trade receivable allowance is charged
as an expense, but no adjustment is made to revenue.
Exhibit 2: Preliminary analysis of Roada’s revenue for the year ended 31 May 20X9 prepared by
Janice Yow (audit assistant)
Revenue from road-building contracts
Roada’s road-building revenue is £69.4 million for the year ended 31 May 20X9. This total includes
revenue on Roada’s largest contract with Pott Construction (“Pott”), as shown below:
Certified work and agreed variations
Uncertified work
Pott
Other
Total
£m
£m
£m
15.6
40.2
55.8
8.9
4.7
13.6
24.5
44.9
69.4
Pott contract
Roada’s construction director, Mark Day, informed me that the Pott contract relates to roads for a
large residential development for Develop UK. Roada is acting as subcontractor to the main
contractor, Pott.
Roada’s work is in line with the timetable it has agreed with Pott, but the main contract is delayed and
the ultimate customer, Develop UK, is unhappy with Pott’s work. Develop UK has refused to certify
work and delayed its payments to Pott, which has, in turn, delayed payments to Roada. Pott paid £5
million to Roada in February 20X9 but has made no further payments since that date.
Pott is asserting that Roada’s working methods have contributed to the delays on the main contract,
and also that the surfacing material used by Roada is inferior to that specified in the contract.
Pott has therefore refused to certify a large amount of Roada’s work. The initial fixed price for this
uncertified work is £13.0 million, but only revenue equal to the cost of £8.9 million has been
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recognised in line with Roada’s revenue recognition policy. The Roada finance director is handling
commercial negotiations on this matter so I have asked him for further details (Exhibit 3).
Revenue from supplying cement and gravel
Sales occur throughout the year but are lower in the winter months of December to February as less
UK construction work takes place during that period.
Roada’s cement and gravel revenue is £118.8 million for the year ended 31 May 20X9. The DWE data
analytics team analysed the detailed transaction listings comprising this total. The table below shows
total revenue per month from June 20X8 to May 20X9, analysed between invoices, credit notes and
journal entries:
Cement and gravel sales from June 20X8 to May 20X9
Month
Invoices
Credit notes
Journals
Total
£m
£m
£m
£m
June
8.30
(3.95)
2.01
6.36
July
9.70
(0.30)
(0.05)
9.35
13.30
(0.20)
(0.01)
13.09
September
7.90
(1.80)
0.03
6.13
October
9.30
(0.20)
15.30
24.40
November
12.20
(0.10)
0.10
12.20
December
5.10
(2.50)
(0.07)
2.53
January
6.80
(0.10)
(0.01)
6.69
February
10.30
(0.30)
0.04
10.04
March
7.80
(1.50)
0.02
6.32
April
9.20
(0.20)
(0.01)
8.99
May
14.70
(0.10)
(1.90)
12.70
114.60
(11.25)
15.45
118.80
August
Total
Roada’s invoiced revenue is at its highest every third month when it reports its quarterly results to the
bank. Roada will sometimes offer special deals to customers in those months to ensure that forecasts
are met.
In most months, the value of journals is very low. For those months where the value was higher, I
obtained the following explanations from the Roada financial controller:
•
In June 20X8, a £2.0 million provision at 31 May 20X8 was reversed. The provision was made in
May 20X8 to provide for credit notes to be issued in June 20X8.
•
In May 20X9, a £2.0 million provision was made to provide for credit notes to be issued in June
20X9.
•
In October 20X8, cash of £15.5 million was received in respect of the sale of Roada’s Brightfield
quarry. I have asked the Roada finance director for more information about this (Exhibit 3).
Exhibit 3: Email from Roada finance director to audit manager
To:
DWE audit manager
From:
Roada finance director
Date:
Audit for year ended 31 May 20X9
Your audit assistant, Janice, asked me for further information on two matters:
(1) Sale of the Brightfield quarry
On 31 October 20X8, the Brightfield quarry was sold to one of Roada’s customers, Buildit plc.
Proceeds of £15.5 million were received in cash by Roada and recognised as revenue.
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207
At the date of the sale, the Brightfield quarry had gravel deposits which were expected to last for
five years at the current rate of extraction. These deposits had a market value of £25 million at that
date. Buildit expects to use the majority of the gravel extracted from the quarry to complete a
major building project.
Following the sale, Roada is obliged to continue to operate the quarry and to extract gravel at the
same rate as in the past. For the next five years, Buildit has the right to collect any gravel that
Roada extracts from the Brightfield quarry up to a cumulative market value of £20 million,
determined using market value on the date of each delivery. Gravel prices can vary.
Roada can sell, and gain the benefits from, any gravel extracted more than £20 million. At the end
of the five-year period, Buildit can require Roada to buy back the quarry for £1. Roada will then be
responsible for cleaning up the site.
(2) Commercial negotiations regarding the Pott contract
Discussions with Pott are proving difficult. Independent experts have inspected the work that Pott
is refusing to certify. They have confirmed that, although a surfacing material different from that
specified in the contract was used for some stretches of road, Roada has provided good-quality
work.
On 1 June 20X9, Roada ceased work on the contract and told Pott that it will not start again until it
is paid for all work. In my view, the real issue is that Pott simply does not have the cash to pay us
until it settles its own contractual dispute with Develop UK. The complaints about Roada’s work are
simply a delaying tactic.
Roada’s relationship with Pott has broken down completely and Pott is now questioning its
obligation to pay for work already certified, saying that Roada has breached the contract.
208
Corporate Reporting
ICAEW 2022
Real exam (November 2019)
63 Your Nature plc
You are Jo Jacks, an audit manager working for TC, a firm of ICAEW Chartered Accountants. You are
assigned to the audit of Your Nature plc (YN) for the year ending 31 December 20X6. YN is an AIMlisted company which sells beauty products under the brand, Nature&U. YN’s key selling point is that
its products are made using environmentally-friendly ingredients and processes.
Until recently, YN had no subsidiary companies but it owned 5% of the ordinary shares in Bay Bath
Oils Ltd (BBO), a company which has a licence to sell bath products under the Nature&U brand. On 1
April 20X6, YN increased its shareholding in BBO to 70% of BBO’s ordinary shares. TC will audit BBO
for the first time for the year ending 31 December 20X6.
The audit engagement partner, Kirsty Fox, gives you the following briefing:
“Elsie Penn, a financial accountant at YN, has prepared a forecast consolidation schedule for YN and
BBO for the year ending 31 December 20X6 and notes (Exhibit 1). Elsie is unsure how to complete
this consolidation schedule.
Elsie has identified some unresolved financial reporting matters relating to the forecast financial
statements of BBO for the year ending 31 December 20X6 (Exhibit 2).
In 20X4, YN developed a five-year sustainability plan. It has provided extracts which will form part of
the strategic report in the YN Group’s annual report and consolidated financial statements for the
year ending 31 December 20X6 (Exhibit 3).
I would like you to prepare a working paper in which you:
(1) Explain:
(a) any adjustments required to the individual financial statements of BBO for the year ending
31 December 20X6 in respect of the unresolved financial reporting matters identified by
Elsie Penn (Exhibit 2). Provide appropriate journal adjustments; and
(b) the impact of these matters for the consolidation of BBO in the YN group financial
statements for the year ending 31 December 20X6.
(2) Identify and briefly explain any errors in the forecast consolidation schedule prepared by Elsie
Penn (Exhibit 1).
(3) Calculate the goodwill and non-controlling interest to be recognised in the forecast
consolidated statement of financial position for the year ending 31 December 20X6. Take into
account the journal adjustments you have proposed.
(4) In respect of the extracts from YN’s five-year sustainability plan (Exhibit 3) to be included in the
YN Group’s annual report and consolidated financial statements for the year ending 31
December 20X6:
(a) Explain the audit issues.
(b) Set out the audit procedures that you would perform.
(c) Describe the implications for the audit report.”
Email
You receive the following email from George Hay, a former partner who left TC in December 20X5.
George was the engagement partner on the YN audit until three years ago.
Jo
I am considering applying for a role as a non-executive director at BBO. I realise that YN has
acquired BBO but there should not be any ethical reasons to prevent me from accepting this role
as YN had only a small investment in BBO when I was involved in the YN audit. Are you aware of
anything I should know about BBO? Perhaps I can buy you lunch next week and we could discuss
this.
ICAEW 2022
Real exam (November 2019)
209
Requirements
63.1 Prepare the working paper requested by the audit engagement partner, Kirsty Fox.
63.2 Explain the ethical implications for you and TC arising from George’s email, and set out the
actions you should take.
Total: 45 marks
Exhibit 1: Forecast consolidation schedule and notes – prepared by Elsie Penn
I have set out below a consolidation schedule for YN and BBO. It is a long time since I studied
financial reporting and I am unsure how to complete the consolidation schedule.
Summary forecast statement of comprehensive income for the year ending 31 December 20X6
Profit for the year
YN
BBO
YN Group
£’000
£’000
£’000
18,000
5,000
23,000
Attributable to:
Equity holders of the parent
21,500
Non-controlling interest
1,500
23,000
Summary forecast statement of financial position at 31 December 20X6
Property plant and equipment
Brand name – Nature&U
YN
BBO
Journals
YN Group
£’000
£’000
£’000
£’000
56,500
16,600
73,100
8,500
Development costs
8,500
3,000
3,000
Financial asset – investment in BBO
13,800
Current assets
50,600
20,800
71,400
129,400
40,400
169,950
15,000
10,000
25,000
Total assets
Equity (£1 ordinary shares)
FVOCI reserve
Retained earnings
Dr 150
300
52,100
17,400
Non-controlling interest
13,950
Cr 150
450
Dr 1,500
68,000
Cr 1,500
1,500
Non-current liabilities
25,000
Current liabilities
37,000
13,000
50,000
129,400
40,400
169,950
Total equity and liabilities
25,000
Additional information
On 1 January 20X3, YN bought 500,000 of the 10 million issued £1 ordinary shares in BBO for
£500,000. The BBO chief executive owned the remaining shares. YN classifies its investment in BBO
shares as a financial asset at fair value through other comprehensive income (FVOCI).
At 31 December 20X5, the 500,000 shares in BBO had a carrying amount of £800,000 and a
cumulative increase in fair value of £300,000 had been recognised in other comprehensive income
and in equity.
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ICAEW 2022
On 31 March 20X6, the fair value of YN’s investment in 500,000 shares in BBO was £950,000 and I
have included the following journal:
£’000
DEBIT
CREDIT
Investment
£’000
150
FVOCI reserve
150
On 1 April 20X6, YN bought a further 6.5 million BBO shares, paying £13 million (£2.00 per share). I
recorded this payment in YN’s investment in BBO.
In addition to the payment of £2.00 per share, YN will pay a further £0.10 per share on 1 April 20X8,
provided BBO achieves agreed profit targets. As this amount is payable only in 20X8, I have not
made any adjustment for this.
Following the acquisition of BBO shares by YN, the BBO board comprises the BBO chief executive,
finance director and three members of the YN board.
YN uses the fair value method to measure non-controlling interest in BBO. The fair value of the noncontrolling interest at 1 April 20X6 was £1.90 per share. YN uses a 9% annual discount rate.
Exhibit 2: Unresolved financial reporting matters relating to the forecast financial statements of
BBO for the year ending 31 December 20X6 – prepared by Elsie Penn
(1) Employment legal proceedings
In 20X5, 10 female BBO employees began a legal case against BBO. The employees claim that they
are not receiving equal pay with their male employee colleagues. The female employees believe that
they are owed a total of £500,000. If the 10 female employees win, it will also result in additional
payments of £1 million to other BBO female employees. The case is ongoing and BBO’s legal team
think that it is possible, but not probable, that BBO will lose the case.
If the public became aware of the legal case, BBO would be seriously disadvantaged. The BBO
directors have not therefore recognised a provision and have not included a disclosure note for this
matter in the financial statements.
(2) Development costs
BBO developed a biodegradable plastic which it uses to manufacture bottles for its products. In
20X5, tests performed by BBO showed that the plastic would degrade within five years. At 1 April
20X6, the carrying amount of the plastic process development costs was £3.2 million in BBO’s
statement of financial position and the fair value was £10 million at that date.
A recent newspaper article quotes a BBO research technician who says that the tests performed in
20X5 were inaccurate and the plastic will take over 50 years to degrade. Since the article was
published, pictures of BBO’s empty bottles washed up on beaches have been posted on social
media by outraged environmental protesters. YN now believes that it has paid too much for its
investment in BBO, as the fair value of the plastic process development costs is now £4 million
following the adverse publicity.
(3) BBO’s Norfolk division
BBO’s Norfolk division has failed to meet legal requirements in respect of environmental legislation.
On 1 November 20X6, the YN board decided to close the BBO Norfolk division over a three-year
period from 1 January 20X7. BBO identifies the Norfolk division as a cash generating unit.
The division has a carrying amount of £7 million. I have prepared cash flow forecasts for the division
for the three years to 31 December 20X9:
Year ending 31 December
Future divisional cash inflows
20X7
20X8
20X9
£’000
£’000
£’000
2,300
1,500
1,000
At 31 December 20X6, the division could be sold for £5.5 million.
BBO uses a 9% pre-tax annual discount rate.
ICAEW 2022
Real exam (November 2019)
211
No adjustments have been made to the carrying amount of the division in BBO’s forecast financial
statements for the year ending 31 December 20X6, as the closure plan is confidential to the YN
board and has not been announced to the BBO board, managers and employees.
(4) Plot of land
At 1 April 20X6, a plot of land included in BBO’s assets had a carrying amount of £3 million which is
equal to its market value based on its current use as an industrial site. Residential development in the
area near to the factory means that, if the land were to be made available for residential purposes, it
would have a value of £3.75 million. I am unsure if this increase in value should be recognised. BBO’s
accounting policy is to value assets at historical cost.
(5) Share appreciation rights
BBO has a high staff turnover rate and absenteeism because of work-related stress.
Feedback from employees suggests that these are due to difficult working conditions, high accident
rates and excessive expectations of performance by management.
On 1 April 20X6, to improve staff morale, the BBO board introduced a share appreciation rights
scheme for all BBO employees, based on the share price of YN. Under the scheme, 500 employees
will receive a cash amount based on the increase in the fair value of YN shares between the grant
date, 1 April 20X6, and the vesting date, 31 March 20X9. The employees must be in continuous
employment to 31 March 20X9.
At 1 April 20X6, there are 500 employees eligible for the scheme, each of whom has appreciation
rights over 400 shares. BBO expects 50 employees to be made redundant by 31 March 20X9
because of the closure of BBO’s Norfolk division. The fair value of the appreciation rights was £9 per
share at 1 April 20X6 and is expected to be £12 per share at 31 December 20X6. No adjustments
have been made for the rights in the financial statements for the year ending 31 December 20X6.
(6) Receivables
Included in BBO receivables is an account balance of £475,000 called ‘accrued income’. The BBO
finance director explained that it relates to goods sold to Beauty Inc and, as he owns 25% of the
shares in Beauty and is a director of Beauty, he could personally guarantee that the debt will be
repaid. He told me that there was no need to include a trade receivable allowance for this account
and, as the amount is not material to the group results, no disclosure is required. I investigated the
balance and it relates to goods sold in May 20X6.
Exhibit 3: Extracts from YN’s five-year sustainability plan
In December 20X4, YN published a five-year sustainability plan. The plan sets out the importance of
protecting the Nature&U brand and focuses on social and environmental issues.
The following extracts have been drafted for the strategic report in the YN Group’s annual report for
the year ending 31 December 20X6. However, no information is yet included relating to BBO.
Extract 1: Responsible production and consumption
YN seeks to increase the use of bio-degradable materials in production and has made excellent
progress in line with the targets set out in the plan for this year. Progress towards targets is as follows:
31 December
Target % use of biodegradable materials
Total materials used
(tonnes)
Bio-degradable
materials
(tonnes)
20X4
10%
7,975
690
20X5
15%
8,900
1,070
20X6
20%
9,500
1,955
The target for 20X7 is 25% and the target for 20X8 is 30%.
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Extract 2: Employee relations
YN seeks to create the conditions that allow people to have high-quality jobs.
•
Employees are respected and enjoy decent working conditions.
•
All employees are treated equally and are paid at least 10% above the average pay for the
industry.
•
Employee reward schemes are fair and appropriate.
The YN board is happy to report that substantial progress has been made and that the above have
been achieved in the year ended 31 December 20X6. Progress towards targets is as follows:
31 December
Target Staff turnover
Actual Staff turnover
%
%
20X4
15
20
20X5
12
14
20X6
10
9
The target for 20X7 is 5% and the target for 20X8 is 4%.
64 RTone plc
You are Margot Jones, an ICAEW Chartered Accountant and the newly-appointed financial controller
at RTone plc, a company which sells home cinema and audio equipment.
RTone was established 30 years ago by its current shareholders and directors, Frank Nickson and
Stephen Ryding, who each own 50% of its issued ordinary share capital.
RTone operates from 26 retail properties located in shopping centres in UK cities. The retail
properties are leased on six-month leases as the company determines which locations generate the
most revenue.
However, from 1 October 20X3, RTone will focus on a smaller number of locations, leasing retail
properties for 10 years. RTone does not own any properties, and has elected to apply any IFRS 16
recognition exemptions. In the year ended 30 September 20X3, revenue increased by 0.8%
compared with the prior year and profit before tax increased by 1.5%.
RTone’s key resource is its employees, who have expert knowledge of the company’s products and
provide exceptional customer service. RTone has developed a strong brand name and customer
loyalty.
RTone faces competition from internet-based retailers and it has identified a potential acquisition, HSound Ltd. This company is an internet-based retailer of home cinema and audio equipment.
You have prepared financial information and key ratios for RTone and H-Sound for the year ended 30
September 20X3, together with background notes (Exhibit 1).
The RTone CEO gives you the following briefing:
“RTone’s finance team has performed preliminary due diligence on the draft financial statements of
H-Sound. The team identified some financial reporting issues (Exhibit 2).
Because it is important to be able to understand the relative performance of RTone and H-Sound, I
need to understand the implications of these issues for H-Sound’s draft financial information and key
ratios.
I would like you to prepare a report for me in which you:
(1) set out and explain any adjustments required to H-Sound’s financial information and key ratios
(Exhibit 1) arising from the financial reporting issues (Exhibit 2). Provide supporting journals;
(2) calculate revised financial information and key ratios for H-Sound for the year ended 30
September 20X3 (Exhibit 1); and
(3) compare and analyse the financial performance and gearing of RTone and H-Sound. Use your
revised financial information and key ratios for H-Sound together with any additional analysis.”
ICAEW 2022
Real exam (November 2019)
213
Requirement
Prepare the draft report requested by the CEO.
Ignore tax and deferred tax.
Total: 30 marks
Exhibit 1: Financial information and key ratios for the year ended 30 September 20X3 with
background notes
Financial information
RTone
H-Sound
£’000
£’000
Revenue
93,531
49,211
Gross profit
19,640
7,873
1,737
–
Depreciation
100
279
Directors’ salaries
140
550
30
407
6,250
4,504
15,691
6,855
608
5,892
2,000
–
RTone
H-Sound
38.5%
38.5%
3.7%
46.2%
£311,770
£328,073
Lease rentals – retail properties
Finance costs
Profit before tax
Equity: Share capital and retained earnings
Net debt
Dividends paid in the year
Key ratios
Return on Capital Employed (ROCE)
Gearing
Revenue per employee
ROCE is defined as:
Profit before interest and tax ÷ Equity plus net debt × 100%
Gearing is defined as:
Net debt ÷ Equity plus net debt × 100%
Background notes on H-Sound
H-Sound was established five years ago by a Japanese audio equipment manufacturer, TDef. TDef
subscribed £5 million for 100% of H-Sound’s issued share capital.
H-Sound operates as an internet-based retailer from a large warehouse. It bought this on 1 October
20X1 using a £6 million bank loan which is secured on the warehouse.
H-Sound’s revenue has increased by 50% compared with last year and profit before tax has increased
by 15%.
Investment in technology
H-Sound’s key resource is its investment in technology. This enables the company to keep inventory
levels low and to answer customer queries efficiently by using artificial intelligence (AI) software with
an online customer service function. H-Sound employs software engineers to keep the company’s
technology up-to-date.
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Exhibit 2: H-Sound financial reporting issues identified by RTone’s finance team
RTone’s finance team has performed preliminary due diligence on the draft financial statements of HSound. The team identified some financial reporting issues.
(1) Non-current assets (NCA)
Property and equipment
Al software
£’000
£’000
Cost
At 1 October 20X2
2,100
Land
1,000
Property – freehold warehouse
5,000
Equipment
1,500
Additions
––––
1,300
At 30 September 20X3
7,500
3,400
100
261
Depreciation/Amortisation
At 1 October 20X2
Charge for the year
179
Property
40
Equipment
60
––––
200
440
7,300
2,960
At 30 September 20X3
Carrying amount at 30 September 20X3
Additions of £1.3 million comprise the wages of software engineers who maintain the AI software
bought by H-Sound during 20X1 for £2.1 million. H-Sound did not amortise the additions as the £1.3
million journal transfer from operating expenses to NCA was only made on 30 September 20X3.
NCA are depreciated or amortised using the following useful lives and residual values:
Number of years
Residual value % of cost
Property
25
80
Equipment
15
40
Al software
10
15
The useful lives and residual values are generous and inconsistent with RTone’s policy, which
depreciates equipment straight-line over five years and amortises software over three years with nil
residual values.
(2) Loan finance
On 1 October 20X1, H-Sound borrowed £6 million from a bank. Under the terms of the loan, interest
of 6% was payable annually in arrears and the loan was repayable in full by 30 September 20X5.
Transaction costs of £203,000 were debited to the loan and the correct effective annual interest rate
of 7% was used to amortise the loan.
ICAEW 2022
Real exam (November 2019)
215
On 30 September 20X3, H-Sound renegotiated the loan with the bank for a later repayment date in
exchange for a higher coupon rate. The terms of the new loan are:
Amount of loan
£6,000,000
Transaction costs
£300,000
Repayment date
30 September 20X9
Coupon rate
8%
The present value of the cash flows of the renegotiated loan at 30 September 20X3 is £6,583,700,
using an effective annual interest rate of 7%.
The fair value of the renegotiated loan at 30 September 20X3 is £6 million.
H-Sound has debited the transaction costs of £300,000 to a receivable account and made no further
adjustments.
(3) Customer reward scheme
On 1 July 20X3, H-Sound introduced a customer reward scheme to encourage customer loyalty. The
scheme rewards a customer with one customer loyalty point for every £10 of purchases. Each point is
redeemable for a £1 discount on any future purchases from H-Sound.
In the year ended 30 September 20X3, customer purchases under the scheme totalled £15 million
and customers earned 1,500,000 points redeemable against future purchases. H-Sound expects
1,425,000 of the 1,500,000 points to be redeemed before the latest permissible redemption date. At
30 September 20X3, 300,000 points have been redeemed.
H-Sound’s revenue for the year ended 30 September 20X3 includes the £15 million for sales under
the scheme.
No adjustment has been made in the financial statements for the year ended 30 September 20X3 for
the unredeemed points awarded under the scheme.
(4) Z-Audio product and online entertainment and music streaming contract
On 1 September 20X3, H-Sound introduced access to an online entertainment and music
subscription for commercial customers who sign a contract to buy its Z-Audio product. Under the
terms of the contract, the customer pays 12 monthly instalments of £400 and receives: a Z-Audio
product; and a 12-month subscription to an online entertainment and music streaming service.
The Z-Audio selling price without the streaming subscription is £4,600. The streaming service
subscription is available without the Z-Audio product for £50 per month.
H-Sound has recognised £2.4 million in revenue in respect of 500 contracts for Z-audio products with
the streaming service. H-Sound sold these contracts in September 20X3.
65 Gentri plc
You are an audit senior working for Ascott LLP, a firm of ICAEW Chartered Accountants. You have just
been assigned to the audit of Gentri plc and the Gentri Group for the year ended 30 September
20X8. Gentri plc, the parent company, is listed on the London Stock Exchange. It manufactures and
distributes engines for the automotive industry.
The Gentri Group has only one subsidiary, CarNation Inc, which is based in Arcadia and audited by a
team from Ascott’s Arcadian office. CarNation supplies Gentri plc with key components for its
engines. All of CarNation’s sales are to Gentri plc, but Gentri plc has many suppliers.
The procedures for the Gentri Group audit are almost complete and both the working papers and
draft financial statements have been reviewed by the engagement partner, Joe Long. The
engagement manager calls you into her office to explain your role:
“Joe has raised three partner review notes on the Gentri Group audit. He was not happy with the
group audit team’s management of the subsidiary audit team in Arcadia nor with the audit
procedures on group taxation. He also identified potential issues with the consolidated statement of
cash flows.
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ICAEW 2022
I have provided you with extracts from the financial statements of Gentri plc and CarNation for the
year ended 30 September 20X8 with my notes (Exhibit 1). I’ve also been through Joe’s review notes
and added responses (Exhibit 2). Group materiality is £7 million.
What I need you to do is:
For each of the three partner review notes raised by Joe Long (Exhibit 2):
(1) explain the relevant financial reporting issues and set out the appropriate financial reporting
treatment; and
(2) describe the key audit procedures we should perform.
Use all available information. You are not required to adjust the consolidated statement of cash
flows.”
Requirement
Respond to the audit manager’s request.
Total: 25 marks
Exhibit 1: Extracts from financial statements for the year ended 30 September 20X8, with notes
from the engagement manager
Gentri plc
CarNation
£m
£m
Revenue
482
137
Profit before taxation
143
44
Taxation
(27)
(14)
Profit for the year
116
30
Investment in CarNation (Note 1)
100
–
Property, plant and equipment
153
145
47
41
Cash
154
34
Loan (Note 2)
(60)
–
Taxation payable
(15)
(14)
Deferred taxation
(6)
–
(109)
(56)
Net assets
264
150
Share capital
200
70
64
80
264
150
Inventories
Other assets and liabilities
Retained earnings
ICAEW 2022
Real exam (November 2019)
217
Notes
(1) On 1 October 20X4, Gentri plc acquired the entire ordinary share capital of CarNation for £100
million. At that date, the fair value of CarNation’s net assets was £80 million and it had retained
earnings of £10 million. There were no other reserves. Goodwill of £20 million arising on the
acquisition is not impaired. No dividends have been paid by CarNation to Gentri plc. However,
Gentri plc’s board has decided that it will extract a dividend of £50 million from CarNation, to be
declared and paid on 1 January 20X9. Assume that tax is payable by Gentri plc at 19% when it
receives dividends from CarNation. CarNation prepares its financial statements using £ sterling
as its functional currency.
(2) Gentri plc repays the principal of its loan in annual instalments of £10 million.
Exhibit 2: Review notes raised by the engagement partner, Joe Long, with responses from the
engagement manager
Partner review note 1
Gentri Group audit team’s management of subsidiary audit team
The audit procedures on CarNation were performed by an audit team from Ascott’s Arcadian office.
The only documentation on the Gentri Group audit file at present is:
•
extracts from CarNation’s financial statements (Exhibit 1)
•
a brief clearance memorandum dated 31 October 20X8, from the subsidiary audit team
This is insufficient for me to evaluate whether the group audit team has adequately considered and
followed up the audit work performed by the CarNation audit team in respect of the group audit.
The clearance memorandum states that all audit procedures are complete and that the subsidiary
audit team has not identified any adjustments above component materiality of £4 million in the
CarNation financial statements.
However, the CarNation audit team has identified two points for the group audit team to consider for
the consolidated financial statements:
•
A large shipment of components was made by CarNation to Gentri plc on 29 September 20X8. It
is likely that these components were still in transit at the year end. CarNation recorded revenue of
£15 million in the year ended 30 September 20X8, in respect of this shipment.
•
Gentri plc plans to introduce a new range of engines. In the year ended 30 September 20X8,
CarNation recognised an impairment charge of £11.5 million in respect of plant used to
manufacture a part which will no longer be used for the new range of engines. In Arcadia,
impairment charges are deductible for tax purposes when they are recognised in the financial
statements.
I cannot see how you have followed up these two points.
Response from the engagement manager
•
We do have some documentation that is not on the group audit file. I sent an email to the
subsidiary audit team on 30 June 20X8. This informed them that component materiality for
CarNation was £4 million, summarised key risks of material misstatement and provided details of
related parties. It asked the subsidiary team to confirm their independence, which they did in an
email response, which also confirmed receipt of my email.
•
The members of the subsidiary audit team have all worked on the audit of CarNation for several
years and I have no concerns about their competence.
Partner review note 2
Audit procedures on taxation
I am concerned about the extent of our audit procedures on taxation. Gentri plc’s tax charge for the
year ended 30 September 20X8 appears to relate wholly to current taxation and has been agreed to
a draft computation prepared by Gentri’s financial controller. No other audit procedures have been
performed and Gentri plc’s deferred tax balances remain unchanged from those recognised at 30
September 20X7. I believe we need to do more audit procedures, both on Gentri plc’s tax balances
and the tax balance for the Gentri Group.
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Response from the engagement manager
•
Historically the only temporary differences arising in Gentri plc have been in respect of plant and
equipment. At 30 September 20X7, the position was as follows:
£m
Carrying amount of plant and equipment
75.0
Tax base of plant and equipment
43.0
32.0
Deferred tax liability at 19%
6.1
In the year ended 30 September 20X8, the Gentri plc carrying amount of plant and equipment was
as follows:
£m
Carrying amount at 30 September 20X7
75.0
Additions (all qualifying for tax depreciation)
21.0
Depreciation
(6.0)
Carrying amount at 30 September 20X8
90.0
The Gentri plc tax computation prepared by the financial controller correctly adds back depreciation
and then deducts tax depreciation of £11.5 million. Gentri plc pays tax at the rate of 19% of taxable
profits.
•
CarNation pays tax at the rate of 30%. The CarNation audit team has confirmed that it has
performed audit procedures on the taxation balances for CarNation and it has not identified any
issues.
•
We need to think further about whether Gentri plc’s plan to extract a dividend from CarNation has
any impact on the reported tax charge for Gentri plc and the Gentri Group.
Partner review note 3
Consolidated statement of cash flows for the year ended 30 September 20X8
The consolidated statement of cash flows has not yet been audited. I have not looked at it in detail
but from a basic review there seem to be missing figures and it does not seem to reflect my earlier
review points.
Response from the engagement manager
•
The figures in the consolidated statement of profit or loss, consolidated statement of financial
position and notes have all been agreed to our audit file, but audit procedures on the
consolidated statement of cash flows are incomplete. The latest draft of the consolidated
statement of cash flows is shown below.
20X8
20X7
£m
£m
187
208
21
20
Decrease in inventory
5
6
Increase in creditors and provisions
7
18
Impairment of property
–
15
Year ended 30 September
Cash flows from operating activities:
Profit before taxation
Add:
Depreciation
ICAEW 2022
Real exam (November 2019)
219
Year ended 30 September
20X8
20X7
£m
£m
Deduct:
Profit on disposal of PPE
Increase in accounts receivable
–
(4)
(3)
(10)
217
253
(41)
(25)
(53)
(95)
Net cash flows from taxation:
Current taxation paid
Net cash flows from investing activities:
Purchase of PPE
Proceeds from disposal of PPE
–––
5
(53)
(90)
–
(10)
(40)
(35)
(40)
(45)
83
93
Cash at beginning of year
105
12
Cash at end of year
188
105
Net cash flows from financing activities:
Repayment of loan
Dividends paid
Net cash inflow
220
Corporate Reporting
ICAEW 2022
Real exam (August 2020)
66 HC plc
HC plc is the parent company of the HC group. HC plc’s subsidiaries operate in a variety of industries
and are located in the UK and internationally. You work as an audit senior for Welfold, a firm of
ICAEW Chartered Accountants. Welfold is the auditor of HC plc, HC group and all its subsidiaries.
You are assisting the HC audit engagement manager, Sara Yang, with the final review points arising
from the audit of HC plc and the consolidation for the HC group for the year ended 31 May 2020.
The audit completion meeting is scheduled for next week.
Sara gives you the following briefing:
“HC plc appointed Maisie Judge, an ICAEW Chartered Accountant, as the new Head of Treasury on 1
April 2020. Maisie worked for an investment bank before joining HC plc and she manages HC plc’s
investments and financial assets.
“The HC plc finance director retired on 10 March 2020, just before Maisie joined HC plc. As there is
no replacement finance director, Maisie is acting in that role. I have concerns that some of her
financial reporting knowledge is out of date.
“I have provided you with extracts from the HC group’s financial statements for the year ended 31
May 2020, including the accounting policy note for financial assets (Exhibit 1).
“The audit planning for financial assets was completed in February 2020, prior to Maisie’s
appointment. The planning indicated that there were no significant changes from the year ended 31
May 2019 and financial assets were assigned a low level of audit risk. Last week, an audit senior, Jane
Smith, performed some procedures on financial assets and has prepared some audit notes (Exhibit
2).
“An audit assistant has also brought some matters to my attention in relation to Maisie (Exhibit 3).
“I would like you to prepare a working paper in which you:
(1) For each of the matters in Jane Smith’s audit notes (Exhibit 2), set out and explain the correct
financial reporting treatment in HC plc’s financial statements and, where relevant, the HC group
financial statements, for the year ended 31 May 2020. Show appropriate journal adjustments and
explain any implications for the accounting policy note (Exhibit 1).
(2) Calculate, taking into account your journal adjustments, the revised profit before tax and other
comprehensive income for HC plc and for the HC group for the year ended 31 May 2020
(Exhibit 1).
(3) Identify and explain the additional audit risks for financial assets arising since the audit planning
was completed in February 2020.
(4) Set out the key audit procedures that we should perform in respect of:
(a) Konditori Ltd’s investment in Clik Ltd
(b) HC plc’s corporate loans
(5) Explain the ethical implications for Welfold and for Maisie, arising from Maisie’s roles and from
the matters highlighted by the audit assistant (Exhibit 3). Set out the actions Welfold should
take.”
Requirement
Prepare the working paper requested by the engagement manager, Sara Yang.
Note: You are not required to make any adjustments for current and deferred taxation.
Total: 40 marks
Exhibit 1: Extracts from draft financial statements
Accounting policy note for financial assets for the year ended 31 May 2020
Investments in subsidiary companies are stated at cost less any allowance for impairment.
On initial recognition of other investments in equity instruments, an irrevocable election is made to
measure each investment at fair value through other comprehensive income, with any fair value gains
or losses accumulated in other components of equity.
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221
Corporate loans are measured initially at fair value plus directly attributable transaction costs and
thereafter at amortised cost less impairments. The objective of the portfolio within which the
corporate loans are held is to collect contractual cash flows.
Extracts from statements of profit or loss for the year ended 31 May 2020
HC plc (parent)
HC (group)
£’000
£’000
8,500
95,600
-
-
Profit before tax
Other comprehensive income
Extract from statement of financial position as at 31 May 2020
HC plc (parent)
Financial assets
2020
2019
£’000
£’000
5,000
5,000
43,150
10,000
48,150
15,000
9,840
15,390
Equity investments (shares)
Investments in subsidiary companies
Other investments in equity instruments
Other financial assets
Corporate loans
Exhibit 2: Audit notes on financial assets – prepared by audit senior, Jane Smith
I have reviewed the financial asset balances in HC plc’s financial statements at 31 May 2020, as set
out below.
Investments in subsidiary companies
There has been no change to the group structure since the previous year end. I have agreed the total
cost of the subsidiaries of £5,000,000 to the consolidation schedules for the HC group.
Other investments in equity instruments
Fair value at 31 May
2020
2019
Historical cost
£’000
£’000
£’000
-
10,000
6,000
VLA plc (320,000 shares)
18,150
-
18,150
Investment
25,000
–––––
25,000
43,150
10,000
Alma plc (800,000 shares)
The investments in shares in Alma plc and VLA plc represent less than 10% of the share capital of
those companies.
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•
Alma plc shares
On 2 April 2020, Maisie authorised the sale of the Alma plc shares because its share price increased
to £17 per share. Maisie calculated that this transaction resulted in a gain of £3,600,000, which she
recognised in the statement of profit or loss.
I agreed this transaction to the contract note and ensured that the cash was correctly recorded.
•
VLA plc shares
On 3 April 2020, Maisie bought 320,000 shares in VLA plc, a client of the investment bank where she
used to work. Maisie recognised the shares at ‘fair value through profit or loss’ and the broker’s fee
for acquiring the VLA shares has been recognised in profit or loss.
The bid-offer spread for one VLA share at 3 April 2020 was:
At 3 April 2020
£55.45 – £56.72
The investment has now fallen in value as the bid-offer spread for one VLA share at 31 May 2020 was
as follows:
At 31 May 2020
£54.45 – £55.72
I confirmed that the carrying amount at 31 May 2020 of £18,150,400 valued each share at £56.72.
•
£25,000,000 investment
This transaction was carried out by the finance director who has now left HC plc. I have found out the
following information:
On 25 February 2020, HC plc transferred £25,000,000 in cash to its 100% owned subsidiary Konditori
Ltd, a high street retailer which sells clothes, food and other goods. In recent years, Konditori food
sales have been very successful.
On 1 March 2020, Konditori entered into an arrangement with Rosen plc, a national supermarket
chain, to set up a new company, Clik Ltd, which will operate a joint online distribution network.
Konditori invested £25,000,000 provided by HC plc, in 50% of the shares of Clik Ltd. Rosen owns the
remaining 50% of Clik’s shares.
Konditori has recognised the £25,000,000 cash received from HC plc as a non-current liability and its
investment in Clik as an expense of £25,000,000 in its operating costs for the year ended 31 May
2020.
Maisie has not made any other adjustments in respect of Clik Ltd in either the HC plc individual
financial statements or the HC group financial statements.
As I have just found out this information, I have not had time to complete any audit procedures.
I have set out below a summary statement of profit or loss for Clik for the 3-month period from 1
March 2020 to 31 May 2020:
£’000
Revenue
14,000
Operating costs
(34,000)
Tax
2,000
Loss after tax
(18,000)
Other financial assets − Corporate loans
At 31 May
2020
2019
£’000
£’000
Corporate bonds in Reggs plc
4,860
10,410
Loan to JUP plc
4,980
4,980
9,840
15,390
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Real exam (August 2020)
223
•
Corporate bonds in Reggs plc
On 1 June 2018, HC plc purchased corporate bonds in Reggs plc, with a par value of £12,500,000,
for £10,000,000. The bonds mature at par on 31 May 2023 and pay annual fixed interest at 4.72%.
HC plc recognised the bonds at amortised cost as the objective of holding them was to collect
contractual cash flows. The implicit interest rate is 10% per annum.
On 31 May 2020, Maisie sold 50% of the Reggs plc corporate bonds with a par value of £6,250,000
for £6,000,000.
The following journal is recorded in HC plc’s financial statements for the sale of the bonds.
£’000
DEBIT
CREDIT
Cash
£’000
6,000
Bonds
6,000
Being sale of 50% of the Reggs plc bonds.
I have agreed the sale proceeds of £6,000,000 to the sale contract and to the bank.
•
£4,980,000 loan to JUP plc
On 31 May 2019, HC plc made a secured loan of £5,000,000 to a supplier, JUP plc. The loan has an
annual interest rate of 8% and is repayable in full on 31 December 2020. The loan objective is
achieved by collecting contractual cash flows and the loan is measured at amortised cost.
On 31 May 2019, the loan had a low credit risk and the probability of default in the next 12 months
was 2% with lifetime credit losses estimated at £1,000,000. An impairment of £20,000 was
recognised.
On 1 May 2020, a credit rating agency indicated that JUP was experiencing financial difficulty and
lowered its credit rating as there was a significant increase in credit risk. The expected credit losses
over the remaining life of the loan were estimated at £1,000,000.
Maisie has made no adjustments in the financial statements for the year ended 31 May 2020 to
reflect the information from the credit rating agency received from the credit rating agency on 1 May
2020.
I have downloaded the report from the credit rating agency and confirmed the lower credit rating.
Exhibit 3: Notes from audit assistant
After an audit meeting I had a brief conversation with Maisie.
She told me that she is enjoying the challenge of acting as finance director as well as her role as
head of treasury. She said that it has been really helpful to have contacts from her previous job with
the investment bank.
She also told me that she agreed a generous profit-related bonus with the HC board because of the
extra responsibility. Maisie will receive a bonus if HC plc’s profit before tax for the year ended 31 May
2020 is greater than £7,000,000.
So far it looks like she will achieve this based on the draft financial statements.
I did not know that she was on a profit-related bonus. I just thought I would draw this to your
attention.
Maisie also mentioned that she understood that the audit will be put out to tender shortly and hopes
that Welfold would be tendering for the audit.
67 React Chemicals plc
You are Alan Khan and you work as a financial accountant at React Chemicals plc (React), an AIMlisted company based in the UK. React manufactures and supplies chemicals to customers in the UK.
It prepares financial statements to 31 July.
The React finance director gives you the following briefing:
“The board has set out two proposals for the year ending 31 July 2021. The board needs to
understand the financial reporting implications of these proposals.
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Corporate Reporting
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Proposal 1 relates to the distribution of chemicals and the board is considering two alternative
contracts, A and B (Exhibit 1).
Proposal 2 relates to a new share option scheme which will be open to all employees (Exhibit 2).
“I have also provided forecast financial information, including information about tax treatments, for
the year ending 31 July 2021 (Exhibit 3). The forecast information does not include any impact from
the board’s proposals.
Instructions from finance director
“I would like you to prepare a briefing paper for the board in which you:
(1) Set out and explain the appropriate financial reporting treatment, including the impact on
current and deferred tax for:
(a) Proposal 1 – Distribution costs (Exhibit 1). Address both Contract A and Contract B; and
(b) Proposal 2 – Share option scheme (Exhibit 2).
Include relevant journal adjustments.
(2) Assuming that React signs Contract B with Dutton (Proposal 1) and grants the share options
(Proposal 2), calculate the total tax charge to be shown in React’s statement of profit or loss for
the year ending 31 July 2021 and React’s total current and deferred tax liability as at 31 July
2021.
(3) Prepare revised forecast financial information for the year ending 31 July 2021 (Exhibit 3).
Include your adjustments for Contract B (Proposal 1), the share option scheme (Proposal 2) and
both current and deferred tax.”
Requirement
Prepare the briefing paper requested by the finance director.
Total: 30 marks
Exhibit 1: Proposal 1 − Distribution costs
Transportation of products to customers is a complex and costly part of React’s business.
From 1 August 2020, React will produce a new chemical which can only be transported in special
containers. React has identified two potential distributors, TrensFar and Dutton, that can deliver the
chemical safely. They have offered the following lease contracts:
Contract A − TrensFar
TrensFar will transport React’s product by road, using tankers. A tanker consists of an engine and a
separate container. TrensFar owns the tankers and will also provide drivers.
TrensFar can use its containers to transport chemicals for different customers, but containers require
cleaning if different chemicals are transported.
TrensFar’s contract with React will be for four years. It states that deliveries to React’s customers can
take place only on Mondays and Tuesdays each week. The contract specifies the maximum and
minimum quantity for each delivery. React will email a weekly delivery schedule to TrensFar,
informing it of the delivery quantities for the following week. The estimated annual cost of the
contract is £5,000,000 and TrensFar will invoice React on a monthly basis, based on the quantity
delivered and distance travelled.
Some TrensFar containers will be stored at React’s premises, so that React can load the chemical the
day before the scheduled delivery. React cannot use the containers other than as specified in the
contract with TrensFar.
The contract specifies that TrensFar can collect any containers that are being stored by React and use
them for other TrensFar customers.
Contract B – Dutton
Dutton will supply larger containers than TrensFar. Dutton will transport containers by road and rail to
React’s customers.
ICAEW 2022
Real exam (August 2020)
225
The contract price has two elements, supply of containers and transport:
•
Supply of containers
React will have the use of 15 specific containers for 9 years. Dutton owns the containers. Each
container is designed for the particular type of chemical which React produces. The 15 containers
will be stored at React’s premises and will be used only by React. Dutton will be responsible for any
repair work and cleaning and must provide a substitute container during any period when a
container is not available.
On 1 August 2020, React will pay a lease set-up fee of £80,000. The cost of the supply of containers
element of the contract will be £4,000,000 per annum payable in arrears. React’s incremental
borrowing rate is 6% per annum.
•
Transport to React’s customers
At React’s request, Dutton will collect the container, transport it by road and rail to React’s customers
and will return the container to React’s premises. React can make requests for delivery at any time.
The cost for the transport element of the contract will be based on an agreed rate, according to the
number of deliveries and the distance travelled. The estimated annual cost of the transport element
of the contract is £1,000,000.
Exhibit 2: Proposal 2 − Share option scheme
On 1 August 2020, React will set up a share option scheme which will be open to all employees.
100 employees will join the scheme on 1 August 2020. Each employee will be granted 2,600
options. Each option permits the holder to subscribe for one share in React. The fair value of each
option at 1 August 2020 is £3.60 and the exercise price is £3.80.
The share options will vest when profit increases by 20% in any year, or by an annual average of 14%
in any two consecutive years. The scheme will lapse after three years if these targets are not met.
An employee must be in continuous employment with React until the vesting date for their share
options to vest.
React has prepared the following projections:
At 31 July
Profits increase by
Price per share
2020
2021
2022
-
12%
18%
£7.30
£8.60
£8.70
No employees are expected to leave the company in the next three years.
React’s board expects that the share options will vest on 31 July 2022 and therefore there will be no
employee cost to record in the year ending 31 July 2021.
Exhibit 3: Forecast financial information for the year ending 31 July 2021
Forecast summary statement of profit or loss for the year ending 31 July 2021
£’000
Revenue
23,731
Gross profit
20,174
Total depreciation
(530)
Other operating costs
(6,384)
Operating profit
13,260
Finance costs
Profit before tax
Tax (to be completed)
Profit for the year
226
Corporate Reporting
(125)
13,135
(x)
13,135
ICAEW 2022
Forecast summary statement of financial position as at 31 July 2021
£’000
Non-current assets
Plant and equipment
21,247
Current assets
26,567
TOTAL ASSETS
47,814
Equity
Share capital (£1 shares) and other reserves
11,810
Retained earnings
17,290
29,100
Non-current liabilities
Borrowings and other financial liabilities
4,264
Deferred tax liability at 1 August 2020
1,741
6,005
Current liabilities
Trade and other payables
12,709
Current tax payable (to be completed)
(x)
12,709
TOTAL EQUITY AND LIABILITIES
47,814
Tax information
In the tax jurisdiction where React operates, accounting profit and taxable profit are calculated using
the same rules except for the following:
•
Plant and equipment
No tax allowance is available for accounting depreciation. Instead, in the year in which an asset is
capitalised (including assets capitalised under lease contracts), tax depreciation is available for plant
and machinery at the rate of 30% of the asset cost recognised in plant and equipment. Thereafter, an
annual writing down allowance of 18% is available on the brought forward tax base. The current tax
rate is 25% and there are no expected changes to this tax rate in the future.
When the forecast financial statements for the year ending 31 July 2021 were prepared, no additions
to plant and equipment or disposals from plant and equipment were included and accounting
depreciation of £530,000 was recognised.
The deferred tax liability at 1 August 2020 arises from a temporary difference on plant and
equipment as follows:
At 1 August 2020
£’000
Carrying amount of plant and equipment
Tax base of plant and equipment
21,777
(14,813)
6,964
Deferred tax liability at 25%
ICAEW 2022
1,741
Real exam (August 2020)
227
•
Share option expense
A tax allowance arises only when a share option is exercised. The tax allowance is based on the
option’s intrinsic value at the exercise date. The intrinsic value is the difference between the market
price of the share at the exercise date and the exercise price of the option.
68 Hyall and Forbes
You are an audit senior working for Hyall and Forbes, ICAEW Chartered Accountants. You are
assigned to the audit of NuTyre plc for the year ending 30 September 2020. NuTyre is listed on the
London Stock Exchange. It manufactures and fits its own brand of car tyres and exhausts and
operates in the UK and internationally.
This is your first time on the NuTyre audit and the audit manager briefs you as follows:
“I need your help to plan the NuTyre audit for the year ending 30 September 2020.
“NuTyre is a challenging audit because, although the company has no subsidiaries, it has 2
manufacturing divisions and 13 retail divisions. Each division has its own management team. All 15
divisions use the same accounting system, but financial and other controls differ between divisions.
“The company manufactures exhausts at its manufacturing division in the UK and tyres at its
manufacturing division in India.
“During the year ended 30 September 2019, NuTyre had three retail divisions in the UK, India and
France. Each retail division operates between four and ten sites, selling and fitting tyres and exhausts
to vehicles owned by individuals.
“In October 2019, NuTyre acquired retail sites in ten additional countries, establishing retail divisions
in Germany, Sweden and eight other countries.
“The retail model is similar in all the countries in which NuTyre operates.
“In the year ended 30 September 2019, Hyall and Forbes performed audit procedures in the UK,
India and France. We will need to think carefully about scoping the audit for the year ending 30
September 2020. For example, we will need to identify which divisions are significant components
for the purposes of our audit to identify where we carry out more detailed audit procedures. I don’t
think it will be practicable to visit all 15 manufacturing and retail divisions and their various sites.
However, in total they are material, so we need to perform some audit procedures for these elements
of the business.
“Planning materiality for the NuTyre audit has been set at £130,000.
“NuTyre produces management accounts which identify separately the results for each
manufacturing or retail division. I’ve provided you with summary information from the management
accounts for the nine months ended 30 June 2020 (Exhibit 1).
“I have also provided notes from my recent meeting with NuTyre’s finance director, Jud Lever (Exhibit
2). He explains how NuTyre’s management reporting has evolved this year and highlights issues at
some divisions. He asks for our guidance on following up an alleged fraud and on disclosure
requirements.
Audit manager’s instructions
“What I need you to do is:
(1) Calculate relevant accounting ratios as preliminary analytical procedures on the summary
information from the management accounts (Exhibit 1).
(2) Use the results of your analytical procedures, together with the other information provided, to:
(a) identify any matters that you believe Hyall and Forbes should investigate further as we plan
the audit of NuTyre for the year ending 30 September 2020.
(b) produce an extract from the audit plan which, for each manufacturing division and retail
division:
228
•
states whether that division is a significant component and explains why; and
•
outlines the extent of the audit procedures we should perform at that division. (I do not
require detailed individual audit procedures, but I do need a justification of the extent
and scope of audit testing required for each division).
Corporate Reporting
ICAEW 2022
(c) provide Jud with guidance on the divisional financial reporting disclosures that should be
included in the NuTyre financial statements for the year ending 30 September 2020. Explain
your guidance and set out any additional information you require to reach a conclusion on
the disclosures required.
(3) Respond to Jud’s request regarding the fraud allegations from the Belgium employee (Exhibit 2),
setting out:
(a) the specific procedures Hyall and Forbes could perform to investigate the occurrence and
extent of the alleged fraud; and
(b) the controls which NuTyre could introduce to minimise the likelihood of a fraud of this
nature being committed in future by a divisional manager.”
Requirement
Respond to the audit manager’s instructions.
Total: 30 marks
Exhibit 1: Summary information from NuTyre’s management accounts for the nine months ended
30 June 2020
Summary information from NuTyre’s management accounts for the nine months ended 30 June
2020
Notes
Manufacturing divisions
India
Total manufacturing
2
Retail divisions
2
India
France
Germany
Sweden
ICAEW 2022
Operating
profit/(loss)
£’000
£’000
Exhausts
4,061
51
Tyres
4,801
1,680
8,862
1,731
Exhausts
2,051
428
Tyres
2,135
320
Exhausts
723
291
Tyres
2,692
807
Exhausts
626
234
Tyres
448
120
Exhausts
253
27
Tyres
1,239
Exhausts
477
97
Tyres
1,354
203
1
UK
UK
Revenue
Product
Real exam (August 2020)
(35)
229
Revenue
Operating
profit/(loss)
£’000
£’000
Exhausts
1,093
208
Tyres
3,466
520
Total retail
16,557
3,220
Total retail and manufacturing
25,419
4,951
Notes
Other: 8 small divisions
3
Product
Less:
Inter-division revenue
1
(8,862)
Less:
Head office costs
(2,303)
Total
16,557
2,648
5,223
1,336
11,334
3,615
Summary by product:
Exhausts
Tyres
Head office
(2,303)
Total
16,557
2,648
Divisional assets at 30 June 2020
Notes
Total assets
£’000
Manufacturing division:
UK
2,395
India
3,484
Retail division:
4
UK
2,018
India
1,539
France
410
Germany
781
Sweden
954
Other: 8 small divisions
Head office
Total
230
3
2,182
263
14,026
Corporate Reporting
ICAEW 2022
Notes
(1) The manufacturing divisions sell only to NuTyre’s retail divisions.
(2) Old tyres removed from customer vehicles can sometimes be refurbished and sold as
reconditioned tyres. This refurbishment work is performed by NuTyre’s manufacturing division in
India. When a retail division sends tyres to India to be refurbished, no inter-divisional sale is
recorded. The Indian manufacturing division bears all associated transport costs.
(3) The eight small divisions are all similar in size.
(4) Retail division site assets comprise the premises and equipment used for the fitting of tyres and
also inventory.
Exhibit 2: Notes from meeting with Jud Lever, NuTyre finance director – prepared by audit manager
Management reporting
Jud explained that, following the establishment of additional divisions in Germany, Sweden and 8
other countries, NuTyre’s management accounts now include more analysis of divisional results, both
geographically and by product.
This information is reviewed monthly by the executive management team and used to assess the
performance of the divisions and to make decisions about any further investment. It is also used to
set prices for inter-divisional sales, so that the company’s overall tax burden is minimised.
The management team’s focus is primarily on the geographical analysis, as the countries in which
NuTyre operates have very different regulatory environments and market conditions. Each
manufacturing and retail division pays tax in the country in which it operates. Tax rates vary between
countries with a particularly high rate in the UK and a low rate in India.
Issues identified
•
An employee at the small retail division in Belgium has contacted Jud and alleged that the
division’s finance manager, Henri Pinot, is defrauding NuTyre. The employee alleges that Henri is
taking tyres which could be refurbished and, instead of sending them to NuTyre’s manufacturing
division in India, is selling them for his own benefit.
The employee also alleges that Henri has made unauthorised payments to Pinot Ltd, a company
owned by his wife. Henri has recorded these as consultancy costs in the division’s financial
statements.
Jud wants our help to investigate these allegations and the NuTyre audit committee has asked us
to recommend controls that NuTyre could introduce to prevent fraud of this type.
•
Total assets in France look low. Jud told me that it is common in France to expense equipment in
the statement of profit or loss, rather than capitalising it.
Disclosure requirements
In the past, NuTyre provided minimal divisional analysis in its published financial statements. Jud has
asked Hyall and Forbes to provide guidance on whether any additional disclosure is necessary now
that the company has more divisions. The Board wants to give as little detail as possible, as it believes
detailed information might benefit its competitors.
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Real exam (August 2020)
231
232
Corporate Reporting
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Real exam (November 2020)
69 SSD
You are an ICAEW Chartered Accountant and an audit manager working for Harris and Henshaw
(HH), a firm of ICAEW Chartered Accountants. You have been assigned to the audit of SSD plc (SSD)
for the year ended 30 September 2020.
SSD is a UK listed company which designs and develops electronic technologies for a range of
industries. Planning materiality for SSD is £35 million.
Your colleague, Sheena Green, the former manager on the SSD audit, has been moved to another
audit assignment. Sheena identified three audit risk areas which are likely to give rise to key audit
matters. She prepared working papers for these risk areas as follows:
•
Intangible assets (Exhibit 1)
•
Issue of bond to ZMedd plc (Exhibit 2)
•
Sale and leaseback transaction (Exhibit 2)
You are the training supervisor and mentor for Chris Yang, who works for HH and is in his first year as
an ICAEW trainee Chartered Accountant. Chris is currently assigned to the audit for ZMedd, an
international pharmaceutical company and an HH audit client. Chris has sent you an email (Exhibit 3).
The audit engagement partner gives you the following instructions:
“Please prepare a briefing document in which you:
For intangible assets (Exhibit 1):
(1) evaluate the appropriateness and completeness of SSD’s accounting policy asdisclosed in the
note;
(2) explain the correct financial reporting treatment for the additions to intangible assets; and
(3) evaluate the adequacy of Sheena’s assessment of audit risk and set out the key audit procedures
that HH should perform.
(4) For the issue of the bond to ZMedd and the sale and leaseback transaction (Exhibit 2):
(a) explain the correct financial reporting treatment in SSD’s financial statements for theyear
ended 30 September 2020; and
(b) recommend appropriate journal adjustments.”
Requirements
69.1 Respond to the audit engagement partner’s instructions.
69.2 Identify and explain the ethical issues for HH, Chris Yang and you, the audit manager arising
from Chris Yang’s email (Exhibit 3). Set out the actions that you should take.
Total: 42 marks
Exhibit 1: Intangible assets audit working paper – prepared by Sheena Green
(1) Extract from SSD’s draft financial statements for the year ended 30 September 2020
I have extracted this information from an early draft of SSD’s financial statements. These have been
prepared by the new financial controller, who is inexperienced in financial reporting.
Intangible assets
Purchased intangibles
Development costs
Total
£m
£m
£m
350
140
490
97
117
214
447
257
704
Cost
At 1 October 2019
Additions
At 30 September 2020
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Purchased intangibles
Development costs
Total
£m
£m
£m
At 1 October 2019
94
49
143
Charge for the year
12
5
17
At 30 September 2020
106
54
160
Carrying amount at 30 Sep 2020
341
203
544
Accumulated amortisation
Accounting policy note for intangibles
•
Recognition and measurement
Purchased intangibles include licences, patents and databases, and are stated in the statement of
financial position at cost less accumulated amortisation.
Development costs comprise internally developed intangibles which are clearly identified and
directly attributable to a particular project.
•
Amortisation
Licences and patents have finite lives and are amortised on a straight-line basis using estimated
useful lives of 3 to 40 years.
Databases have indefinite lives and are subject to annual impairment reviews.
Development costs are amortised based upon the predicted sales revenue derived from the
products.
•
Impairment reviews
The carrying amounts of development costs are reviewed where there are indications of possible
impairment. An impairment review involves a comparison of the carrying amount of the asset with
estimated values in use based on the latest management cash flow projections approved by the
Board. The cash flows cover a forecast period of five years and the discount rate is based on SSD’s
weighted average cost of capital.
(2) Assessment of audit risk
We need to focus on the additions to intangible assets because SSD capitalised costs of £214 million
in the year ended 30 September 2020. The key audit risk is that expenditure may have been
inappropriately capitalised.
(3) Additions to intangible assets
I have identified additions of £179 million which will provide audit coverage of 83.6% of the £214
million additions to intangible assets recognised in the year ended 30 September 2020:
£m
Taste database
87
Project Smart
13
Project Textel
79
Total
•
179
Taste Database – £87 million
SSD recognised an addition to purchased intangible assets as follows:
£m
Debit purchased intangible assets
87
Credit operating costs
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£m
In respect of costs expensed in the year ended:
30 September 2019
22
30 September 2020
65
On 1 October 2018, SSD acquired the Taste database for £150 million which is recognised in
purchased intangible assets at cost.
In November 2018, SSD commenced a research project using this database to develop a machine
which uses artificial intelligence to learn to taste. At 30 September 2019, research costs for this
project of £22 million were expensed in the statement of profit or loss. No amortisation of the Taste
database was charged in the year ended 30 September 2019.
On 1 July 2020, work on this research project ceased because key personnel left the company. Costs
incurred to 1 July 2020 of £65 million were initially expensed to profit or loss in the year ended 30
September 2020.
At 30 September 2020, the board estimates that, as a result of the research undertaken by SSD from
1 November 2018 to 1 July 2020, the fair value of the Taste database increased to £237 million. SSD
therefore recognised an addition to purchased intangibles of £87 million, giving a total carrying
amount of £237 million.
Because the £22 million relating to the year ended 30 September 2019 is not material, no prior year
adjustment has been proposed.
•
Project Smart – £13 million
SSD has developed a micro device called Smart, which, when sewn into a sports garment, will
measure an athlete’s heart rate and aerobic capacity. At 30 September 2019, development costs of
£10 million had been capitalised as future economic benefits were probable. In October 2019, a
further £13 million of development costs in respect of this project were capitalised. Production and
sales of the Smart commenced on 1 December 2019.
At 1 December 2019, SSD produced forecast discounted net operating cash flows under two
scenarios as follows:
Year ending 30
September
Estimated cash flows
Discounted cash flows
Scenario A
Scenario B
£000
£000
£000
2020
7,250
6,590
6,590
2021
8,600
7,104
7,104
2022
4,250
3,192
3,192
2023
3,378
2,307
2,307
2024
2,400
1,490
1,490
2025
2,355
1,328
1,328
2026
2,000
1,026
1,026
23,037
23,037
2026 onwards
20,000
43,037
Assumptions
Scenario A
The cash flows for the seven years to 30 September 2026 are discounted using a 10% annual
discount rate. This discount rate is SSD’s weighted average cost of capital based on the amounts in
the financial statements for the year ended 30 September 2019.
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Scenario B
The cash flows for the seven years to 30 September 2026 are the same as Scenario A, but it is now
assumed that cash flows will continue indefinitely after 30 September 2026 and remain constant.
Since 1 December 2019, a rival company has brought to market a copy of the Smart device. As a
result, cash flows of the Smart device for the period from 1 December 2019 to 30 September 2020
were only £4.2 million.
The financial controller told me that the total Smart development costs of £23 million were not
impaired because the present value of the forecast cash flows, prepared on 1 December 2019,
ranged from £23.037 million to £43.037 million. Even the lower end of this range is greater than the
carrying amount of the Smart development costs at 30 September 2020.
•
Project Textel – £79 million
SSD has recognised the following amounts as development costs for the year ended 30 September
2020 in respect of the Textel research project.
Period
£m
1 October 2019 – 1 March 2020
32
1 March 2020 – 30 September 2020
47
79
This research project commenced in July 2019. SSD developed a material called Textel with
integrated electronic fibres. When worn by a person, the material will identify warning signs of heart
disease. Research costs prior to 1 October 2019 were expensed to profit or loss because the project
outcomes were uncertain.
On 1 March 2020, SSD presented Textel at a medical conference in Geneva. As a result of interest
expressed by ZMedd, one of the pharmaceutical companies at the conference, Textel was deemed
commercially viable. To take Textel to market, SSD raised finance (see Exhibit 2).
Exhibit 2: Working paper on the issue of a bond and a sale and leaseback transaction – prepared by
Sheena Green
I have identified two significant transactions which will increase debt recognised in the statement of
financial position by over 75%:
•
issue of a bond to ZMedd
•
sale and leaseback transaction
I have proposed journals but I am not sure that they are correct.
Issue of a bond
On 1 April 2020, one month after the Geneva conference, SSD issued a zero-coupon bond for
£20.25 million to ZMedd. Transaction costs of £100,000 have been charged to the statement of profit
or loss at 1 April 2020. The bond will be redeemed on 31 March 2023 for £24 million. The bond has
been recorded as follows:
£m
DEBIT
Cash
20.15
DEBIT
Profit or loss
0.10
CREDIT
Non-current liability
£m
20.25
The annual effective interest rate on the bond is 6%.
Sale and leaseback transaction
On 1 April 2020, SSD sold an office building to YB bank for its fair value of £40 million. The building
is used by SSD’s research department. The carrying amount of the building at 1 April 2020 was £30
million. As SSD intended to continue to use the building, it entered into a contract with YB bank to
lease back the building for 10 years for annual payments in arrears of £3.6 million. The annual
implicit interest rate in the lease has been correctly calculated at 5%.
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The SSD financial controller has recorded this as follows:
£m
DEBIT
Cash
£m
40
CREDIT
PPE
30
CREDIT
Profit or loss
10
Being recognition of profit on disposal of building
£m
DEBIT
Leased asset
CREDIT
£m
27.8
Liability
27.8
Being recognition of the building and lease liability corresponding to 10 annual payments of £3.6
million discounted at 5% per annum.
Exhibit 3: Email from Chris Yang
Hi,
I know that you are currently auditing SSD so I thought you might be interested in some information I
have discovered while auditing ZMedd.
I was asked to review the ZMedd board minutes. These include approval of ZMedd’s purchase of a
zero-coupon bond, issued by SSD for £20.25 million. I thought it would be useful for you to know
that this transaction was approved by ZMedd’s board.
Immediately prior to the purchase of the bond, the ZMedd board signed a contract with SSD for the
sole distribution rights for Textel. The board noted that wearing Textel will lead to a significant
increase in the predicted number of heart disease cases as a result of an increase in monitoring. This
will increase the sales of a heart drug produced by ZMedd called Atrilfib, generating additional
revenue of around £300 million for ZMedd.
I also came across an article published in a technical magazine which I thought might be of use to
you on the SSD audit. Here is an extract from the article:
“Research conducted by a university concluded that Textel garments will identify warning signs
of heart disease in many people who will not go on to develop any symptoms. Unnecessarily
treating these people with heart drugs such as Atrilfib could seriously damage their long-term
health.”
When I was auditing entertainment costs, I came across a large amount spent at the March 2020
medical conference in Geneva. ZMedd paid for the hotel and travel costs of an SSD research team
and two main board members of SSD. The expenses were correctly authorised at board level, but I
wonder if this is an ethical issue. Please advise me what I should do.
70 Beta World
You are Sam Kota and you work as the assistant to the finance director at Beta World plc (BW plc), an
AIM-listed company based in the UK. BW plc is in the travel and leisure industry and prepares
financial statements to 30 September.
The BW plc finance director gives you the following briefing:
“On 1 April 2020 BW plc decided to buy 45% of the ordinary shares in Flyline, a listed airline based in
Australia. Having consulted with their technical department, the BW auditors have advised the BW
board that Flyline must be treated as a subsidiary. As this is BW plc’s first acquisition, consolidated
financial statements will be prepared for the year ended 30 September 2020. Both BW plc and
Flyline have a 30 September year end.
“The BW board wants to understand why, if BW plc only owns 45% of the ordinary shares in Flyline,
Flyline should be treated as a subsidiary. I have provided you with details of BW plc’s acquisition of
Flyline and the consideration for the acquisition (Exhibit 1).
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“The BW plc financial accountant prepared a working paper which includes extracts from the draft
statements of comprehensive income for the year ended 30 September 2020 for BW plc and Flyline.
She asked for help with the consolidation of Flyline and advice about some financial reporting issues
(Exhibit 2).
“I would like you to prepare a briefing paper for the board in which you:
(1) In respect of the acquisition of Flyline (Exhibit 1):
(a) Explain why Flyline should be treated as a subsidiary in the BW consolidated financial
statements for the year ended 30 September 2020.
(b) Set out and explain how the investment in Flyline should be recognised in the BW plc
individual company financial statements for the year ended 30 September 2020.
(2) Set out and explain the appropriate financial reporting treatment of the issues identified by the
BW plc financial accountant for the year ended 30 September 2020 (Exhibit 2). Include relevant
journal adjustments.
(3) Calculate the goodwill on the consolidation of Flyline to be included in the BW consolidated
financial statements at 30 September 2020; and
(4) Prepare a revised draft consolidated statement of profit or loss and other comprehensive income
for BW for the year ended 30 September 2020. Include your recommended adjustments for (1),
(2) and (3) above. Identify separately the amount attributable to the non-controlling interest at 30
September 2020.”
Requirement
Prepare the briefing paper requested by the BW plc finance director.
Total: 30 marks
Exhibit 1: Information about the acquisition of Flyline and the consideration for the acquisition –
prepared by BW plc finance director
On 1 April 2020, BW plc acquired 45 million of the 100 million ordinary shares in Flyline, a company
located in Australia. The currency in Australia is the A$. Ten shareholders each own 5.5 million of the
remaining ordinary shares in Flyline.
The initial consideration for 45 million ordinary shares of A$238 million was settled on 1 April 2020.
The terms of the acquisition agreement are:
•
A further A$60 million in cash is payable on 1 October 2021 provided that Flyline’s EBITDA
increases by 5%. The fair value of this additional consideration at 1 April 2020 was A$50 million
and remained unchanged at 30 September 2020.
•
BW plc has the right to appoint all members of the Flyline board.
•
BW plc has an option to buy a further 30% of the ordinary shares in Flyline from its existing
shareholders at any time before 1 December 2021. The exercise price for the shares under this
option is 5% lower than the price per share BW plc paid to acquire the 45% shareholding on 1
April 2020.
Cost of investment in Flyline
The A$238 million initial cost for Flyline is recognised in the statement of financial position of BW plc
and comprises:
£000
Shares in BW plc
40,000
Cash
70,000
Professional fees for the acquisition
9,000
119,000
The exchange rate at 1 April 2020 was £1 : A$2.
Issue of ordinary shares in BW plc
On 1 April 2020, BW plc issued 5 million £1 ordinary shares to the shareholders of Flyline as a share
for share exchange as part consideration for 45 million ordinary shares in Flyline.
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The market value of BW plc’s ordinary shares at that date was £8 per share. A journal entry was made
to increase BW plc’s ordinary share capital by £40 million and increase the cost of the investment in
Flyline in the BW plc statement of financial position.
Other information
BW plc has decided to use the fair value method to measure non-controlling interest.
At 1 April 2020, the fair value of the remaining 55 million ordinary shares in Flyline was A$5.55 per
share. At 30 September 2020, the fair value of these remaining 55 million ordinary shares was A$6.50
per share.
Relevant exchange rates
At 1 April 2020
£1 : A$2.00
Average for the six-month period to 30 September 2020
£1 : A$1.88
At 30 September 2020
£1 : A$1.75
Exhibit 2: Working paper prepared by BW plc financial accountant
I have set out below extracts from the draft statements of comprehensive income for the year ended
30 September 2020.
BW plc
Flyline
£000
A$000
427,000
578,000
Cost of sales
(254,000)
(371,000)
Gross profit
173,000
207,000
Operating expenses
(54,600)
(118,500)
Finance costs
(15,000)
–––––––
Profit before tax
103,400
88,500
Tax
(19,600)
(16,000)
83,800
72,500
–––––––
–––––––
83,800
72,500
180,600
173,800
83,800
72,500
264,400
246,300
Revenue
Profit for the year
Other comprehensive income
Total comprehensive income for the year
Other financial information
Retained earnings
As at 30 September 2019
Profit for the year
As at 30 September 2020
Ordinary share capital
£1 shares (see Exhibit 1)
A$1 shares
140,000
100,000
Financial reporting issues
I am preparing the translation of Flyline’s financial statements for the year ended 30 September 2020
from its functional currency, the A$, to the BW Group’s presentation currency, £ sterling, in
preparation for its consolidation.
I need your advice on the appropriate financial reporting treatment of the following issues for the
financial statements of Flyline and for the BW consolidated financial statements for the year ended
30 September 2020.
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Purchase of aircraft
On 1 May 2020, Flyline received delivery of aircraft it had purchased from Petang KL, a company
based in Malaysia, for RM56 million (RM is the currency in Malaysia). Flyline recorded the cost of the
aircraft in assets and the corresponding liability to Petang KL at the exchange rate on 1 May 2020
which was A$1 : RM2.8.
On 1 July 2020 Flyline paid Petang KL an amount of RM26 million, which was translated to
A$8,125,000. At 30 September 2020, the balance on the Petang KL payable account in Flyline’s draft
statement of financial position is A$11,875,000.
After complying with local regulations, the aircraft was available and came into use on 1 October
2020.
No depreciation was provided as Flyline was not sure what exchange rate to use for the depreciation
charge. The estimated useful life of the aircraft is 10 years with a zero residual value. The exchange
rate is A$1 : RM3.3 at 30 September 2020.
Hedged transaction
Aviation fuel is priced in US$ on the commodity market. The Flyline board was concerned about the
foreign currency risk of buying aviation fuel and Flyline entered into a hedging transaction.
Flyline has a contractual commitment with a supplier to purchase 40,000 tonnes of aviation fuel on
10 November 2020 at a fixed price per tonne of US$700.
On 1 June 2020, to hedge the foreign currency risk, Flyline entered into a forward contract at a zero
price to purchase US$28 million for A$42 million on 10 November 2020. At 30 September 2020, a
new forward contract at a zero price for the purchase of US$28 million on 10 November 2020 could
have been entered into at A$44 million.
Documentation has been prepared and the conditions satisfy the requirements of IFRS 9 to treat this
as a hedged transaction.
I understand that Flyline has an accounting policy choice regarding this transaction. The board wants
to adopt the accounting policy which minimises the impact on profit or loss and on reserves for the
year ended 30 September 2020.
71 GlamFood
You are the manager for the audit of GlamFood plc for the year ended 30 September 2020.
GlamFood is a listed company and next week it plans to announce its results for the year ended 30
September 2020. GlamFood supplies catering for events.
Your firm, Gupta & Rowe (GR) has audited GlamFood for four years.
You receive the following briefing from the audit partner:
“There is still a lot of work to complete on the GlamFood audit before the company announces its
results next week. My review of the audit team’s work identified some matters of concern (Exhibit 1).
Audit planning materiality is £150,000 based on GlamFood’s profit before tax of £3 million.
“I am not satisfied with the substantive analytical procedures carried out by the audit assistant
(Exhibit 2). He has performed some analysis but has neither used the results nor included all the key
analyses I expected to see. We need to demonstrate that we have done enough audit work in this
area. In particular, there is a new incentive scheme for directors, based on achieving target levels of
revenue and profit that should be examined more closely.
“In addition to resolving the matters arising from my review, we need to perform audit procedures to
address going concern risk. I have received a going concern paper from the GlamFood finance
director (Exhibit 3), which provides some relevant information. However, it will be important to take
into account your findings from the audit procedures in other areas.
“What I want you to do is:
(1) For each of the matters of concern identified in Exhibit 1:
(a) Set out and explain the correct financial reporting treatment, identifying any additional
information you require; and
(b) Explain the key audit risks that arise.
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(2) Using the information in Exhibit 2:
(a) Identify and justify which entries should be the subject of further audit investigation; and
(b) Set out and explain the additional key substantive analytical procedures and other key audit
procedures that GR should perform on revenue and on journal entries.
(3) For each of the elements of the GlamFood finance director’s paper on going concern (Exhibit 3):
(a) Evaluate the finance director’s comments and identify any factors you believe give rise to
significant doubt about GlamFood’s ability to continue as a going concern; and
(b) Set out any additional information you require to complete your assessment of going
concern.”
Note: Take into account your findings in (1) and (2).
Requirement
Respond to the audit partner’s requests.
Total: 28 marks
Exhibit 1: Matters of concern – prepared by audit partner
From my review of the audit working papers, I identified the following matters where I have concern
about both the financial reporting treatment and the lack of adequate audit procedures.
(1) GlamFood Club
Revenue has increased due to the success of a new incentive scheme, the GlamFood Club (the
Club). The Club was introduced on 1 October 2019 and closed to new members on 31 March
2020.
During the six months to 31 March 2020, customers who booked catering for an event were
invited to pay an annual membership fee of £500 for the Club at the time of booking. This
entitles Club members to a discount of 20% for any additional events they book within one year
of joining the Club. All booked events under the discount scheme must take place before 30
September 2022.
Many customers have signed up for the Club. Membership fees totalling £900,000 were
received and recognised as revenue in the year ended 30 September 2020.
In the year ended 30 September 2020, Club members booked additional events totalling £3
million, after deducting the 20% discount. At the time of booking, Club members are required to
pay a deposit of 50% of the total amount for the event, which is non-refundable. These deposits
have been recognised in revenue in the year ended 30 September 2020.
(2) Share options
During the year ended 30 September 2020, GlamFood issued share options to a key supplier
rather than paying them in cash. A comment in the Board minutes suggests that the total value of
the goods received by GlamFood in return for the options was £1.2 million and the share
options issued had a fair value of £1.1 million.
No entries were recorded for the share options issued or for the goods received, as the options
cannot be exercised until 31 October 2022.
Exhibit 2: Substantive analytical procedures – prepared by audit assistant
We have used substantive analytical procedures to identify and investigate high-risk items from the
population of transactions recorded in the GlamFood nominal ledger during the year ended 30
September 2020.
Our work focused on revenue and journal entries and the results are summarised below:
Analysis of revenue
The chart below analyses the transactions which comprise GlamFood’s total revenue of £30.285
million for the year ended 30 September 2020.
The deferred income column shows the net value of amounts transferred from and to deferred
income during the year. All invoiced income is initially posted to revenue and month-end
adjustments are made to defer income which has not yet been earned or release income deferred in
previous months.
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Source of entry
Analysis of revenue entries
Other journals
Deferred income
Cash
Credit notes
Sales invoices
-5,000
0
5,000
10,000
15,000
20,000
25,000
£000
Sales invoices
Credit notes
Cash
Deferred income
Other journals
24,321
-2,960
3,805
4,091
1,028
Duplicate entries
Our search for revenue entries with the same reference number and value identified sales invoices
with a total value of £476,000 which appear to have been posted twice. We discussed these with the
GlamFood accountant who told us that it was not unusual to have a series of stage payments for the
same event.
Day of journal posting
The charts below analyse the total debit value of all journal entries by the day of the week on which
they were posted. Normal working days for the GlamFood accounts team are Monday to Friday.
Value of journal entries by day
£000
5820
5782
6000
5021
5000
4987
5137
4000
3000
1902
2000
1615
1000
0
Mon
Tue
Wed
Thu
Fri
Sat
Sun
Days of
the week
Number of journal entries by day
Number of
journal entries
180
160
140
120
100
80
60
40
20
0
150
112
Mon
110
Tue
153
119
Wed
Thu
Fri
12
5
Sat
Sun
Days of
the week
Unexpected double entry
A data analytics search for entries in which the combination of debit and credit entries appeared
unusual identified the following item.
DEBIT
CREDIT
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Cash
Deferred income
£2 million
£2 million
ICAEW 2022
The GlamFood accountant explained that this entry relates to a loan received on 30 September 2020.
The lender is a key GlamFood customer. GlamFood invoices this customer approximately £100,000
each month for catering services.
Invoices to be issued to the customer during the year ended 30 September 2021 will be offset
against the loan, so the loan has been classified as deferred income. Any remaining loan balance at
30 September 2021 will be payable on that date, together with interest of £300,000.
Exhibit 3: Going concern paper – prepared by GlamFood finance director
This paper sets out the board’s assessment of GlamFood’s ability to continue as a going concern. We
have considered a period of two years from 30 September 2020.
Revenue and profitability
GlamFood’s draft financial statements for the year ended 30 September 2020 show revenue of
£30.285 million which is 5% higher than in the previous financial year and in line with market
expectations. Our forecasts show that revenue growth is expected to continue at an annual rate of
5% for the next two years.
The profit before taxation in the draft financial statements is £3 million. This is 8% higher than in the
previous financial year. Our forecasts show profit growth at an annual rate of 10% for the next two
years. There is no reason why we cannot achieve this with our cost-cutting programme and loyal
customer base.
Cash
At 30 September 2020 GlamFood had cash of £1.9 million. This is a similar level to the cash balance
at 30 September 2019. Our forecasts show that the cash balance is not expected to fall below zero at
any point in the next two years.
Obligations
No long-term liabilities or loans are recorded in the financial statements at 30 September 2020.
There is a pension fund deficit of £4.7 million (£3.2 million at 30 September 2019). The increase in
the deficit is due to reduced employer contributions paid during the year ended 30 September
2020. We hope to continue to pay the reduced level of contributions for the next few years.
Deferred income, which represents amounts billed to customers in advance, totalled £2.3 million at
30 September 2020 (2019: £6.4 million).
Conclusion
The board believes that GlamFood will continue as a going concern.
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Advance Information
The Advance Information relates to Question 1 only of the Corporate Reporting Examination for July
2021.
Panther Metals Ltd
The Advance Information comprises:
(a) This document which includes the scenario, background information (Exhibit A) and some
interim audit matters (Exhibit B); and
(b) The nominal ledger data for Panther Metals Ltd (Panther) for the 11 months ended 30 November
2020, contained within the data analytics software:
http://icaew21.inflosoftware.com/redirect/Exam?code=ALCRJUL21AI
Examination
During your examination on 19 July 2021, you will be provided with the nominal ledger data for the
full 12 months ended 31 December 2020 for Panther contained within the data analytics software.
You will need to address the new data for the month of December 2020 and to consider the data,
patterns and trends for the year ended 31 December 2020 as a whole.
The data for the 11 months to 30 November 2020 will remain valid and will be unchanged. However,
in the exam, you will not be able to access the data analytics software for the 11 months to 30
November 2020 made available in the Advance Information or any notes you have made in the data
analytics software for the 11 months to 30 November 2020.
Scenario
You are an audit senior working for Marr LLP, a firm of ICAEW Chartered Accountants. Marr is the
statutory auditor of Panther for the year ended 31 December 2020.
Panther prepares its financial statements in accordance with IFRS. You have just been assigned to the
audit of Panther and you receive the following email from the audit engagement manager, Albert
Ramsay:
Panther Audit
From Albert Ramsay
Date 21 June 2021
To Audit Senior
An interim audit of Panther was carried out during December 2020.
During the interim audit, Panther’s management provided Marr with data for the 11 months ended
30 November 2020 from its nominal ledger. This was imported into the data analytics software which
is used by Marr to carry out its audit procedures.
The audit senior for the Panther interim audit, Ben Brown, no longer works for Marr. However, he
prepared some background information (Exhibit A) and also identified some interim audit matters
(Exhibit B).
Since the completion of the interim audit of Panther, there have been a number of problems with
staff illness at Panther. These have delayed the production of Panther’s nominal ledger data for the
full year ended 31 December 2020. As a result, the final audit visit is now scheduled for July 2021
and I would like you to act as audit senior.
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I will give you more details immediately prior to the final audit visit, but meanwhile I would like you to
review:
(a) The background information (Exhibit A) and interim audit matters (Exhibit B) prepared during
the interim audit by Ben Brown; and
(b) The nominal ledger data for Panther for the 11 months ended 30 November 2020, contained
within the data analytics software.
Exhibit A: Background information – prepared by Ben Brown, 15
December 2020
Business model
Panther purchases metals and recycled waste metals which it then processes into high-purity metals
and alloys, for example nickel, cobalt, tungsten and chromium. Alloys are made by combining two or
more metals.
It sells the high-purity metals and alloys to its customers which operate in a range of industries such
as aerospace, power generation, petrochemical and medical instruments.
Panther purchases from and sells to a range of countries. The prices that it pays for metal purchases
and the prices it is able to achieve on metal sales are strongly influenced by the prices on commodity
markets which are volatile.
Set out below are the members of the accounts department at Panther and their roles.
Organisation roles for key people
Paul Parker
Financial controller
Sunil Bank
Assistant financial
controller
Michael Morden
Sales ledger –
resigned February 2020
•
Alain Smith
Accounts assistant –
resigned August 2020
Julie Lao
Accounts assistant –
joined July 2020
Paul Parker – Panther financial controller
Paul is an ICAEW Chartered Accountant and has worked at Panther for many years. Paul is the
head of the finance function and is responsible for the production of the financial statements and
quarterly management accounts. He processes manual journals and sometimes corrects and
assists the processing of sales and purchase invoices and credits.
•
Sunil Banks – Assistant financial controller
Sunil has worked for Panther for three years. He is an ICAEW Chartered Accountant and is
responsible for the purchase ledger and posts purchase invoices and credit notes, purchase
payments and payments on account. He also processes bank payments and bank receipts. After
Michael Morden (see below) resigned in February 2020, Sunil has also managed the sales ledger
function. He has been assisted by Alain Smith (see below) and from July 2020, by Julie Lao (see
below).
•
Michael Morden – sales ledger manager
Michael was responsible for the sales ledger until he resigned in February 2020 and left the
company.
•
Alain Smith – accounts assistant
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Alain assisted Michael with the sales ledger. After Michael left the company in February 2020,
Alain processed sales invoices and sales credits, supervised by Sunil. In August 2020 Alain
resigned and left the company.
•
Julie Lao – Accounts assistant
Julie joined Panther in July 2020. She is a student member of ICAEW. Julie works mostly on
processing bank payments and receipts. She also works on the sales ledger supervised by Sunil.
She acts as an assistant to both Sunil and Paul.
Revenue recognition
Two types of sale arrangements used by Panther, with differing commercial terms, are:
•
Pro forma invoice arrangements
Some sales are made using a pro forma invoice arrangement. A pro forma invoice is a confirmed
sales order, where Panther and the customer agree on the terms of sale, and the details and
prices of the metals and alloys to be sold and shipped to the customer. Panther raises a pro forma
invoice when it is ready to dispatch these goods.
Shipping to the customer may take several months. According to the commercial terms of sale,
control of the goods only passes to the customer when they are received by the customer. At this
point, a final invoice is raised, the transaction is recorded in the accounting records and the
revenue is recognised.
•
Bill-and-hold arrangements
Some sales are made under bill-and-hold arrangements. These arise when a customer is invoiced
for goods that are ready for delivery, but Panther retains possession of the goods in its warehouse
on the customer’s behalf and does not ship the goods to the customer until a later date.
Panther uses the following criteria to determine whether a particular transaction qualifies as a billand-hold arrangement:
(1) the reason for the bill-and-hold arrangement must be substantive (for example, the
customer has requested the arrangement for commercial reasons);
(2) products can be physically identified separately as belonging to the customer;
(3) products must be ready for physical transfer to the customer; and
(4) products cannot be used or directed to another customer.
When bill-and-hold arrangements apply, Panther recognises revenue despite the fact that the goods
are still in Panther’s possession.
Commodity prices and futures markets
Metals are a commodity and metal futures contracts are available to buy and sell in markets such as
the London Metal Exchange (LME). Futures prices reflect the prices of the underlying metals bought
and sold in trading of the physical product.
Impact of changes in metal prices on Panther – nickel and cobalt
I have set out below an extract from Panther’s draft strategic report for the year ended 31 December
2020.
The purchase price of nickel, which is used in many alloys, increased during the six months ended
30 June 2020 because of supply concerns. However, the price of nickel fell during the second half
of the year.
Another significant metal, cobalt, experienced volatility of prices during the year ended 31
December 2020. Sales of cobalt-based alloys provided strong growth for Panther but, at some
points in the year, it was difficult to obtain sufficient supplies of cobalt-based alloys to match
customer demand.
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Exhibit B: Interim audit matters – prepared by Ben Brown, 16 December
2020
I have raised the following issues for Paul Parker, the financial controller.
Interim audit matter 1: Debit transactions on Account 4000 − Nickel based alloy sales
Nickel based alloy sales have increased significantly compared with last year. I have reviewed
account 4000 for unusual transactions. I identified the following debit transactions processed by
Alain Smith, who resigned in August 2020.
In March 2020:
Transaction
ID
Description
Debit
Credit
Account
code
Effective
dates
User IDs
131735
Cancel
proforma
invoices
324,000
0
4000
01/03/2020
Alain
Transaction
ID
Description
Debit
Credit
Account
code
Effective
dates
User IDs
134203
Cancel
proforma
invoices
145,551
0
4000
01/06/2020
Alain
In June 2020:
I cannot find any information about these adjustments because Alain resigned in August 2020 and
no longer works at Panther. Paul has told me that he believes that Alain sometimes posted proforma
invoices to revenue by mistake. The final sales invoices were posted when the goods were received
by the customer. Alain then corrected his mistake by cancelling the proforma invoices with sales
credit notes, debiting the relevant sales account. Paul cannot be certain that all the proforma invoices
posted by Alain in error before he left have been corrected.
Interim audit matter 2: Revenue recognition
Alain was replaced by Julie Lao who joined Panther in July 2020. I discussed the accounting policy
for revenue recognition with Julie. She told me that Panther had recently considered a potential
contract with a customer on a basis. However, she seemed uncertain about how to account for this
type of contract and about other matters relating to revenue recognition. This is a key area of audit
risk which should be followed up at the year-end audit visit.
72 Panther Metals Ltd
The final audit visit for Panther started last week and you have joined the audit team as audit senior.
Jason Green, an audit assistant, has also joined the audit team for the final audit visit.
The engagement manager for the Panther audit, Albert Ramsay, gives you the following briefing:
“You will have reviewed the interim audit information prepared by Ben Brown, the previous audit
senior. You will also have familiarised yourself with the data for Panther for the 11 months ended 30
November 2020.
“Data for December 2020 has now been imported into the data analytics software from Panther’s
nominal ledger, so the full year nominal ledger data for the year ended 31 December 2020 is now
available.
“Jason followed up on the two interim audit matters set out by Ben Brown and has carried out some
further audit work. As a result, Jason has set out three audit issues (Exhibit 1).
“Jason has also performed preliminary analytical procedures for revenue for each type of metal and
alloy in comparison with last year (Exhibit 2) and he has added some brief comments.
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“The Panther board is concerned about how the volatility of metal prices affects the value of
inventories and impacts profit. The board has provided an illustrative example of a hedging
transaction prepared by Paul Parker (Exhibit 3).
“Materiality has been set at £165,000, but performance materiality has not yet been finalised.”
Instructions
(1) In respect of each of the three audit issues identified by Jason Green (Exhibit 1), review relevant
transactions in the data analytics software; and
– Set out and explain the appropriate financial reporting treatment, including correcting journal
entries.
– Identify and explain the key audit risks.
(2) From Jason’s preliminary analytical procedures for revenue (Exhibit 2), select three revenue
accounts which you regard as having the highest audit risk. For each of these three accounts:
– Explain and justify why you have selected the account.
– Identify individual transactions which give rise to key audit risks and explain the nature of these
risks.
– Set out the information and explanations that you need from Panther’s management in respect
of the audit risks identified.
(3) Determine and justify an appropriate level of performance materiality for the audit of Panther’s
revenue.
(4) Set out and explain the financial reporting treatment for the illustrative example hedging
transaction proposed by Paul (Exhibit 3).
You should include relevant journals. Explain how the suggested hedging transaction may
reduce the volatility of future reported profits.
Requirement
Respond to the audit engagement manager’s instructions.
Total: 40 marks
Exhibit 1: Audit issues – prepared by Jason Green, audit assistant
Audit Issue 1 – Proforma invoices
At the interim audit, Ben Brown raised a concern regarding whether Panther has appropriate and
effective controls over transactions using proforma invoices. I have investigated further and have
identified a proforma invoice in the Account code Nickel 4003 in April 2020 posted by Alain.
A final invoice for this amount was posted later in 2020 when the nickel was delivered to the
customer.
Audit issue 2 – Sale to YYM
YYM has been a customer of Panther for many years. YYM is a wholesaler and global distributor of
metals and alloys, based in South Africa.
In December 2020, Panther sold £342,556 of chromium to YYM. (The sale is recorded in Account
code 4012 Chromium.) In the sales agreement, YYM agreed to assume risk for the chromium and
had the right to control the destination and timing of delivery. YYM had agreed to sell this chromium
to one of its German customers, Zeinn.
YYM therefore asked Panther to store the chromium in its warehouse on a bill-and-hold basis until
February 2021. This was to avoid the costs of transport to South Africa and then later to Germany.
Panther agreed to this request from YYM. This chromium was included in the inventory count at 31
December 2020 and recognised in inventory at its cost to Panther of £270,500. I have checked and
confirmed that the cost is correct.
Audit Issue 3 – Goods in transit
On 6 December 2020, a ship set sail to deliver tungsten to a customer, GTEX, in San Diego on the
west coast of the US. A proforma invoice amounting to £450,562 was prepared.
The tungsten was in transit for some weeks and the ship was due to arrive in the San Diego on 27
December 2020.
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On 21 December 2020, Julie, the Panther accounts assistant, emailed GTEX’s purchase ledger
department. She informed them that the tungsten would be held at the port in San Diego until GTEX
paid the outstanding amount owing from previous sales of £352,411. This amount had been due for
payment on 30 November 2020.
On 2 January 2021, after some negotiation, GTEX made a payment on account of £150,000 in
respect of the total outstanding amount owing.
Following the receipt of the payment on account, Panther agreed to release the tungsten held at the
San Diego port. The goods were eventually delivered to GTEX on 15 January 2021.
Because the goods had left Panther’s factory, they were not included in inventory at 31 December
2020. I verified this by reviewing the inventory listing. The cost price of the tungsten was £395,500.
Exhibit 2: Preliminary analytical procedures for revenue − prepared by Jason Green
Account
Code
Account
Description
Prior Year
£
Current
Year
% change
£
Brief comments
prepared by Jason
Green4000
4000
Nickel Based
Alloys
6,041,028
12,178,537
102%
4001
Cobalt Based
Alloys
1,516,635
2,357,616
55%
4003
Nickel
(73,923)
337,199
556%
Movement already
explained by Audit
issue 1
4004
Other Raw
Materials
292,047
296,846
2%
Consistent with
previous year, no
significant
fluctuations
4005
17/4 ph type
74,967
137,191
83%
4007
Tungsten
2,778,353
3,186,947
15%
Consistent with
previous year, no
significant
fluctuations
4008
Niobium
2,065,017
2,537,320
23%
Consistent with
previous year, no
significant
fluctuations
4011
Titanium
703,088
693,235
(1)%
Consistent with
previous year, no
significant
fluctuations
4012
Chromium
161,075
827,775
414%
Movement already
materially explained
by Audit issue 2
Invoice to YYM in
December 2020 for
£342,566 on a ‘billand-hold’
arrangement
4013
Molybdenum
3,495,861
5,511,292
58%
Per Paul, Panther
accountant, sales of
molybdenum have
increased following
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Account
Code
Account
Description
Prior Year
£
Current
Year
% change
£
Brief comments
prepared by Jason
Green4000
acquisition of two key
customers. The
increase is in line with
budget.
4014
Tantalum
6,500,389
3,673,605
(43)%
Paul was not sure
what had happened
to Tantalum sales this
year.
4015
Hafnium
2,868,814
1,499,248
(48)%
Large sale in
February but then
small amounts – per
Paul, Panther no
longer sells this type
of metal.
4017
Toll Cutting
687,500
638,035
(7)%
4018
Cobalt
99,914
–
(100)%
4019
Aluminium
304,435
337,796
11%
4020
Monel
1,943
98,270
4958%
One large sale in July
4021
Rhenium
198,446
7,778
(96)%
Per Paul, Panther no
longer sells this type
of metal.
4024
Maraging
–
22,940
N/A
4025
Turnings – (Unit
8 Sales)
10,440
–
(100)%
4026
Zirconium
44,082
345,426
684%
One-off transactions –
per sales department,
not a metal that
Panther sells
frequently.
4028
Dense alloy
1,200,479
137,556
(89)%
Confirmed with sales
department that
Panther currently no
longer makes this
type of alloy.
4029
Low Grade to
Sell
351,045
257,740
(27)%
4030
MP35N
194,941
64,763
(67)%
4031
Refine/Reclaim
–
1,941
N/A
4040
Sales –
Processing
166,316
161,789
(3)%
29,682,894
35,310,842
Total revenue
Totals subject to roundings
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Exhibit 3: Illustrative example hedging transaction
Nickel makes up a large majority, by volume and value, of the nickel alloys produced by Panther. The
selling price for nickel alloys achieved by Panther is heavily dependent on the market value of the
nickel content at the time of the sale.
The Panther board wishes to reduce fluctuations in future cash inflows from the sale of nickel alloys
currently held in inventory. It wants to do this by hedging the cash flows from the nickel alloys which
are to be sold from inventory. It will use nickel commodity futures contracts as the hedge.
Panther has used this type of hedging in the past, and there is strong evidence from previous
contracts that it is effective.
Paul has prepared the following illustrative example based on a hedge which is expected to take
place on 30 September 2021:
Estimated nickel alloy in inventory at 30 September 2021
Quantity
Cost price
per tonne
Inventory
cost
Tonnes
£
£
540
12,600
6,804,000
The sales value of the nickel alloy at 30 September 2021 is estimated to be £7,540,000 if sold at that
date. However, Panther does not expect to sell the nickel alloy until 31 March 2022, when it knows a
regular customer will need a delivery.
On 30 September 2021, Panther will sell futures contracts for 540 tonnes of nickel at £14,000 per
tonne. The contracts will mature on 31 March 2022.
On 31 December 2021, the fair value of the inventory of nickel alloy is expected to be £7,330,000. At
31 December 2021, the futures price for nickel for delivery on 31 March 2022 is expected to be
£13,500 per tonne.
73 E-Van Ltd
E-Van Ltd is a component manufacturer for the electric vehicle industry. The Sennhauser family owns
100% of E-Van’s ordinary shares and the board is comprised entirely of Sennhauser family members.
You are Jo Maine, the assistant to Hanna Sennhauser, the finance director. You and Hanna are both
ICAEW Chartered Accountants.
Yesterday evening Hanna sent you the following email:
To:
Jo Maine
The Sennhauser family intends to sell all its shares in E-Van and has identified a potential buyer,
Karpart Ltd, which is E-Van’s largest customer.
As part of Karpart’s due diligence for the acquisition, the Karpart board has requested the
financial statements of E-Van for the year ended 30 June 2021 as soon as they have been
finalised. The reported profit of E-Van for that year will be one factor in determining a valuation for
the E-Van shares.
Draft financial statements for E-Van for the year ended 30 June 2021 are provided for you in
Exhibit 1.
The E-Van board wants to present the company’s results as favourably as possible to maximise the
sale price of E-Van’s shares. However, the board recognises the need to comply with IFRS. In
particular, the other directors on the E-Van board have requested that I review the financial
reporting treatment of the following three areas:
•
property, plant and equipment (PPE)
•
investment property
•
the net defined benefit pension liability.
I have looked at these and provided you with my proposed adjustments (Exhibit 2) to implement
the board’s request. The financial statements (Exhibit 1) do not yet include any of my proposed
adjustments.
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So that I can report to the board, I would like you to prepare a working paper for me in which you:
(1) Set out and explain, for each of the three areas identified above, your recommended financial
reporting treatment in E-Van’s financial statements for the year ended 30 June 2021. The
recommended treatment should comply with IFRS while maximising reported profit. Justify
and calculate any differences from my proposed adjustments. Include journals.
(2) Prepare revised draft financial statements for E-Van for the year ended 30 June 2021 (Exhibit
1), which reflect your recommendations. Show your workings.
Telephone call
Shortly after sending the email, Hanna telephoned you and made the following comment:
“I sent you an email earlier today. I want to emphasise how important it is to report a high profit
figure and maximise the price we achieve for the sale of E-Van’s shares. I did not want to put this in
writing but I would like you to prioritise this over complying with IFRS.”
“I am planning to retire in six months. Clearly, I will be able to recommend you as my successor if you
help me.”
Requirements
73.1 Prepare the working paper requested by Hanna Sennhauser.
(22 marks)
73.2 Explain the ethical implications for you arising from Hanna’s comment and the actions you
should take.
(8 marks)
Note: Ignore any adjustments for current and deferred taxation.
Total: 30 marks
Exhibit 1: Draft financial statements for E-Van for the year ended 30 June 2021
Draft statement of comprehensive income for the year ending 30 June 2021
£’000
Revenue
50,353
Operating profit
10,655
Finance costs
(6,150)
Profit before tax
4,505
Other comprehensive income:
Remeasurement (loss) on net defined benefit obligation (Exhibit 2, note 3)
(3,480)
Draft statement of financial position as at 30 June 2021
£’000
Assets
Non-current assets
Property, plant and equipment (Exhibit 2, note 1)
83,700
Investment property (Exhibit 2, note 2)
24,200
Current assets
39,500
Total assets
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253
£’000
Equity and liabilities
Equity
Ordinary share capital (£1 shares)
50,000
Other reserves
5,000
Retained earnings
12,600
67,600
Non-current liabilities
Net defined benefit pension liability (Exhibit 2, note 3)
54,000
Non-current payables and provisions
7,000
61,000
Current liabilities
18,800
Total equity and liabilities
147,400
Exhibit 2: Hanna’s proposed adjustments
Note 1 – PPE: depreciation of production line
I carried out a review of E-Van’s accounting policy for plant and equipment.
E-Van set up a new production line on 1 July 2019 for £36 million. E-Van recognised this production
line at cost and has depreciated it on a straight-line basis over seven years with an £8 million residual
value in accordance with its accounting policy.
A depreciation charge on this basis is included in the draft financial statements for the year ended 30
June 2021.
I asked the production manager whether he could justify a longer useful life for this production line.
He told me that it has been clear since July 2020 that demand from our customers for the car parts
produced on the production line is likely to end in June 2024. As a result, the production line would
be sold at that date.
However, I have obtained the electric vehicle component manufacturer industry averages as shown
below:
Industry average
Useful life − number of years
Residual value as % of cost
8
30%
Proposed adjustment
I propose that the depreciation charge for this production line should be revised as from 1 July 2020
to reflect the average useful lives and residual values used by the electric vehicle component
manufacturer industry.
Note 2 – Investment property
On 1 July 2015, E-Van bought a freehold office building for £27.5 million. The office building had a
50-year useful life at that date and a zero residual value.
The office building was used as the company’s head office until 1 July 2020, when E-Van moved its
head office to another property.
The freehold office building previously used by E-Van as its head office, was leased out to a third
party under a 10-year lease and reclassified by E-Van as an investment property.
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At 1 July 2020, E-Van chose to recognise the office building under the cost model for investment
properties. It continued to depreciate the office building over its remaining useful life and included a
depreciation charge in the draft financial statements for the year ended 30 June 2021.
Proposed adjustments
From the change of use on 1 July 2020, I propose that instead of choosing the cost model, E-Van
should choose the fair value model for the office building in accordance with IAS 40.
To establish the fair value, I did some research and obtained details of two office buildings of similar
size to E-Van’s head office which were sold in the local area in the past year.
One office building was sold at a public auction for £30 million; the other was sold for £35 million to
an international consortium seeking to make its first purchase in the UK property market.
I think that we should use the higher of these two figures as the fair value of E-Van’s head office
building. The fair value at 30 June 2021 can be assumed to be the same as the fair value at 1 July
2020.
Note 3 – Net defined benefit pension liability
The present value of the defined benefit obligation and the fair value of the plan assets at 30 June
2021 were provided by E-Van’s actuary.
The changes in the fair value of the assets and the present value of the liabilities over the year are
reflected in the draft financial statements for the year ended 30 June 2021 as follows:
At 1 July 2020
Interest 2%
Contributions paid
Fair value of
plan assets
Present value
of obligation
Net defined benefit
pension liability
£’000
£’000
£’000
16,000
(67,000)
(51,000)
320
(1,340)
(1,020)
3,500
Current service cost
Less: Benefits paid to retired members
3,500
(2,000)
(2,000)
(3,300)
3,300
16,520
(67,040)
(50,520)
Remeasurement
1,480
(4,960)
(3,480)
At 30 June 2021
18,000
(72,000)
(54,000)
Proposed adjustments
•
IAS 19 requires that the net interest cost and the liabilities of the pension scheme are discounted
using the interest rate applicable to high-quality corporate bonds. We currently use 2% per
annum based on AA-rated corporate bonds. However, I propose instead that a BBB investment
grade corporate bond interest rate of 4.2% rate would be acceptable and should be used. As a
result of using the higher interest I estimate that the net defined benefit pension liability at 30
June 2021 will reduce to £35 million.
•
E-Van made an offer to the scheme’s retired members to give up any future pension increases in
return for a higher current pension which will remain constant. By 15 July 2021, nearly all the
members had accepted this offer. The actuary informed me that this will result in a past service
curtailment gain of £3.8 million for the year ended 30 June 2021. However, the actuary has not
included this adjustment in the figures provided above. I propose that this adjustment should be
recognised in the draft financial statements for the year ended 30 June 2021.
74 Hughes Watson LLP
You are an audit senior at Hughes Watson LLP (HW), a firm of ICAEW Chartered Accountants. Numilla
plc, an audit client of HW, is listed on the London Stock Exchange. It is the parent company of a
group which supplies wind turbines and other equipment to the renewable energy industry in the
UK. You have been assigned to the group audit of Numilla for the year ended 30 June 2021.
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You receive the following briefing and instructions from the Numilla group audit manager, Alex
Matuke:
“On 30 June 2021, Numilla acquired 80% of the issued ordinary share capital of Localex Inc, a
company based in Utopia. An assistant in Numilla’s corporate finance team has provided background
notes on the acquisition (Exhibit 1) and the Numilla financial controller has set out his preliminary
calculation of goodwill arising on the acquisition of Localex (Exhibit 2). We need to complete our
audit procedures on this goodwill.
“Please review all of the information I have provided (Exhibit 1 and Exhibit 2) and:
(1) In respect of the calculation of goodwill on the acquisition of Localex:
(a) Identify and explain fair value adjustments and any errors or omissions made by the Numilla
financial controller. Where possible, quantify the effect of each fair value adjustment, error or
omission on goodwill, showing all relevant figures.
(b) As far as the information permits, set out a corrected calculation of goodwill in the functional
currency and the amount to be recognised in Numilla’s consolidated statement of financial
position at 30 June 2021.
Where appropriate, use an annual discount rate of 5%.
(2) Explain the key audit risks that HW should address in its audit of the goodwill arising on the
acquisition of Localex. For each key audit risk identified, set out the appropriate audit
procedures for the year ended 30 June 2021.”
Requirement
Respond to Alex Matuke’s instructions.
Total: 30 marks
Exhibit 1: Background notes on the acquisition of Localex – prepared by an assistant in Numilla’s
corporate finance team
Localex is Numilla’s first acquisition outside the UK. Localex operates an energy supply business in
Utopia. It also manufactures wind turbines which the Numilla group intends to sell in the UK.
Localex has developed a small wind turbine, known as the MiniMax. This can be used by individual
households or small businesses. The MiniMax is technically superior to similar products on the UK
market and can be manufactured more cheaply in Utopia than in the UK. Following its acquisition by
Numilla, Localex will continue to supply energy in Utopia. Localex will also expand its manufacturing
facility so that it can supply MiniMax to both the UK and its local market.
The acquisition
On 30 June 2021, Numilla acquired 80% of the issued ordinary share capital of Localex from the
company’s chief executive, Mattie Sven. Mattie still owns the remaining 20% of issued ordinary share
capital. Mattie will continue as Localex chief executive under a three-year employment contract
expiring on 30 June 2024.
The currency in Utopia is the $, which is also the functional currency of Localex.
Consideration
Consideration for the 80% of Localex ordinary shares acquired by Numilla was structured as follows:
•
Cash of $1 million paid on 30 June 2021.
•
2 million ordinary shares in Numilla plc issued on 30 June 2021, when the market price per share
was £4.20.
•
500,000 ordinary shares in Numilla plc to be issued on 31 July 2024 if the Localex financial
statements show average annual growth in profit before taxation of at least 10% over the threeyear period ending 30 June 2024. I believe that there is only a 40% probability that this target will
be achieved. It is estimated that the Numilla plc price per share on 30 June 2024 will be £5.
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Net assets
The Localex draft financial statements for the year ended 30 June 2021 show net assets with a
carrying amount of $5 million comprising:
Notes
$ million
$ million
PPE
Freehold property – at valuation
1
3.0
Plant and equipment at depreciated cost
2.7
5.7
Research and development costs for MiniMax
1.6
Current assets
2.9
Current liabilities:
Decommissioning liability
2
Other
1.5
3.7
(5.2)
Net assets
5.0
Notes
(1) Localex uses the revaluation model in respect of freehold property. I believe that the carrying
amount of freehold property is equivalent to its fair value.
(2) The decommissioning liability relates to a fossil-fuel power station which is recognised in plant
and equipment. Localex is legally obliged to dismantle this power station at the end of its useful
life on 30 June 2026. The liability has been calculated using an estimated cost at 30 June 2026
of $1.9 million and a discount rate of 5% per annum. Localex estimates that, on 30 June 2026, a
third party would charge $3.3 million to assume this liability.
Tax
In Utopia, company taxable profits are equal to accounting profits. The Utopian tax rate is 7.5%.
The UK tax rate is 19%.
Exchange rate
The exchange rate on 30 June 2021 was £1 = $0.8.
Exhibit 2: Calculation of goodwill on the acquisition of Localex – prepared by Numilla financial
controller
Notes
£’000
Consideration
Cash
1,000
2 million shares at £4.20
8,400
Professional fees incurred in respect of the acquisition and associated
issue of shares
Non-controlling interest – 20% of $5 million, translated at exchange rate
of £1 = $0.8
100
1
Total consideration
1,250
10,750
Less: Net assets
As reported in the Localex draft financial statements at 30 June 2021
2
5,000
3
1,600
Fair value adjustments:
Contractual right to supply power and equipment in Utopia
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Provision for UK patent costs
Notes
£’000
4
(125)
Total net assets
6,475
Goodwill
4,275
Notes
(1) It is Numilla group policy to value the non-controlling interest using the proportion of net assets
method.
(2) Localex prepares its financial statements in accordance with IFRS and adopts the same
accounting policies as Numilla group.
(3) Localex has an exclusive licence to supply power in the Southern Region of Utopia until 30 June
2030. Based on anticipated net cash inflows from this contract, I have calculated that its value in
use is $1.28 million (£1.6 million) higher than its carrying amount at 30 June 2021. I have made a
fair value adjustment to reflect this.
(4) Following the acquisition, Numilla plans to patent Localex’s MiniMax wind turbine in the UK and
other markets. I have therefore included a provision for the estimated cost of obtaining this
patent.
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Data Analytics Software
Background
Practice Questions 1 and 2 are not exam standard; they are designed to give you practice in applying
the data analytics software (DAS) features and functionality in the context of exam scenarios.
You should only attempt these Practice Questions having studied the Explanatory Guidance Notes
for the DAS. The Explanatory Guidance Notes explain and demonstrate how to use the software and
provide the basic knowledge, understanding and skills required to attempt the Practice Questions in
a meaningful way.
Practice Questions 3 and 4 are designed to bridge the gap between Practice Questions 1 and 2
(which are not exam standard) and Practice Questions 5 and 6, and the Corporate Reporting mock
exams (which are fully exam standard).
You should only attempt these Practice Questions having studied the Explanatory Guidance Notes
for the DAS and having attempted Practice Questions 1 and 2.
Both the Explanatory Guidance Notes and the Practice Questions use the same version of the
software. They also have the same data contained within the software, which relates to a real
company, Elephant Company.
Underlying assumptions of the Practice Questions
Whilst all Corporate Reporting Practice Questions use the same software and the same data set
contained within that software, they should be considered as separate companies.
The Elephant company provides marketing services, mainly to digital businesses based in the UK
(domestic) and the rest of Europe (overseas). However, whilst this is the core business model for all
Practice Questions, each question scenario is a separate company and will therefore explain and
develop additions to, and variations of, the core business model.
Aside from the business model, the scenarios differ in each Practice Question in terms of the audit
risks, roles of individuals, activities, accounting problems, and additional transactions outside the
data in the software. Issues described in one company scenario should not therefore be assumed to
exist in another company in another Practice Question.
In the real Corporate Reporting exam, the version of the software will be the same as that in the
Explanatory Guidance Notes and Practice Questions, but the data contained within it will be a
different real company from Elephant.
In the real Corporate Reporting exam there will be Advance Information with 11 months of data. The
full year’s data will then be provided in the exam itself. As these Practice Questions are not full exam
standard, there is no Advance Information and the full 12 months data is provided for each question.
There are three elements to each Practice Question:
•
The question.
•
Mark plan. (Traditional mark plan – but with narrative references to the DAS.)
•
Appendix. Screen shots showing the visualisations that were useful in obtaining the answer and
which support the narrative in the mark plan (but are not part of the answer).
The software contains a series of visualisations, which you may be required to interrogate, analyse
and interpret. However, for Corporate Reporting exams in 2022 you will not be able to copy
visualisations (or any other information) from the software into your script. Therefore, the
screenshots in the Appendix of each question are for guidance only, to show how, for each Practice
Question, the answer was obtained using the software. You will not be able to replicate the Appendix
of the Practice Questions in the exam.
Dates
Elephant’s accounting year-end for the data in the software is 31 December 2018.
Each Practice Question will state an assumed date within the scenario where you are undertaking a
role in the audit of Elephant. Typically, this will be in the first few months of 2019 (ie, shortly after
Elephant’s accounting year end).
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Which browser and which device?
The software works on most browsers. However, it is strongly recommended that you do not use
Safari.
If you use a laptop, some visualisations may appear slightly more compressed than shown in these
guidance notes, or may not show the full screen. It is recommended that you do not use an iPad or
other tablet or phone to access the software.
75 Practice Question 1
Click below to access the data analytics software
DATA ANALYTICS SOFTWARE
Assume that the current date is 28 January 2019.
Your firm is the external auditor of Elephant Company (Elephant), a digital marketing company based
in the UK. Elephant’s customers sign a contract for a specific project for Elephant to deliver
marketing services. Each project is short term, up to three months.
You are an audit senior on the audit of Elephant for the year ended 31 December 2018. An interim
audit took place in December 2018, but you were not involved in that audit visit.
Materiality for the audit of Elephant has been set at £30,000.
Your firm has extracted draft data from Elephant’s nominal ledger and imported it into your firm’s
DAS.
Engagement partner’s concerns
The engagement partner, Mary Moore, has asked you to consider the following two key areas of
audit risk:
(1) Cost of sales
(2) Trade payables
Mary is concerned that some of the accounts making up cost of sales have increased substantially.
Mary is also concerned about the amount of expenses being claimed by staff using a company credit
card and she considers this could be an audit risk. Typically, staff will charge expenses, or make
purchases, using the company’s credit card, which is then settled directly by Elephant.
Interim audit
The audit junior, Brian Best, attended the interim audit and wrote the following notes:
All direct costs (labour, expenses and materials) incurred for each marketing project are manually
recorded in Elephant’s job costing system. The job costing system is used to record costs allocated
to each job. It is maintained outside the nominal ledger and therefore does not form part of the data
held in the DAS.
Expenses include travel and accommodation costs incurred by staff. Costs of materials include mockups (ie a visual, graphic or physical representations of a marketing design). These are used for digital
marketing presentations in visualising ideas, concepts and developing designs.
As these job costs are not recorded within the nominal ledger, I did not plan, or carry out, any audit
procedures on these costs at the interim audit visit.
I am concerned about internal controls over expenses incurred by staff. Many of these expenses
seem to be settled in May, September and October. One of the staff claiming expenses is Philippa
Wright, who is the daughter of Frank Wright, the senior accounts manager.
Also:
•
Elephant does not have an authorised supplier list; and
•
Supplier statements are not reconciled with the trade payables ledger.
Brian extracted the following sample items during the interim audit visit. However, he fell ill shortly
afterwards and did not have an opportunity to carry out any audit procedures on these sample items:
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Sample item A
Extracted from trade payables account:
Transaction 'PIN029525'
Transaction Id
Account Code
Amount
Effective Date
Document Type
Journal Description
User Id
PIN029525
72000
20,650
23/05/2018
PIN - Purchase Invoice
P001/007 - Newcastle rent 24/6/15–28/9/15
FWRIGHT
29/05/2018 18:54:41
PIN029525
31010
-20,650
23/05/2018
PIN - Purchase Invoice
-PIN029525 - Posting Run Control
FWRIGHT
23/05/2018 18:54:41
Show
10
Line Description
lines
Created Date
Showing 1 to 2 of 2 lines
1
Brian’s notes:
I selected Sample item A due to its size.
Sample item B
Extracted from trade payables. This sample item has more than one transaction, as follows:
Transaction 'PIN029477'
Transaction Id
Account Code
Amount
Effective Date
Document Type
Journal Description
User Id
PIN029477
61070
4,080
11/05/2018
PIN - Purchase Invoice
2284 - Adult & Kiddi Clings.
FWRIGHT
17/05/2018 19:19:32
PIN029477
33020
816
11/05/2018
PIN - Purchase Invoice
-PIN029477 - Posting Run Control
FWRIGHT
17/05/2018 19:19:32
PIN029477
31010
-4,896
11/05/2018
PIN - Purchase Invoice
-PIN029477 - Posting Run Control
FWRIGHT
17/05/2018 19:19:32
Show
10
Line Description
Created Date
Showing 1 to 3 of 3 lines
lines
1
Extracted form trade payables transactions:
Transaction 'PPY013791'
Transaction Id
Account Code
Amount
Effective Date
Document Type
Journal Description
User Id
PPY013791
31010
4,896
12/05/2018
PPY - Purchase Payroll
-PPY013791 - Posting Run Control
FWRIGHT
18/05/2018 12:12:31
PPY013791
20040
-4,896
12/05/2018
PPY - Purchase Payroll
Think Ambient Ltd - CJBCard Jun
FWRIGHT
18/05/2018 12:12:31
Show
10
Line Description
lines
Created Date
Showing 1 to 2 of 2 lines
1
Brian’s notes:
Sample item B was the purchase of bespoke marketing materials, comprising ‘Adult and Kiddi
Clings’, from the supplier, Think Ambient Ltd. The purchase was made with a credit card (CJB card). I
selected this sample item due to its size.
Account balance extracts – key areas of audit risk
Brian extracted the following account balances in respect of the key areas of audit risk identified by
Mary, the engagement partner:
(1) Cost of sales (from Financial Statement view)
Cost of Sales
809,659
881,464
Cost of goods sold
805,061
876,096
Other cost of sales
4,599
5,368
71,805 (
71,035 (
9%)
9%)
769 ( 17%)
(2) Trade payables (from Financial Statement view)
Trade Payables
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148,109
151,941
3,832 (
3%)
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261
Other data
You have obtained the following list of account codes from Elephant’s accounting system:
Account name
Account code
Payables Control Account (trade payables)
31010
Sales tax input control (input VAT)
33020
Credit card (balance)
20040
Printing (expense)
61070
Travel and subs on jobs (expense)
61085
Rent charge (expense)
72000
Requirements
75.1 In respect of the two sample items extracted by Brian, describe the audit procedures that
should be carried out.
(10 marks)
75.2 Justify why items (1) and (2) above have been identified as key areas of audit risk. For each key
area, describe the audit procedures that should be included in the audit plan to address those
risks. (Do not repeat the audit procedures from 1.1 above).
(27 marks)
75.3 Recommend and justify internal control improvements to address potential control
deficiencies.
(8 marks)
Total: 45 marks
76 Practice Question 2
Click below to access the data analytics software
DATA ANALYTICS SOFTWARE
Assume that the current date is 28 February 2019.
You are assigned as audit senior to the audit of the financial statements of Elephant Company Ltd
(Elephant) for the year ended 31 December 2018.
Elephant is a digital marketing company based in the UK. Elephant’s customers sign a contract for a
specific marketing project for the delivery of marketing services. Each project Elephant undertakes is
typically short term, up to six months. In order to monitor and control costs incurred in relation to
each project, the direct costs incurred for each project are recorded in individual memorandum
accounts within the accounting system.
Audit materiality for the financial statements of Elephant has been assessed at £30,000.
At the interim audit, discussions with management identified that Elephant was facing weaker UK
economic conditions and increased competition which were making trading conditions more
challenging for Elephant in 2018. Management informed you prior to the final audit that Elephant is
seeking to raise further private equity funding in 2019 and that the audited 2018 financial statements
will be used by the potential investor for the process of establishing a valuation for the company. As
a consequence, management insist that the audit must be completed and the audit report signed by
31 March 2019.
At the planning meeting for the final audit, the engagement partner identified income as a key audit
risk. She also mentioned the shorter time available for the audit than usual and that Elephant’s
management had made it very clear that it is important that the 2018 audit goes as smoothly as
possible without any unexpected problems.
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A member of the audit team, Maureen Ho, has already performed a review to identify large
transactions after the year end. She has prepared audit working papers highlighting the following
four entries:
Account
code
Amount
Effective
date
51010
38,000
31/1/2019
21010
–38,000
31/1/2019
Account
code
Amount
51010
24,320
31/1/2019
21010
–24,320
31/1/2019
Account
code
Amount
Effective
date
72000
21,342
1/1/2019
Effective
date
Document
type
Journal description
User ID
Created
date
SIN–Sales
Invoice
Reversal – Dec18 sales
FWRIGH
T
15/2/2019
SIN–Sales
Invoice
SIN001008 – Posting
Run Control
FWRIGH
T
15/2/2019
Journal description
User ID
Created
date
SCR–Sales
Credit
Hilditch Mobile refund
for October inv error
TPOTTS
09/2/2019
SCR–Sales
Credit
SCR000231 – Posting
Run Control
TPOTTS
09/2/2019
Journal description
User ID
Created
date
JSMITH
09/2/2019
JSMITH
09/2/2019
Document
type
Document
type
PIN –
Purchase
Invoice
Rent – Newcastle
PIN –
Purchase
Invoice
PIN002349 – Posting
Run Control
1/10/18 – 31/12/18
31010
–21,342
1/1/2019
Account
code
Amount
Effective
date
71080
18,982
22/2/2019
PIN –
Purchase
Invoice
Invoice 23910 –
Executive Search Ltd
JSMITH
13/1/2019
31010
–18,982
22/2/2019
PIN –
Purchase
Invoice
PIN004889 – Posting
Run Control
JSMITH
13/1/2019
Document
type
Journal description
User ID
Created
date
Navan Patel, the finance director of Elephant, has informed your firm of the following developments
related to Elephant’s management team:
Changes have been made during 2018 to strengthen the management team. In August 2018,
Elephant employed an external consultant to carry out an executive search for a marketing director.
This resulted in an appointment being made in November 2018.
Navan intends to retire in May 2019. The board of Elephant would like your firm to assist with the
recruitment of a suitable candidate to replace him and also advise on structuring an appropriate
remuneration package.
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263
The following list of relevant account codes has been identified from Elephant’s accounting system:
Account name
Account code
Receivables control account
21010
Payables control account
31010
Domestic Sales
51010
Overseas Sales
52010
Other income
54800
Recruitment and selection
71080
Rent
72000
Suspense Account
990
Requirement
76.1 Justify why the engagement partner has identified income as a key audit risk. You may use the
Explore module in your firm’s data analytics software to support your answer.
(6 marks)
(a) Using the Heat Map, identify transactions related to income that give rise to a high risk of
material misstatement.
(b) Justify why you have identified the transactions in (a) as high risk.
(c) Describe the audit procedures that should be applied to address the risks of the
transactions identified in (a).
(18 marks)
76.2 Identify and explain the key audit risks arising from the four post year end transactions
identified in Maureen’s working papers. You may use the Explore module to support your
answer.
(6 marks)
76.3 From the information provided, identify and explain any threats to objectivity and state how
your firm should respond to those threats.
(5 marks)
Total: 35 marks
77 Practice Question 3
Click below to access the data analytics software
DATA ANALYTICS SOFTWARE
Assume that the current date is 7 March 2019.
Your firm is the external auditor of Elephant Company (Elephant).
Elephant is a digital marketing company based in the UK. Elephant agrees fixed price contracts with
its customers to deliver digital and traditional marketing services related to specific marketing
projects. Each marketing project Elephant undertakes is short term, typically less than three months
in duration. Each project is assigned to a project leader who is responsible for controlling costs and
ensuring that Elephant delivers all marketing services specified in the contract.
Project leaders record costs related to each contract in an electronic job sheet for each contract.
Contract costs include time spent by web developers working in Elephant’s digital design studio. The
standard rate at which web developer time is recorded includes payroll costs (salary and NI) and an
apportionment of Elephant’s central overheads.
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You are Lesley Mills, an audit senior on the Elephant audit for the year ended 31 December 2018.
Materiality has been set at £30,000. Elephant’s general ledger has been successfully imported into
your firm’s DAS.
The current executive directors of Elephant founded the company and retain significant
shareholdings. Executive directors benefit from an incentive plan involving the payment of
substantial cash bonuses if 5% per annum annual growth in profit before tax is achieved.
The Elephant board has stated that they intend to float the company on AIM in the near future. This
will provide an opportunity to raise additional capital for Elephant and permit the executive directors
to realise part of their shareholdings. The investment bank advising Elephant has informed the
directors that a profitable recent history is essential to a successful flotation.
The audit engagement partner has identified Land, buildings & improvement within non-current
assets as a key audit risk and has asked you to look into this area. You have identified that two
accounts make up land, buildings & improvement.
13010 Fixtures & fittings
13020 Office Equipment
At the planning stage, it was identified that the business environment in 2018 was very challenging
for Elephant. Management has also informed you that during the year Elephant developed its own
website and external and internal costs have been recognised as a non-current asset in accordance
with Elephant’s accounting policies.
You have identified the following transaction related to the capitalisation of website development
within the DAS.
Transaction 'SRC006972'
Transaction Id
Account Code
Amount
Effective Date
Document Type
Journal Description
User Id
SRC006972
13020
95,000
29/09/2018
SRC - Sales Receipt
Website dev
FWRIGHT
06/10/2018 09:44:22
SRC006972
61060
-20,000
29/09/2018
SRC - Sales Receipt
Photography
FWRIGHT
06/10/2018 09:44:22
SRC006972
21010
-75,000
29/09/2018
SRC - Sales Receipt
Digital Dreams Ltd
FWRIGHT
06/10/2018 09:44:22
Show
10
lines
Line Description
Created Date
Showing 1 to 3 of 3 lines
1
You sent an email to Frank Wright, Elephant’s financial controller, requesting further information
regarding the nature of the capitalised website development costs. His response is provided as
Exhibit 1.
Requirements
77.1 Explain why the engagement partner identified land, buildings & improvement at the planning
stage as a key audit risk. Use the Data Analytics Software to support your answer.
(4 marks)
77.2 Identify and explain any transactions relating to land, buildings & improvement (other than
Transaction SRC006972 shown above) which may represent key audit risks. Justify why each
transaction is a key audit risk. Use the Data Analytics software to support your answer.
(4 marks)
77.3 Describe appropriate audit procedures to address the key audit risks relating to the
transactions identified in 3.2 above. Set out any information and explanations that you would
require of management.
(10 marks)
77.4 In relation to the recognition of website costs as a non-current asset shown in Transaction
SRC006972 above:
(a) Identify and explain relevant financial reporting issues and critically assess the
appropriateness of the proposed financial reporting treatment.
(b) Describe further audit procedures you should undertake. Set out any further information
and explanations that you would require of management.
(12 marks)
Total: 30 marks
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265
Exhibit: Email from Frank Wright in response to your enquiries related to capitalisation of website
costs
To:
Lesley Mills
From:
Frank Wright
Subject: Website development costs
Our website is intended to provide two functions: Firstly, it serves as a point of presence on the
internet to showcase the type of marketing campaigns we are able to deliver to potential
customers. We have commissioned new digital photography of our staff and facilities for inclusion
in case studies illustrating what we have done for previous customers. Secondly, we are also
intending to develop a full e-commerce suite, although this functionality is not yet operational.
The e-commerce suite is intended to enable customers to submit electronic requests for
quotations and facilitate online contract management, such as client approval of copy and
artwork.
The website costs that we have capitalised relate to two types of cost:
•
New photography commissioned to provide artwork for the website. This amounted to
£20,000 and had previously been expensed as incurred.
•
Time spent on the project by our digital design studio web developers and related national
insurance costs. Unfortunately, when these costs were incurred during the year no-one was
sure of how to record them. So, as a short-term measure, these costs were accumulated at the
standard rate in a pre-existing job sheet for a contract completed in 2017 for Digital Dreams
Ltd. Unfortunately, during the year an invoice was raised in error and an amount of £75,000
was posted to 51010 Domestic sales and 21010 Receivables Control A/c.
In the course of looking into this for you, I have identified that website costs have been incorrectly
posted to the wrong non-current asset account - 13020 Office Equipment. Accordingly, I intend to
create a new account, 13000 Intangible assets, and post the following correcting journal with an
effective date of 31 December 2018:
DEBIT
CREDIT
13000 Intangible assets (SOFP)
£95,000
13020 Office Equipment (SOFP)
£95,000
I have also realised that amounts recorded in respect of website development in the year were
incomplete as they omitted the payroll costs for the web administrator responsible for the website
since it went live in October 2018. To address this, I intend to post the following journal with an
effective date of 31 December 2018.
DEBIT
13000 Intangible assets
£18,326
CREDIT
71000 Admin Salaries
£16,687
CREDIT
71005 Admin NI
£1,549
In response to your question about our amortisation policy we have decided that our policy will
be to amortise all development costs on the website on a straight-line basis over seven years.
Regards,
Frank
78 Practice Question 4
Click below to access the data analytics software
DATA ANALYTICS SOFTWARE
Assume that the current date is 25 February 2019.
Your firm is the auditor for Elephant Company (Elephant).
You are Dougal Skye, the audit senior for the final audit of Elephant for the year ended 31 December
2018.
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Materiality has been set at £30,000.
Elephant provides marketing services, mainly to digital businesses based in the UK and the rest of
Europe. Customers sign a contract with Elephant for the provision of a specific project. Each project
is typically short term. For short term projects, customers are invoiced when the customer signs to
confirm their acceptance at the end of a completed project.
Typical cost of sales incurred by Elephant for each contract include payroll, artwork and promotional
products together with travel and subsistence costs incurred by Elephant staff arising from visiting
clients.
You have received an email from Brian Newbie (Exhibit 1), who is the most junior member of the
audit team. Brian joined your firm last month after graduating from university. Elephant is Brian’s first
audit assignment. You have asked Brian to be responsible for the audit of prepayments and accruals.
You have also received an email from another audit assistant in the audit team, Dylan Buck (Exhibit 2)
who has been assigned to reviewing transactions in the cash account.
Requirements
78.1 Use the ‘Explore’ module of the Data Analytics Software to identify and explain any audit risks
arising from the matter raised by Brian in his email (Exhibit 1).
(8 marks)
78.2 Identify appropriate audit procedures that should be undertaken in relation to accrued income
for Elephant. Describe additional information and explanations you would require from
management.
(5 marks)
78.3 Identify and explain any audit quality control issues arising from Brian’s email.
(8 marks)
78.4 Set out and explain the correct financial reporting treatment for the two matters raised by
Dylan in his email (Exhibit 2) in respect of the financial year ended 31 December 2018 and the
financial year ending 31 December 2019. Provide correcting journals for the year ended 31
December 2018.
(9 marks)
Total: 30 marks
Exhibit 1: Email from Brian Newbie
To:
Dougal Skye
From:
Brian Newbie
Subject: Prepayments and accruals
Hi,
Sorry to bother you, but I have used the Data Analytics Software to review prepayments and
accruals and I really don’t understand what is going on. Last year the accrued income for uninvoiced sales was £170,294. However, this year the value of this account is nil. I have also noticed
that prepayments have increased by nearly 500%. Does all this seem strange?
You can see the relevant balances below from our Data Analytics Software for the prior year and
the current year.
22200 – Accrued income
23040 – Pre-Payments Control A/C
170,294
0
51,066
300,000
-170,294
100%
248,934
487%
I am concerned that perhaps there might be a fraud here, so perhaps you should review my work.
Regards,
Brian
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Exhibit 2: Email from Dylan Buck
To:
Dougal Skye
From:
Dylan Buck
Subject: Loans and investments
Hi
I have identified two related matters from my review of account 20010 – Bank, current account,
Elephant’s main bank account.
Debenture issue
From my review of large cash transactions in the year I identified that a debit of £75,000 was
posted by A Bloggs to 20010 with an effective date of 29 December 2018. In the course of
reviewing cash entries after the year end, I also identified a payment of £1,375 in January 2019
made to Close Advisors with the description ‘costs of 2018 debenture loan’.
Further investigation revealed that both these entries related to the issue of a debenture loan to a
private investor. The debenture loan was issued at a price of £75,000 on 1 December, it pays no
cash interest and will be redeemed in 5 years at £90,000. Using this information, I have calculated
the annual effective interest rate at 3.7%, or 4.1% if the issue costs are taken into consideration.
The debenture issue was arranged by Close Advisors, a division of the same bank that provides
Elephant with invoice finance facilities. For this reason, I believe that this transaction was
mistakenly assumed to relate to invoice finance facilities and has been recorded incorrectly.
Purchase of UK government bonds
From my review of cash entries in January 2019, I have identified that £75,100 was paid on 2
January 2019 to settle a purchase of UK Government Bonds. Dealing costs for this transaction
totalled £100. I have asked Elephant’s financial controller about this and she stated that the
purpose of raising £75,000 from the debenture loan was to obtain funds to meet future liquidity
requirements. The date on which additional liquidity will be required is uncertain. Therefore,
Elephant’s objective in purchasing UK government bonds is to manage its liquidity needs and
generate a return. In holding assets to meet this objective Elephant expects to both hold assets to
receive contractual cashflows and sell assets to realise their value.
I have examined the contract note received from the stockbroker for this transaction. It shows a
purchase of UK government bonds for a consideration of £75,000 with a trade date (when the
terms were agreed) of 30 December 2018 with settlement on 2 January 2019. I have checked and
using the closing market price, the value of this holding of UK government bonds at 31 December
was £74,250.
I asked Elephant’s financial controller why this investment doesn’t appear in the 2018 financial
statements and she informed me that no entries were necessary because Elephant’s policy is to
use settlement date accounting.
79 Practice Question 5
ADVANCE INFORMATION: ELEPHANT LTD
Assume that the current date is 15 February 2019.
This Advance Information relates only to Corporate Reporting Practice Question 5.
The Advance Information comprises:
(1) This document which includes the scenario, notes of a meeting with Frank Wright, Elephant Ltd’s
finance director (Exhibit A) and a working paper prepared by an assistant working for Smith &
Ives, Elephant’s auditor (Exhibit B); and
(2) The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the Data Analytics Software. To access the data analytics software please
click below.
DATA ANALYTIC SOFTWARE
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Exam - 12 months
When you attempt Practice Question 5, you will be provided with the nominal ledger data for
Elephant for the full 12 months ended 31 December 2018 contained within the DAS. You will need to
address the new data for the month of December 2018 and to consider the data, patterns and trends
for the year ended 31 December 2018 as a whole.
The data for the 11 months to 30 November 2018 will remain valid and will be unchanged. However,
in the real exam you will not be able to access the DAS data for the first 11 months or any notes you
have made in the DAS.
In attempting this Practice Question, you should therefore replicate this real exam experience and
not access the DAS data for the 11 months to 30 November 2018 or any notes you have made in the
DAS for the 11 months to 30 November 2018.
Scenario
You are an audit senior working for Smith & Ives LLP, a firm of ICAEW Chartered Accountants.
Elephant prepares its financial statements in accordance with IFRS. You have just been assigned to
the audit of Elephant Ltd for the year ending 31 December 2018.
You receive the following email from the audit engagement manager for the Elephant audit, Tian
Turner.
To:
Audit Senior
From:
Tian Turner
Date:
15 February 2019
In August 2018, Smith & Ives was appointed as Elephant’s auditor. In September 2018, I had an
introductory meeting with Frank Wright, Elephant Ltd’s finance director. I have summarised my
notes from this meeting, which include background information about Elephant and its business
(Exhibit A).
Elephant has been slow to provide its nominal ledger data. Therefore, the final audit visit for the
year ended 31 December 2018 is scheduled for March 2019.
In January 2019, Smith & Ives started planning the Elephant audit for the year ended 31
December 2018. An audit assistant prepared a working paper analysing some information from
the previous year ended 31 December 2017. He also included information about the current
members of the Elephant finance team and their roles (Exhibit B).
Last Friday, (8 February 2019), Elephant’s management provided Smith & Ives with the nominal
ledger data for the 11 months ended 30 November 2018. This has been imported into the Data
Analytics Software that Smith & Ives uses to carry out its audit procedures.
Elephant are processing final journals and the nominal ledger data for the full year ended 31
December 2018 will be available for the final audit visit in March 2019.
Before the final audit visit commences in March 2019, I would like you to familiarise yourself with
Elephant by reviewing:
(1) The notes of my introductory meeting with Frank Wright (Exhibit A) and the working paper
prepared by the audit assistant (Exhibit B); and
(2) The nominal ledger data for Elephant for the 11 months ended 30 November 2018,
contained within the Data Analytics Software.
Audit materiality has been set at £30,000.
Exhibit A: Notes of introductory meeting with Frank Wright in September 2018 prepared by Tian
Turner
I had an introductory meeting with Frank Wright to discuss Elephant and, in particular, its income
streams and direct payroll. I have summarised below the key points from my meeting.
Income streams
Elephant has three income streams from the services that it offers. These are:
•
Long-term marketing contracts for large customers (Contract sales)
•
Promotional events and exhibitions (Exhibition sales)
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•
Other advertising assignments (Other sales)
(1) Contract sales
Elephant provides marketing services, under long-term contracts, mainly for large businesses based
in the UK (domestic) and the rest of Europe (overseas).
Customers sign a contract for the provision of marketing services across a spectrum of activities –
including digital marketing such as creating and maintaining website content, in-store advertising
and promotional material. The customer will typically be a retailer, such as a supermarket.
A typical marketing contract will comprise a contract price for concept design and artwork. In
addition, the contract will specify the selling price for promotional products such as banners, posters
and marketing gifts (eg, pens, key rings etc). The price is calculated based on the quantity ordered by
the customer.
(2) Exhibition sales
Elephant designs and builds temporary exhibitions for customers hosted at trade events. This
includes preparing artwork, constructing exhibition stands and promotional video content.
(3) Other sales
Customers sign a contract with Elephant for the provision of a specific advertising project. Each
project is short term, up to two months.
Revenue recognition
Customers for all three income streams are invoiced, and revenue is recognised, when the customer
signs to confirm their acceptance of the element of the contract or a completed project. International
customers are sometimes invoiced in their local currency.
Elephant’s nominal ledger records the sales invoices and sales credit notes for the three income
streams in the following accounts:
Account code
Customer type
51010 – Domestic sales
UK customers
51020 – Overseas sales
Customers in other European countries
Direct payroll
Payroll costs directly attributable to each income stream (direct payroll) are initially recorded in the
following account codes:
Income stream
Direct Payroll Account cost code
Contract sales
62100 – Studio salaries
62105 – Studio NI
Exhibition sales
62130 – Fitting salaries
62135 – Fitting NI
Other sales
62120 – Sales salaries
62125 – Sales NI
For management accounting purposes, some of the payroll costs initially recorded in Account code
62100 (Studio salaries); and in Account code 62105 (Studio NI), which relate to employees working
on ‘Exhibition sales’ or on ‘Other sales’, are reallocated (to accounts 62130, 62135, 62120 and
62125).
Other indirect payroll costs, including directors’ and administrative salaries, are not directly
attributable to an income stream and are not therefore included in the measurement of gross profit.
Gross profit
Elephant’s management accounts measure gross profit as income (from the three income streams)
less direct payroll costs.
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Other costs of sales, including travel, accommodation, motor vehicle costs and consumables, cannot
normally be traced directly to a particular income stream. They are not therefore included gross
profit in Elephant’s management accounts.
Organisation roles for key members of accounts staff
Set out below are the members of the accounts department at Elephant (Users) and their roles.
Frank Wright
Finance director
Andrea Bloggs
Financial accountant
Tanya Potts
Accounts assistant
John Smith
Accounts assistant
Emma Davids
Trainee
Joined March 2018
Steve Thompson, an accounts assistant, left in January 2018 and was replaced by Emma Davids as an
accounts assistant.
Frank Wright – finance director (and acts as accounting department manager)
Frank is an ICAEW Chartered Accountant and has worked at Elephant since 2016. Frank prepares
budgets for Elephant and negotiates loans and contracts on behalf of the Elephant board. As
Elephant is a small company, he is closely involved with recording all types of transactions on a dayto-day basis.
Frank records sales invoices and sales credit notes for Contract sales in Account codes for 51010
(Domestic sales) and 51020 (Overseas sales). Frank does not record any sales invoices or sales credit
notes for Exhibition sales and Other sales.
Emma Davids – Accounts assistant
Emma joined Elephant in March 2018. She assists Frank with posting Contract sales invoices and
sales credit notes in Account codes for 51010 (Domestic sales) and 51020 (Overseas sales). Emma
does not record any sales invoices or sales credit notes for Exhibition sales and Other sales.
Jo Smith – Financial accountant
Jo has worked for Elephant for two years. Jo is the only member of the finance team who posts the
sales invoices and sales credit notes for Exhibition sales in Account codes 51010 (Domestic sales)
and 51020 (Overseas sales). Jo does not record any sales invoices or sales credit notes for Contract
sales and Other sales.
Tanya Potts – Accounts assistant
Tanya records sales invoices and sales credit notes for Other sales in Account codes 51010
(Domestic sales) and 51020 (Overseas sales). Tanya does not record any sales invoices or sales credit
notes for Contract sales and Exhibition sales.
Andrea Bloggs – Accounts assistant
Andrea records sales invoices and sales credit notes for Other sales in Account codes 51010
(Domestic sales) and 51020 (Overseas sales). Andrea does not record any sales invoices or sales
credit notes for Contract sales and Exhibition sales.
Exhibit B: Working paper prepared by Smith & Ives audit assistant in January 2019
Elephant – Calculation of gross profit, analysed by income stream
As part of the audit planning for the year ended 31 December 2018, I have prepared the following
analysis for the previous year ended 31 December 2017. This shows revenue by income stream and
how revenue and direct payroll costs are recorded in the relevant Account codes to calculate a gross
profit per income stream for management accounting purposes.
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Contract sales
Exhibition
sales
Other sales
Total
£000
£000
£000
£000
51010 – Domestic sales
500
398
942
1,840
51020 – Overseas sales
408
75
306
789
Total revenue
908
473
1,248
2,629
Account code
Less: direct payroll costs
62100 – Studio salaries
(580)
62105 – Studio NI
(49)
Total studio salary cost
(629)
62130 – Fitting salaries
(629)
(18)
62135 – Fitting NI
(2)
Total fitting salary cost
(20)
62120 – Sales salaries
(20)
(356)
62125 – Sales NI
(36)
Total sales salary cost
(392)
(392)
(392)
(1,041)
Total salary costs
(629)
(20)
126
(126)
Reallocate studio salary costs to:
*Exhibition salary costs
**Other sales salary costs
Total direct payroll costs
94
-
(94)
-
(409)
(146)
(486)
(1,041)
Gross profit for management
accounts
499
327
762
1,588
Gross profit %
55%
69%
61%
60%
Notes on the preparation of the above table:
Notes
1
Amounts are rounded to the nearest £1,000.
2
Studio wages have been reallocated as follows:
*4 staff members included in studio salaries worked exclusively for Exhibition sales.
**3 staff members included in studio salaries worked exclusively for Other sales assignments.
3
272
The revenue by income stream has been determined according to the totals of the postings to
Account codes 51010 (Domestic sales) and 51020 (Overseas sales) made by the Users as follows:
Income stream in Account codes 51010 and 51020
Users making postings
Contract sales
Frank Wright and Emma Davids
Exhibition sales
Jo Smith
Other sales
Tanya Potts and Andrea Bloggs
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Average number of employees for the years ended 31 December
Staff (excluding directors)
2018
2017
No.
No.
Studio
20
20
Fitting
2
1
Sales
12
10
34
31
END OF ADVANCE INFORMATION
Before attempting this question, you should refer to the Advance Information. This comprises:
Notes
1
The Advance Information document; and
2
The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the Data Analytics Software.
To access the data analytics software please click below.
DATA ANALYTIC SOFTWARE
Assume that the current date is 15 March 2019
You are an audit senior working for Smith & Ives LLP, a firm of ICAEW Chartered Accountants.
The final audit visit for Elephant started last week and you have joined the audit team today as audit
senior.
Tian Turner, the audit engagement manager, gives you the following briefing:
“You will have reviewed the notes of my introductory meeting with Frank Wright, Elephant’s finance
director, and a working paper prepared by a Smith & Ives audit assistant. You will also have
familiarised yourself with the data for Elephant for the 11 months ended 30 November 2018.
“Data for December 2018 has now been imported into the Data Analytics Software from Elephant’s
nominal ledger, so the full year nominal ledger data for the year ended 31 December 2018 is now
available.
“Last week, I met with Frank Wright. Frank updated me about some changes since our meeting in
August 2018. I have summarised this for you (Exhibit 1).
“An audit assistant has identified an audit matter which I would like you to consider (Exhibit 2).
I have set out instructions for the tasks I would like you to perform in a separate document (Exhibit 3
).”
Requirement
Respond to the audit engagement manager’s instructions (Exhibit 3).
Ignore any adjustments for current and deferred taxation
Total: 45 marks
Exhibit 1: Changes at Elephant – prepared by Tian Turner
Frank updated me about the following changes:
(1) New contract
In October 2018, Elephant appointed a new sales manager, Jenny Hines. On 1 December 2018,
Jenny signed a new contract with one of Elephant’s Contract sales customers. Jenny provided
Andrea Bloggs with the following breakdown of the contract and its financial impact.
Contract terms
£
Payment terms
£3,000 monthly fee for ongoing support for brand
development for 24 months period
72,000
Monthly – 35 days after
invoice
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Contract terms
£
Payment terms
One-off fee in exchange for 18% discount on
services and goods supplied in the two financial
years ending 31 December 2019 and 31
December 2020.
228,000
Payable on 1 January 2021
Total
300,000
December 2018 was a very busy month and Frank told me that he did not get chance to raise any
invoices for this new contract. He therefore asked Andrea to record this transaction for £300,000 in
Elephant’s nominal ledger. She made the posting in Account 54800 in December 2018. No cash has
yet been received.
(2) New internal control
Frank informed me that a new internal control had been introduced on 1 December 2018. He has
been concerned that accounts assistants are too junior to have responsibility for posting very large
transactions. He was particularly concerned that in December 2018 there were risks of cut off errors,
in addition to other risks of junior staff posting significant transactions at any time during the year.
The new internal control is that, from 1 December 2018, accounts assistants should not post any
transactions with an amount of £100,000, or more.
Frank said that he hopes that Smith & Ives will be able to rely on this new internal control in their
audit of Elephant for the year ended 31 December 2018.
Exhibit 2: Audit matter by audit assistant
Exhibition sales assignment for MonaHomes
In 2018, Elephant signed a contract for an exhibition sales assignment for a caravan manufacturer,
MonaHomes. The assignment had three parts.
The first part of the assignment was the production of a ‘Switched Back’ video for MonaHomes, which
was completed and invoiced in January 2018 (Transaction ID SIN18405).
In September 2018, for the second part of the assignment, Elephant designed and built an exhibition
stand and seating for MonaHomes for an exhibition at a caravan trade fair where the promotional
video was shown. The services were completed and invoiced in September 2018 (Transaction ID
SIN19262).
As the third part of the assignment, in September 2018, Elephant provided 2,000 boxed kits as
promotional gifts for the exhibition. The goods were delivered and invoiced in September 2018
(Transaction ID SIN19347).
The payment terms agreed with MonaHomes for the three invoices were 30 days after the invoice
date. All three sales invoices are still outstanding at the year ending 31 December 2018.
Unfortunately, the exhibition stand fitted by Elephant for MonaHomes at the caravan trade fair
collapsed and several visitors were seriously injured. At 31 December 2018, MonaHomes said that it
was unable to pay Elephant’s invoices as it is experiencing financial difficulties arising from a court
case commenced against it by the injured visitors.
Elephant applies IFRS 9 and uses a predetermined matrix for the calculation of allowances for
impairment losses allowances in respect of receivables.
Days overdue
Expected impairment loss allowance
1 to 30
5%
31 to 60
15%
61 – 90
20%
90 +
25%
Elephant has also been informed that the injured visitors have appointed a legal team and a court
case has commenced against Elephant. A claim for damages of £100,000 is expected to be made
against Elephant by the visitors. Elephant’s legal team has said that, at 31 December 2018, there is an
80% probability that Elephant will be found liable. However, the highest amount it would reasonably
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be expected to pay as settlement will be £60,000. The court case is expected to be settled by
January 2021.
Elephant uses an annual discount rate of 8%.
Exhibit 3: Audit engagement manager’s instructions – prepared by Tian Turner
As part of our audit planning for Elephant for the year ended 31 December 2018, I would like you to:
(1) For the new contract (Exhibit 1) set out and explain the appropriate financial reporting treatment.
(2) For the new internal control (Exhibit 1):
(a) Use the Data Analytics Software to evaluate whether the control has been applied effectively
in December 2018. Identify any evidence of where the new internal control has not been
appropriately applied.
(b) Set out relevant audit procedures relating to any related internal control deficiencies.
(3) Using preliminary analytical procedures (see guidance below) and other information, identify
and explain the key audit risks for revenue, direct payroll and gross profit.
For each audit risk identified, set out any information and explanations you require from
management.
(4) For the audit matter identified by the audit assistant (Exhibit 2):
(a) Set out and explain the financial reporting treatment in Elephant’s financial statements for
the year ended 31 December 2018. Include relevant journal entries.
(b) Set out key audit procedures that Smith & Ives should perform.
Guidance on preliminary analytical procedures
The relevant account codes for revenue and direct payroll costs are:
Account code
Account description
51010
Domestic sales
51020
Overseas sales
62100
Studio salaries
62105
Studio NI
62130
Fitting salaries
62135
Fitting NI
62120
Sales salaries
62125
Sales NI
You should identify specific transactions in the data analytics software where they represent items of
significant audit interest.
80 Practice question 6
ADVANCED INFORMATION: ELEPHANT LTD
Assume that the current date is 15 December 2019.
This Advance Information relates only to Corporate Reporting Practice Question 6.
The Advance Information comprises:
(1) This document which includes the scenario, background information (Exhibit A) and results of
audit procedures carried out at the interim audit visit (Exhibit B); and
(2) The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the Data Analytics Software. To access the data analytics software please
click below.
DATA ANALYTIC SOFTWARE
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Exam - 12 months
When attempting Practice Question 6, you will be provided with the nominal ledger data for
Elephant for the full 12 months ended 31 December 2018 contained within the DAS. You will need to
address the new data for the month of December 2018 and to consider the data, patterns and trends
for the year ended 31 December 2018 as a whole.
The data for the 11 months to 30 November 2018 will remain valid and will be unchanged. However,
in the real exam you will not be able to access the DAS data for the first 11 months or any notes you
have made in the DAS.
In attempting this Practice Question, you should therefore replicate this real exam experience and
not access the DAS data for the 11 months to 30 November 2018 or any notes you have made in the
DAS for the 11 months to 30 November 2018.
Scenario
You are an audit senior working for Parker, Coltrane and Getz LLP (PCG), a firm of ICAEW Chartered
Accountants. You have just been assigned to the audit of Elephant Ltd for the year ending 31
December 2018.
Elephant prepares its financial statements in accordance with IFRS. Recently, an audit plan was
prepared by an audit manager, Vijay Shankar, who has now left the firm. You receive the following
email from the newly appointed audit engagement manager, Emily Francis.
To:
Audit Senior, PCG
From:
Emily Francis, Elephant audit engagement manager
Date:
15 December 2018
We carried out an interim audit visit in early December 2018. During the visit, the client provided
PCG with data for the 11 months ended 30 November 2018 from Elephant’s nominal ledger. This
has been imported into the Data Analytics Software used by PCG.
The final audit visit is scheduled for March 2019.
In September 2018 Vijay Shankar, the previous audit manager, had an audit planning meeting
with Frank Wright, the Elephant finance director. After this meeting, Vijay prepared some
background information (Exhibit A).
An audit assistant, Tracey Bashir, performed some substantive procedures in relation to expenses
at the interim audit visit and prepared a workpaper describing the outcome of these audit
procedures Exhibit B).
Before the final audit commences in March 2019, I would like you to familiarise yourself with
Elephant by reviewing:
•
The background information (Exhibit A) prepared by Vijay Shankar and the workpaper
prepared by Tracey Bashir describing the results of the audit procedures performed (Exhibit B);
and
•
The nominal ledger data for Elephant for the 11 months ended 30 November 2018, contained
within the Data Analytics Software.
Audit materiality has been set at £30,000.
Exhibit A: Background information – prepared by Vijay Shankar, September 2018
Elephant provides marketing services, mainly to businesses based in the UK (domestic) and the
rest of Europe (overseas). On occasion, Elephant also provides marketing services to businesses
based in other countries. Customers sign a contract with Elephant for the provision of a specific
marketing project. Each project is usually short term, up to two months, but occasionally Elephant
may enter longer term contracts which typically have a higher transaction value.
In relation to short-term contracts, customers are invoiced, and revenue is recognised, when the
customer signs to confirm their acceptance of a completed project. Longer term contracts may
specify several deliverables or contract stages and may include terms for invoicing once each
stage of the contract has been completed and accepted by the customer. If Elephant does not
have an existing business relationship with a customer, it may insist on the payment of a deposit
on agreement of the contract.
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A typical marketing contract comprises a contract price for design artwork and concept and brand
development. In addition, the contract may specify the selling price for promotional products
such as banners, posters and marketing gifts (e.g., pens, key rings etc). The price is calculated
based on the quantity ordered by the customer.
Costs are incurred by Elephant for each contract, including payroll and cost of sales for
promotional products. Also, a large element of cost of sales is in respect of travel,
accommodation, motor vehicle costs and consumables. Travel and accommodation mainly relate
to expense claims from Elephant staff arising from visiting clients.
The Elephant board comprises of:
Name
Role
Amy Quincey
CEO
Gerry Morris
Creative director
Jerry Holmes
Sales director
Frank Wright
Finance director
I had a brief meeting with Frank Wright. He told me that the board expects that the profit for the
year ending 31 December 2018 will show a significant improvement on the profit for the year
ended 31 December 2017.
Organisation chart
Set out below are the members of the accounts department at Elephant and their roles.
Frank Wright – Finance director (and acts as accounting department manager)
Frank is an experienced accountant and has worked at Elephant since 2016. As Elephant is a small
company, he is closely involved with recording all types of transactions on a day-to-day basis.
Frank prepares budgets for Elephant and negotiates loans and contracts on behalf of the
Elephant board.
If a member of the accounting department is unsure about how to record a transaction, it is
normally recorded in Account code 00990 Suspense account. Frank later corrects the entries by
raising a journal and clears the suspense account.
Andrea Bloggs – Assistant financial accountant
Andrea has worked for Elephant for two years. She previously worked in the purchase ledger
department for a large manufacturing company. She is very competent at posting invoices for
purchases and cash entries. She has less experience in posting entries for sales invoices and credit
notes but does sometimes assist in recording these types of transactions. She reconciles the bank
statement monthly. Andrea is married to Jerry Holme, sales director of Elephant.
Tanya Potts – Accounts assistant.
Tanya prepares the payroll together with John Smith. She also helps with sales ledger and
purchase ledger transactions.
John Smith – Accounts assistant
John prepares the payroll together with Tanya Potts. He also helps with sales ledger and purchase
ledger transactions. John joined Elephant from a firm of ICAEW Chartered Accountants, he did
not complete his studies to become an ICAEW Chartered Accountant.
Emma Davids – Trainee
Steve Thompson, an accounts assistant left in January 2018 and was replaced by Emma Davids in
March 2018. She left school in 2017 and has been recruited as a trainee. Elephant intends to train
Emma to be an accounts assistant. So far, she has only been on a short course covering the basics
of bookkeeping and accounting. Accordingly, she works under close supervision of one of the
other members of the team. Emma is only permitted to post transactions up to an individual value
of £30,000.
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Exhibit B: Matters arising from substantive procedures – prepared by Tracey Bashir - 6 December
2018
I performed substantive audit procedures on expenses for a sample of items from the first 11
months of the year. This involved confirming a sample of expenses to supporting documentation
such as purchase order, purchase invoice and employee expense claim.
As instructed, my audit procedures focused only on the following expense accounts:
Other direct costs
61055
Travel and subs on jobs
61085
Travel expenses
61025
Travel expenses other
61026
I identified three issues:
Issue 1: Inadequate supporting documentation
I identified three transactions recorded in these four accounts where there was either no
supporting documentation, or it was inadequate.
Transaction
Id
PIN29468
Description
Amount
Account
£
604000677 – 3 Night
Holiday for two
people to Monte
Carlo with
3,200
Created date
Comment
(Effective
date)
61055
09/05/2018
(03/05/2018)
NOM6038
2
Premier Inn –
JH/Private travel 11
April
154
61085
17/03/2018
NOM6036
7
Grange Holborn
Hotel – JH/Grange
Holborn Hotel –
Private travel
167
61085
12/03/2018
186
62026
(06/03/2018)
(11/03/2018)
Handwritten
note requesting
payment from
Jerry Holmes
No supporting
documentation
available
No supporting
documentation
available
Comment on materiality
The value of these transactions is low and likely to be well below materiality. I assume that even if
there is a misstatement of expenses here, presumably all we need to do is record them on our
summary of unadjusted audit errors schedule.
Issue 2: Expenses included in loan balances
While conducting these procedures, I examined several staff expense claims and observed that
some elements of expenses related to vehicle use, such as the cost of fuel, servicing and minor
repairs were not recorded in expenses accounts. Instead, these amounts have been debited to car
loan accounts.
The affected car loan accounts that I have identified are:
Car loan 2
26505
Car loan 6
26524
Car loan 8
26537
Below is an example of a transaction related to fuel purchase.
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Transaction Id
NOM063254
Description
Weatherby MWSA – GM Nov Fuel
Amount
Created date
£
(Effective date)
60
29/10/2018
Account
26524
(23/10/2018)
Issue 3: Large item posted by trainee
Also, while looking at transactions in the nominal ledger I also noticed the following transaction
posted by Emma Davids which seems to be rather large for someone so junior to be posting.
Transaction Id
NOM063189
Description
TFR
Amount
Created date
£
(Effective date)
44,099
26/10/2018
(20/10/2018)
Account
20010,
20014
Conclusion
I hope this work is acceptable. I only started at PCG a few months ago. The audit senior who
assigned this task to me became occupied with problems on another client and was not available
to help me for most of the interim audit visit. Fortunately, John Smith, one of the accounts
assistants at Elephant, used to be an auditor and has been very helpful. He assisted me in
selecting samples and in identifying supporting documentation for the sample items. Therefore, I
conclude that expenses are not materially misstated.
END OF ADVANCE INFORMATION
Before attempting this question, you should refer to the Advance Information. This comprises:
Notes
1
The Advance Information document; and
2
The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the DAS.
To access the data analytics software please click below:
DATA ANALYTIC SOFTWARE
Assume that the current date is 28 February 2019.
You are part of the PCG audit team that has just commenced the final audit visit for Elephant.
Emily Francis the PCG engagement manager for the Elephant audit gives you the following briefing:
“You will have reviewed the interim audit information prepared by Vijay Shankar after the audit
planning visit. You will also have familiarised yourself with the data for Elephant for the 11 months
ended 30 November 2018.
“Data for December 2018 has now been imported into the data analytics software from Elephant’s
nominal ledger, so the full year nominal ledger data for the year ended 31 December 2018 is now
available. Materiality has been set at £30,000.
“I have had a meeting with Frank Wright, Elephant’s financial director. There are two specific matters
arising from this meeting that we need to focus on (Exhibit 1).
“Also, the Elephant board is concerned about the effect of further weakening of the Chinese yuan on
the outcome of the contract with Rino Ltd. The board has provided an illustrative example of a
currency forward to mitigate this exposure. The example was prepared by Frank Wright before he
went on sick leave (Exhibit 2).
“I am also concerned about the comments made by Tracey Bashir in the note included in her
description of the results of audit procedures on expenses carried out at the interim audit visit.
“I have set out instructions for you in a separate document (Exhibit 3).”
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Requirement
Respond to the instructions from Emily.
Use your firm’s Digital Audit Software to identify transactions and balances to support your answers
where appropriate.
Ignore any adjustments for current and deferred taxation
Total: 40 marks
Exhibit 1: Matters arising from meeting with Frank Wright – prepared by Emily Francis.
Matter 1 – Contract with Rino Ltd
Frank explained that on 1 December 2018, Elephant agreed a large contract with a Chinese
company, Rino Ltd, for the supply of a digital marketing campaign in the UK and Europe. He
explained that Elephant had not dealt with Rino before and insisted on the payment of a substantial
deposit being invoiced at the commencement of the contract.
Rino agreed to the payment of deposit with a value of £100,000 but insisted that the contract be
denominated in Chinese yuan (CNY). Therefore, the total contract transaction price was set at CNY2.7
million when the contract was agreed on 1 December 2018. The deposit was also invoiced in yuan
for an amount equivalent to £100,000 at the prevailing exchange rate on 1 December 2018 of
exactly 9 yuan to the British pound. Therefore, on 1 December 2018, Elephant invoiced Rino
CNY900,000 in respect of the deposit. Frank posted a transaction to recognise the deposit as an
overseas receivable, but incorrectly recorded the description as relating to a brand management
contract with another client, Spooks.
The remainder of the contract price is due for payment 30 days after performance of the contract is
accepted by Rino. Elephant expects contract acceptance to occur in August 2019.
On 31 December 2018, the exchange rate was £1 = CNY10.2
Frank stated that, at 31 December 2018, he estimated the total overall costs incurred and forecast to
be incurred in relation to the contract with Rino over the contract’s life at £270,000. All costs in
relation to the Rino contract will be incurred by Elephant in the UK.
Matter 2 – Expenses with inadequate documentation
I also discussed with Frank the fact that, at the interim audit visit, expense transactions had been
identified with inadequate supporting documentation.
In response, Frank informed me that the accounts department generally do not question expense
claims made by Elephant’s directors. He also mentioned that, although there were expense claim
authorisation and approval procedures, this was not applied to directors’ claims, as there was no one
more senior to approve them.
Frank also pointed out that the items I raised with him were for small amounts that had no real effect
on the financial statements.
Exhibit 2: Illustrative example – currency forward prepared by Frank Wright
Due to the fall in value of the Chinese yuan, the Elephant board has become very concerned about
foreign exchange risk related to the receipt of the remaining transaction price.
Assume that on 1 March2019, Elephant enters into a six-month currency forward to sell 1.8 million
yuan at an exchange rate of 10.35 yuan to the British pound. This has the effect of removing
Elephant’s exposure to fluctuations in the value of the remaining contract price expected to be
received on 1 September 2019.
Assume the spot exchange rates are:
£1 = CNY10.1 on 1 March 2019
£1 = CNY9.4 on 1 September 2019.
Elephant will designate the value of the spot element of the currency forward as the hedging
instrument. Assume the change in the value of the forward related to financing cost (forward points)
between the forward’s inception and 1 September 2019 is £4,304.
Elephant has decided to treat the currency forward as a cash flow hedge.
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Exhibit 3: The audit engagement manager, Emily Francis’ instructions – audit of Elephant for the
year ended 31 December 2018
(1) In respect of the three issues identified by Tracey Bashir (Advance Information, Exhibit A) from
substantive testing of expenses at the interim audit visit:
(a) Identify and explain the key audit risks for the audit of Elephant for the year ended 31
December 2018. Use the Data Analytics Software to identify further specific transactions in
relation to these issues which require investigation. Include any additional information that
you require from Elephant’s management.
(b) Identify and explain any weaknesses in the substantive audit procedures on expenses
carried out by Tracey Bashir at the interim audit (Advance Information, Exhibit B.) Include an
evaluation of the audit implications of Tracey’s comment on materiality (Issue 1) and her
conclusion.
(2) In respect of the contract with Rino discussed with Frank Wright (Exhibit 1):
(a) Set out and explain the appropriate financial reporting treatment for the year ending 31
December 2018 for the overseas receivable arising from the deposit on the Rino Ltd
contract. Provide appropriate journals.
(b) Explain the financial reporting implications arising from the information provided by Frank
regarding the expected cost for the contract with Rino Ltd. Set out the audit procedures that
you would undertake in relation to this matter.
(3) Set out and explain the appropriate financial reporting treatment for the year ending 31
December 2019 for the illustrative example of a currency forward prepared by Frank Wright
(Exhibit 2). Include journal entries.
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Answer Bank
284
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Financial reporting 1
1 Kime
Scenario
The candidate has been appointed to assist an FD for a property company, in the preparation of the
financial statements. The auditors are due to start their work and the FD would like to be aware of any
contentious issue in advance of their arrival. The candidate is required to determine whether the
accounting treatment applied is correct and determine the appropriate treatment given directors’
instructions to maximise the profit in the current period. The adjustments in respect of current tax
and deferred taxation are to be completed given the assumptions in the scenario. The financial
reporting issues include IAS 16 (recognition of appropriate costs and depreciation), IFRS 15
(construction of a long-term asset), lessor accounting, asset held for sale and foreign currency
adjustment in respect of a receivable, and a cash flow hedge. The candidate is required to prepare a
summary statement of financial position and statement of profit or loss and other comprehensive
income.
Marking guide
Marks
Explain the potentially contentious financial reporting issues.
Determine any adjustments you consider necessary and explain the impact of your
adjustments on the financial statements, identifying any alternative accounting
treatments
Renovation of Ferris Street
Sports stadium (IFRS 15)
FX House disposal
Estate agency buildings
Property management contract
Foreign currency receivable and forward contract
Taxation
After making adjustments for matters arising from your review of the outstanding
issues, prepare a draft statement of financial position and statement of comprehensive
income.
Marks Available
3
6
5
4
2
4
3
8
35
Maximum
30
Total
30
Response as follows:
To FD
From Jo Ng
XX July 20X2
Subject Draft financial statements
Please find attached a draft statement of financial position and statement of profit or loss and other
comprehensive income (Attachment 1). I have also attached an explanation of my adjustments and a
determination of their impact and proposed alternative accounting treatments (Attachment 2).
Regards
Jo
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Attachment 1
Draft statement of profit or loss and other comprehensive income for the year ended 30 June 20X2
£m
Revenue (549.8 + 10.2 – 1)
559.0
Cost of sales (322.4 + 18)
340.4
Gross profit
218.6
Distribution costs
60.3
Administrative expenses (80.7 – 21.5 + 8)
67.2
Finance costs (4.8 + 2.0 – 1.3 + 0.2 + 1.3 )
7.0
Finance income
(1.0)
Profit before tax
85.1
Income tax expense (17.1 + 3.4)
(20.5)
Profit for the year
64.6
Cash flow hedge
1.3
Reclassification of cash flow hedge
(1.3)
Total comprehensive income for the year
64.6
Draft statement of financial position as at 30 June 20X2
£m
ASSETS
Non-current assets
Property, plant and equipment
(80.7 – 18 + 120 – 22.8)
159.9
Current assets
Finance lease receivable
20.5
Gross amounts due from customers
10.2
Trade receivables (174.5 – 10 + 1.3)
165.8
Cash and cash equivalents
183.1
379.6
Non-current assets classified as held for sale
2.0
––––––
Total assets
541.5
EQUITY AND LIABILITIES
Equity
Share capital
Share premium
Retained earnings b/f 102 Profit for year 64.6
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100.0
84.0
166.6
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£m
Non-current liabilities
Long-term borrowings
80.0
Deferred tax liability (33 + 3.4)
36.4
Current liabilities
Trade and other payables (54.9 + 17.1)
72.0
Contract liability
1.0
Financial liabilities
1.5
Total equity and liabilities
541.5
Attachment 2
Freehold land and buildings
(1) Additions
Renovation of Ferris Street property – allocation of costs
The basis on which the renovation costs have been allocated between repairs and maintenance and
capital appears somewhat arbitrary and has not been supported by adequate analysis.
IAS 16 requires that only direct expenditure on property improvements should be capitalised and
that maintenance costs should be written off to profit or loss. The 80:20 split was based on budgeted
costs but has been used to allocate actual spend to date.
It is possible that the expenditure to date may include a higher or lower proportion of maintenance
than that expected for the project as a whole. As repairs should be expensed as the work is
performed, this could affect the result for the period. Hence it is important to review a breakdown of
the costs actually incurred for the period.
For costs which are capital in nature, we need to evaluate whether any could more appropriately be
recorded as plant and machinery rather than included within building costs. The asset lives and
depreciation rates would then differ if the asset is not treated as a single composite property asset. I
need much more information on the nature of the project to do this.
No disposals have been recorded in the year for any previous renovation or construction work on the
Ferris Street building which has been replaced by the work done in the year. In a major project of this
type it is likely that there will be elements of the original cost or of previous renovation projects which
should be written off. I need to ascertain the nature of building and previous work on it in order to
determine what element of the carrying amount, if any, should be written off. For example there may
be partition walls which have been demolished and replaced.
I need to review the budget and the basis of the 80:20 split proposed by the project manager. The
project manager may not understand the requirements of accounting standards and in particular of
IAS 16 and may have been motivated by capital budget constraints or other funding/approval limits
than by an analysis of the true nature of the costs to be incurred.
The allocation of costs on a project which includes both types of cost is open to manipulation and
can be judgmental and be challenged by our auditors.
Adjustments required?
I cannot at present quantify whether any adjustment is required without further analysis being
performed on the additions accounts in the general ledger.
Construction of a sports stadium
The cost of £18 million has been incorrectly treated as an addition to PPE and I have therefore
corrected this as follows:
Kime as the contractor should account for the construction of the sports stadium in accordance with
IFRS 15, Revenue from Contracts with Customers. This appears to be a contract specifically
negotiated for the construction of an asset for which a fixed contract price has been agreed.
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It is a contract in which the performance obligation is satisfied over time because it meets the
following IFRS 15 criteria:
•
“The entity’s performance creates or enhances an asset (eg, work in progress) that the customer
controls as the asset is created or enhanced.”
(The contract specifies that control is transferred to the local authority as the stadium is
constructed.)
•
“The entity’s performance does not create an asset with an alternative use to the entity and the
entity has an enforceable right to payment for performance completed to date.”
Kime can have no alternative use for the sports stadium.
For a performance obligation satisfied over time, IFRS 15 states that revenue should be recognised
by measuring progress towards complete satisfaction of that performance obligation. Appropriate
methods of measuring progress include output methods and input methods. An appropriate output
method allowed by IFRS 15 is ‘surveys of performance completed to date’, often referred to in the
construction industry as ‘work certified’. An appropriate input method allowed by IFRS 15 is costs
incurred.
Contract costs were predicted to be £16 million. However, the estimated total costs to complete the
project have now increased to £22.5 million. The project is still expected to make a profit of £11.5
million.
This is a fixed price contract and therefore there is reasonable reliability in respect of the
measurement of contract revenue but there is less certainty regarding the costs to be incurred.
However, the surveyor has determined that these can now be reliably measured.
Under the input method, ie, using the costs incurred as a method of measuring progress towards
satisfaction of the performance obligation, the obligation is ((£18m/£22.5m) × 100 =) 80% satisfied.
Therefore £27.2 million representing 80% of the contract revenue would be recognised.
Using the output method, ie, work certified, the contract is 70% complete ((£23.8/34.0) × 100).
Revenue of £23.8 million would therefore be recognised.
In the statement of financial position gross amounts due from customers should be presented as
contract costs incurred plus recognised profits less invoices raised to customers. Trade receivables
should include the amounts invoiced less amounts received from the local authority.
A comparison of the two methods (assuming costs are recognised on an incurred basis) is as follows:
Statement of profit or loss
Revenue
Cost of sales
Profit
Statement of financial position
Costs incurred basis
Work certified basis
£m
£m
27.2
23.8
(18.0)
(18.0)
9.2
5.8
Costs incurred
Work certified
£m
£m
18.0
18.0
9.2
5.8
27.2
23.8
(17.0)
(17.0)
10.2
6.8
0
0
Gross amounts from customers
Costs incurred
Recognised profit
Progress billings
Receivables (£17.0m – £17.0m)
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Implication for the financial statements
Using the work certified to date method results in a lower profit, although this method is also less
subjective since it does not rely on estimations of future costs to calculate the percentage complete.
To maximise the amount of profit recognised the directors could select the costs incurred method.
Ultimately the profit recognised overall on the contract is the same over time, but the allocation to
accounting periods is affected by the choice of presentation.
As £17 million of revenue has already been recognised, the following adjustment to the financial
statements is required if the maximum amount of profit is to be recognised:
DEBIT
Gross amounts from customers
CREDIT
£10.2m
Revenue
£10.2m
Also I have reversed the additions to property, plant and equipment as follows:
DEBIT
Cost of sales
CREDIT
£18m
PPE
£18m
The assumption has been made that this has been classified as an asset under construction and no
depreciation has been charged.
(2) Disposals
FX House
The lease does appear to be a finance lease given the transfer to the lessee at the end of the
contract; this appears to be the case for both the buildings and the land.
As the lease to the third party is a finance lease it is correct to treat the property sale as a disposal.
However the junior assistant has failed to account correctly for the disposal and the new finance
lease following the guidance for lessor accounting as set out in IFRS 16, Leases. As title to both land
and buildings transfer to the lessee at the end of the lease period, the lease should be accounted for
as a single lease comprising both land and building elements. Assuming that the new lease is at fair
market rates, Kime should realise a gain on the asset disposal and show a new lease receivable equal
to the net investment in the lease. This will be equal to the minimum lease payments discounted at
the rate implicit in the lease.
Correcting journal entries
Hence entries required to correct the accounting are:
At inception of lease on 1 January 20X2:
DEBIT
Non-current assets – net investment in lease
CREDIT
Gain/loss on non-current asset disposal
DEBIT
Gain/loss on non-current asset disposal
CREDIT
£21.5m
£21.5m
£5.8m
Administrative expenses
£5.8m
Thus giving rise to a gain on disposal of £21.5 million less carrying amount at date of disposal of £5.8
million = £15.7 million.
As this is material it will require disclosure.
To record correctly the receipt of annual rental payment on 1 January 20X2:
DEBIT
CREDIT
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Finance costs (reversing incorrect entry made by
the assistant)
£2m
Non-current assets – net investment in lease
£2m
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289
To record interest income for 6 months to 30 June 20X2:
DEBIT
Non-current assets – net investment in lease (6/12
of interest income at 10% on (£21.5m less £2m))
CREDIT
£975,000
Interest income
£975,000
Therefore the net investment in the finance lease receivable will be £20.475 million (£21.5m – £2m +
£0.975m).
To confirm that these are the correct entries, I need to see evidence that £21.5 million is the fair value
of the property at its disposal date.
Estate agency buildings
As the properties were not sold at the year end, it is incorrect to derecognise the assets and
recognise a gain in profit or loss. IFRS 5 requires that a non-current asset should be classified as ‘held
for sale’ when the company does not intend to utilise the asset as part of its ongoing business but
intends to sell it. The Estate agency buildings, having been closed, potentially fall in this category. To
be held in this category, the likelihood of a sale taking place should be highly probable. As the sale is
to be completed within 12 months of the year end, then this categorisation would appear to be
appropriate. Therefore the following adjustment has been made:
DEBIT
Assets held for sale
CREDIT
DEBIT
£10m
Trade receivables
Admin expenses (Gain on disposal)
CREDIT
£10m
£8m
Assets held for sale
£8m
Discontinued operations
Separate disclosure in the statement of profit or loss as ‘discontinued operations’ may also be
required.
The question of whether the closures are a withdrawal from the market is a question of judgment as
the business is now operated entirely online.
There is insufficient information in the summarised trial balance to determine this issue but it will be
required before the auditors can commence their work next week.
Depreciation
The depreciation charge suggests a cost of £295 million based upon the accounting policy of the
company (£5.9m × 50 years).
This is significantly greater than the cost in the financial statements and is an issue which should be
investigated.
Foreign currency receivables and forward contract
£m
Receivable originally recorded (R$60.48m/5.6)
10.8
Receivable at year end (R$60.48m/5.0)
12.1
Exchange gain
1.3
£m
DEBIT
CREDIT
290
Corporate Reporting
Trade receivables
Profit or loss (other income)
£m
1.3
1.3
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Forward contract:
This is a cash flow hedge:
DEBIT
Equity – (Other comprehensive income)
1.3
DEBIT
Finance cost
0.2
CREDIT
Financial liability
1.5
As the change in cash flow affects profit or loss in the current period, a reclassification adjustment is
required:
DEBIT
CREDIT
Profit or loss
1.3
Equity – (Other comprehensive income)
1.3
Foreign currency and financial instruments gains and losses are taxed on the same basis as IFRS
profits. As the finance cost and the exchange gain are both in profit or loss, there are no further
current or deferred tax implications.
The scenario states that “the arrangement satisfies the necessary criteria in IFRS 9, Financial
Instruments to be accounted for as a hedge”. This is an objective-based test that focuses on the
economic relationship between the hedged item and the hedging instrument, and the effect of
credit risk on that economic relationship. This transaction could be treated as either a fair value or
cash flow hedge. However, as a receivable is created there is no need for hedge accounting as the
exchange difference on the receivable and the future are both recognised through profit or loss.
Therefore an alternative accounting treatment would be not to apply hedge accounting.
Property management services contract
Following IFRS 15, revenue should be recognised when, or as, a performance obligation is satisfied.
The performance obligation in the property management services contract with the local authority is
the provision of those services (a contract in which the performance obligation is satisfied over time).
As at 1 June 20X2, when the deposit is received, those services have not been provided and so the
performance has not been satisfied.
Therefore it was incorrect to recognise the £1 million as revenue. Instead, it is a contract liability,
defined by IFRS 15 as “an entity’s obligation to transfer goods or services to a customer for which the
entity has received consideration (or the amount is due) from the customer”.
The following journal is required to correct the error:
DEBIT
Revenue
CREDIT
£1m
Contract liability
£1m
Taxation
The following journal is required to adjust for current and deferred tax as noted in the assumptions:
DEBIT
Income tax expense
CREDIT
£17.1m
Current tax obligation
£17.1m
Being current tax adjustment – revised profit (85.1 – 14) × 24%
DEBIT
Income tax expense: £14m × 24%
CREDIT
Deferred tax obligation
£3.4m
£3.4m
Being adjustment for increase in temporary differences.
Deferred tax summary
£m
Deferred tax liability brought forward
33.0
Increase in taxable temporary differences (£14m × 24%)
3.4
Deferred tax liability at 30 June 20X2
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36.4
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291
2 Mervyn plc
Marking guide
Explanations:
Sale of land: The Ridings/Event after reporting period
Sale of land: Hanger Hill/sale and leaseback
Pensions
Provision
Revenue
Share appreciation rights
Adjusted profit calculations:
Elimination of gain on sale of The Ridings
Sale and leaseback
Pensions
Provision
SARs
Revenue
Closing inventories
Quality of discussion
Marks Available
Marks
2
4
6
3
2
2
1
4
5
1
5
1
1
2
39
Maximum
30
Total
30
Explanation as follows:
(1) Sale of land: The Ridings
This sale and profit earned have been treated as an adjusting event after the reporting period. This
appears to contravene IAS 10, Events After the Reporting Period. The completion of the sale in
November does not give evidence of circumstances as at the reporting date. This would only have
been the case if the contract in existence at 30 September had been unconditional, or if the
condition, that is, detailed planning consent, had been met by the year-end.
The gain, and associated tax effect, should be eliminated from the financial statements, to be
recognised in the following accounting period.
The land probably met the criteria to be classed as ‘held for sale’ under IFRS 5, Non-current Assets
Held for Sale and Discontinued Operations at the year-end. However, this has no profit impact as IFRS
5 only requires recognition of a loss when fair value less costs to sell is below book value, which is
clearly not the case here.
The transaction may be disclosed in the notes as a non-adjusting event after the reporting period if
considered material to the user.
Sale of land: Hanger Hill
This is a sale and leaseback transaction in which the conditions in IFRS 15, Revenue from Contracts
with Customers for a genuine sale have been met, as indicated by the fact that Mervyn plc has no
right to repurchase the land at the end of the lease period. However, the lease rental payment has
been incorrectly charged to operating expenses.
Under IFRS 16, Leases, the asset sold must be derecognised and a right-of-use asset recognised
together with a lease liability relating to the right of use retained and a gain/loss in relation to the
rights transferred. The right-of-use asset is depreciated and the lease liability is amortised.
The £80,000 lease payment should therefore be added back to profit, and a gain on disposal relating
to the rights transferred of £184,070 should also be added to profit, rather than the £250,000
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currently included. Depreciation of £47,470 and interest of £30,328 should be deducted from profit.
Calculations of these figures are shown in W1.
Pensions
The contributions paid have been charged to profit or loss in contravention of IAS 19, Employee
Benefits.
Under IAS 19, the following must be done:
•
Actuarial valuations of assets and liabilities revised at the year-end
•
All gains and losses recognised:
– Current service cost*
– Transfers*
– Interest on net defined asset/liability*
– Remeasurement (actuarial) gains and losses – In other comprehensive income (per IAS 19, as
revised in 2011)
*In profit or loss
Deferred tax must also be recognised. The deferred tax is calculated as the difference between the
IAS 19 net defined benefit liability less its tax base (ie, nil as no tax deduction is allowed until the
pension payments are made). IAS 12, Income Taxes requires deferred tax relating to items charged or
credited to other comprehensive income to be recognised in other comprehensive income hence
the amount of the deferred tax movement relating to the actuarial losses charged directly to OCI
must be split out and credited directly to OCI.
Provision
According to IAS 37, Provisions, Contingent Liabilities and Contingent Assets a provision shall be
recognised when:
•
an entity has a present obligation as a result of a past event;
•
it is probable that an outflow of resources embodying economic benefits will be required to settle
the obligation; and
•
a reliable estimate can be made of the amount of the obligation.
If these conditions are met then a provision must be recognised.
The assessment of a provision for a legal claim is always a difficult area as it will be based upon the
evidence available but it could also be argued that any provision or disclosure could be prejudicial
to the court case itself.
In this case it would appear that the lawyers and management are fairly certain that damages and
costs will be payable. The problem is the amount of any provision to be made. As there is a timescale
involved here then the first stage will be to calculate the present value of each of the outcomes.
Management have also assigned probabilities to each of the three possible outcomes so a further
decision must be made as to whether to calculate an expected value or take the value of the most
likely outcome. IAS 37 states that where a single obligation is being measured the individual most
likely outcome may be the best estimate of the liability. Although in some circumstances the range of
outcomes may mean that a higher figure is required.
Discount factor
@ 10%
Outcome
£’000
Best
Most likely
Worst
Present value
Probability
£’000
Expected
value
£’000
200
1/1.10
182
25%
46
800
2
661
60%
397
1/1.103
1,127
15%
169
1,500
1/1.10
612
IAS 37 requires the estimated value of the provision to be the amount that the entity would rationally
pay to settle the obligation. The directors are likely to want as low a provision as possible so they are
likely to prefer the expected value of £612,000. However, this is a single event, and IAS 37 requires
£661,000 as the most likely outcome or £612,000.
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Bill and hold sales
When a buyer requests that the delivery of goods purchased does not take place immediately even
though the buyer takes legal title of the goods and pays for them, such arrangements are commonly
referred to as ‘bill and hold’ sales. Revenue from such sales should be recognised when the buyer
takes title to the goods provided that (IFRS 15: paras. B64–B76):
•
the reason for the bill-and-hold arrangement must be substantive (for example, the customer has
requested the arrangement, as here)
•
the product must be identified separately as belonging to the customer (as here, since it is in a
separate storage area)
•
the product currently must be ready for physical transfer to the customer (as here – the product is
ready for delivery)
•
the entity cannot have the ability to use the product or to direct it to another customer –in this
case the product is exclusively for one customer.
In this case it would appear that these sales are bill and hold sales. Therefore the goods must be
removed from closing inventories in the statement of financial position at their cost price of £99,000,
with a corresponding increase in cost of sales, and the additional revenue of £138,000 for the year to
30 September 20X7 must be recognised in the profit or loss for the year.
Share appreciation rights
The granting of share appreciation rights is a cash settled share based payment transaction as
defined by IFRS 2, Share-based Payment. IFRS 2 requires these to be measured at the fair value of the
liability to pay cash. The liability should be re-measured at each reporting date and at the date of
settlement. Any changes in fair value should be recognised in profit or loss for the period.
However, the company has not remeasured the liability since 30 September 20X6. Because IFRS 2
requires the expense and the related liability to be recognised over the two-year vesting period, the
rights should be measured as follows:
£‘000
At 30 September 20X6: (£6 × 10,000 × ½)
30
At 30 September 20X7 (£8 × 10,000)
80
At 1 November 20X7 (settlement date) (£9 × 10,000)
90
Therefore at 30 September 20X7 the liability should be re-measured to £80,000 and an expense of
£50,000 should be recognised in profit or loss for the year.
The additional expense of £10 million resulting from the remeasurement at the settlement date is not
included in the financial statements for the year ended 30 September 20X7, but is recognised the
following year.
(2) Amended profit
£‘000
Profit for the year – per question
Eliminate net gain on sale – The Ridings (100 – 27)
1,471
(73)
Eliminate lease rental incorrectly charged to P/L
80
Eliminate gain currently included for Hanger Hill
(250)
Add gain relating to rights transferred
184
Depreciation on right-of-use asset retained
(47)
Interest on lease liability
(30)
Pension contributions
405
Current service cost
(374)
Interest on obligation (W2)
(253)
Interest on plan assets (W2)
216
294
Corporate Reporting
ICAEW 2022
£‘000
Transfers (400,000 – 350,000)
(50)
Share appreciation rights
(50)
Deferred tax on pension obligation (W3)
13
Provision for damages for court case (see above)
(661)
Additional revenue from bill and hold sales
138
Reduction in closing inventories
(99)
Amended profit for the year
620
WORKINGS
(1) Sale and leaseback (Hanger Hill Estate)
The accounting treatment currently used is:
£
Proceeds = fair value
1,150,000
Carrying value
900,000
Gain
250,000
However a gain should only be recognised in respect of the part of the asset transferred to the
lessor.
Rentals £80,000 pa
Fair value of future lease payments: £80,000 × 3.791 = £303,280
Part of the carrying amount of the asset is allocated to be a right-of-use asset retained. This is
calculated based on the right-of-use asset (lease liability) as a proportion of fair value:
Right-of-use asset = £900,000 × 303,280 ÷ 1,150,000 = £237,350
The remaining carrying amount of £662,650 (900,000 – 237,350) represents the transferred
asset.
The overall gain on disposal is £250,000; only that part of the gain relating to the transferred
asset is recognised:
Gain relating to retained rights £250,000 × 303,280 ÷ 1,150,000 = £65,930
Therefore the recognised gain relating to the transferred rights is £184,070 (250,000 – 65,930).
At 1 October 20X6, the following entries are required:
DEBIT
Right-of-use asset
£237,350
DEBIT
Bank
£1,150,000
CREDIT
PPE
£900,000
CREDIT
Gain on disposal
£184,070
CREDIT
Lease liability
£303,280
The right-of-use asset is subsequently depreciated over the lease term of five years, therefore in
the year ended 30 September 20X7:
DEBIT
Depreciation expense (£237,350/5)
CREDIT
Right-of-use asset
£47,470
£47,470
The lease liability is amortised.
ICAEW 2022
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295
£
1 October 20X6
303,280
Interest at 10%
30,328
Lease payment
(80,000)
30 September 20X7
253,608
Amortisation for the year ended 30 September 20X7 is recognised by:
DEBIT
Finance charge
£30,328
DEBIT
Lease liability
£49,672
CREDIT
Bank
£80,000
(2) Pension scheme
Pension scheme
assets
Pension scheme
liabilities
£’000
£’000
2,160
2,530
At 1 October 20X6
Interest cost (10% × 2,530,000)
253
Interest on plan assets (10% × 2,160,000)
216
Current service cost
374
Contributions
405
Transfers
(400)
(350)
Pensions paid
(220)
(220)
(71)
38
2,090
2,625
 Loss on remeasurement through other
comprehensive income (note)
At 30 September 20X7
Note: IAS 19 (revised) stipulates that remeasurement losses must be recognised in other
comprehensive income in the period in which they arise.
(3) Deferred tax on pension liability
£
Net pension liability at 30 September
20X6
Contribution
Current tax
(P/L)
OCI
Deferred tax
asset
£
£
£
370,000
85,100
(405,000)
Cr (93,150)
(93,150)
411,000
Dr 94,530
94,530
50,000
11,500
11,500
Profit and loss debits
service cost 374,000 + interest
costs 37,000
Transfers (400,000 – 350,000)
Loss on remeasurement to OCI
109,000
Profit or loss/OCI movement
Net pension liability/deferred tax asset
at 30 September 20X7
296
Corporate Reporting
12,880
535,000
25,070
25,070
25,070
37,950
123,050
ICAEW 2022
3 Billinge
Marking guide
Explanations and calculations of deferred tax implications of:
Fair value adjustment
Share-based payment
Unrealised profit
Unremitted earnings
Property, plant and equipment
Lease
Marks Available
Marks
1
5
6
5
5
5
8
35
Maximum
30
Total
30
MEMO
(1) Fair value adjustment
IFRS 3, Business Combinations requires the net assets in the subsidiary acquired to be recognised at
their fair value in the group financial statements. Therefore, in the group financial statements at the
acquisition date of 1 November 20X2, the net assets of Hindley will be recognised at their fair value
of £8 million.
The revaluation gain of £1 million will not be recognised by the tax authorities until the item of
property, plant and equipment has been disposed of or taxable income has been generated through
use of the asset. This gives rise to a temporary difference.
As Hindley will have to pay tax on the taxable income generated through use of the asset and
ultimately on any gain on disposal, this temporary difference results in a deferred tax liability in the
group financial statements.
£m
Carrying amount in group financial statements
8
Tax base
(7)
Temporary difference
1
Deferred tax liability (30%)
(0.3)
The deferred tax is recognised as a liability in the statement of financial position and results in an
increase in goodwill, rather than a charge to other comprehensive income, as the fair value gain is
recognised on acquisition.
The deferred tax is recognised even though the entity does not intend to dispose of the asset. The
fair value adjustment still represents a taxable temporary difference as the asset’s value will be
recovered through use rather than sale, generating taxable income in excess of the depreciation
(based on original cost) allowed for tax purposes.
In Hindley’s individual accounts, no fair value adjustment is required and no deferred tax liability will
arise as both the carrying amount and the tax base will be the same ie, £7 million.
The initial recognition of goodwill that arises on acquisition (£10m – £8m = £2m) will not give rise to
any deferred tax: IAS 12 does not permit recognition of deferred tax as goodwill is measured as a
residual and the recognition of a deferred tax liability would increase the carrying amount of the
goodwill.
ICAEW 2022
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297
(2) Share-based payment
IFRS 2, Share-based Payment requires equity settled share based payments to be recognised at the
fair value at the grant date ie, £5. The expense should be spread over the vesting period of three
years with a corresponding increase in equity.
For the year ended 31 October 20X2, the equity and expense would have been recorded at
£666,667 (1,000 options × 500 employees × 80% to remove estimated leavers × £5 fair value at
grant date × 1/3 vested).
As at 31 October 20X3, equity would be revised to £1.25m (1,000 options × 500 employees × 75%
to remove revised estimated leavers × £5 fair value at grant date × 2/3 vested). The movement in the
year of £583,333 (£1.25m – £666,667) would be posted to profit or loss.
The tax authorities, however, do not give tax relief until exercise. This gives rise to a temporary
difference.
The tax relief is based on the intrinsic value so this is the value used to measure the deferred tax
asset.
The deferred tax asset correctly recognised at 31 October 20X2 would have been calculated as
follows:
£m
Carrying amount of share-based payment expense
0
Tax base (1,000 options × 500 employees × 80% to remove leavers × £3 intrinsic
value × 1/3 vested)
(0.4)
Temporary difference
(0.4)
Deferred tax asset (30%)
0.12
The deferred tax asset to be recognised at 31 October 20X3 is calculated as follows:
£m
Carrying amount of share-based payment expense
0
Tax base (1,000 × 500 × 75% × £8 × 2/3)
(2)
Temporary difference
(2)
Deferred tax asset (30%)
0.6
The amount of deferred tax that relates to the excess of the intrinsic value over the fair value at the
grant date should be recognised in equity as there is no corresponding expense to match it to in
profit or loss:
£m
Cumulative tax deduction
Cumulative expense (1,000 × 500 × 75% × £5 at grant date × 2/3)
2.000
(1.250)
Excess
0.750
Deferred tax to be recognised in equity (30%)
0.225
The remaining movement in the deferred tax asset of £0.255 million (£0.6m – £0.12m b/d – £0.225m
to equity) should be credited to profit or loss for the year.
(3) Unrealised profit
In the group accounts, the unrealised profits on goods sold internally, which still remain in
inventories at the year-end, must be cancelled. In future years, once the inventories have been sold
on to third parties, this cancellation is no longer required.
This gives rise to a temporary difference as the tax authorities still tax the sale regardless of whether it
is internal or external as they work from the individual companies’ profit figures not the group
figures.
298
Corporate Reporting
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The unrealised profit is calculated as follows:
£5m × 25%/125% × ¾ in inventories = £0.75m
The temporary difference results in a deferred tax asset as, in the group accounts, there is a tax
charge on a non-existent profit which needs to be removed.
The deferred tax asset in the group accounts is calculated as follows:
£m
Carrying amount in group accounts – inventories [(£5m × 3/4) – £0.75m]
3.000
Tax base – inventories (£5m × ¾)
(3.750)
Temporary difference
(0.750)
Deferred tax asset (30%)
0.225
The result is a deferred tax credit to profit or loss of £0.225 million in the current period.
There is no deferred tax impact in Ince’s individual accounts because the unrealised profit is not
cancelled.
(4) Unremitted earnings
There is a potential deferred tax liability of £0.4 million on the unremitted earnings of Quando. This is
because the Quando’s profits of 5 million corona have been consolidated in the group accounts, but
the additional tax will not be paid by Billinge until these profits are remitted to owners as dividends,
giving rise to a temporary difference. However, as Billinge controls the timing of the Quando’s
dividends (being a 100% shareholder) and it is probable that the temporary difference will not
reverse in the foreseeable future as Billinge intends to leave the profits within Quando for
reinvestment, IAS 12, Income Taxes dictates that no deferred tax liability should be recognised.
(5) Property, plant and equipment
The carrying amount of property, plant and equipment is its net book value. The grant may either be
deferred and released to profit or loss over the useful life of the asset or deducted from the cost of
the asset.
The tax base is the tax written down value.
Since the depreciation and capital allowances are charged at different rates, this gives rise to a
temporary difference.
The resultant deferred tax liability is calculated as follows (on the assumption that the grant is
recognised as deferred income):
£m
£m
Carrying amount:
Property, plant & equipment (£12m – £12m/5)
Deferred grant (£2m – £2m/5)
9.60
(1.60)
Tax base (£12m – £2m) – [(£12m – £2m) × 25%]
8.00
(7.50)
Temporary difference
0.50
Deferred tax liability (30%)
(0.15)
A deferred tax liability has arisen because the capital allowances granted to date are greater than the
depreciation and grant amortisation recognised in profit or loss. Therefore too much tax relief has
been granted and this needs to be reversed.
The deferred tax liability of £0.15 million is charged to profit or loss as that is where the effect of the
depreciation and grant amortisation have been shown.
Tutorial Note
It the grant had been deducted from the cost of the asset, the carrying amount would have been
calculated as [(£12m – £2m) – ((£12m – £2m × 1/5)] ie, £8 million, resulting in the same carrying
amount as if it had been treated as deferred income.
ICAEW 2022
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299
(6) Lease
Under IFRS 16, Leases, a right-of-use asset and a lease liability must be recognised in the statement
of financial position.
A temporary difference arises because in the accounts, the right-of-use asset is depreciated over the
shorter of the lease term or the asset’s useful life and the finance cost is recognised at a constant rate
on the carrying amount of the lease liability; whereas the tax authorities give tax relief as the rentals
are paid.
The deferred tax is calculated as follows:
£m
£m
Carrying amount:
Property, plant and equipment (£6m – £6m/5 years)
Lease liability (£6m + [8% × £6m] – £1.5m)
4.800
(4.980)
(0.180)
Tax base
0.000
Temporary difference
(0.180)
Deferred tax asset (30%)
0.054
The resultant deferred tax is an asset (and credit in profit or loss) because the tax relief is based on
the rental of £1.5 million yet the expense in the profit or loss is £1.68 million (ie, depreciation of £1.2
million and interest of £0.48 million) which means that part of the future tax saving on rental
deductions is recognised now for accounting purposes, so the tax charge is reduced representing
the tax recoverable in the future.
4 Longwood
Marking guide
Change in tax rate
Revised tax losses adjustment
Fair value adjustments
Goodwill calculation
Deferred taxes, goodwill and share versus asset deals
Marks Available
Marks
8
8
7
7
8
38
Maximum
30
Total
30
Response as follows:
(1) Change of tax rate
Per IAS 12, Income Taxes, the tax rate to be used is that expected to apply when the asset is realised
or the liability settled, based upon laws already enacted or substantively enacted by the year end.
The deferred tax assets and liabilities therefore need to be measured using the enacted rate for 20X7
of 23%, rather than 30%.
The net change in the carrying amount of the deferred tax assets and liabilities (£0.26 million, as
shown in the table below) arising from a change in rates will normally need to be taken to profit or
loss for the year of Portobello Alloys. However, this will not be the case where it relates to a
transaction or event which is recognised in equity (in the same or a different period), when the
resulting deferred tax is also included in ‘other comprehensive income’. This is the case for the
investments.
The schedule below calculates the adjustments to the deferred tax assets and liabilities by reworking
the temporary differences at the new rate.
300
Corporate Reporting
ICAEW 2022
Deferred tax schedule (in £m)
at 30%
at 23%
Adjustment
Property, plant and equipment
(1.54)
(1.18)
0.36
Equity investments at FVTOCI
(0.32)
(0.25)
0.07
Post-retirement liability
0.11
0.09
(0.02)
Unrelieved tax losses – recognised
0.66
0.51
(0.15)
(1.09)
(0.83)
0.26
(1.86)
(1.43)
0.43
0.77
0.60
(0.17)
(1.09)
(0.84)
0.26
Deferred tax liability
Deferred tax asset
The resultant adjustments are:
Debit
Credit
£m
£m
Deferred tax asset
Deferred tax liability
0.17
0.43
Tax charge – profit or loss
0.19
Equity – in respect of investments
0.07
(2) Deferred tax asset recognition for losses
The increased forecast profitability may allow Portobello Alloys to recognise a deferred tax asset in
respect of all the thus-far unrecognised unrelieved tax losses incurred. However, there is a risk that no
losses will be available to carry forward. This will be the case if there is a major change in the nature
and conduct of the trade post-acquisition. The amount of unrecognised losses is shown below.
Tax losses working
£m
Total losses for tax purposes
7.40
Already utilised
(1.20)
Remaining
6.20
Recognised
(2.20)
Unrecognised
4.00
The analysis of the adjustment between current and non-current deferred taxes can be derived from
the profit forecast as below.
ICAEW 2022
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301
Profit forecasts for tax loss utilisation
20X7
20X8
Total
£m
£m
£m
Forecast taxable profit – original
0.98
1.22
2.20
Forecast taxable profit – revised
1.90
4.74
6.64
Additional taxable profits
0.92
3.52
4.44
Additional recoverable losses
0.92
3.08
4.00
Addition to deferred tax asset at 23%
0.21
0.71
0.92
Note that the additional recoverable losses for 20X8 are restricted to £3.08 million (rather than being
equal to the additional taxable profits of £3.52 million) since the total of unrecognised losses is only
£4.00 million.
Note that the change in the deferred tax asset must be recognised in profit or loss:
£m
DEBIT
Deferred tax asset
CREDIT
£m
0.92
Tax charge – profit or loss
0.92
(3) Deferred taxes on fair value adjustments
These adjustments will arise as consolidation adjustments rather than in the financial statements of
Portobello Alloys.
The land will not be depreciated, and the deferred tax on the temporary difference will only
crystallise when the land is sold. It is clear that there is no intention to sell the property in the current
horizon.
The required adjustments to the deferred tax assets and liabilities are summarised in the table below.
Fair value
Carrying
amount
Temporary
difference
Deferred tax
at 23%
£m
£m
£m
£m
21.65
18.92
(2.73)
(0.63)
5.26
0.00
(5.26)
(1.21)
(1.65)
(0.37)
1.28
0.29
25.26
18.55
(6.71)
(1.55)
Property, plant and equipment
Development asset
Post-retirement liability
Deferred tax liability
(1.84)
Deferred tax asset
0.29
(1.55)
The resulting consolidation adjustment is:
Deferred tax asset
Debit
Credit
£m
£m
0.29
Deferred tax liability
Goodwill adjustment
302
Corporate Reporting
1.84
1.55
ICAEW 2022
(4) Goodwill calculation
The first step is to determine the fair value of the consideration.
Deferred consideration must be measured at its fair value at the date that the consideration is
recognised in the acquirer’s financial statements, usually the acquisition date. The fair value depends
on the form of the deferred consideration.
Where the deferred consideration is in the form of equity shares:
•
Fair value is measured at the date the consideration is recognised, usually the acquisition date.
Consequently, the share price used must be £1.88.
Where the deferred consideration is payable in cash:
•
Fair value is measured at the present value of the amount payable, hence the present value of the
£10 million cash.
Under IFRS 3 all acquisition-related costs must be written off as incurred. They are not included in the
consideration transferred.
Fair value of consideration
£m
Cash payment
57.00
Deferred equity consideration (5m × £1.88)
9.40
Deferred cash consideration (£10m/1.13)
7.51
73.91
The value of the net assets acquired needs to be adjusted for the changes to reflect the fair value of
PPE, the development asset, the pension and deferred taxes as shown below
Fair value of net assets acquired
£m
Book value per statement of financial position provided
9.90
Fair value adjustment to PPE
2.73
Fair value adjustment to development asset
5.26
Fair value adjustment to pension liability
(1.28)
Deferred tax – rate change
0.26
Deferred tax – tax losses (0.21 + 0.71)
0.92
Deferred tax – fair value adjustments (0.29 – 1.84)
(1.55)
16.24
The resulting fair value of goodwill, on which no deferred tax is applicable is:
£m
Fair value of consideration
Fair value of net assets acquired
Goodwill
73.91
(16.24)
57.67
(5) Deferred taxes and goodwill
Goodwill and share acquisitions
When an entity purchases the shares in a target and gains control, IFRS 3 requires that consolidated
financial statements are produced and the target is introduced at fair value, including any
attributable goodwill.
The goodwill arising in this manner does not appear in any of the companies’ individual financial
statements, but arises as a consolidation adjustment in the consolidated financial statements.
Tax authorities look at the individual financial statements of the companies within the group and tax
the individual entities. As such, no goodwill is recognised for tax purposes. The individual financial
ICAEW 2022
Financial reporting 1
303
statements of the buyer will simply reflect an investment in shares in its statement of financial
position, not the subsidiary assets, liabilities or goodwill.
Under IAS 12, Income Taxes, a deferred tax liability or asset should be recognised for all taxable and
deductible temporary differences, unless they arise from (inter alia) goodwill arising in a business
combination. As such, no deferred tax is recognised.
Goodwill and asset acquisitions
The essential difference here is that the buyer has not purchased shares, but the assets and liabilities
of the target. The assets and liabilities are measured and introduced at fair value, including any
purchased goodwill. These are introduced directly into the individual financial statements of the
buyer.
It is this goodwill that the tax authorities will recognise as a purchased asset and on which they may
charge tax.
As tax relief is permitted over 15 years but goodwill is not amortised, then the tax base and the
accounting base are not the same, therefore a taxable temporary difference arises and deferred tax
recognised.
5 Upstart Records
Scenario
The candidate is required to reply to a request by a group finance director to assist with the
finalisation of the group accounts. The group’s investment in Liddle Music Ltd has increased twice
during the year such that the investment has moved from being accounted for as an associate to a
subsidiary requiring the calculation of a profit to be recognised in the statement of profit or loss on
crossing the ‘control’ threshold. A further acquisition of more shares later in the year however,
requires no further profit to be recognised but does require changes to the percentage of noncontrolling interest. Adjustments are required for a restructuring provision and for share-based
payment.
The candidate is required to explain the impact of the acquisition of shares in Liddle Music on
goodwill and non-controlling interest, to explain and calculate any required adjustments with regard
to restructuring provisions and share options, to prepare a consolidated statement of profit or loss
including Liddle Music and finally to explain the impact of Upstart adopting an alternative accounting
policy regarding the recognition of the non-controlling interest.
Requirement
Skills
Show and explain with supporting
calculations, the appropriate financial
reporting treatment of goodwill and noncontrolling interests for Liddle in Upstart’s
consolidated statement of financial position
as at 30 June 20X5. Use the proportion of
net assets method to determine noncontrolling interests.
Apply technical knowledge to identify implications
of crossing control threshold.
Apply technical knowledge to distinguish between
and calculate the deferred and contingent
consideration.
Identify the incorrect treatment of the professional
fees.
Apply technical knowledge to calculate goodwill
including the fair value adjustment and
subsequent depreciation adjustment.
Appreciate that the second acquisition does not
create a further profit and recommend the
appropriate adjustment.
Identify intra-group transactions and recommend
adjustments.
Explain incorrect treatment of the German loan
and recommend the accounting adjustment
required.
304
Corporate Reporting
ICAEW 2022
Requirement
Skills
Explain, with supporting calculations, the
appropriate financial reporting treatment for
the restructuring plans and the share
options.
Apply technical knowledge to determine whether
a provision should be recognised and calculate the
amount of the provision.
Appreciate that no provision should be made in
respect of the second proposal.
Identify that the share options represent an equitysettled share-based payment.
Apply technical knowledge to account for the
share-based payment correctly.
Prepare Upstart’s consolidated statement of
profit or loss for the year ended 30 June
20X5, to include Liddle.
Assimilate adjustments and prepare revised
consolidated statement of profit or loss.
Explain (without calculations) the impact on
Upstart’s consolidated financial statements if
the fair value method for measuring noncontrolling interests were to be used instead
of the proportion of net assets method.
Assimilate information, and apply technical
knowledge to explain that NCI valuation would
impact on goodwill.
Marking guide
Marks
Appropriate financial reporting treatment of goodwill and non-controlling interests
Appropriate financial reporting treatment for the restructuring plans and the share
options
Consolidated statement of profit or loss
16
Impact of the fair value method
Marks Available
5
38
9
8
Maximum
30
Total
30
Response as follows:
(1) Explanation of financial reporting treatment of goodwill and non-controlling interest
Goodwill
Goodwill arises at the date when control is achieved. In the case of Upstart and Liddle this is on 1
October 20X4, when Upstart’s investment in Liddle passes the 50% threshold.
Until that date, Liddle has been treated as an associate. Under the equity accounting method the
group’s share of Liddle’s profits after tax is credited to the consolidated statement of profit or loss,
and the investment is measured at cost plus share of post-acquisition profits in the consolidated
statement of financial position. In the year ended 30 June 20X5 Liddle is therefore treated as an
associate for the period 1 July to 1 October 20X4.
On 1 October 20X4, the equity value of Liddle was £7.174 million (W8) and this was remeasured to
fair value of £7.5 million (W8) for the purposes of calculating goodwill. The difference between the
two figures (£326,000) was credited to the statement of profit or loss.
Goodwill is measured as the fair value of consideration paid less the fair value of the net assets
acquired.
The fair value of the consideration consists of the following elements:
•
Cash paid of £2 million.
•
The fair value of the original 25% investment in Liddle at 1 October 20X4.
•
The shares issued on 1 October 20X4.
ICAEW 2022
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305
•
The £3 million payable on 1 October 20X6 is discounted to fair value, and the interest is then
unwound in the statement of profit or loss.
•
The £3 million contingent consideration payable on 1 October 20X7 is measured at its fair value
(determined by the probability of it occurring), again discounted to a present value, and unwound
in the statement of profit or loss.
The professional fees of £250,000 are excluded from the goodwill calculation and instead expensed
to the statement of profit or loss as incurred.
As a result of applying these principles a goodwill figure of £13.077 million arose on the acquisition
of Liddle (W3).
There is no further adjustment to goodwill when Upstart acquired a further 100,000 shares in Liddle
on 1 April 20X5. Instead, the difference between the consideration paid and the decrease in the noncontrolling interest’s share of net assets is taken to group reserves (W6).
Goodwill is subject to annual impairment reviews.
Non-controlling interests (NCI)
When Upstart acquired a controlling interest in Liddle on 1 October 20X4, NCI arose in relation to
the 30% of Liddle not owned by Upstart at this date.
There are two permitted methods of determining the NCI, the proportionate and fair value method,
and Upstart chose the former.
The NCI is therefore measured at its share of the net assets of Liddle at the control date, adjusted for
fair value movements.
In the six months between 1 October 20X4 to 1 April 20X5 the NCI are allocated 30% of the profits of
Liddle (W4). This is added to the original NCI total.
On 1 April 20X5 the NCI reduce their investment in Liddle from 30% to 20%. The reduction in net
assets (W4) is compared to the cost of the shares bought by Upstart, and the difference is taken to
group reserves (W6).
From 1 April to 30 June 20X5 the NCI are allocated 20% of the profits of Liddle (W4).
In the statement of financial position the NCI are effectively given their share (20%) of the fair value of
Liddle’s net assets at 30 June 20X5. This gives a figure of £3.664 million (W4).
(2) Financial reporting treatment of restructuring plans and share options
Restructuring plans
Plan 1:
A provision for restructuring should be recognised in respect of the closure of the retail outlets in
accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets. The plan has been
communicated to the relevant employees (those who will be made redundant) and the outlets have
already been identified. A provision should only be recognised for directly attributable costs that will
not benefit ongoing activities of the entity. Thus, a provision should be recognised for the
redundancy costs and the lease termination costs, but none for the retraining costs:
£‘000
Redundancy costs
300
Retraining
–
Lease termination costs
50
Liability
DEBIT
CREDIT
350
Profit or loss
Current liabilities
£350,000
£350,000
Plan 2:
No provision should be recognised for the reorganisation of the finance and IT department. Since
the reorganisation is not due to start for two years, the plan may change, and so a valid expectation
that management is committed to the plan has not been raised. As regards any provision for
306
Corporate Reporting
ICAEW 2022
redundancy, individuals have not been identified and communicated with, and so no provision
should be made at 30 June 20X5 for redundancy costs.
Share options
IFRS 2, Share-based Payment requires that the expense in respect of the share options must be
recognised in profit or loss for the year. This is an equity-settled share-based payment, so the fair
value of the share options is that at the grant date, and the corresponding credit is to equity:
DEBIT
CREDIT
Profit or loss
£133,333
Equity
£133,333
The expense is calculated as follows:
£’000
30 June 20X4 Equity b/d: 1,000 × 4 × £50 × 1/3
66.67
Profit or loss (balancing figure)
133.33
30 June 20X5 Equity c/d: 1,000 × 6 × £50 × 2/3
200.00
(3) Consolidated statement of profit or loss for year ended 30 June 20X5
£’000
Revenue (see (W5))
34,420
Cost of sales
(10,640)
Gross profit
23,780
Operating costs
(5,358)
Profit from operations
18,422
Investment income
905
Fair value gain on associate
326
Associate income
424
Interest paid (625 + 169 + 78 + 123 + 141)
(1,136)
Profit before tax
18,941
Taxation
(3,700)
Profit for year
15,241
Profit attributable to:
Shareholders of the parent
13,901
Non-controlling interests
1,340
15,241
(4) Fair value method implications
If the fair value method in relation to the non-controlling interest was used instead of the proportion
of net assets method, the potential implications would be as follows:
•
Goodwill would be higher, because the non-controlling interest (NCI) would include their share of
goodwill in addition to their share of net assets.
•
If a goodwill impairment arose, the NCI would bear a share of the impairment, this would
decrease the NCI allocation in the consolidated statement of profit or loss.
ICAEW 2022
Financial reporting 1
307
Assuming that the NCI is higher for the reasons discussed above, gearing would be lower as NCI is
deemed to be part of equity.
WORKINGS
(1) Group Structure
Upstart
25% 3 months
70% 6 months
80% 3 months
Liddle
(2) Net Assets
Share capital
30 Jun
20X5
1 Apr 20X5
1 Oct 20X4
1 Jan 20X3
£’000
£’000
£’000
£’000
1,000
1,000
1,000
1,000
Reserves: At 1 January 20X3
6,600
Reserves: At 1 July 20X4
9,000
9,000
9,000
Profits for 12/9/3 months
6,780
5,085
1,695
Fair value adjustment
1,600
1,600
1,600
Depreciation on FV adjustment
(60)
(1,600 × 1/20 × 9/12 and 6/12)
18,320
1,675
Movement
––––––
––––––
16,645
13,295
7,600
3,350
5,695
(40)
(3) Goodwill
Consideration:
£’000
Shares issued (800,000 × £11.50)
9,200
Cash 01.10.20X4
2,000
Deferred cash (£3 million/1.092)
2,525
Contingent cash ((£3 million × 50%)/1.093)
1,158
Fair value of previously held equity investment (250,000 ×
£30)
7,500
Non-controlling interest at 01.10.X4
3,989
Less: Net assets at control (W2)
Goodwill
(13,295 × 30%)
(13,295)
13,077
(4) Non-controlling interests
£’000
At 1 October 20X4 (W3)
3,989
Share of profit to 1 April 20X5
£5,025,000 (W5) × 6/9 × 30%
1,005
NCI at 1 April 20X5
4,994
*Share transferred to Upstart
308
Corporate Reporting
ICAEW 2022
£’000
(4,994 × 10/30) see working below
(1,665)
Share of profits 1 April–30 June 20X5
(1,675 (W2) × 20%)
335
At 30 June 20X5
3,664
*Share of net assets based on old interest = 16,645 × 30%
4,994
Share of net assets based on new interest = 16,645 × 20%
3,329
Adjustment required
1,665
(5) Group SPL
Revenue
Upstart
Liddle (9/12)
Adjust
Group
£’000
£’000
£’000
£’000
23,800
11,700
(1,080)
34,420
1,080
(10,640)
Additional depreciation
Cost of sales
(60)
(7,400)
(4,050)
Unrealised profit
Operating costs
(210) (W9)
(3,500)
Professional fees
(250)
Restructuring provision
(350)
Share-based payment
(133)
Investment income
890
(1,125)
135
(5,358)
(120) (W9)
905
Gain on previously held equity
investment (W8)
326
326
Associate income (6,780 × 25% ×
3/12)
424
424
Interest paid
(520)
Unwinding of discount on deferred
consideration (W10)
(169)
(169)
Unwinding of discount on
contingent consideration (W10)
(78)
(78)
Foreign loan interest (W11)
(141)
(141)
Exchange loss on loan (W7)
(123)
(123)
Taxation
Profit for year
NCI: (5,025 × 6/9 × 30%)
(5,025 × 3/9 × 20%)
Total
ICAEW 2022
(225)
120 (W9)
(625)
(2,350)
(1,350)
(3,700)
9,676
5,025
15,241
1,005
335
1,340
Financial reporting 1
309
(6) Increase in investment in Liddle 1 April 20X5
£’000
CREDIT
Cash
DEBIT
DEBIT
£’000
3,500
NCI
1,665
Group Reserves (balance)
1,835
(7) Exchange loss on loan
£’000
Borrowed at 1 October 20X4 (€4 million at £1 = €1.30)
3,077
Restate at 30 June 20X5 (€4 million at £1 = €1.25)
3,200
Exchange loss
(123)
(8) Associate
£’000
Cost
5,750
Share 01.01.20X3 to 01.10.20X4 (25% × 5,695 (W2))
1,424
7,174
Fair value at 1 October 20X4 (250 × £30)
7,500
Increase in value to SPL
326
(9) Profit in inventories
100%
60%
160%
Cost
Profit
Sales Price
210
560
Reduce profit by £210,000
Intra-group transactions
£120,000 × 9 months = £1,080,000 – remove from revenue and cost of sales
Cancel £2 million × 8% × 9/12 = £120,000 from investment income and finance cost
(10) Deferred consideration
At 01.10.20X4 At 30.6.20X5
Movement
£’000
£’000
£’000
Deferred cash (£3 million/1.092)
2,525
2,694
169
Contingent cash ((£3 million × 50%)/1.093)
1,158
1,236
78
Also acceptable = £2,525,000 × 9% × 9/12 = £170,000
(11) Foreign loan interest
€4 million × 6% × 9/12 = €180,000 at £1 = €1.28 = £141,000
310
Corporate Reporting
ICAEW 2022
6 MaxiMart plc
Marking guide
Marks
Share option scheme
Pension scheme
Reward card
Futures contract
7
14
5
7
Proposed dividend
Marks Available
5
38
Maximum
30
Total
30
MEMO
Transactions of MaxiMart
(1) Share options awarded
This is an equity-settled share-based payment. An expense should be recorded in profit or loss,
spread over the vesting period of five years with a corresponding increase in equity.
Each option should be measured at the fair value at the grant date ie, £2. The year-end estimate of
total leavers over the five-year vesting period (25%) should be removed in the calculation of the
expense as they will never be able to exercise their share options.
There are two other vesting criteria here:
•
The average profit which should be taken into account because it is a performance criterion. The
average profit for the next five years is £1.3 million ([£0.9m + £1.1m + £1.3m + £1.5m + £1.7m]/5
years), resulting in 120 options per employee.
•
The share price which should not be taken into account because it is a market condition which is
already factored into the fair value. So the fact that the share price target of £8 has not been met
by the year end does not need to be taken into account.
The expense and the corresponding increase in equity for the year ended 30 September 20X1 is
calculated as follows:
= 1,000 employees × 75% employees remaining × 120 options × £2 FV × 1/5 vested
= £36,000
(2) Pension scheme
Statement of financial position as at 30 September 20X1 (extract)
30 September 20X1 30 September 20X0
£’000
£’000
–
100
40
–
Non-current assets
Defined benefit pension plan
Non-current liabilities
Defined benefit pension plan
ICAEW 2022
Financial reporting 1
311
Statement of profit or loss and other comprehensive income for the year ended 30 September
20X1 (extracts)
£’000
Profit or loss
Defined benefit expense
185
Other comprehensive income
Actuarial gain on defined benefit obligation
(30)
Return on plan assets (excluding amounts in net interest)
53
Net remeasurement loss
23
Note: IAS 19 requires remeasurement gains and losses to be recognised in other comprehensive
income.
Notes to the financial statements
Defined benefit plan: amounts recognised in the statement of financial position
30 September
20X1
30 September
20X0
£’000
£’000
2,410
2,200
(2,370)
(2,300)
40
(100)
Present value of defined benefit obligation
Fair value of plan assets
Defined benefit expense recognised in profit or loss for the year ended 30 September 20X1
£‘000
Current service cost
90
Net interest on the net defined benefit asset (115 – 110)
(5)
Past service cost
100
185
Changes in the present value of the defined benefit obligation
£‘000
Opening defined benefit obligation at 1 October 20X0
2,200
Past service cost
100
Interest on obligation (2,200 × 5%)
110
Current service cost
90
Benefits paid
(60)
Remeasurement gain through OCI (balancing figure)
(30)
Closing defined benefit obligation at 30 September 20X1
2,410
Changes in the fair value of plan assets
£‘000
Opening fair value of plan assets at 1 October 20X0
Interest on plan assets (2,300 × 5%)
312
Corporate Reporting
2,300
115
ICAEW 2022
£‘000
Contributions
68
Benefits paid
(60)
Remeasurement loss through OCI (balancing figure)
(53)
Closing fair value of plan assets at 30 September 20X1
2,370
(3) Reward card
The reward points provide a material right to customers that they would not receive without entering
into a contract. Consequently, the promise to provide goods and services to the customer in
exchange for points is a performance obligation under IFRS 15, Revenue from Contracts with
Customers. Total revenue of £100 million is allocated between the food sales and the reward points
based on standalone prices.
Here, total reward points have a face value of £5 million at the year end but only two in five
customers are expected to redeem their points, giving a value of £2 million (ie, £5m × 2/5).
£’000
Food sales
Loyalty points
£100m/£102m × £100m
98,039
£2m/£102m × £100m
1,961
100,000
In substance, customers are implicitly paying for the reward points they receive when they buy other
goods and services and hence some of that revenue should be allocated to the points, as a separate
performance obligation.
£98.04 million would be recognised as revenue in the year ended 30 September 20X1 and £1.96
million would be recognised as a contract liability in the statement of financial position until the
reward points are redeemed.
(4) Futures contract
IFRS 9, Financial Instruments has an objective-based assessment for hedge effectiveness, under
which the following criteria must be met.
•
There is an economic relationship between the hedged item and the hedging instrument ie, the
hedging instrument and the hedged item have values that generally move in the opposite
direction because of the same risk, which is the hedged risk.
•
The effect of credit risk does not dominate the value changes that result from that economic
relationship ie, the gain or loss from credit risk does not frustrate the effect of changes in the
underlyings on the value of the hedging instrument or the hedged item, even if those changes
were significant.
•
The hedge ratio of the hedging relationship (quantity of hedging instrument vs quantity of
hedged item) is the same as that resulting from the quantity of the hedged item that the entity
actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge
that quantity of hedged item.
The loss on the forecast sale should not be accounted for as the sale has not yet taken place.
However, the gain on the future should be accounted for under IFRS 9, Financial Instruments.
Assuming the hedge effectiveness criteria have been met, hedge accounting can be applied.
The double entry required is:
DEBIT
Financial asset (future)
£2m
CREDIT
Retained earnings (with effective portion)
£1.9m
CREDIT
Profit or loss (with ineffective portion)
£0.1m
(5) Proposed dividend
The dividend was proposed after the end of the reporting period and therefore IAS 10, Events After
the Reporting Period applies. This prohibits the recognition of proposed equity dividends unless
ICAEW 2022
Financial reporting 1
313
these are declared before the end of the reporting period. The directors did not have an obligation
to pay the dividend at 30 September 20X1 and therefore there cannot be a liability. The directors
seem to be arguing that their past record creates a constructive obligation as defined by IAS 37,
Provisions, Contingent Liabilities and Contingent Assets. A constructive obligation may exist as a
result of the proposal of the dividend, but this had not arisen at the end of the reporting period.
Although the proposed dividend is not recognised it was approved before the financial statements
were authorised for issue and should be disclosed in the notes to the financial statements.
7 Robicorp plc
Scenario
Requirement
Skills
Recommend any adjustments, with
accompanying journal entries, that are required
to make the accounting treatment comply with
IFRS, explaining the reasons for your proposed
changes.
Apply technical knowledge of IAS 38 to the
scenario to determine appropriate accounting
treatment of the application.
Identify need for amortisation of development
costs.
Analyse and interpret journal to determine
reversal of accrued production costs required.
Link information to determine the correct
accounting treatment for the revenue from the
XL5 order.
Apply technical knowledge to determine
treatment of bond.
Explain the appropriate treatment required to
reflect the share option scheme and the
adjustment required.
Calculate the profit on disposal of the Lopex
shares and the appropriate recognition of the
investment in Saltor.
Identify the difference between the fair value
and the face value of the interest-free loan to
the employees as being the cost to the
employer, to be treated as compensation under
IAS 19.
Apply the IFRS 9 rules in accounting for the loan
at amortised cost using the effective interest
method.
Revise the draft basic earnings per share figure
(Exhibit 2) taking into account your adjustments
and calculate the diluted earnings per share.
Assimilate adjustments and prepare revised
profit after tax.
Calculate basic EPS and diluted EPS.
Marking guide
Marks
Recommended adjustments
26
Revised earnings per share and diluted earnings per share
Marks Available
8
34
Maximum
30
Total
30
314
Corporate Reporting
ICAEW 2022
XL5 costs and revenues
In order for development costs to be capitalised, the following criteria have to be satisfied. The
project must:
•
be technically feasible
•
be intended to be completed and used/sold
•
be able to be used/sold
•
be expected to generate probable future economic benefits
•
have sufficient resources to be completed
•
have costs that can be separately recognised
In the period to 1 January 20X4 not all these criteria appear to have been satisfied, and so the costs
of £2 million a month should have been expensed in the statement of profit or loss.
Once the breakthrough was made on 1 January, the development costs should have been
capitalised until the project was completed on 30 June. An intangible asset of £15 million (6 × £2.5
million) should therefore have been created.
The following journal is therefore required:
DEBIT
CREDIT
Profit or loss
£6m
Intangible asset
£6m
Once sales of the XL5 commenced on 1 August 20X4 the development costs should be amortised.
This could be done either on a time or sales basis. I have amortised the £15 million over the number
of XL5 units delivered to customers by 30 September 20X4, and this gives an amortisation charge of
£500,000 (£15 million × 1,200/36,000).
DEBIT
CREDIT
Profit or loss
£500,000
Intangible asset
£500,000
Revenue should only be recognised once the risks in relation to the XL5 orders have been
transferred to the buyer. This normally is upon delivery, and so revenue in respect of 1,200 units
should be included in the statement of profit or loss.
The accrual for cost of sales should therefore be removed in relation to the original journal for
revenue and the cash received in relation to orders not yet fulfilled should be treated as a contract
liability.
DEBIT
CREDIT
DEBIT
CREDIT
Revenue (1,800 × £25,000)
£45m
Contract liability
Accrued expenses
£45m
£19.8m
Cost of sales (1,800 × £11,000)
£19.8m
The net impact is to reduce profits by £25.2 million.
Convertible bond
Per IFRS the bond should be split between a debt and equity element at the issue date. The debt
element is calculated by discounting the cash flows in relation to the bond by the rate chargeable for
a similar non-convertible instrument.
This gives a debt bond element of £33.037 million (W1) and the balance of the bond is taken directly
to equity, giving a figure of £6.963 million.
DEBIT
Share capital
£4m
DEBIT
Share premium
£36m
CREDIT
Bond liability
£33.037m
CREDIT
Equity
£6.963m
ICAEW 2022
Financial reporting 1
315
An interest charge of £2.478 million (£33.037m × 10% × 9/12) should therefore have been charged
in the statement of profit or loss and added to the liability and the interest accrual reversed.
DEBIT
Profit or loss
CREDIT
£2.478m
Bond liability
DEBIT
Accruals
CREDIT
£2.478m
£0.9m
Finance costs
£0.9m
Share option scheme
Robicorp’s share option scheme is equity settled because the company is committed to issuing
shares if the scheme conditions are satisfied.
The scheme is partially market based as the options will only vest if a share price target is achieved.
Because this part of the scheme is market based the achievement of the share price target is ignored
when calculating the option cost.
The scheme is also non-market based because the shares will only be issued if the executives are still
employed by Robicorp at 1 October 20X6. Therefore the total cost of the options takes into
consideration the expected number of executives at the vesting date.
Per IFRS 2 the fair value of the options at 1 October 20X3 should be expensed over the vesting
period of the scheme.
This gives a cost for the year to 30 September 20X4 of £1.568 million (28 execs (30 – 2 leavers) ×
48,000 options × 350 pence × 1/3).
An expense is recognised for this amount and an equal sum credited to equity at 30 September
20X4.
DEBIT
Profit or loss
CREDIT
£1.568m
Equity
£1.568m
Investment in Lopex/Saltor
Robicorp’s original investment in Lopex is insignificant in terms of group accounting, and is therefore
governed by IAS 32/IFRS 9.
Because they were being treated as investments in equity instruments at FVTOCI at 30 September
20X3, they would have been measured at fair value of £3.68 million (400,000 × £9.20) and a credit to
other comprehensive income and other components of equity in equity of £1.28 million would have
been credited (400,000 × £3.20).
The takeover by Saltor means that the investment in Lopex should be derecognised because
Robicorp no longer has any rights to cash flows in respect of the Lopex shares. A further gain would
be recognised in other comprehensive income/other components of equity of £1.82 million, to
reflect the gain on fair valuing the Lopex shares to their fair value at the takeover date of £5.5 million
(400,000 × 2.5 × £5.50). This £5.5 million is the deemed consideration at the takeover date. The
gains on the Lopex shares are not reclassified to profit or loss.
Robicorp should also have recognised a new financial asset in the form of the shares in Saltor at 1
August 20X4 at the fair value of £5.5 million.
DEBIT
CREDIT
Financial asset (shares in Saltor)
£5.5m
Financial asset (shares in Lopex) (3.68 + 1.82)
£5.5m
At 30 September 20X4 the shares in Saltor should be remeasured at fair value, which per IFRS 9 is
the bid price of £4.80. This gives a value of £4.8 million (1m × 480 pence) and the movement in fair
value of £700,000 (£5.5 million less £4.8 million) is taken to profit or loss.
DEBIT
CREDIT
Profit or loss
Financial asset
£700,000
£700,000
The sales commission of 4 pence per share is ignored.
316
Corporate Reporting
ICAEW 2022
Loans to employees
IFRS 9, Financial Instruments requires financial assets (except those at FVTPL or FVTOCI) to be
measured on initial recognition at fair value plus transaction costs. Usually the fair value of the
consideration given represents the fair value of the asset. However, this is not necessarily the case
with an interest free loan. An interest free loan to an employee is not costless to the employer, and
the face value may not be the same as the fair value.
To arrive at the fair value of the loan, Robicorp needs to consider other market transactions in the
same instrument. The market rate of interest for a two year loan on the date of issue (1 October
20X3) and the date of repayment (30 September 20X5) is 6% pa, and this is the rate that should be
used in valuing the instrument. The fair value may be estimated as the present value of future
receipts using the market interest rate. There will be a difference between the face value and the fair
value of the instrument, calculated as follows:
£‘000
Face value of loan at 1 October 20X3
8,000
Fair value of loan at 1 October 20X3: (£8m/(1.06)2)
7,120
Difference
880
The difference of £880,000 is the extra cost to the employer of not charging a market rate of interest.
It will be treated as employee compensation under IAS 19, Employee Benefits. This employee
compensation must be charged over the two year period to the statement of profit or loss and other
comprehensive income, through profit or loss for the year.
The question now arises as to how to measure the loan under IFRS 9, Financial Instruments. To
measure the loan at amortised cost, the following criteria must be met:
(1) Business model test. The objective of the entity’s business model is to hold the financial asset to
collect the contractual cash flows (rather than to sell the instrument prior to its contractual
maturity to realise its fair value changes).
(2) Cash flow characteristics test. The contractual terms of the financial asset give rise on specified
dates to cash flows that are solely payments of principal and interest on the principal
outstanding.
These tests have been satisfied. Accordingly, the loan should be measured at 30 September 20X4 at
amortised cost using the effective interest method. The effective interest rate is 6%, so the value of
the loan in the statement of financial position is: £7,120,000 × 1.06 = £7,547,200. Interest will be
credited to profit or loss for the year of: £7,120,000 × 6% = £427,200.
The double entry is as follows:
At 1 October 20X3
DEBIT
Loan
£7,120,000
DEBIT
Employee compensation
£880,000
CREDIT
Cash
£8,000,000
At 30 September 20X4
DEBIT
CREDIT
Loan
Profit or loss – interest
£427,200
£427,200
Earnings per share
After taking into consideration the above changes basic earnings per share decreases to 75.7 pence
(W2).
A diluted earnings per share figure is calculated to take into account the worst case scenario in
respect of potential increases in the equity base of the company.
ICAEW 2022
Financial reporting 1
317
This therefore takes into consideration that:
(1) the convertible bond could potentially increase Robicorp’s share capital by 4 million new shares,
but the interest saved by conversion is added back to profit. This is usually calculated net of tax,
but as per your instructions I have ignored the tax consequences; and
(2) the share option scheme could increase Robicorp’s share capital by a number of free shares. This
is calculated by converting the amount to be recognised in the profit or loss to a per share
amount. This is then added to the exercise price to work out the amount that is expected to be
received on exercise. Dividing this by the exercise price and comparing to the total number of
shares to be issued results in the number of free shares.
Diluted earnings per share is 75.2 pence (W3).
WORKINGS
(1) Robicorp convertible bond
£’000
PV Interest 31/12/X4 @10%
1,091
PV Interest 31/12/X5 @10%
992
PV Interest and capital 1/1/X7 @10%
30,954
Total
33,037
(2) Basic earnings per share
Earnings
Shares
£’000
Draft
66,270
Development costs expensed
(6,000)
Development costs amortised
(500)
Revenue/costs not recognised
(25,200)
Bonds instead of shares
Interest expense
Finance cost previously charged
Share option expense
(2,478)
900
(1,568)
(700)
Employee compensation (loan to employees)
(880)
Revised totals
Basic EPS
318
(4,000,000)
Fair value loss on Saltor
Interest on employee loan
Corporate Reporting
44,000,000
427
––––––––––
30,271
40,000,000
75.7 pence
ICAEW 2022
(3) Diluted EPS
£’000
Basic totals
30,271
40,000,000
–
–
––––––
232,611
30,271
40,232,611
Convertibles (see below)
Share options (free shares)
Total
Diluted EPS
75.2 pence
Options calculation
Fair value of services yet to be rendered (48,000 × (30 – 2)) × £3.50 × 2/3)
£3,136,000
Per option £3.136m/(48,000 × (30 – 2))
£2.33
Adjusted exercise price (£4.00 + £2.33)
£6.33
Number of shares under option: 48,000 × 29 =
1,392,000
Number that would have been issued at average market price [1.392m ×
£6.33/£7.60]
 Number of shares treated as issued for nil consideration (free shares)
(1,159,389)
232,611
Convertibles calculation – dilution test
Earnings/Shares = £2,478,000/(4m × 9/12) = 82.6p
As 82.6p is more than the basic EPS of 75.7p then the convertibles are anti-dilutive and therefore
must not be included in the diluted EPS calculation.
8 Flynt plc
Scenario
The candidate is in the role of a newly appointed financial controller who is asked to produce
journals and adjust a statement of profit or loss and other comprehensive income in respect of three
technical issues: share options, defined benefit scheme and lease of surplus machinery. The
candidate is also asked to calculate the EPS and diluted EPS taking into account the adjustments to
the statement of profit or loss and other comprehensive income.
Marking guide
Marks
Redraft consolidated statement of profit or loss and other comprehensive income
28
Calculate EPS and diluted EPS where appropriate
Marks Available
7
35
Maximum
30
Total
30
To Andrea.Ward@flynt.co.uk
From Miles.Goodwin@flynt.co.uk
Re Finalisation of financial statements for year ended 31 May 20X6
ICAEW 2022
Financial reporting 1
319
I would respond to your email as follows:
Share option scheme
Shane Ponting’s treatment of the option scheme is incorrect. IFRS 2, Share-based Payment should
have been applied as follows:
The fair value of the options at the grant date should be treated as an expense in profit or loss and
spread over the vesting period, which is from the grant date until the date the scheme conditions
vest.
The scheme conditions are both market and non-market based, as they are impacted by both the
share price and continuing employment.
The fact that the share price has increased since the grant date is ignored when determining the
charge to profit or loss. This is because market based conditions are embedded in the fair value
calculations.
The continuing employment condition should be based on the best estimates at the statement of
financial position date, which in this case is for 16 executives to be employed at the vesting date.
The journal entry is as follows:
DEBIT
CREDIT
Profit or loss
Equity (retained earnings)
£378,000
£378,000
The charge to profit or loss is therefore £378,000 (10,000 × 16 × £12.60 × ¼ × 9/12). This will reduce
profit after tax and therefore EPS.
In addition this sum is also credited in the statement of financial position to equity. IFRS 2 does not
state where in equity this entry should arise, and many companies add it to retained earnings.
When calculating diluted EPS it will normally be necessary to take into consideration the number of
‘free’ shares being allocated to executives assuming the whole scheme will vest. Also, normally, there
is an adjustment to be made to the option exercise price in terms of the remaining IFRS 2 cost to be
expensed in future (per IAS 33 example 5A). However in the case of Flynt there is a share price
condition to be satisfied, in addition to the mere passage of time. There are therefore performance
based share options and, in accordance with para 48 of IAS 33, these should be treated as
contingently issuable shares.
Para 54 of IAS 33 therefore applies which states that ‘the calculation of diluted EPS is based on the
number of ordinary shares that would be issued if the market price at the end of the reporting period
were the market price at the end of the contingency period’. In the case of Flynt, to satisfy this
contingency the price would need to rise to £58.5 (ie, £39 × 150%). At the period end it is only £52,
so in accordance with para 54 there is no dilution.
Lease of machinery
Shane Ponting’s analysis of the agreement as an operating lease is incorrect under IFRS 16, Leases.
This would appear to be a finance lease because:
(1) the lease term and useful life of the asset are the same; and
(2) the present value of the lease payments received, plus the residual value guaranteed by Prior plc
come to £607,000 (Appendix 2), which is almost all of the fair value of the machinery.
The asset should therefore be derecognised and a receivable created. This is called the net
investment in the lease. The direct costs incurred should be included in the initial measurement of
the finance lease receivable and will therefore be recognised in profit or loss over the lease term as
part of interest receivable.
The rental income of £150,000 is removed from profit or loss. Interest receivable of £61,000 is
credited to profit or loss (Appendix 3).
Because the machinery is being derecognised the depreciation charge should be added back to
profit. Overall the reclassification of the lease to a finance lease will increase EPS.
In the statement of financial position at 31 May 20X6 there will be a receivable of £524,000
(Appendix 3) which should be analysed between amounts due in less than and more than one year.
320
Corporate Reporting
ICAEW 2022
Journal entries are as follows:
DEBIT
Depreciation provision
CREDIT
£122,000
Profit or loss
£122,000
Being removal of the depreciation charge
DEBIT
Net investment in lease
CREDIT
£1,000
Profit or loss
£1,000
Being adjustment re-allocation of direct costs
DEBIT
CREDIT
Profit or loss
£150,000
Net investment in lease
£150,000
Being removal of rental income
DEBIT
CREDIT
Net investment in lease
£61,000
Profit or loss
£61,000
Being interest income
Dipper pension scheme
The accounting treatment for a defined benefit scheme is considerably different to that of a defined
contribution scheme. It is therefore necessary to remove the charge of £480,000 made by Shane
Ponting and replace it with the following. The profit or loss charge is split into two elements:
(1) Service cost: This is the pension earned by the employees of Dipper in the year, and is an
operating cost. This means that operating costs will rise by a net £80,000 after deducting the
contributions paid into the scheme that have been incorrectly charged by Shane Ponting.
(2) Net interest on the net defined benefit liability. This in turn consists of two elements:
(a) Interest on plan assets: This works out as £55,000 (5% × £2.2m × 6/12). IAS 19 does not
specify where this should appear in the statement of profit or loss and other comprehensive
income. I have treated it as investment income but it would not be incorrect to offset it
against operating costs.
(b) Interest on obligation: This is the unwinding of the present value of the pension liability due
to employees who are one year closer to retirement at the end of the accounting period. A
charge of £65,000 (5% × £2.6m × 6/12) should therefore be made in profit or loss. Because
it relates to a present value, I have added this to finance costs, but once again IAS 19 is silent
on the issue.
The net charge to profit or loss is thus £(65,000 – 55,000) = £10,000
The actuarial difference reflects that some of the above figures are estimates, and also the increase in
the net liability in the pension fund to £670,000 (£2.75m – £2.08m). This net liability will appear in the
statement of financial position as a liability.
Per Appendix 4 there is a net remeasurement loss of £180,000. IAS 19 requires immediate
recognition of this in other comprehensive income.
Journal entries are as follows:
DEBIT
CREDIT
Profit or loss
£560,000
Pension obligation
£560,000
Being recognition of service costs
DEBIT
CREDIT
Pension asset
Profit or loss
£480,000
£480,000
Being contributions paid into the scheme
ICAEW 2022
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321
DEBIT
Interest on assets
CREDIT
£55,000
Profit or loss
£55,000
Being recognition of interest on assets
DEBIT
Profit or loss
CREDIT
£65,000
Pension obligation
£65,000
Being recognition of interest on obligation
DEBIT
Other comprehensive income
£205,000
£205,000
CREDIT
Pension asset
Being recognition of remeasurement loss on pension asset
DEBIT
Pension obligation
CREDIT
£25,000
Other comprehensive income
£25,000
Being recognition of gain on pension obligation
Goodwill impairment
The goodwill impairment should be charged to profit or loss rather than other comprehensive
income. The entries to correct are:
DEBIT
Profit or loss
CREDIT
£400,000
Other comprehensive income
£400,000
Being correct treatment of goodwill
This will impact on EPS.
Summary of adjustments
As a result of these adjustments EPS has increased from £1.21 to £1.50 per share from the previous
year.
Appendix 1 – Flynt plc: Revised statement of profit or loss and other comprehensive income for
year ended 31 May 20X6
20X6
Options
Lease
Pension
Goodwill
Total
£’000
£’000
£’000
£’000
£’000
£’000
Revenue
14,725
14,725
Cost of sales
(7,450)
(7,450)
Gross profit
7,275
7,275
Operating costs
(3,296)
(378)
122 + 1
(80)
Goodwill impairment
Other operating income
Operating profit
Investment income
Finance costs
(3,631)
(400)
150
(150)
0
4,129
39
(452)
(400)
3,244
61
100
(10)
(462)
Profit before tax
3,716
2,882
Taxation at 23%
(1,003)
(663)
2,713
2,219
Profit after tax
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Corporate Reporting
ICAEW 2022
20X6
Options
Lease
Pension
Goodwill
Total
£’000
£’000
£’000
£’000
£’000
£’000
Other comprehensive
income
Remeasurement loss on
pension
Goodwill impairment
(180)
(180)
(400)
400
2,313
0
2,039
Appendix 2 – PV of lease agreement at 10%
Cash flow
PV
£‘000
£‘000
1
150
136
2
150
124
3
150
113
4
150
103
5
211
131
9
6
Year
5 Unguaranteed
Total
613
Fair value plus the direct costs is equal to the net investment in the lease.
£612,100 + 1,000 = 613,100
Appendix 3 – Net investment in lease
Bal b/f
Interest income
Instalment
At 31 May
£‘000
£‘000
£‘000
£‘000
1 June 20X5
613
61
(150)
524
1 June 20X6
524
52
(150)
426
Appendix 4 – Pension calculations
Balance at Acquisition
Interest on assets
Asset
Obligation
£’000
£’000
2,200
2,600
55
Unwinding of discount (interest on liability)
65
Service cost
560
Contributions
480
Pension Paid
(450)
(450)
Expected closing bal
2,285
2,775
Actual closing balance
2,080
2,750
Difference on remeasurement through OCI
(205)
25
Net actuarial loss
(180)
ICAEW 2022
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323
Appendix 5 – Basic EPS
Profit after tax
Shares at start and end of year (000s)
Basic EPS
20X6
20X5
£’000
£’000
2,219
1,699
*1,475
1,400
£1.50
£1.21
*6/12 × 1,400,000 = 700,000
6/12 × 1,550,000 = 775,000
1,475,000
As reported above, there is a share price condition to be satisfied, in addition to the mere passage of
time. There are therefore performance based share options and, in accordance with para 48 of IAS
33, these should be treated as contingently issuable shares. Para 54 of IAS 33 applies and there
should therefore be no dilution.
9 Gustavo plc
Scenario
The candidate is in the role of a newly appointed financial controller of a company called Gustavo
who is asked to prepare a draft consolidated statement of profit or loss and other comprehensive
income incorporating the results of two subsidiaries. The company has sold and purchased shares in
the subsidiaries during the year.
The sale of shares in its UK subsidiary called Taricco involves the candidate recognising that the
investment should be consolidated as a subsidiary for the six months until the date of disposal takes
place. On sale of the shares the investment decreases to 35% and is therefore a partial disposal.
Candidates need to recognise that because Gustavo has the ability to appoint directors to the board
this is a strong indication that Taricco would be treated as an associate for the remaining six months
of the year.
The acquisition of shares is an investment in 80% of the share capital of an overseas company. The
investment is made on 1 January and therefore should be treated as a subsidiary from that date.
The candidate is specifically asked to explain the impact on the consolidated statement of profit or
loss and other comprehensive income and to show separately the impact on the non-controlling
interest and the impact of future changes in exchange rates on the consolidated statement of
financial position.
Marking guide
Prepare the draft consolidated statement of profit or loss and other comprehensive
income and prepare briefing notes to explain the impact of the share transactions
Advise on the impact that any future changes in exchange rates will have on the
consolidated statement of financial position
Marks Available
Marks
27
7
34
Maximum
30
Total
30
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To Antonio Bloom
From Anita Hadjivassili
Subject Gustavo plc financial statements
I attach the draft consolidated statement of profit or loss and other comprehensive income for the
year ended 30 September 20X6, the explanations you requested, and supporting workings.
Gustavo plc: Consolidated statement of profit or loss and other comprehensive income for year
ended 30 September 20X6 (Requirement 1)
£‘000
Revenue
57,357
Cost of sales
(37,221)
Gross profit
20,136
Operating costs
(9,489)
Gain on sale of subsidiary
13,340
Profit from operations
23,987
Share of profit of associate
160
Investment income
424
Finance costs
(2,998)
Profit before taxation
21,573
Income tax expense
(2,974)
Profit for the year
18,599
Other comprehensive income
Exchange differences on translating foreign operations
7,369
(Restatement of goodwill 4,370
Exchange gain in year 2,999)
Total comprehensive income for the year
––––––
25,968
Profit attributable to:
Non-controlling interests (W9)
Owners of parent company
170
18,429
18,599
Total comprehensive income attributable to:
Non-controlling interests (W9)
Owners of parent company
1,644
24,324
25,968
Supporting notes (Requirement 2)
(1) Taricco Limited
Taricco is treated as a subsidiary for the six months until disposal takes place. This is because
Gustavo has a 75% stake in the company until that date. Upon the sale of the shares on 1 April
20X6 the investment decreases to 35%. Because Gustavo still has the ability to appoint directors
to the board Taricco should be treated as an associate, and the equity accounting method used
for the last six months of the year.
The non-controlling interest (NCI) have a 25% share of profit of Taricco for the first six months of
the year until disposal takes place.
ICAEW 2022
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325
A gain on disposal arises of £13.34 million in the statement of profit or loss and other
comprehensive income. The dividend received by Gustavo from Taricco of £210,000 should be
eliminated on consolidation, as it is replaced by share of Taricco’s profits. As the dividend is paid
after the disposal of the majority stake in Taricco it is not deducted from the net asset total at
disposal.
It should be noted that in future years Taricco will make less of a contribution to group profit due
to the reduction in the investment.
(2) Arismendi Inc
Gustavo acquired an 80% stake in Arismendi, and so the investment should be treated as a
subsidiary from 1 January 20X6.
The acquisition fees of £400,000 have been incorrectly treated, and should be expensed in
profit or loss in the year of purchase.
The results of Arismendi are translated into sterling at the average rate for the nine months post
acquisition in the statement of profit or loss and other comprehensive income.
The impact that any future changes in exchange rates will have on the consolidated statement of
financial position (Requirement 3)
An exchange difference will arise each year, due to the movement in exchange rates from each
statement of financial position date in relation to net assets, and also because the profits in the
statement of profit or loss and other comprehensive income will be retranslated from the average to
the closing rate in the statement of financial position. This gives a gain on translation of £2.999
million, and is taken to other comprehensive income, and 20% is allocated to the NCI, representing
their share of Arismendi.
The cost of the investment is restated each year for consolidation purposes to take into consideration
the movement in exchange rates.
As a consequence goodwill is restated at the year end to take into account the change in exchange
rates, as it is deemed to be an asset of the subsidiary.
As a consequence goodwill has increased from £8.739 million to £13.109 million (W7). This is taken
to other comprehensive income in the statement of profit or loss and other comprehensive income,
and 20% is allocated to the NCI, representing their share of Arismendi.
WORKINGS
(1) Consolidation schedule
Revenue
Cost of sales
Gustavo
Taricco
6 months
Arismendi
9 months
Adjust
Total
£’000
£’000
£’000
£’000
£’000
35,660
14,472
7,225
57,357
(21,230)
(11,082)
(4,639)
(37,221)
Depreciation (£14.4m/8 years ×
9/12)/5
Operating costs
Acquisition fees
(270)
(5,130)
(2,478)
(1,481)
(400)
Gain on disposal (W4)
Share of associate’s profit (W6)
Investment income
(9,489)
13,340
13,340
160
160
(210)
424
580
54
–
Interest paid
(2,450)
(330)
(218)
(2,998)
Income tax expense
(2,458)
(180)
(336)
(2,974)
PAT
*4,572
456
281
13,290
18,599
*As originally stated £4,972,000 less acquisition fees £400,000
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Corporate Reporting
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(2) Net assets of Taricco
On disposal
At acquisition
£’000
£’000
Share capital
2,000
2,000
Retained earnings b/f
4,824
2,400
Profits to disposal (6 months)
Dividend paid
Total
456
0
–––––
7,280
4,400
(3) Goodwill
Taricco
£’000
Cost to parent
NCI at acquisition (25%)
15,000
1,100
Less net assets
(4,400)
Goodwill
11,700
Impairment
(2,500)
Goodwill at disposal
9,200
(4) Gain on sale of Taricco shares
£’000
Proceeds
19,800
FV of interest retained
8,200
NCI at disposal (W5)
1,820
29,820
NA at disposal (W2)
(7,280)
Goodwill at disposal (W3)
(9,200)
Gain on disposal
13,340
(5) NCI at disposal
£’000
At acquisition
1,100
Up to disposal (25% × (4,824 – 2,400)) + 114 (W9)
At disposal
720
1,820
(6) Share of profits of associate
Taricco
35% × PAT × 6/12
ICAEW 2022
160
Financial reporting 1
327
(7) Goodwill of Arismendi
Cost of investment
01.01.X6
(Kr 6)
30.09.X6
(Kr 4)
Kr’000
£’000
£’000
75,600
12,600
18,900
12,000
2,000
3,000
87,600
14,600
21,900
35,164
5,861
8,791
52,436
8,739
13,109
NCI at acquisition
12Kr × 5,000 shares × 20%
Net assets at Acquisition
Share capital
Retained earnings
5,000
14,846
Three months to 1 January 20X6
3,670 × 3/12
918
Fair value adjustment
£2.4m × Kr 6
14,400
Goodwill
Increase to other comprehensive
income
4,370
(8) Exchange difference arising in Arismendi
£’000
£’000
Net assets at acquisition
Kr 35,164 @ closing rate 4Kr : £1
8,791
Kr 35,164 @ acquisition rate 6Kr : £1
5,861
2,930
Nine months profit to 30.9.X6
Kr 3,670 per question × 9/12 = 2,753 – *1,350 = 1,403
@ closing rate Kr4:£1
350
Kr 3,670 per question × 9/12 = 2,753 – *1,350 = 1,403
@ average rate Kr5:£1
281
69
2,999
*depreciation on FV adjustment ((14,400/8) × 9/12)
(9) Non-controlling interests
£’000
Taricco
456 × 25%
114
Arismendi
281 × 20%
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Corporate Reporting
56
ICAEW 2022
£’000
Share of goodwill restatement for Arismendi
4,370 × 20%
874
Share of exchange difference
2,999 × 20%
600
1,644
ICAEW 2022
Financial reporting 1
329
330
Corporate Reporting
ICAEW 2022
Financial reporting 2
10 Inca Ltd
Scenario
This was the single silo corporate reporting question and included ethical issues. The scenario was a
company supplying plant and machinery to the oil drilling industry. At the beginning of the year it
acquired an 80% interest in an overseas subsidiary. The candidate was employed on a temporary
contract, reporting to the managing director. There was some concern about the impact of the new
subsidiary on the statement of financial position, and there were some outstanding financial
reporting issues, particularly with regard to deferred tax. The accountant had identified five particular
matters that needed to be resolved: accelerated capital allowances on PPE; development costs; tax
trading losses; a foreign currency loan which required correct treatment by considering both IAS 21
and IFRS 9; and a loan to a director. Candidates were provided with a draft statement of financial
position for the parent and the overseas subsidiary.
Candidates were required firstly, to explain the correct financial reporting treatment for each of the
five issues identified; secondly, to prepare the consolidated statement of financial position; thirdly to
show the difference between the two permitted methods of calculating non-controlling interest and
fourthly as a separate requirement, to highlight any ethical concerns and actions with respect to the
email from the MD.
Marking guide
Marks
An explanation of the appropriate financial reporting treatment
The consolidated statement of financial position of Inca at 30 April 20X1
A calculation of NCI at fair value
12
7
5
Explain any ethical concerns
Marks Available
8
32
Maximum
30
Total
30
Deferred tax
Deferred tax is calculated on all temporary timing differences, and is based on the tax rates that are
expected to apply to the period when the asset is realised or liability is settled. The tax rates are
those that have been enacted or substantively enacted by the end of the reporting period. In the
absence of any other information to the contrary, therefore the current rate of 20% should be used.
(1) Property, plant and equipment (PPE)
There is a temporary taxable timing difference of CU22 million (CU60m – CU38m) at 1 May 20X0.
This agrees to the opening deferred tax liability of CU4.4m shown in Excelsior’s statement of financial
position.
At 30 April 20X1 this has increased to CU28 million (CU64m – CU36m) and therefore the deferred tax
liability in respect of PPE increases to CU5.6 million.
Therefore a deferred tax charge on the increase in the difference of CU1.2 million is required. This
would be charged to the statement of profit or loss and other comprehensive income of Excelsior.
(2) Development costs
There is a temporary taxable difference arising in respect of development costs because they have a
carrying amount of CU7 million at 30 April 20X1 in the statement of financial position. However they
have a zero tax base because they have been treated as an allowable deduction in the company’s tax
computation at that date.
When the development costs are amortised in the statement of profit or loss and other
comprehensive income the timing difference will reverse.
ICAEW 2022
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331
This gives a deferred tax liability of CU1.4 million (20% × CU7m) and a charge to the profit or loss.
(3) Tax losses
A deferred tax asset arises because the tax losses can be used to reduce future tax payments when
being offset against future taxable profits.
However, the amount of the deductible difference should be restricted to the extent that future
taxable profit will be available against which the losses can be used. This is an application of the
prudence principle.
As such, the deferred tax asset should be recognised on the budgeted profit of CU5 million for the
next two financial years only.
Therefore, the deferred tax asset would be CU2 million (20% × (CU5m × 2)). This will be a credit to
profit or loss.
Given the inexperience of the company accountant, the validity of these forecasts must be
considered and verified.
(4) American loan
The loan should initially be measured at the sum received of US$15 million, which at the borrowing
date is CU48.0 million.
Excelsior’s accountant has incorrectly charged the repayment of ($800,000 × 2.8) CU2.2 million to
profit or loss. This should be reversed and replaced with the interest calculated using the amortised
cost method. Therefore the interest charge for the year is US$1.6 million (US$15m × 10.91%).
In Excelsior’s own statement of profit or loss and other comprehensive income this could be
translated at either the average or the closing rate of exchange.
I have used the average rate in my figures and this gives an interest charge of CU4.8 million
(US$1.6m × 3 = CU4.8m). Therefore an adjustment to profit or loss of CU2.6 million (4.8 million less
2.2 million) is required.
No deferred tax adjustment arises as only the interest paid is tax deductible and not the discount or
premium on redemption.
The loan constitutes a monetary liability, and therefore should be translated in the books of Excelsior
using the closing rate of exchange between the CU and the US dollar. The loan is US$15.8 million
which gives a figure of CU44.2 million ($15.8m × year end rate of 2.8). The loan is currently stated
after the above interest correction, at CU50.6 million (CU48 million plus the adjustment for interest of
CU4.8 million less interest paid of CU2.2 million) and has not yet been translated by the accountant
at the year-end rate. Therefore an exchange gain of CU6.4 million arises, and this is taken to the
statement of profit or loss and other comprehensive income.
(5) Director’s loan
Given the issues in terms of recoverability of the loan, it should be written off and removed from
receivables. This will also result in an expense in profit or loss.
As the loan is to a director, it is likely to be treated as a related party transaction, and as such should
be disclosed in the notes to the financial statements. The writing off of the loan should also be
disclosed.
There are likely to be current tax implications of this loan write off and the Ruritanian tax treatment of
this would need to be ascertained.
Consolidation of subsidiary
Goodwill
As Excelsior is a subsidiary, goodwill arises at the acquisition date, and is restated at 30 April 20X1
using the exchange rate at that date. The initial recognition of goodwill does not in itself create a
deferred tax consequence. This is because goodwill is only recognised in the consolidated financial
statements.
The assets and liabilities of Excelsior at 30 April 20X1, after any adjustments to align IFRS and
Ruritanian GAAP, should be translated using the closing rate of exchange in the consolidated
statement of financial position, and at the average rate in the consolidated statement of profit or loss
and other comprehensive income. Any gain or loss arising in respect of the movement in exchange
rates is taken to other comprehensive income.
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Goodwill should be subject to an impairment review at the end of the first year of acquisition. This is
especially important because of the post-acquisition losses generated by Excelsior.
Goodwill with non-controlling interest at fair value
If non-controlling interest in Excelsior is valued at its fair value of CU20 million, the goodwill is CU2
million greater, at CU50 million, which is £11.1 million on translation. The exchange difference on
translation of the goodwill remains at £1.1 million (see W2).
Ethical issues
Director‘s loan
The loan to the director should be investigated to see if it is legal in accordance with Ruritanian
company law. It is advisable to seek expert advice on this issue.
On a separate issue it would be unethical to disregard the rules in relation to IAS 24 in respect of
related party transactions. I would expect that Excelsior’s auditors will insist that the transaction is
disclosed in the notes to the financial statements.
The board’s wish that the loan is not disclosed on the grounds of immateriality is irrelevant;
materiality is determined by nature in related party transactions rather than by value.
Potential permanent contract
The offer of a permanent contract in return for my ‘silence’ in respect of the preparation of the
working papers creates an improper working relationship and a threat to independent judgement.
This demonstrates a lack of integrity and professional behaviour on behalf of the managing director.
Actions to be taken
Initially the issues I have should be discussed with the managing director, to make him aware of the
ethical responsibilities that a Chartered Accountant must abide by.
If those discussions are fruitless, then representations should be made to Inca’s audit committee,
assuming that it has one.
If the above fails to resolve the issues with the managing director in a satisfactory manner then the
ICAEW ethical hotline, or legal counsel, should be sought. As a last resort resignation should be
considered.
Workings for adjustments to Excelsior financial statements for Exhibit 3
CUm
PPE
Carrying amount
64.0
Tax base
(36.0)
Temporary taxable difference
28.0
Tax rate
20%
Deferred tax
5.6
Provision at 1 May 20X0
4.4
Increase in provision
1.2
Development costs
Carrying amount
7.0
Tax base
0.0
Temporary taxable difference
7.0
Tax rate
20%
Deferred tax liability
ICAEW 2022
1.4
Financial reporting 2
333
Tax losses: Deferred tax asset is restricted to the extent that probable taxable profit is available.
CUm
20X2 and 20X3 Expected profits
10.0
Tax rate
20%
Deferred tax asset
2.0
American loan
Borrowed
Interest for year to income statement (10.91%)
Interest paid
US$m
Rate
CUm
15.0
3.2
48.0
1.6
3.0
4.8
(0.8)
2.8
(2.2)
Balance pre exchange adjustment
50.6
Balance at year end
15.8
2.8
44.2
Exchange gain on loan
(6.4)
Statement of Financial Position of Excelsior: Adjustment to Excelsior’s financial statements for
issues in Exhibit 3
Draft
PPE
Dev
costs
CUm
CUm
CUm
Tax loss
Interest/
exchange
adj.
Director’s
loan
Final
CUm
CUm
CUm
CUm
Non-current assets
PPE
64.0
64.0
Intangible assets
7.0
7.0
Total non-current
assets
71.0
71.0
Inventories
16.6
16.6
Accounts receivable
35.2
Cash
12.8
12.8
Total current assets
64.6
62.6
135.6
133.6
Share capital CU1
10.0
10.0
Share premium
account
16.0
16.0
Retained earnings at
acq’n
64.0
64.0
Net assets at
acquisition
90.0
90
Current assets
(2.0)
33.2
Equity and Liabilities
Loss since acquisition
(16.0)
(1.2)
(1.4)
2.0
4.4
1.2
1.4
(2.0)
(2.6) 6.4
(2.0)
(14.8)
Non-current liabilities
Deferred tax
334
Corporate Reporting
5.0
ICAEW 2022
Loans
Draft
PPE
Dev
costs
CUm
CUm
CUm
Tax loss
Interest/
exchange
adj.
Director’s
loan
Final
CUm
CUm
CUm
CUm
48.0
Current liabilities
Total equity and
liabilities
2.6 (6.4)
44.2
9.2
9.2
135.6
133.6
The subsidiary is translated at the closing rate for the assets and liabilities in the statement of
financial position and average rate for loss for the year.
Statement of financial position for Excelsior
CUm
Rate
£m
64
4.5
14.2
7
4.5
1.6
Inventories
16.6
4.5
3.7
Trade receivables
33.2
4.5
7.4
Cash
12.8
4.5
2.8
PPE
Intangible assets
Current assets
133.6
29.7
Equity and liabilities
Share capital
10
5
2.0
Share premium
16
5
3.2
64
5
12.8
(14.8)
4.8
(3.1)
Retained earnings
Pre acquisition
Post acquisition
Translation reserve (W1)
1.8
16.7
Non current liabilities: Deferred tax
Loans
Current liabilities
5
4.5
1.1
44.2
4.5
9.8
9.2
4.5
2.1
133.6
29.7
WORKINGS
(1) Translation reserve
Gain/(Loss)
£m
Opening net assets @ Closing rate
Opening net assets @ Opening rate
90 @ 4.5
20
90 @ 5
18
£m
2.0
Loss for the year
@ Closing rate
ICAEW 2022
(14.8) @ 4.5
(3.3)
Financial reporting 2
335
Gain/(Loss)
@ Average rate
(14.8) @ 4.8
Translation reserve for Excelsior
£m
£m
(3.1)
(0.2)
1.8
Inca group – Consolidated statement of financial position
£m
PPE (32.4 + 14.2)
46.6
Goodwill (W2)
10.7
Intangible (12.4 + 1.6)
14.0
71.3
Inventories (9.8 + 3 .7)
13.5
Trade receivables (17.4 + 7.4)
24.8
Cash (1.6 + 2.8)
4.4
114.0
Share capital
4.0
Share premium
12.0
Retained earnings (W2)
41.6
NCI (W2)
3.4
Deferred tax (12 + 1.1)
13.1
Loans (5.8 + 9.8)
15.6
Current liabilities (22.2 + 2.1)
24.3
114.0
(2) Consolidation of Excelsior
Goodwill on consolidation
CUm
Consideration
NCI @ acquisition (90 × 20%)
NA: 10 + 16 + 64
Goodwill
120
18
(90)
48
£m
48 @ Opening rate 5
9.6
48 @ Closing rate 4.5
10.7
Exchange difference on translation of goodwill
1.1
Goodwill on consolidation with NCI at fair value
CUm
Consideration
NCI @ FV
336
Corporate Reporting
120
20
ICAEW 2022
CUm
NA: 10 + 16 + 64
(90)
Goodwill
50
£m
50 @ Opening rate 5
10.0
50 @ Closing rate 4.5
11.1
Exchange difference on translation of goodwill
1.1
Consolidated retained earnings
£m
Inca – retained earnings
41.6
Excelsior (80% × 3.1)
(2.5)
Exchange differences:
Translation of goodwill
1.1
Group’s share of exchange difference on translation of Excelsior (1.8 × 80%)
1.4
41.6
Non-controlling interest (NCI) in consolidated statement of financial positions
20% × 16.7
3.4
11 Aytace plc
Scenario
The candidate is in the role of a financial controller for Aytace plc, the parent company of a group
that operates golf courses in Europe. The candidate is requested to explain the financial reporting
treatment of a number of outstanding matters which include revenue recognition, defined benefit
scheme, a holiday pay accrual, executive and employee incentive schemes and the piecemeal
acquisition of a subsidiary. The question requires the candidate to produce a revised consolidated
statement of profit or loss and other comprehensive income.
Marking guide
Marks
Appropriate financial reporting treatment of the outstanding matters highlighted by
Meg in Exhibit 1
26
A revised consolidated statement of profit or loss and other comprehensive income
Marks Available
6
32
Maximum
30
Total
30
(1) Golf tournament
Tender costs
Tender costs should be expensed in the year in which they were incurred, and therefore a further
£1.05 million should be charged to profit or loss. This is because at the tender date there was no
probable inflow of economic benefits to Aytace and therefore it would not be possible to capitalise
the tender costs as an intangible asset as it is highly unlikely to satisfy the recognition criteria as an
internally generated asset per IAS 38.
ICAEW 2022
Financial reporting 2
337
TV revenues
Under IFRS 15, Revenue from Contracts with Customers, the broadcasting contract is a contract in
which performance obligations are satisfied over time. The performance obligation in this case is the
hosting of the golf tournament which the television company will broadcast. IFRS 15 para 35 states
that an entity transfers control of a good or service over time and therefore satisfies a performance
obligation and recognises revenue over time if one of the following criteria is met:
•
The customer simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs;
•
The entity’s performance creates or enhances an asset (eg, work in progress) that the customer
controls as the asset is created or enhanced; or
•
The entity’s performance does not create an asset with an alternative use to the entity and the
entity has an enforceable right to payment for performance completed to date.
The first criterion will be met once the tournament starts in September 20X3. An advance payment of
£1 million was made on 1 May 20X3 and revenue recognised from the date the contract was signed
(1 February 20X3). £400,000 (£4.8m × 4/48) is recognised as revenue in profit or loss for the year
ended 31 May 20X3. However, as at 31 May 20X3, the performance obligation has not been satisfied,
as the tournament has not started, so no revenue can be recognised under IFRS 15.
Therefore revenue should be reduced by £400,000 (£4.8m × 4/12 × ¼). The journal for this would
be:
DEBIT
CREDIT
Revenue
£400,000
Contract liability
£400,000
(2) Pension scheme
The pension expense in the statement of profit or loss and other comprehensive income consists of a
number of elements.
Pension assets are the equities, bonds and other investments in the fund, and the interest income on
these is credited to profit or loss.
Scheme liabilities are the pension obligations due to current and former employees, and these are
discounted by the market rate on high quality corporate bonds. The interest charge on the liability is
expensed to profit or loss.
The improvement in the pension benefit should be recognised by adding £400,000 to the liability
immediately. Interest on this increased liability should therefore be charged to profit or loss. As the
liability is increased at 1 June 20X2, an interest charge is made in relation to this increase of £24,000
(6% × £400,000).
Instead of the contributions paid into the scheme, the calculation should be as follows:
Defined benefit expense recognised in profit or loss
£’000
Current service cost
1,200
Net interest on net defined benefit liability (732 – (1,080 + 24))
372
Past service cost
400
Total expense
1,972
IAS 19 is silent on how this expense should be charged, I have therefore charged it all to operating
costs, but some companies separate out the interest costs, and take these to finance costs.
Therefore operating costs should be increased by the difference of £1,072,000 (£1,972,000 –
£900,000) over the contributions paid into the scheme, which was the sum incorrectly charged to the
statement of profit or loss and other comprehensive income.
338
Corporate Reporting
ICAEW 2022
Pension scheme
Opening balance
FV asset
PV obligation
£’000
£’000
12,200
18,000
Past service cost
400
Interest on plan assets
732
Interest on obligation
1,080
Interest cost on past service cost
24
Contributions
900
Pensions paid
(1,100)
(1,100)
––––––
1,200
12,732
19,604
768
196
13,500
19,800
Current service cost
Expected closing balance
Difference on remeasurement through OCI
Actual closing balance
The net actuarial gain of £572,000 (768,000 – 196,000), should be recognised in other
comprehensive income.
The net pension obligation recognised in the statement of financial position is £6.3 million (£19.8m –
£13.5m).
(3) Holiday pay accrual
IAS 19, Employee Benefits requires that an accrual be made for holiday entitlement carried forward
to next year.
Number of days c/fwd: 900 × 3 × 95% = 2,565 days
Number of working days: 900 × 255 = 229,500
Accrual = (2,565 ÷ 229,500) × £19m = £0.21m
DEBIT
CREDIT
Operating costs
Accruals
£0.21m
£0.21m
(4) Investment in Xema
Accounting method to be used
Xema should be treated as an associate only up to 1 September 20X2, when control is achieved.
Therefore the equity method should credit the statement of profit or loss and other comprehensive
income with only £102,000 (£1.02m × 3/12 × 40%). For the remaining nine months of the year Xema
should be consolidated using the acquisition method, and income and expenditures included in the
financial statements on a line by line basis. As Xema is 100% owned at the statement of financial
position date there are no entries in respect of non-controlling interests.
Gain on increase in stake
At 1 September 20X2 the carrying amount of the stake held in Xema is £2.962 million, calculated as
follows:
Original cost
2,300
Share of profit to 31 May 20X2
560
Share of profit to 1 Sept 20X2
102
(40% × (£4.8m – £3.4m))
See above
2,962
ICAEW 2022
Financial reporting 2
339
At 1 September per IFRS 3 this should be restated to the fair value of the shares of £3.8 million.
The gain of £838,000 is recognised in the profit or loss for the year. It would most likely be shown as
‘other operating income’ or netted off against operating costs.
Goodwill
Goodwill only arises when control is achieved and is therefore calculated at 1 September 20X2.
The calculation should be as follows:
£’000
FV of original investment
Cost at 1 Sep 20X2
3,800
12,400
––––––
16,200
Less net assets at fair value (W1)
Goodwill
6,055
10,145
(5) Incentive schemes
Executive scheme
This is an equity settled share-based payment scheme. The vesting conditions are market-based as
they relate to a share price target and a non-market-based condition requiring the director to still
hold office at 31 May 20X5. Because the vesting condition relates to the market price of Aytace’s
shares, the probability of achieving the target price by 31 May 20X5 is integrated into the fair value
calculation. Therefore, your concerns about not achieving the share price rise can be ignored when
determining the charge to profit or loss. The non-market-based condition will impact on the number
of options expected to vest and as it is anticipated that one of the directors will leave by the vesting
date this is taken into consideration when calculating the charge. Per IFRS 2 the fair value of the
options is spread over the vesting period of three years to 31 May 20X5. The charge should therefore
be £360,000 (£2.70 × 100,000 × 4 directors × 1/3), and the same amount should be included in
equity.
Share appreciation rights
These are deemed to be cash settled share-based rights because they do not involve the issue of
shares. The vesting conditions are not market based, because the scheme only relates to continued
employment.
Instead of recognising a credit in equity, a liability is created in the statement of financial position.
The fair value of the liability is remeasured at each reporting date, and also takes into consideration
the expected number of employees in the scheme at the vesting date.
The charge is therefore £152,000 (£2.28 × 4,000 × 50 × 1/3), with an equal increase in liability.
(6) Revised profit figures
After taking into consideration the above adjustments my revised profit is as follows:
340
Corporate Reporting
ICAEW 2022
Consolidated statement of profit or loss and other comprehensive income for year ended 31 May
20X3
Golf/TV
Pension
Holiday
accrual
Options
Xema 9
mnths
Total
£’000
£’000
£’000
£’000
£’000
£’000
4,050
18,100
£’000
Revenues
14,450
(400)
Operating costs
(9,830)
(1,050)
(1,072)
(210)
–––––
Operating profit
(360)
(2,700)
(152)
(15,374)
4,620
2,726
Other operating
income
838
838
Associate income
867
(765)*
102
Other investment
income
310
180
490
(1,320)
(540)
Finance charges
Profit before taxation
(ignore tax as
instructed)
4,477
(1,860)
2,296
Other comprehensive income
Net gain on remeasurement in year
572
Total comprehensive income for the year
2,868
WORKINGS
(1) Net assets at carrying amount/fair value:
£’000
Share capital
1,000
Retained earnings (at 31.05.20X2)
4,800
Retained earnings to 01.09.20X2 (1,020 × 3/12)
255
Net assets at carrying amount/FV
6,055
The goodwill figure should be reviewed for impairment at 31 May 20X3.
(2) Adjustment to income for associate
£’000
Xema’s revenue
Costs
4,050
(2,700)
Investment income
180
Finance costs
(540)
990
Tax for nine months
(225)
(765)
ICAEW 2022
Financial reporting 2
341
12 Razak plc
Scenario
The candidate is in the role of a member of the financial reporting team at Razak plc. Razak has
increased its shareholding in the year in an investment, a company called Assulin. This mid-year
acquisition of shares results in a change in accounting treatment of the investment from a financial
asset to a subsidiary. The accounting is made further complex by a contingent payment which is to
be made provided that Razak’s management team remain in post.
The candidate is also asked to explain the accounting adjustments needed in respect of a bond
purchased in Imposter plc. Imposter is now in financial difficulties. The candidate must also explain
the appropriate accounting for a proposed pension plan.
The chief executive of Razak is a director of, and a minority shareholder in Imposter. The candidate is
asked for the ethical implications of this scenario in the knowledge that the purchase of the bond
was not recorded in the Razak board minutes.
Marking guide
Marks
Treatment of increase in the stake in Assulin in the financial statements of the Razak
group
Purchase of the bond in Imposter plc and ethical issues
Razak’s consolidated statement of financial position at 30 September 20X2
12
9
9
Explain how to account for the proposed pension plan
Marks Available
9
39
Maximum
30
Total
30
Explanations of how the increase in the stake in Assulin will be treated in the financial statements of
Razak group.
Status as subsidiary
At 31 March 20X2 Assulin becomes a subsidiary because Razak now has a controlling stake (80%).
This means that goodwill arises on the transaction and a non-controlling interest will be created in
relation to the 20% of Assulin owned by minority shareholders.
Remeasurement of original investment
The gains on the equity investment of £750,000 previously taken to OCI are not reclassified to profit
or loss.
In addition the cost of the original stake is remeasured to the fair value of £20 each immediately prior
to acquisition. This gain of ((£20 – £16) × 75,000) = £300,000 is added to the cost of the investment,
and taken to other comprehensive income.
Intra group balance
The intra group loan of £800,000 is eliminated upon consolidation.
Contingent consideration
The contingent consideration should be measured at fair value (IFRS 3). A liability should be
recognised to pay £1.95 million (£6 × 325,000).
However, as the payment is not due for two years from the acquisition date, it should be discounted
at the cost of capital of 9% to a present value of £1.641 million. This sum should be added to
consideration when calculating goodwill.
This discount should be unwound for six months to the SFP date, giving a charge of £73,845
(£1.641m × 9% × 6/12) to profit or loss, and increasing the liability by the same amount.
Fair value adjustment
The assets of Assulin should be remeasured to fair value at the acquisition date as a property with a
carrying amount of £1.2 million has an estimated fair value of £2.6 million, giving an increase in PPE
342
Corporate Reporting
ICAEW 2022
of £1.4 million. This sum should then be depreciated over the remaining useful life of the property of
five years, reducing both PPE and profits for the year by £140,000 (£1.4m × 1/5 × 6/12).
Goodwill
The consideration for goodwill takes into account the remeasurement of the fair value of the original
investment, plus the cost of the shares on 31 March 20X2, plus the fair value of the NCI. The
remeasured net assets of Assulin are then deducted from this total to give a goodwill total of £8.826
million (W3).
Imposter bond
The bond was correctly classified and valued on initial recognition, but no adjustments have been
made to calculate the value at the year end, including the significant increase in the present value of
lifetime expected credit losses. This increase in allowance will be written off to profit or loss (see W6).
Ethical issues
First of all, both Andrew and Kay are chartered accountants and are both therefore bound by the
ICAEW Code of Ethics.
It is clear that there has been a significant deterioration in the credit quality of the Imposter bond. If it
was foreseeable that the bond would be so severely impaired, the chief executive would be in
breach of his fiduciary duty and potentially guilty of an illegal act. At worst this is a case of fraud and
at best a conflict of interest. We must first ascertain the facts, including why this matter does not
appear in the board minutes and whether the other board members are aware that this transaction
has occurred.
As the chief executive is a shareholder and a director of Imposter there is potentially a self-interest
threat here and he may be seen to be behaving in the best interests of Imposter in preference to the
best interests of the shareholders of Razak. The question to be resolved is – did the chief executive
know of the financial position of Imposter at the time when the bond was issued and was there
evidence at that point that the bond would or could go bad? As a member of the board this would
appear highly likely.
Kay and Andrew should consider reporting the matter to the company’s money laundering
compliance principal (MLCP) and possibly discussing their concerns with a non-executive director.
Advice from ICAEW can also be taken regarding their own positions considering they are both
chartered accountants.
Razak’s consolidated statement of financial position at 30 September 20X2
Razak
Assulin
Adjs.
Consol.
£’000
£’000
£’000
£’000
8,826
8,826
FV
adjustment
1,400 – 140
10,720
Goodwill
W3
Non-current assets
Property, plant and
equipment
6,000
Investment in Assulin
9,325
(9,325)
800
(800)
1,193
(503) (W6)
Loan to Assulin
Other financial assets
3,460
690
W6
17,318
Current assets
Inventories
Receivables
Bank
Total assets
ICAEW 2022
1,255
610
1,865
960
400
1,360
0
70
70
2,215
1,080
–
3,295
19,533
4,540
(542)
23,531
Financial reporting 2
343
Razak
Assulin
Adjs.
Consol.
£’000
£’000
£’000
£’000
£1 ordinary shares
2,800
500
Share premium account
7,400
Retained earnings
2,510
Equity
Other components of equity
(500)
2,800
7,400
2,740
750
NCI
(2,740)
(529)(W5)
1,981
W5
300
1,050
W5
2,012
2,012
W4
1,715
1,641 + 74
(unwinding
6/12 months)
13,460
Non-current liabilities
Contingent consideration
Other
1,715
2,788
Loan from Razak
2,788
800
(800)
Current liabilities
Bank overdraft
1,220
Trade payables
865
290
1,155
1,200
210
1,410
3,285
500
19,533
4,540
Tax payable
Total equity and liabilities
1,220
–
(542)
3,785
23,531
Consolidated statement of financial position
£’000
Non-current assets
Goodwill
Property, plant and equipment
Other financial assets
8,826
10,720
690
Current assets
Inventories
1,865
Receivables
1,360
Bank
70
Total assets
23,531
Equity
£1 ordinary shares
2,800
Share premium account
7,400
Retained earnings
3,031
Non-controlling interests
2,012
344
Corporate Reporting
ICAEW 2022
£’000
Non-current liabilities
Contingent consideration
1,715
Other
2,788
Current liabilities
Bank overdraft
1,220
Trade payables
1,155
Tax payable
1,410
Total equity and liabilities
23,531
WORKINGS
(1) Group structure
Razak’s shareholding has increased from 15% to 80% therefore the investment should now be
accounted for as a subsidiary.
(2) Net assets
SFP
Acquisition
£’000
£’000
500
500
Retained earnings
2,740
2,540
Fair value adjustment
1,400
1,400
(140)
––––––
4,500
4,440
Share capital
Depreciation (six months)
Total
Since acquisition (4,500 – 4,440)
60
(3) Goodwill
£’000
Original cost of 15% shares in Assulin
450
Revalue 15% shareholding to £16 per share at 30 Sept 20X1 through OCI/OCE
750
Revalue 15% shareholding to £20 per share at 31 March 20X2
300
Cost of 325,000 shares at £25 per share 31 March 20X2
8,125
Contingent consideration (£6 × 325,000 DCF 9% 2 years)
1,641
NCI at acquisition 100,000 shares × £20 per share
2,000
Total
13,266
Less net assets at acquisition including FV adjustment (W2)
(4,440)
Goodwill at acquisition
ICAEW 2022
8,826
Financial reporting 2
345
(4) Non-controlling interest
£’000
At acquisition
2,000
Profit share of Assulin since acquisition (60 × 20%)
12
Total
2,012
(5) Reserves
Retained earnings
Razak per draft
£’000
£’000
2,510
750
Revalue 15% shareholding in Assulin at 31 March 20X2 (W3)
300
Unwinding of contingent payment
(74)
80% of Assulin’s profit since acquisition (60 × 80%)
48
Imposter – net adjustments
(529)
(503)
––––––
–––––
1,981
1,050
Total
(6) Imposter bond
Loan receivables (gross carrying amount)
£
At 1 October 20X1
Finance income (7.5% × 1,200,000)
1,200,000
90,000
Cash received
At 30 September 20X2
(–)
1,290,000
Allowance for credit losses
At 1 October 20X1 (Stage 1) (12-month expected credit losses)
£
7,000
Finance cost (unwind discount) (7.5% × 7,000)
525
7,525
Finance cost (increase in allowance)
592,475
At 30 September 20X2 (Stage 2) (Lifetime expected credit losses)
600,000
Value of bond at 30 September 20X2, net of allowance: £(1,290,000 – 600,000) = £690,000
Therefore adjustment = £1,193,000 – £690,000 = £503,000.
Adjustments are required to retained earnings as follows:
£
Finance income (7.5% × 1,200,000)
Finance cost (unwind discount) (7.5% × 7,000)
346
90,000
(525)
Finance cost (increase in allowance)
(592,475)
Net
(503,000)
Corporate Reporting
ICAEW 2022
Proposed pension plan
Razak wishes to account for its proposed pension plan as a defined contribution scheme, probably
because the accounting is more straightforward and the risk not reflected in the figures in the
financial statements. However, although the entity’s proposed plan has some features in common
with a defined contribution plan, it needs to be considered whether this is really the case.
With defined contribution plans, the employer (and possibly, as proposed here, current employees
too) pay regular contributions into the plan of a given or ‘defined’ amount each year. The
contributions are invested, and the size of the post-employment benefits paid to former employees
depends on how well or how badly the plan’s investments perform. If the investments perform well,
the plan will be able to afford higher benefits than if the investments performed less well.
With defined benefit plans, the size of the post-employment benefits is determined in advance ie,
the benefits are ‘defined’. The employer (and possibly, as proposed here, current employees too) pay
contributions into the plan, and the contributions are invested. The size of the contributions is set at
an amount that is expected to earn enough investment returns to meet the obligation to pay the
post-employment benefits. If, however, it becomes apparent that the assets in the fund are
insufficient, the employer will be required to make additional contributions into the plan to make up
the expected shortfall. On the other hand, if the fund’s assets appear to be larger than they need to
be, and in excess of what is required to pay the post-employment benefits, the employer may be
allowed to take a ‘contribution holiday’ (ie, stop paying in contributions for a while).
The main difference between the two types of plans lies in who bears the risk: if the employer bears
the risk, even in a small way by guaranteeing or specifying the return, the plan is a defined benefit
plan. A defined contribution scheme must give a benefit formula based solely on the amount of the
contributions.
Razak’s scheme, as currently proposed, would be a defined benefit plan. Razak, the employer, would
guarantee a pension based on the average pay of the employees in the scheme. The entity’s liability
would not be limited to the amount of the contributions to the plan, but would be supplemented by
an insurance premium which the insurance company can increase if required in order to fulfil the
plan obligations. The trust fund which the insurance company builds up, is in turn dependent on the
yield on investments. If the insurer has insufficient funds to pay the guaranteed pension, Razak has to
make good the deficit. Indirectly, through insurance premiums, the employer bears the investment
risk. The employee’s contribution, on the other hand is fixed.
A further indication that Razak would bear the risk is the provision that if an employee leaves Razak
and transfers the pension to another fund, Razak would be liable for, or would be refunded the
difference between the benefits the employee is entitled to and the insurance premiums paid. Razak
would thus have a legal or constructive obligation to make good the shortfall if the insurance
company does not pay all future employee benefits relating to employee service in the current and
prior periods.
In conclusion, even though the insurance company would limit some of the risk, Razak, rather than its
employees, would bear the risk, so this would be a defined benefit plan.
13 Melton plc
Marking guide
Up to 1 mark for each valid point
Appropriate ratios and comparatives
Other points
Up to 1 mark for each valid point
Up to 1 mark for each valid point
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347
Notes for meeting of investment team
Diluted earnings per share
Information that helps users of financial statements make predictions of future earnings and cash
flows is very useful. The diluted EPS disclosure provides additional information regarding the future
of the basic EPS amount, in that it relates current earnings to a possible future capital structure.
Where financial instruments have been issued by a company which will potentially lead to the issue
of further new equity shares, the earnings will be shared by more equity shares. In some cases
earnings themselves will be directly affected by the issue of the shares, in other cases, they will not.
The diluted EPS figure shows how the current earnings of the company, as adjusted for any profit
effect of the issue of the new shares, would be diluted, or shared out amongst the future, potential
new shares as well as the current shares. This gives the current shareholders an idea of the effect that
these dilutive financial instruments could have on their shareholding in the future.
However, there are limitations to the use of these figures:
•
The diluted EPS is based upon the current earnings figure, as adjusted for any profit effect of the
issue of the new shares. This earnings figure may not be relevant in future years. What is more
important is the level of earnings at the time conversion actually takes place.
•
Also, the calculation assumes a worst case scenario, that all potential diluting financial instruments
will be exercised. It may be that future events do not unfold like this. For example, holders of
convertible debt may choose to redeem rather than convert their debt or share options issued
may lapse if the holders leave the company or there are adverse future movements in the share
price.
The diluted EPS is therefore a ‘warning’ to existing shareholders about potential future events. It is
not a forecast of future earnings. Shareholders often find it helpful to calculate the P/E ratio based on
diluted EPS to show the potential valuation effects.
Analysis of performance of Melton plc
Further ratios could be calculated. For example:
20X7
20X6
Operating profit % (3,200 as % of 37,780) and (2,610 as % of 29,170)
8.5%
8.9%
Gross profit – existing outlets (87 as % of 354) and (83 as % of 343)
24.6%
24.2%
Gross profit – new outlets (69 as % of 256)
26.9%
–
Administration expenses % (6,240 as % of 37,780) and (4,480 as % of
29,170)
16.5%
15.4%
Depreciation and amortisation as % of (cost of sales + administration
expenses) – (3,060 as % of (28,340 + 6,240)) and (2,210 as % of (22,080
+ 4,480))
8.8%
8.3%
Interest cover (3,200/410) and (2,610/420)
7.8 times
6.2 times
Cash interest cover (6,450/410) and (4,950/440)
15.7 times
11.3 times
Cash generated from operations as % of operating profit (6,450 as % of
3,200) and (4,950 as % of 2,610)
202%
190%
EBITDA/interest expense (6,260/410) and (4,820/420)
15.3 times
11.5 times
P/E ratio (302/26.8) and (290/21.3)
11.3 times
13.6 times
P/E ratio (based on diluted EPS) (302/21.2) and (290/19.2)
14.2 times
15.1 times
Performance ratios
Cash flow and liquidity ratios
Investor ratios
(Credit will be given for other ratios; the basis of the calculation should be given.)
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Introduction
A first look at the information indicates that the group has grown significantly during 20X7. Revenues
have increased by 29.5% ((37,780/29,170) – 1) and operating profits by 22.6% ((3,200/2,610) – 1).
However, the additional information shows that there have been structural changes in the business
with a 35% ((30/(115 – 30)) – 1) increase in the number of outlets that have opened. These structural
changes will need to be considered in determining the performance of the business.
A review of the statement of cash flows shows strong operating cash flows. However, these cash flows
are being reinvested in new outlet openings (through capital expenditure). The group’s objective is
to limit its new debt financing but this may be hindering the availability of distributions to investors.
Profitability
Revenue has grown by 29.5% during the year. For existing outlets (those open at 30 September
20X6) growth during the year has been 3.0% ((354/343) – 1). The real rate of growth may be lower
than this as some outlets may have only been open for part of the previous year (ie, 20X7 is first full
year of opening).
This rate of ‘organic’ growth is disappointing and below the sector average of 4.1%. It may be that
Melton only operates in a part of this sector which has a different growth rate that management are
concentrating on new outlets.
Gross profit margins have grown year on year from 24.3% to 25.0%. However, the segmental analysis
shows that gross margins from existing outlets have only improved marginally to 24.6% and the new
outlets have far better gross margins at 26.7%. This could be due to:
•
the locations of the new outlets in more profitable sites;
•
strong promotional activities of new outlets in their initial phase;
•
older outlets require refitting or advertising support; or
•
management focusing on new outlets to the detriment of older ones.
Revenue per employee has grown from £37,900 to £41,100. This is an increase of 8.4%. This is
significant as wage costs will be a major cost for the business. It may be that new working practices
have reduced employee numbers or that staff numbers (eg, admin) do not increase linearly with the
number of outlet openings.
Administration costs as a percentage of revenue have increased significantly from 15.4% to 16.5%.
These costs have increased by approximately £1.8 million. The list of key issues for Melton did not
mention operating costs and this may not have been the focus of management’s attention.
Alternatively, investment in administration may have been made with a view to further expansion.
Melton has a reputation for ‘under depreciating’ assets. Some support for this is indicated by the
losses on disposal in both years (see statement of cash flows). The depreciation rates are
inconsequential when considering the cash flow which is strong (see below). Depreciation is 8.8% of
the total of costs of sales and administrative expenses but it is growing significantly (up from 8.3%
and from £2.21 million to £3.06 million) and any future change in estimates could significantly affect
profit.
EBITDA has improved significantly, mainly because of better absolute profit figures due to the
continuing expansion. EBITDA is strong and confirms the strong cash flows (see below).
The return on capital employed (ROCE) has improved from 19.1% to 20.0% giving the indication that
the overall efficiency of management in employing the resources of the group has improved.
Operating cash flows are strong and net capital employed has only increased by a small amount as
the capital expenditure is almost covered by the operating cash flow. Resources have been well
managed. However, this should be viewed against the fact that no dividend has been paid.
Non-current asset turnover supports the assertion that management have managed the assets well. It
has improved and the assets have been sweated harder.
Interest costs in the statement of profit or loss have reduced slightly (by £10,000) but the statement
of cash flows shows that net debt (new borrowings less cash increase) has increased. This may be a
result of the timing of the cash flows (in particular capital expenditure and new outlet openings)
during the year.
Cash flow (and changes in financial position)
The improvement in ROCE is supported by the increase in the cash return on capital employed to
40.2%. As expected it is higher than traditional ROCE as that ratio takes into account depreciation
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and amortisation. The cash return on capital employed suggests that cash flow is strong and capital
has been well managed. It appears that the objective of funding growth from existing cash flows is
being achieved and this is having a positive effect on performance statistics.
This is supported by the interest cover (7.8 times), which demonstrates the strong financial position
and the possibility of further growth through borrowing if necessary.
Other measures of interest are also strong – cash interest cover is 15.7 times and EBITDA/interest is
15.3 times. Both have improved as new outlet openings have improved operating cash flows whilst
net debt has not changed significantly.
The cash flows show that the quality of operating profits is strong. Cash generated from operations
as a percentage of profit from operations is over 200% and improving year on year. The concerns
about depreciation should only improve this ratio if depreciation increased.
The current ratio is low at 0.56 times but this may not be unusual in an industry where customers will
pay cash for their products and cash flow will be almost immediate. However, cash is high, and
probably inventory, which may indicate a high payables balance.
The trade payable period has fallen but the absolute amount of trade payables has increased. This
will be due to the expansion of the business. Trade payables will be principally for sourcing goods
and possibly lease rentals. It may be due to changes in payment patterns as the number of outlets
expand.
Investor ratios
EPS has grown by 25.8% ((26.8/21.3) – 1) but diluted EPS has only increased by 10.4% ((21.2/19.2) –
1). This is potentially a concern. There appear to be some diluting instruments in issue that are having
a potential adverse effect on future earnings. This could affect the future movements in market price.
The P/E ratio has fallen. This may be in line with general trends in share prices or may be as a result of
investor disappointment. The company is not paying a dividend and investors may be unhappy
about this. The policy of reinvestment of cash flows limits dividend payments without taking on more
debt.
Further matters for investigation
•
Further analysis of revenue – is there true ‘like for like’ growth and what was the timing of the
outlet openings in the prior year?
•
Locations of new outlet openings and product offerings to understand the higher margins on new
against older outlets.
•
Non-current asset disclosure information – to determine the depreciation and amortisation
policies and quantify the potential effect of any differences from industry averages.
•
Analysis of capital expenditure between expenditure on existing and new outlets to determine
profile of ongoing replacement expenditure required by the business.
•
Dividend policy – shareholders will undoubtedly demand a return on their investment. The
operating and financial review may indicate dividend and financing policy.
•
Details of future outlet openings and planned levels of capital expenditure.
•
An analysis of employee numbers by function and details of any changes in working practices to
understand the strong increase in revenue per employee.
•
Details of administration costs changes – are there any non-recurring items disclosed in the notes
or any details of costs in the Operating & Financial Review/Management Commentary?
•
Details of the tax charge and the tax reconciliation should be reviewed in the notes to the financial
statements to understand why it is low (21.9% (610 as % of 2,790)) and the year on year change.
•
Receivables have increased significantly. As almost all sales will be for cash, this needs
investigation.
•
Details of the potential diluting financial instruments (terms, timing etc) that may affect future EPS.
Payment of dividend
Distributable profits (the profits that are legally distributable to investors) are determined as the
accumulated realised profits less accumulated realised losses of an entity. Generally they equate to
the retained earnings of an entity.
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However, the legality of a dividend distribution is determined by the distributable profits in the
separate financial statements (of a single company) rather than by the consolidated retained
earnings.
A company may have a debit balance on its consolidated retained earnings (for example due to
losses in subsidiaries) but it may have a credit balance on its own retained earnings which would
allow the payment of a dividend to the parent company’s shareholders.
In addition, a public company may not make a distribution if this reduces its net assets below the
total of called-up share capital and undistributable reserves. In effect any net unrealised accumulated
losses must be deducted from the net realised accumulated profits.
The colleague’s comment is incorrect and further investigation is needed to determine why no
dividends have been paid or proposed.
Proposed sale of stake in R.T. Café
The director proposes to sell 2,000 of Melton’s 8,000 shares in R.T. Café, which has a share capital of
10,000 shares, in January 20X8. In doing so it would be selling a 20% shareholding and going from
an 80% stake to a 60% stake. R.T. Café would remain a subsidiary. In substance, under IFRS 3,
Business Combinations there would be no disposal. This is simply a transaction between group
shareholders, with the parent (Melton) selling a 20% stake to the non-controlling interest.
The transaction would be dealt with by increasing the non-controlling interest in the statement of
financial position, which has effectively doubled from 20% to 40% and recording an adjustment to
the parent’s equity.
The formula used to calculate the adjustment to equity at disposal is:
£’000
Consideration received
X
Increase in NCI on disposal
(X)
Adjustment to parent’s equity (to be credited to group retained earnings)
X
Since the adjustment is recognised in retained earnings rather than profit for the year, there would
be no impact on earnings per share.
14 Aroma
Marking guide
Financial performance discussion and ratios
Growth
Profitability
Efficiency
Financial position discussion and ratios
Liquidity
Working capital management
Solvency
Conclusion and recommendation
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Introduction
The aim of this report is to analyse the financial performance and position of Aroma and determine
whether or not it would make a good investment.
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351
Financial performance
Growth
Revenue has increased by an impressive 62% in the year. This is largely due to the newly appointed
sales director’s actions:
(1) Setting up a new online store which has been trading for the last 14 months – even though this is
a new venture, it generated 18% of Aroma’s total revenue in the year ended 30 June 20X1.
(2) Securing a lucrative deal with a boutique hotel chain to manufacture products for the hotel. This
new contract generated 15% of total revenue in the year ended 30 June 20X1, even though it
had only been in place for six months, and can therefore be expected to generate twice as much
revenue in future years. In addition, with the sales director’s contacts, other such deals could be
won in the future, so generating further growth in revenue.
Profitability
Gross margin has improved slightly from 30% in the year ended 30 June 20X0 to 32% in the year
ended 30 June 20X1. An analysis of the margins of the three different business areas reveals that the
improvement is largely due to the strong margin of 43% on the new hotel contract. This could be due
to a mark-up on the sales price for the right of the hotel chain to use its own name and logo on
Aroma’s products. Aroma needs to ensure that it does not lose its own brand strength by allowing
others to put their name to Aroma products.
Net margin has also improved from 8.3% to 9% despite the increase in finance costs due to reliance
on an overdraft in the current year and an increase in long-term borrowings. This is largely due to the
online store generating the strongest margin of 12.6%. The overheads associated with running an
online business are likely to be lower than those associated with operating retail stores from
expensive premises. Furthermore, set-up costs incurred by the online part of the business would
have been recognised in the year ending 30 June 20X0, causing that year’s net margin to be low.
The net margin of the hotel contract part of the business is 9.1% in the year ended 30 June 20X1.
This contract is relatively new and initial legal and other costs will be included in this segment’s costs.
This margin may be expected to improve in the future.
The online store and new hotel contract have been successful initiatives in terms of growing revenue
and increasing both absolute profit and margins.
Aroma could improve their overheads cost control though as administration expenses have
increased by 111% in the year. As discussed, this may be the result of the initial costs of the new hotel
contract, however a detailed breakdown of costs would be required in order to establish whether
this were, in fact, the case.
Distribution costs have increased by 30%; this is proportionately lower than the increase in revenue.
This may be because online customers are required to pay their own postage and packing and
therefore the increase in revenue associated with this part of the business does not result in a
corresponding increase in distribution costs.
Efficiency
Aroma’s efficiency in using its assets to generate both revenue and profit has improved as illustrated
by asset turnover increasing from 1.91 to 2.84 and return on capital employed from 21.8% to 33.3%.
This can be attributed to improved margins (see above).
Financial position
Liquidity
The current ratio has declined slightly from 4.05 to 3.98 – this is largely due to reliance on an
overdraft in the current year and reduced receivable and inventory days.
However, the quick ratio has increased from 0.93 to 1.06 largely due to paying suppliers more
quickly (32 days compared to 53 days).
Overall though, Aroma can easily afford to pay its current liabilities out of its current assets. However,
long-term reliance on an overdraft is both risky as the overdraft facility could be withdrawn at any
time (especially in light of the bank’s recent rejection of Aroma’s request for additional funds) and
expensive.
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Working capital management
Inventory days have decreased from 166 days to 113 days indicating that Aroma is selling their
inventories more quickly. This could be to meet the increased demand from the new online store and
the new hotel contract, or it may be to release some cash since the overdraft has not been extended.
Inventory days remain high though – presumably this is due to the nature of the products (perfumes,
lotions and candles) having a long shelf-life. If the development costs result in new improved
products, there is a risk of obsolescence amongst the existing products.
Receivable days are low as expected when the majority of the sales are from retail stores where the
customers pay in cash. Aroma is now only taking 28 days on average to collect cash from its credit
customers as opposed to 31 days in the prior year. It may be that favourable credit terms have been
negotiated with the hotel chain.
Interestingly, Aroma is paying its suppliers more quickly in 20X1 ie, taking on average 32 days as
opposed to 53 days in 20X0. This seems inadvisable given that a significant overdraft has arisen in
the current year. Aroma should take full advantage of the credit period offered by their suppliers. It
may be that they are sourcing from a new supplier with stricter credit terms to fulfil the hotel contract.
Solvency
Even though the bank is refusing further funding, Aroma’s gearing, despite a small increase in the
year, remains at a manageable level (38% in the current year). Furthermore, Aroma can easily afford
to pay the interest on its debt as illustrated by an interest cover of 13.6 in the current year.
Conclusion
On initial analysis, there seems to be a strong case for investing in Aroma. The business is growing
and innovative having just expanded into two new areas with the online store and new hotel contract
due to the skills of the new sales director. It is also profitable and the profitability is improving year on
year. Perhaps the only concern is reliance on the overdraft but this can be resolved by improving
working capital management and ensuring that the full credit period of suppliers is taken advantage
of. With further new initiatives from the sales director such as new contracts with other hotel chains
and further growth of online sales, there is potential for even more growth in the future.
One issue to raise, however, is whether the owner-managers are using a cash investment – and have
tried to increase the overdraft – in order to pay themselves excessive dividends. However profitable
the company, this needs clarification before any investment is made.
Appendix
20X1
20X0
Return on capital employed =
PBIT/(Debt + Equity – Investments)
(540 + 43) ÷ (412 + 68 +
1,272) = 33.3%
(307 + 34) ÷ (404 + 1,160) =
21.8%
Asset turnover = Revenue/total
assets
6,000 ÷ 2,115 = 2.84
3,700 ÷ 1,942 = 1.91
Gross margin = Gross
profit/Revenue
1,917 ÷ 6,000 = 32.0%
1,110 ÷ 3,700 = 30%
Gross margin of retail operations
1,200 ÷ 4,004 = 30.0%
Gross margin of online store
330 ÷ 1,096 = 30.1%
Gross margin of hotel contract
387 ÷ 900 = 43%
Operating profit margin =
PBIT/Revenue
(540 + 43) ÷ 6,000 = 9.7%
(307 + 34) ÷ 3,700 = 9.2%
Net margin = PBT/Revenue
540 ÷ 6,000 = 9%
307 ÷ 3,700 = 8.3%
Net margin of retail operations
320 ÷ 4,004 = 8.0%
Net margin of online store
138 ÷ 1,096 = 12.6%
Net margin of hotel contract
82 ÷ 900 = 9.1%
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353
20X1
20X0
Current ratio = Current
assets/Current liabilities
1,715 ÷ 431 = 3.98
1,532 ÷ 378 = 4.05
Quick ratio = (Current assets –
Inventories)/Current liabilities
(1,715 – 1,260) ÷ 431 = 1.06
(1,532 – 1,180) ÷ 378 = 0.93
Inventory days = (Inventories/Cost
of sales) × 365
(1,260 ÷ 4,083) × 365 = 113
days
(1,180 ÷ 2,590) × 365 = 166
days
Receivable days =
(Receivables/Revenue) × 365
(455 ÷ 6,000) × 365 = 28
days
(310 ÷ 3,700) × 365 = 31 days
Payable days = (Payables/Cost of
sales) × 365
(363 ÷ 4,083) × 365 = 32
days
(378 ÷ 2,590) × 365 = 53 days
Gearing = Debt/Equity
(412 + 68) ÷ 1,272 = 38%
(404 – 42) ÷ 1,160 = 31%
Interest cover = PBIT/Interest
expense
(540 + 43) ÷ 43 = 13.6
(307 + 34) ÷ 34 = 10.0
15 Kenyon
Marking guide
Financial performance discussion and ratios
Profitability
Earnings per share
Contingent liability
Pension
Financial position discussion and ratios
Liquidity
Working capital management
Conclusion and recommendation
Contingent liability – impact on ratios
Contingent liability – further information
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Analysis
Introduction
This is an analysis of the financial performance and position of Kenyon plc (an operator of bottling
plants) for the year to 31 October 20X1 in the context of whether or not it would make a good
investment.
Financial performance:
Kenyon plc’s revenue has grown in the year by 43%. This is due to a combination of increased
volume of sales to existing customers and a new contract secured at the start of the year.
This increased volume has not been at the cost of profitability, which has improved in the year with
return on capital employed increasing from 26% to 48%. This is due to both improved efficiency in
using non-current assets to generate revenue (non-current asset turnover has increased from 1.34 to
1.74) and improved margins (see below).
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Kenyon plc’s gross profit margin has improved from 32% to 40% implying an improvement in how
Kenyon management is running its core operations. This could well be due to a higher selling price
under the new contract compared to the existing contracts. Alternatively there may have been some
production efficiencies.
The operating profit margin has improved in line with the gross margin (32% in 20X1; 24% in 20X0).
However administration expenses have increased by more proportionately than other expenses or
revenue implying some cost control issues with overheads.
The investment in the associate partway through the year was a good investment, generating a
return of 12.5%, (7/56).
The investment income has declined significantly in the year in relation to the falling cash balance.
The fall in the cash balance is discussed below.
The earnings per share has improved from 31 pence to 58.7 pence in line with the improved
profitability above. However, although the share price has increased in absolute terms from £2.80 to
£4.90, the P/E ratio has deteriorated from 9.03 to 8.35. This implies decreased market confidence in
Kenyon plc despite its increased volume and profitability. This is likely to be for two main reasons:
(1) There is a contingent liability relating to a court case pending against Kenyon plc as a result of a
chemical leak shortly before the year end. The lawyers believe that Kenyon plc is likely to lose
the case but the amount of potential damages cannot be reliably estimated. The decline in P/E
ratio indicates that the market is concerned about the impact that the loss of this case could have
on the future profitability of Kenyon plc. In a worst case scenario, Kenyon plc’s going concern
could be called into doubt.
(2) The net pension liability which must relate to a defined benefit pension scheme has increased
from £5 million to £38 million indicating a serious deficit in the scheme. This will undoubtedly
result in increased contributions in the year ended 31 October 20X2, however, the amount is
unknown. This is another uncertainty likely to have an impact on the share price.
A cash-seeking investor would have been happy with the £100 million dividend paid in 20X1 (57% of
profit for the year).
Financial position
There has been a significant decline in liquidity in the year as illustrated by the fall in the quick ratio
from 1.64 to 0.79 and the fall in the cash balance from £60 million to £3 million. Arguably Kenyon plc
were wrong to keep such a large balance of cash in 20X0 as better returns could usually be earned
elsewhere. This could be the reason for the investment in the associate in 20X1 which is generating a
healthy 12.5% return. Kenyon plc has also invested in non-current assets in the year which will be
good for future growth.
Working capital management has deteriorated slightly. Inventory days have nearly doubled from 46
to 79 days. This could be deliberate in terms of building up inventory levels to meet increased
demand from existing and new contracts. However, Kenyon plc will be incurring significant holding
costs and there is a risk in light of bad publicity from the court case, that Kenyon plc will be unable to
sell all of the inventory, resulting in a write down.
Receivable days have seen a slight increase from 38 days to 40 days but it seems that Kenyon plc’s
credit control function is working efficiently. It may be that longer than standard credit terms were
awarded under the new contract.
Payable days have increased from 76 to 88 days. Whilst it is advisable to take advantage of free
credit, Kenyon plc must be careful not to alienate their suppliers as it could ultimately result in
withdrawal of credit or even supplies.
Conclusion
Kenyon plc’s growth and profitability make it an attractive investment proposition. However, there are
two significant uncertainties making it a risky investment:
•
A pending court case which Kenyon plc is likely to lose.
•
A large pension deficit and future contributions to make good the deficit are uncertain.
It would be advisable to wait until the amount of likely damages from the court case and the increase
in contributions to the pension scheme are known before making a final decision on whether or not
to invest.
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355
Best and worst case potential impact of the contingent liability
The lawyers have estimated the potential damages as being between £7 million and £13 million. The
amount cannot be measured reliably, as there is no information available as to the likelihood of
either outcome. However, it might be useful to consider the best and worst case scenarios of the
potential impact on selected key ratios.
The results (see Appendix) can be summarised as follows:
Ratio
No liability
recognised
Liability of £13m
recognised
Liability of £7m
recognised
ROCE
48%
46%
47%
Operating margin
32%
30%
31%
EPS
58.7p
54.3p
56.3p
The potential effect on profitability ratios is only slight, with ROCE decreasing by 2% if the liability is
£13 million and only 1% if it is £7 million and the operating margins showing the same variation. The
fall in EPS is proportionally greater, but not such as to deter an investor. The main concern is as yet
unquantifiable, and relates to the bad publicity that could arise from the negative outcome of the
court case, and the potential future effect on sales.
Further information regarding the contingent liability
•
The report resulting from the investigation into the potential environmental damage from the
chemical spill to try and ascertain the likelihood of Kenyon plc losing the case and the possible
damages they might have to pay.
•
Whether the chemical leak caused damage to the buildings, machinery and inventories and
whether a write down was needed at the year end and if so, for how much?
•
How the incident has been reported in the press to ascertain the potential damage toKenyon
plc’s reputation and subsequent loss of business?
•
Post year-end sales orders to ascertain potential loss of business as a knock-on effect from the
spill.
•
Whether the plant has been repaired and is still in working order to ascertain ability to keep
operating at the same capacity in the future.
•
Whether safeguards have been put in place to prevent it from happening again/in other plants.
•
Details of the length of the new contract, other contracts in place which expire soon and future
contracts under negotiation.
Appendix
Key ratios (excluding potential impact of contingent liability)
All workings in £m
20X1
20X0
ROCE = PBIT ÷ (Equity + Debt –
Investments
(221 – 1 – 7) ÷ (465 + 38 – 56)
= 48%
(117 – 6) ÷ (432 +5) = 26%
Gross margin = Gross
profit/Revenue
268/663 = 40%
148/463 = 32%
Operating margin = Operating
profit/Revenue
(221 – 1 – 7) ÷ 663 = 32%
(117 – 6) ÷ 462 = 24%
EPS = Profit for year/Weighted
average no of equity shares (Note:
50 pence shares)
176/300 = 58.7p
93/300 = 31p
P/E ratio = Price per share/EPS
490/58.7 = 8.35
280/31 = 9.03
Non-current asset turnover =
Revenue/Non-current assets
663/381 = 1.74
463/346 = 1.34
356
Corporate Reporting
ICAEW 2022
All workings in £m
20X1
20X0
Quick ratio = (Current assets –
Inventories)/Current liabilities
(161 – 86)/95 = 0.79
(148 – 40)/66 = 1.64
Inventory days = Inventory/Cost of
sales × 365
86/395 × 365 = 79 days
40/315 × 365 = 46 days
Receivable days =
Receivables/Revenue × 365
72/663 × 365 = 40 days
48/463 × 365 = 38 days
Payable days = Payables/Cost of
sales × 365
95/395 × 365 = 88 days
66/315 × 365 = 76 days
Selected key ratios (including potential impact of contingent liability)
All workings in £m
Damages of £13m
Damages of £7m
ROCE = PBIT ÷ (Equity + Debt –
Investments
(221 – 1 – 7 – 13) ÷ (465 – 13 +
38 – 56) = 46%
(221 – 1 – 7 – 7) ÷ (465 – 7
+ 38 – 56) = 47%
Operating margin = Operating
profit/Revenue
(221 – 1 – 7 – 13) ÷ 663 = 30%
(221 – 1 – 7 – 7) ÷ 663 =
31%
EPS = Profit for year/Weighted
average no of equity shares
176 – 13/300 = 54.3p
176 – 7/300 = 56.3p
(Note: 50 pence shares)
ICAEW 2022
Financial reporting 2
357
358
Corporate Reporting
ICAEW 2022
Audit and integrated 1
16 Dormro
Scenario
The candidate has recently assumed responsibility for the audit of Dormro Ltd and its consolidated
financial statements. Dormro heads a group of companies which supply security surveillance
systems. An assistant has completed work on the parent company and consolidation. The candidate
is asked to brief the audit manager on the status of the audit work, and potential issues arising and
additional information required from the client. An overseas subsidiary company has been acquired
during the year, audited by another firm overseas which raises technical audit issues regarding the
audit approach and the application of ISA 600 (UK) (Revised November 2019). In addition, the
candidate is required to prepare a revised statement of financial position incorporating the new
subsidiary.
The candidate is required to review the junior assistant’s work papers identifying potential audit
adjustments. The financial reporting requirement is therefore embedded within the exhibits. The
candidate must identify potential financial reporting errors, including the correction of an accounting
error (incorrect treatment of intragroup balances), incorrect application of a financial reporting
standard (treatment of loan under IFRS 9) and the identification of embedded potential financial
reporting adjustments arising from the scenario (understatement of provisions for warranty and
inventory). There is also the potential non-compliance with IFRS with respect to the recognition of fair
value adjustments on the acquisition of CAM. The candidate needs to identify whether there is
sufficient information to propose an adjustment or whether further enquiries are required to
determine the appropriate accounting treatment.
A successful candidate will understand fully the principles and mechanics of a consolidation and be
able to identify issues from the information provided. The scenario also tests the candidate’s ability to
determine what is significant to a group (as opposed to an individual subsidiary) audit and to
consider wider implications across the group of issues identified at a particular subsidiary.
Marking guide
Marks
Issues and potential adjustments
Additional audit procedures
20
10
Revised consolidated statement of financial position including Klip
Marks Available
14
44
Maximum
40
Total
40
Work paper for the attention of audit engagement manager
Introduction
The purpose of this work paper is to identify and explain the issues which may give rise to an
adjustment or an indication of a significant audit risk in the group accounts and additional audit
procedures to enable FG to sign off the Dormro group accounts. The work paper also includes a
revised consolidated statement of financial position at Appendix, reflecting an adjustment for the
accounting treatment of the £8 million loan and the acquisition of Klip.
Investments (Notes 1 and 2)
Issues and potential adjustments
•
The work of the audit senior is inadequate and this in itself presents a risk for the firm. The
insufficient audit procedures performed have a direct impact on the audit opinion. Agreeing a
£10 million investment to bank statement alone is clearly inadequate.
•
The audit senior has failed to identify a subsidiary requiring consolidation and this will require
adjustment – see below.
ICAEW 2022
Audit and integrated 1
359
•
CAM appears to have an investment which has not been considered further. The amount is
immaterial (£15,000) but it should be determined whether this is a trade investment or an
investment in a subsidiary or associate whose results should be included in the group accounts.
Further information on the nature of this investment and a determination of subsidiary/associate
treatment are required so that the need for, and materiality of, any adjustment can be fully
assessed.
•
The consolidation entries for the acquisition of CAM seem very simplistic and may not comply
with IFRS. No fair value exercise appears to have been carried out at the date of acquisition and
the difference between the net assets in CAM and the acquisition price has been posted to
goodwill. There may be elements which should be allocated to intangibles. There may be
consequential effects on performance for the year because of amortisation of the identified
intangibles.
•
In addition, costs and revenues for CAM have been assumed to occur evenly throughout the year
which may not be the case, especially as CAM is clearly a growing company. Given materiality of
CAM’s results and goodwill balance, adjustments here could clearly be material. Further enquiries
are required.
Additional audit procedures
Detailed reviews of the audit senior’s work should be carried out by an appropriate member of the
audit team to ensure no further inadequacies in the senior’s work.
The sale and purchase agreement for CAM and for Klip should be reviewed to ensure there is no
additional consideration payable, or adjustments required (for example, in respect of inventories and
warranties). Also evidence of ownership of shares through examination of share certificates must be
confirmed in particular it is important to check that ownership of CAM is 100% as has been assumed
in consolidation entries.
Need to enquire as to how any costs related to the acquisition of CAM have been treated as these do
not appear to have been included within the investment value.
Audit work on the acquisition of CAM should be performed to substantiate that no fair value
adjustments are required and to identify separate intangible assets, if any. An expert valuer may be
required to assess this, unless an exercise was carried out at the time of the acquisition. Also,
consideration should be given to whether adjustments should be made at the acquisition date for
the application of group policies.
Need to obtain management accounts or other evidence which give a more precise analysis of the
split between pre and post-acquisition results. Likely to be significant additional work to do in
auditing this once this information is available.
Consolidation schedules are at summarised level. Work should be performed on the detailed
disclosures within group accounts.
Work done on consolidation adjustments comprises largely a description of the adjustment. Need to
ensure that the amounts of the adjustments and the accounts to which they have been posted have
been substantiated by agreement to individual company results or other supporting documentation.
Need to confirm that Dormro has not issued any shares in year through reviewing Board meeting
minutes and documents filed at Companies House. Review of Board minutes and legal
correspondence for the holding company are important tests which do not appear to have been
performed/documented.
Intragroup balances and transactions (Note 3)
Issues and potential adjustments
•
There is a difference on the intragroup balances which has been written off to profit or loss. Need
to investigate further the difference on intragroup balances as the current treatment may be
incorrect.
•
There does not appear to be any consolidation entries to eliminate intragroup sales and
purchases. Given that all group companies operate in similar sectors, it seems unlikely that the
only intragroup trading is management recharges so consolidation entries may well be
incomplete.
360
Corporate Reporting
ICAEW 2022
Additional audit procedures
FG needs to enquire further into the nature of intragroup trading to ascertain whether further
adjustment to eliminate intragroup sales and purchases is required.
Also need to ensure that completeness of the consolidation entries has been considered by
comparison to prior year and our knowledge of the way the companies trade and interact.
Loan (Note 4)
Issues and potential adjustments
No loan interest has been accrued on the long-term loan and the loan arrangement fee of £200,000
appears to have been treated incorrectly as an administrative expense. Under IFRS 9 it should
instead have been deducted from the loan balance outstanding and charged over the loan period in
proportion to the outstanding balance on the loan. The adjustment proposed by the junior to charge
accrued interest of £480,000 to profit or loss is incorrect. Interest should be calculated using the
effective interest rate which would give a charge for the year of £521,040 not £480,000 as proposed.
The accrued interest payable should be recognised in current liabilities and deducted from the long
term loan. The loan should also be split between current liabilities, £1,000,000, and long term
borrowings £6,841,040 as follows:
£8,000,000 – £200,000 = £7,800,000
Instalment paid
£
Year 1
7,800,000
Year 2
7,841,040
£
(1,000,000)
Finance charge Interest payable
£
£
£
521,040
(480,000)
7,841,040
456,981
(480,000)
6,818,021
Journals required
£’000
DEBIT
CREDIT
DEBIT
CREDIT
DEBIT
CREDIT
DEBIT
CREDIT
Loan
£’000
200
Admin expenses
Loan
200
480
Accrued interest
Finance costs
480
521
Loan
Loan – long term borrowings
Loan – current liabilities
521
1,000
1,000
Additional audit procedures
Need to consider carefully cash flow forecasts and ability of Dormro to repay its debts as they fall
due. In addition, terms of the loan agreement need to be reviewed and covenant compliance
assessed both now and over the next year as any breach of covenant might render the entire debt
repayable immediately.
Outstanding audit work
Issues and potential adjustments
•
Going concern sign off is not required on each individual company for the sign off of group
accounts. However, the overall cash position of the group is relevant and this looks poor,
especially given that the first instalment of £1m on long-term debt was due on 1 May 20X2 and
both Secure and CAM have very high trade payables. Although companies are profitable, there
are also signs that trading is difficult.
•
The group policy on the obsolescence provision is potentially concerning. The potential
adjustment identified in CAM is not material but should be considered along with any other
unbooked adjustments at subsidiary or group level. An overall group adjustment schedule should
be maintained.
ICAEW 2022
Audit and integrated 1
361
•
If a similar error rate which is identified in CAM is applied to the provision in the other group
companies, then the total error could be material. The Klip auditors have not raised this as an
issue but that may be because their audit work has not gone beyond ensuring compliance with
group policies (see below). However, the same issue could apply to Klip, particularly as a fair value
adjustment on acquisition required a significant adjustment to inventory.
•
Warranty provision – Although the balance is not material, the key audit consideration here will be
whether it is complete. An understatement could be material.
•
The tax position of Secure looks incorrect as no tax credit has been recognised at present. This
requires further investigation and explanation to ensure that tax losses have been claimed
appropriately.
•
There is also no deferred tax balance separately identified on the SOFP of all three companies
and this needs to be followed up to ensure compliance with IFRS.
Additional audit procedures
The bank letters should be obtained as these also provide details of any loan accounts and other
arrangements and are important audit evidence.
Confirmations of all intragroup balances are not required, providing the balances eliminate on
consolidation – there is in fact a difference and this is discussed above. The difference requires
further investigation and possible adjustment.
The nature of inventories in each entity should be considered and to evaluate further any potential
error which may arise.
In respect of the potential understatement of the inventory provision, discussion is required with
management and the other audit teams to determine the extent to which additional analysis is
required based on actual post year-end sales and sales forecasts rather than historic data.
The warranty provision should be assessed based on the number of months for which warranty is
given, historic experience of warranty claims and any known issues or problems with security
equipment supplied.
The tax position of Secure should be discussed with management to determine whether an
adjustment is appropriate. The tax computation should be reviewed and discussed with a tax expert.
Overseas subsidiary – Klip
Issues and potential adjustments
•
Control is established when a parent owns more than 50% of the voting power of an entity. A 90%
shareholding in Klip would therefore signify that control exists unless Dormro management can
identify reasons why the ownership of the shares does not constitute control. Therefore, an
adjustment is required to include the results from the date of acquisition and the assets and
liabilities of Klip – see Appendix.
•
No assessment appears to have been made at the planning stage of whether Klip is a significant
component.
•
FG has placed reliance on other auditors to audit this entity. There appears to be no evidence,
however, that FG has obtained an understanding of the component auditor as required by ISA
600 (UK) (Revised November 2019), or confirmed that the component auditor meets the relevant
independence requirements. Furthermore, confirmation appears to have been addressed to
Dormro FD and not to FG.
•
The audit of Klip has been conducted under Harwanian Standards of Auditing, which may not be
equivalent to the ISA.
•
Klip has prepared financial statements under group accounting policies supplied by group
financial controller. Local policies have been used where group policies are silent. There is a risk
that these are not compliant with IFRS or that they are incomplete.
Additional audit procedures
To determine whether Klip is a significant component, FG will need to assess whether Klip has
financial significance, is significant by nature of its circumstances or due to its nature or
circumstances is likely to lead to a significant material risk of misstatement to the group. The
outcome of this assessment will determine the nature of the audit approach; full audit, audit of
specific balances, specified procedures based on specified risks.
362
Corporate Reporting
ICAEW 2022
ISA 600 (UK) (Revised November 2019) requires FG to evaluate the reliability of the component
auditor and the work performed. A formal confirmation of the independence of the Harwanian
auditors will be required as this is not covered in the clearance supplied. FG will need to assess their
competence by reviewing size, reputation, experience, client base of the firm.
FG will need to assess adequacy of the audit procedures performed by the Harwanian auditors. This
could be achieved by asking them to complete a questionnaire confirming their compliance with the
ethical and independence requirements of the group audit, their professional competence, and the
level of involvement the group auditor is able to have in the component auditor’s work.
If the component auditor does not meet the independence requirements, their work must not be
relied upon, and FG must perform additional risk assessment or further audit procedures on the
financial information of the component.
If there are less serious concerns about the component auditor’s competency, FG should be able to
overcome the problems by being involved in the component auditor’s work. In particular, FG will
need to conduct a very detailed review of completeness and appropriateness of policies supplied.
As Klip is in a different business (manufacturing) to the UK entities, there may well be omissions and
differences in the accounting policies adopted.
Appendix – Dormro: Revised consolidated statement of financial position
Group
£’000
ASSETS
Non-current assets
Property, plant and equipment (3,014 + 462)
3,476
Goodwill (6,251 + 52)
6,303
Investments
15
Current assets
Inventories (6,327 + 262)
6,589
Trade receivables (9,141 + 143)
9,284
Cash and cash equivalents (243 + 10)
Total assets
253
25,920
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings (W4)
200
5,766
Foreign exchange reserve (W6 and W7)
52
Non-controlling interests
22
Non-current liabilities
Long-term borrowings (6,841 (see above) + 333)
7,174
Current liabilities
Loan
Trade and other payables (10,252 + 329 + 480)
1,000
11,061
*Current tax payable
Total equity and liabilities
645
25,920
*Further adjustments may be required to taxation
ICAEW 2022
Audit and integrated 1
363
WORKINGS
(1) Translation of the statement of financial position of Klip
H$’000
H$’000
Rate
£’000
1,940
4.2 CR
462
1,100
4.2 CR
262
600
4.2 CR
143
40
4.2 CR
10
ASSETS
Non-current assets
Property, plant and equipment
Current assets
Inventories
2,100
Less write down at acquisition
1,000
Trade receivables
Cash and cash equivalents
Total assets
3,680
877
EQUITY AND LIABILITIES
Equity
Share capital
200
5.4 HR
37
Pre-acquisition reserves
575
5.4 HR
107
Post-acq. reserves (inc exchange diff. to date)
125
Balance
71
1,400
4.2 CR
333
Trade and other payables
1,380
4.2 CR
329
Total equity and liabilities
3,680
Non-current liabilities
Long-term borrowings
Current liabilities
877
(2) Pre-acquisition reserves
H$’000
Balance at 30 April 20X2
1,700
Less earnings post acquisition
125
Reserves at 31 January 20X2
1,575
Less inventory write down
1,000
Pre-acquisition reserves
575
(3) Goodwill
H$’000
Consideration transferred
Non-controlling interest
£’000
918
775 × 10%
77
995
Less net assets of acquiree
775
Goodwill
220
HR 5.4
Exchange gain
Retranslated at closing rate
364
Corporate Reporting
41
11
220
CR 4.2
52
ICAEW 2022
(4) Consolidated retained earnings
£’000
Dormro (see below)
5,743
Adjustments
Share of Klip post-acquisition profits
3 months × 90% of Klip H$500,000 = 112.5
@AR 4.8
23
5,766
Retained earnings at 1 May 20X1
5,496
Add profit for the year
568
Add write back of arrangement fee on loan
200
Less finance charge on loan
(521)
–––––
Revised retained earnings at 30 April 20X2
5,743
(5) Non-controlling interest
£’000
Closing net assets (37 + 107 + 71)
215,000 × 10%
22
(6) Exchange difference on retranslation of subsidiary
H$’000
Net assets at acquisition
£’000
775
HR 5.4
144
775
CR 4.2
185
Gain
41
Retained profits since acquisition
500 ×3/12
125
AV 4.8
26
125
CR 4.2
30
4
Total gain (41 + 4)
45
Group share 90%
41
(7) Foreign exchange reserve
£’000
Exchange gain on Goodwill
11
Exchange difference on retranslation of subsidiary
41
52
ICAEW 2022
Audit and integrated 1
365
17 Johnson Telecom
Marking guide
Marks
Treatments
Disposal of Cole
Hedge re International Energy
Acquisition of Routers
Loan note and swap
Hedging
Explanation of hedging principles
Draft hedging documentation
Note independence issues
Key risks and internal controls
1 mark for each risk/control identified and explained
Audit evidence
3
5
4
2
4
3
2
9
1 mark for each piece of evidence
Marks Available
9
41
Maximum
40
Total
40
Memorandum: Year-end reporting of financial instruments at Johnson Telecom
Accounting treatment of financial instruments
(1) Disposal of equity investment in Cole plc
•
50,000 shares initially recorded at cost of £163,000.
•
The fair value (FV) at 31 December 20X6 was £230,000, hence £67,000 gains accumulated in
other components of equity.
•
As the investment was classified as being at fair value through other comprehensive income it was
correct to adjust its carrying amount to fair value at bid price at each reporting date.
•
However, IFRS 9 para 3.2.12 requires that the investment be remeasured at the date of
derecognition prior to the disposal. The difference of £12,000 (£242,000 – £230,000) would be
recorded in other comprehensive income.
•
Neither the gains of £67,000 accumulated in other components of equity at 31 December 20X6,
nor the gain to the disposal date of £12,000, are reclassified to profit or loss on disposal of the
investment, so the total profit or loss impact is £nil.
The journal entries are as follows:
£’000
DEBIT
CREDIT
Investment
£’000
12
Other comprehensive income
12
Being revaluation of the investment in Cole plc at the date of disposal
The journal entries are as follows:
£’000
DEBIT
CREDIT
Cash
Investment
£’000
242
242
Being the disposal of the investment in Cole plc
366
Corporate Reporting
ICAEW 2022
(2) Investment in Routers plc
8 November 20X7
•
16,000 shares out of 50,000 shares were acquired, giving Johnson Telecom a holding of 32%.
Routers plc should therefore be treated as an investment, not as a subsidiary.
•
The investment in Routers plc has been recorded at the offer price of £5.83.
•
Acquisition of 16,000 shares should have been initially recorded at bid price of £5.80 per share, a
cost of £92,800.
•
The bid-offer spread of 3p reflects the transaction cost and as the investment is classed as at fair
value through profit or loss, this cost of £480 should have been expensed to profit or loss for the
year.
•
The journal entry to adjust for the transaction cost is as follows:
£’000
DEBIT
Profit or loss
CREDIT
£’000
0.48
Investment
0.48
31 December 20X7
•
In addition, as the investment is classed as at fair value through profit or loss, the investment
should have been re-measured to its fair value at the year end.
•
The year-end bid price is £5.85. The fair value of the investment at the year end should therefore
be £93,600, with a gain of £800 being recorded in profit or loss.
£’000
DEBIT
Investment
CREDIT
£’000
0.8
Profit or loss
0.8
(3) Hedged investment in International Energy plc
Eligibility to apply special hedge accounting rules
In order to apply special hedge accounting rules, IFRS 9, Financial Instruments requires that the
hedge be designated and documented at inception, and the effectiveness of the hedge to be tested
at least every reporting date. As there is currently no documentation to support the hedge, Johnson
will not be permitted to apply hedge accounting, because the hedge was not formally designated
and documented at inception. By implication, IFRS 9 does not permit documentation to be
backdated, nor for hedge accounting to be applied retrospectively.
It is therefore incorrect to apply hedge accounting rules.
Equity investment in International Energy
•
IFRS 9 states that if a hedging instrument hedges an equity investment at fair value through other
comprehensive income, the gain or loss on the hedging instrument is recognised in other
comprehensive income (IFRS 9, para 6.5). Since hedge accounting has been applied, the loss on
revaluing the investment has been charged to other comprehensive income, in accordance with
the IFRS 9 treatment of fair value hedges. Therefore, no adjusting entries are required because
the loss would be recorded in other comprehensive income irrespective of the hedge accounting
rules.
•
30,000 shares measured at FV at 31 December 20X6 are valued at £255,000 (£8.50 per share),
and £228,000 at 31 December 20X7 based on bid price of £7.60 per share.
•
Without applying special hedge accounting rules, the loss of £27,000 is recognised in the other
components of equity, as follows:
£’000
DEBIT
CREDIT
ICAEW 2022
Other components of equity
£’000
27
Investment
27
Audit and integrated 1
367
No adjustment is required to the investment to reverse the hedge accounting as the investment is at
fair value through other comprehensive income.
Put options
•
The put options are initially measured at cost and re-measured to fair value at each reporting
date.
•
The original cost of the put options was £60,000 (30,000 @ £2.00). At the year end, the fair value
of the options is £72,000 (30,000 @ £2.40).
•
Without hedge accounting, the £12,000 fair value gain is recorded in profit or loss:
£’000
DEBIT
Derivative asset
CREDIT
£’000
12
Profit or loss
12
However, hedge accounting had been applied and the fair value gain recorded in other
comprehensive income/other components of equity:
£’000
DEBIT
CREDIT
Derivative asset
£’000
12
Other components of equity
12
Therefore, the journal required to reverse the hedge accounting is:
£’000
DEBIT
Other components of equity
CREDIT
£’000
12
Profit or loss
12
(4) Investment in Spence & May bonds
Year-end disposal of 50% of holding
•
The journal entry recording the disposal of the 50% holding neglected the gain arising from the
disposal. As the supporting workings correctly calculate, the amortised cost of the debt
investment sold was £72,227 (£144,454/2), giving a gain of £10,773 to be taken to the profit or
loss, as follows.
£’000
DEBIT
Cash
£’000
83
CREDIT
Profit or loss
10.8
CREDIT
Debt investment
72.2
The journal entry to adjust for this error is as follows:
£’000
DEBIT
CREDIT
Debt investment
Profit or loss
£’000
10.8
10.8
(5) Loan note and interest rate swap
•
The treatment of the interest rate swap appears to be correct. However, the accounting note
made no mention of the effectiveness of the swap, a factor upon which the appropriateness of
hedge accounting depends. (Please see Audit evidence section below.)
368
Corporate Reporting
ICAEW 2022
Hedge accounting rules and hedging principles
Hedging principles
•
The fair value of the derivative is comprised of an intrinsic value (exercise price less share price)
and a time value, based on the period to expiry of the option.
•
Where the share price is higher than the exercise price, the intrinsic value is zero as the put option
is out-of-the-money and will not be exercised.
•
At acquisition, the share price was £9 (30,000 shares with a total cost of £270,000). The exercise
price of the put option was also £9. The intrinsic value is therefore zero.
•
At the year end, the fair value of an option is £2.40 representing an intrinsic value of £1.40 (£9 –
£7.60) and a time value of £1.
•
The share price has fallen by £1.40 since acquisition and this is exactly matched by the increase in
the intrinsic value of the options from zero to £1.40. Hence it can be seen that the intrinsic
element of the option provides a highly effective hedge for the change in fair value of the share
price below £9.00.
•
It can be seen that the hedge constitutes a ‘fair value hedge’ as the option is protecting against
movements in the fair value of the recognised equity investments below £9.
Tutorial Note
The company does not have to designate only the changes in the intrinsic value of the option as
the hedging instrument: it could in fact designate the changes in the total fair value of the option
as the hedging instrument instead. However, in this case the hedge would not be effective.
Fair value hedge accounting
Without applying hedge accounting, a mismatch would arise: the gain on the options and the loss on
the associated investment are not recorded in the same financial statement. While the gain on the
options is recorded in profit or loss, the loss on the investment is charged to other comprehensive
income. Hedge accounting prevents such a mismatch.
•
The £27,000 loss arising on the FV movement in the shares would be accounted for as per the
irrevocable election made on recognition, that is it would be recorded in other comprehensive
income and other components of equity.
•
The gain on the derivative of £12,000 could be analysed as follows:
– Gain on the intrinsic value change of £27,000 (90p × 30,000)
– Loss on the time value change of £15,000 (50p × 30,000)
•
The £27,000 loss arising on the FV movement in the shares would be hedged by the gain arising
on the increase in the intrinsic value of the options of £27,000.
•
The IFRS 9 hedge accounting rules would require the loss on the shares to be matched in
OCI/OCE against the gain on the intrinsic element of the options, so this increase in the intrinsic
value of the options would be recorded in OCI rather than in profit or loss as is usual.
•
The net effect on other comprehensive income for the year would be to show a loss of £15,000,
reflecting the change in the time value of the options.
Hedge documentation: International Energy plc
As discussed above, the hedging documentation cannot be prepared retrospectively. The following
is therefore for reference only. We should make clear to the Directors that they must use the
documentation to support the hedge in question. As stated, hedge accounting should not be
applied in this case.
Hedge No.
X
Date
7 February 20X8
Risk management objective and strategy:
The investment in the equity of International Energy plc is exposed to fluctuations in the market
value. To hedge exposure of a decline in share price, management has entered into a put option
over the entire holding.
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Hedge type
Fair value
Hedged risk
Market risk that share price falls below £9.00
Hedged item
Investment in holding of 30,000 equity shares in International Energy plc.
Hedging instrument
Put option in 30,000 equity shares in International Energy plc at an exercise price of £9.00
exercisable until 31 December 20X8.
Hedge effectiveness
Monitor on a quarterly basis comparing change in intrinsic value of options to change in share
price where price falls below £9.00.
From an ethical perspective, the preparation of documents for financial reporting purposes on behalf
of the client would constitute a self-review threat. We should explain to the client that due to our
obligation to remain independent, we are unable to prepare supporting documentation for the
financial statements.
Risks from derivatives trading:
Key risks
There are a number of concerns that we should address as auditors.
•
Credit risk is the risk that a customer or counterparty will not settle an obligation for full value. This
risk will arise from the potential for a counterparty to default on its contractual obligations and it is
limited to the positive fair value of instruments that are favourable to the company.
•
Legal risk relates to losses resulting from a legal or regulatory action that invalidates or otherwise
precludes performance by the end user or its counterparty under the terms of the contract or
related netting agreements.
•
Market risk relates to economic losses due to adverse changes in the fair value of the derivative.
These movements could be in the interest rates, the foreign exchange rates or equity prices.
•
Settlement risk relates to one side of a transaction settling without value being received from the
counterparty.
•
Solvency risk is the risk that the entity would not have the funds to honour cash outflow
commitments as they fall due. It is sometimes referred to as liquidity risk. This risk may be caused
by market disruptions or a credit downgrade which may cause certain sources of funding to dry
up immediately.
Necessary general controls and application controls
Tutorial Note
This answer assumes that a computer system is used in processing trades involving derivatives.
General controls
A number of general controls may be relevant:
•
For credit risk, general controls may include ensuring that off-market derivative contracts are only
entered into with counterparties from a specific list and establishing credit limits for all customers.
•
For legal risk, a general control may be to ensure that all transactions are reviewed by properly
qualified lawyers and regulation specialists.
•
For market risk, a general control may be to set strict investment acceptance criteria and ensure
that these are adhered to.
•
For settlement risk, a general control may be to set up a third party through whom settlement
takes place, ensuring that the third party is instructed not to give value until value has been
received.
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•
For solvency (liquidity) risk, general controls may include having diversified funding sources,
managing assets with liquidity in mind, monitoring liquidity positions, and maintaining a healthy
cash and cash equivalents balance.
Application controls
These include the following:
•
A computer application may identify the credit risk. In this case an appropriate control may be
monitoring credit exposure, limiting transactions with an identified counterparty and stopping any
further risk-increasing transactions with that counterparty.
•
For legal risk, an application control may be for the system not to process a transaction/trade until
an authorised person has signed into the system to give the authority. Such an authorised person
may be different depending on the nature and type of transaction. In some cases it may be the
company specialist solicitor, or the dealer’s supervisor.
•
For market risk, an application control may be to carry out mark-to-market activity frequently and
to produce timely exception management reports.
•
For settlement risk, an application control may be a computer settlement system refusing to
release funds/assets until the counterparty’s value has been received or an authorised person has
confirmed to the system that there is evidence that value will be received.
•
For solvency risk, an application control may be that the system will produce a report for
management informing management that there needs to be a specific amount of funds available
on a given date to settle the trades coming in for settlement on that date.
In addition to the above, a fraud risk arises because the Financial Director – who has maintained the
accounting records for the derivatives almost single-handedly – also appears to be the only person
within the company familiar with the accounting treatment for the financial instruments (including the
derivatives). An effective system of internal controls will go some way to mitigate the fraud risk, but
an informed management with an adequate understanding of derivatives and hedge accounting is
crucial.
Audit evidence:
The additional audit evidence that we will need to obtain with regards to the financial instruments
includes the following:
Equity investments
•
Confirmations from management regarding the basis on which the year end valuation of the
equity investments were made.
•
Information from third-party pricing sources regarding the fair value of the investments (including
details of valuation techniques, assumptions and inputs).
•
Observable market prices at the year end for comparison.
•
Supporting documentation (board meeting minutes, accounting notes produced by the Treasury
department) to support the classification of the investments in Cole plc and International Energy
plc as investments in equity instruments at FVTOCI.
•
Details of controls that management has in place to assess the reliability of information from thirdparty pricing sources.
•
For the disposal of the investment in Cole plc, the sale agreement to support the disposal value of
£242,000 and bank statement to confirm the receipt of the consideration.
•
For the acquisition of the investment in Routers plc, documentation (sale agreement, valuation
documentation) to support the purchase price; bank statement and sale documentation to
confirm the payment of the consideration.
Hedged investment in International Energy plc
•
Copy of the put option agreement, and back-office report confirming the processing of the put
option.
•
Statement from the clearing agents confirming the details of the options.
•
Third-party pricing sources to support the fair value of the options.
(As discussed above, hedge accounting is not expected to be applied, as the hedge documentation
has been lost and the criteria for hedge accounting have therefore not been met.)
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Investment in Spence & May bonds
•
Copy of the purchase agreement for the initial purchase of the bonds.
•
Board meeting minutes or internal analysis confirming the suitability of measuring the bond at
amortised cost under IFRS 9.
•
Sale agreement for the disposal of the bonds during the year.
•
Bank statements supporting interest payments and disposal proceeds.
Loan note and interest rate swap
•
Copy of the loan documentation.
•
Copy of the interest rate swap agreement.
•
Counterparty and broker confirmations agreeing the details of the interest rate swap.
•
Copy of the hedging documentation for the files.
•
Supporting workings analysing the effectiveness of the swap as a hedge, including an explanation
of the method used and any assumptions made.
•
Bank statements showing the interest payments on the loan and the interest receipts from the
swap.
•
Supporting documentation for the fair value of the swap at the year end (including details of the
methodology used, assumptions made, and report from independent experts where relevant).
The exercise of professional scepticism will be particularly important around fair value
measurements. Where the audit evidence obtained is inconsistent or incomplete, we must seek to
perform further audit procedures. Further, where external experts have been consulted by the entity,
the degree of reliance that can be placed on the external experts also needs to be considered.
18 Biltmore
Marking guide
Treatments
General
Harmony Tower 3
Grove Place
Head office
Northwest Forward
Teesside
Essex Mall
Subone Head Office
Coventry Building
Adjustments
1 mark for each journal entry, maximum of
Impact on the auditor’s report
Quantify the combined impact
Appropriate audit opinion and explanation, maximum of
Marks
2
3
3
3
2
3
2
3
3
8
4
4
40
Total
40
As requested, I report below on the issues raised by the Biltmore Group’s investment properties.
Proposed treatment
Broadly, the group has not met the requirements of IAS 40, Investment Property in most cases. Each
of those breaches has the effect of overstating profit and of overstating the value attributed to
investment properties in the statement of financial position.
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Harmony Tower 3
We cannot accept the directors’ claim that this property must remain at cost because there is no
reliable means of estimating its fair value. This is a standard office block in an area where there is a
thriving market for such properties. There are observable market prices. It would be reasonable to
expect this property to be valued at around £150 million because there is good evidence of that
being the current market valuation.
IAS 40 states that fair value must be measured in accordance with IFRS 13, Fair Value Measurement,
which defines fair value as:
”the price that would be received to sell an asset in an orderly transaction between market
participants at the measurement date.”
IFRS 13 states that entities should maximise the use of relevant observable inputs and minimise the
use of unobservable inputs.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use to
measure fair value:
Level 1
Quoted prices (unadjusted) in active markets for identical assets or liabilities that the
reporting entity can access at the measurement date.
Level 2
Inputs other than quoted prices included within Level 1 that are observable for the
asset or liability, either directly or indirectly eg, quoted prices for similar assets in
active markets or for identical or similar assets in non-active markets or use of quoted
interest rates for valuation purposes.
Level 3
Unobservable inputs for the asset or liability ie, using the entity’s own assumptions
about market exit value.
Harmony Tower may be valued using a Level 2 input, that is, prices that are directly observable for
identical buildings in an active market.
To obtain further evidence that a fair value of £150 million is appropriate, the use of auditor’s experts
may be necessary.
Grove Place
The fair value of the property is £220 million. The £30 million spent during the year should only have
been capitalised in accordance with IAS 16 if it represented an improvement in the asset – ie,
increased the future economic benefits rather than maintaining the asset. Evidence has shown that
the refurbishment work has not created the future economic benefits. Therefore, the £250 million
carrying value must be written down to fair value at the year end, being £220 million, with the
refurbishment expense of £30 million charged to profit or loss for the year.
Head office – upper floors
This is not an investment property. Biltmore plc occupies and uses a significant part of the building
and the vacant part is not capable of being leased or sold separately. The whole building will have to
be treated as normal owner-occupied property.
Northwest development
Biltmore plc’s use of this property is restricted to only a very small proportion, and the complex
cannot be sold separately. It is therefore acceptable, under IAS 40, to treat the whole development as
investment property.
Buy-to-let portfolio – Teesside
The fair value should be decided in terms of market conditions as at the year end. Thus, the
company’s proposed valuation of £150 million is correct providing that the downturn arose after the
year end. There may be an argument for treating this downturn as a non-adjusting event after the
reporting period and disclosing the change in the market value in a note to the accounts.
Essex Mall
IAS 40 states that a property which is being developed for future sale cannot qualify as an investment
property. Thus, the building must be treated in accordance with IAS 2 until such time as it is ready for
disposal. Its initial recognition should be at cost, but it should be written down to its net realisable
value if this falls below cost.
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Subone plc’s head office
It is perfectly legitimate for Subtoo plc to treat this property as an investment property in its
individual company financial statements because it is occupied by a third party. However, the
Biltmore Group cannot treat the property as an investment property because it is owned by one
group member and occupied by another. There is nothing to prevent the group from showing the
property in its statement of financial position, but the revaluation gain on consolidation cannot be
recognised in profit or loss for the year and must instead be recognised as other comprehensive
income and accumulated in a revaluation reserve in equity.
Coventry development
This property ceased to be an investment property when it was placed on the market. It should have
been transferred to inventory at that time at its deemed cost of £345 million which is its fair value at
the date of its change in use. It should be accounted for under the requirements of IAS 2, Inventories.
Any subsequent downward reassessment of the sales value would cause the asset to be written
down to the new net realisable value.
Required adjustments
Harmony Tower 3
Recognise loss:
£m
DEBIT
Gains on investment properties
CREDIT
£m
50
Investment properties
50
Grove Place
Treat costs incurred as revenue:
£m
DEBIT
Repairs
CREDIT
£m
30
Investment properties
30
Head office – upper floors
Cancel gain recognised for year:
£m
DEBIT
Gains on investment properties
CREDIT
£m
20
Investment properties
20
Reclassify building as non-investment property:
£m
DEBIT
CREDIT
Property, plant and equipment
£m
80
Investment properties
80
Charge depreciation on additional non-investment property:
£m
DEBIT
CREDIT
Depreciation expense
Property, plant and equipment
£m
4
4
Northwest development
No adjustment required.
Buy-to-let portfolio – Teesside
No adjustment required.
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Essex Mall
Cancel gain recognised for year:
£m
DEBIT
Gains on investment properties
CREDIT
£m
80
Investment properties
80
Reclassify development as non-investment property:
£m
DEBIT
Property under construction
CREDIT
£m
770
Investment properties
770
Subone plc’s head office (consolidation adjustment only)
Reclassify building as non-investment property:
£m
DEBIT
Property, plant and equipment
CREDIT
£m
150
Investment properties
150
Charge depreciation on additional non-investment property:
£m
DEBIT
CREDIT
Depreciation expense
£m
6
Property, plant and equipment
6
(Book value throughout the year = £120m, divided by 20-year life = £6m.)
Transfer recognised gain to revaluation reserve:
£m
DEBIT
Gains on investment properties
30
DEBIT
Property, plant and equipment
6
CREDIT
£m
Revaluation reserve
36
(The additional depreciation charged to profit or loss has to be added to the recognised gain on
revaluation and added back to property, plant and equipment at valuation less depreciation.)
Coventry development
Cancel the revaluation gain recognised since property became part of inventory:
£m
DEBIT
CREDIT
Gains on investment properties
£m
15
Investment properties
15
Transfer property to inventory:
£m
DEBIT
CREDIT
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Inventory
£m
345
Investment properties
345
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Impact on auditor’s report
If Biltmore’s directors refuse to put through the reclassifying adjustments in respect of investment
properties, several different accounts in the consolidated statement of financial position will be
misstated as follows:
Investment
properties
PPE
Current
assets
Property under
construction
Total
£m
£m
£m
£m
£m
2,360
57
6
0
2,423
Draft
Harmony Tower 3
(50)
(50)
Grove Place
(30)
(30)
Head office
(100)
Essex Mall
(850)
Subone Head Office
(150)
Coventry building
(360)
Revised
820
76
(24)
770
(80)
150
–
345
283
351
(15)
770
2,224
In addition, the misclassification has resulted in profit being overstated by £235 million as a result of
associated adjustments, as follows:
£m
Harmony Tower 3 (fair value gain)
50
Grove Place (refurbishment costs)
30
Head office – upper floors (depreciation and fair value gain)
24
Essex Mall (fair value gain)
80
Subone plc’s head office (depreciation and fair value gain)
36
Coventry (revaluation gain)
15
Total
235
The revaluation reserve is also understated by £36 million.
The materiality level for the financial statements as a whole is £24 million (total group assets of
£2,423m × 1%). This shows clearly that the misstatements in each of the affected accounts are
material. Indeed, the overstatement in investment properties alone represents 64% of the group’s
total assets.
Besides materiality for the financial statements as a whole, ISA 320 (UK) (revised June 2016) requires
us to consider performance materiality. In particular, specific materiality levels may be set for
particular account balances that could have a particular influence on users’ decisions in the particular
circumstances of the entity.
As Biltmore is a property business, and investment properties currently represent the largest account
balance in the group’s statement of financial position, the investment properties account should be
assigned a lower performance materiality. This makes the level of misstatement in the investment
properties account even less acceptable.
Arguably, inventory and properties under construction are equally significant to the users’ economic
decisions. The difference between an inventory of less than £6 million (current assets in the summary
statement of financial position) and £345 million, and indeed between properties under construction
of £nil and £770 million, is highly important. Left unadjusted, it could be very misleading to the users
of the financial statements.
Finally, assuming the directors do agree to make the remaining adjustments listed above, keeping
the four properties in the investment properties account at their adjusted carrying amount simply
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would not make any sense from an accounting point of view. As they currently stand, the properties
would not be accounted for in accordance with IAS 40.
I would recommend explaining the above to the directors, so that they understand that the
reclassification adjustments do have a material impact on the financial statements.
Should the directors still refuse to make the adjustments, an unmodified opinion cannot be issued.
Given that this misstatement represents a substantial proportion of the financial statements, there is
an argument for this being considered both material and pervasive, which would lead to an adverse
opinion; should this be considered material and not pervasive though, a qualified opinion would be
used.
As a separate point, given the directors’ attitude, it may be necessary to consider adjusting our
materiality level, and to think about how this may impact other classes of transactions, account
balances and disclosures.
19 Hillhire
Marking guide
Key audit risks and financial reporting treatment
General
Discontinuation
Audit risk
Financial reporting treatment
Audit procedures
Acquisition
Swap
Audit risk
Financial reporting treatment
Audit procedures
New system
Share options
Ethical
Marks Available
Marks
5
3
4
3
7
3
4
3
4
5
4
45
Maximum
40
Total
40
Memorandum: Hillhire plc audit for the year ended 31 March 20X8
Audit risks
General points
The profit for the year of £27,240,000, after taking into account the loss for the year from
discontinued operations, has decreased by 6.7%. Although this is not particularly serious in itself,
management might be concerned that the shareholders will react unfavourably. We need to take
particular care over any matters of accounting judgement that could have distorted the results in
order to improve matters. It may be that the profit according to the draft statement of profit or loss
and other comprehensive income has been overstated already in order to mitigate the effects of this
decline.
Continuing operations
More importantly we need to check that the profit from discontinued operations has been correctly
classified. Excluding the loss arising from discontinued operations, profit for the year from continuing
operations has shown an increase of 8.4%. The increase in revenue for 20X8 compared to 20X7 is
10%.
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Cost of sales
In 20X8 cost of sales has increased by 11.5% over 20X7, compared with a 10% increase in revenue.
Administrative expenses
In spite of the 10% increase in revenue, administrative expenses (excluding amortisation) have
increased by only 1.2%.
Gearing and borrowing costs
The company continues to be highly geared. Indeed, a great deal of additional borrowing has been
raised. There does not appear to be any particular concern about going concern issues arising from
this, but we should be sceptical about any accounting practices that have the effect of smoothing
profits, as well as any that have the effect of increasing reported income.
Long-term borrowings have increased by £69,240,000 or 22% whereas finance costs have increased
by 11.56%. We need to look at the movement of interest rates in the period, look into the company’s
other borrowings and request details of finance costs reflected in the profit or loss and other
comprehensive income, to establish these have been correctly calculated and accounted for. We also
need to ensure that the allocation of finance costs has been correctly made and not inappropriately
allocated to the discontinued operations.
It is possible that the figure for long-term borrowings could be even higher if the divested depots
have borrowings which have been netted off within assets held for sale. This treatment would not be
correct.
Are depots able to raise their own finance? If so their borrowings are included within total
borrowings in 20X7 but it is unclear how the liabilities of depots held for sale are treated in the
current year. Have they been incorrectly netted off within assets held for sale or are they listed within
total liabilities?
We should also establish when repayment of the long-term borrowings is due as it’s a large amount.
The company’s ability to repay any borrowings due in the near future needs to be considered, as this
could affect the going concern assumption.
In addition, perhaps the new borrowings were taken on mid-year so there’s not a full year’s finance
charge, which will have implications for the future.
Audit procedures
Evaluate any adjustments that are proposed to the draft accounts that have the effect of increasing
the reported profit and challenge directors over their suitability where appropriate.
Perform analytical procedures on expenses to identify trends and confirm whether there is any risk of
material misstatement from continuing operations. As part of these analytical procedures, we should
be challenging any increases in costs which have not been reflected in higher sale prices.
We also need to confirm that administrative expenses relating to continuing operations have not
been incorrectly allocated by analytical procedures.
Confirm the treatment of borrowing undertaken by depots held for sale by analysis of liabilities.
Discontinued operations risks
There is a risk that IFRS 5, Non-current Assets Held for Sale and Discontinued Operations has not
been complied with.
Professional scepticism would identify this as a risk here especially as the directors’ bias in the current
year may well be to try to classify these depots as ‘discontinued’ as this allows them to disclose the
losses separately in the hope of downplaying their significance to analysts assessing the company’s
future prospects.
In order to be treated as a discontinued operation, the Scottish depots would have to be a
component of Hillhire which either has been disposed of or is classified as held for sale, and:
•
represents a separate major line of business or geographical area of operations;
•
is part of a single coordinated disposal plan; or
•
is a subsidiary acquired exclusively with a view to resale and the disposal involves loss of control.
IFRS 5 defines a component of an entity as ‘operations and cash flows that can be clearly
distinguished operationally and for financial reporting purposes from the rest of the entity’. As each
depot is viewed as a cash-generating unit the group of Scottish depots represents a component of
Hillhire.
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All of the depots are located in Scotland and the decision to sell is based on a strategic decision to
withdraw from this part of the country. This suggests that this is a separate geographical area of
operations. However further details would be required to determine what proportion of the total
number of depots held is represented by the 15 being sold to assess whether this constitutes a
major geographical area of operations.
The plan to dispose of the Scottish depots would appear to be a single coordinated disposal plan
based on the information provided.
Despite meeting two of the criteria to be classified as a discontinued operation, the Scottish depots
have not been disposed of by the reporting date and do not appear to meet the definition of ‘held
for sale’ at this date.
A disposal group is classified as held for sale only if its carrying amount will be recovered primarily
through a sales transaction rather than through continuing use. The following criteria must be met in
order for this to be the case:
•
The depots must be available for immediate sale in their present condition. In this case the depots
are not available for immediate sale as they are still in use and no alternative arrangements have
been made to store the vehicles currently held at these depots.
•
The sale must be ‘highly probable’, that is:
– being actively marketed at a reasonable price;
– changes to the plan are unlikely;
– management must be committed to the sale;
– there must be an active programme to locate a buyer; and
– the sale must be expected to be completed within one year from the date of classification.
From the information currently available, whilst management appear committed to the sale,
indicated by the recording of the decision in the board minutes, there is currently no active
programme to locate a buyer. Marketing of the properties is not due to start until May or June of
20X8.
On this basis the Scottish depots should not be classified as either held for sale or discontinued
operations and the loss for the year in respect of this group of depots should not be separated from
the results of the continuing operations of the business in the statement of profit or loss and other
comprehensive income.
In the statement of financial position, the depots should not have been reclassified as held for sale
on 1 January 20X8 but should have been retained in property, plant and equipment and depreciated
for the remainder of the year.
From the draft financial statements we can see that on transfer to held for sale, the depots have been
measured at the lower of carrying amount and fair value less costs to sell. Therefore, the following
journals are required to reverse this transfer and record depreciation for the three months to 31
March 20X8:
DEBIT
Property, plant and equipment
£44,520,000
CREDIT
Profit or loss – discontinued operations
£4,390,000
CREDIT
Assets held for sale
£40,130,000
and:
DEBIT
CREDIT
Profit or loss (44,520/25 × 3/12)
£445,200
Accumulated depreciation
£445,200
The carrying value of the depots at 31 March 20X8 is therefore £44,074,800 (44,520 – 445.2).
An assessment should be made to determine whether the depots have suffered an impairment. The
depots are impaired if the carrying amount is in excess of the recoverable amount, being the higher
of fair value less costs to sell and value in use. The carrying amount would appear to be in excess of
fair value but further information is required in order to calculate the value in use.
Audit procedures
Discuss the necessary adjustments with the directors to confirm that action will be taken.
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Confirm the progress of the planned sale of the depots with directors.
Inspect board minutes and budgets and forecasts for evidence that management intend to sell the
depots.
Determine the proportion of depots which the sales of the 15 Scottish depots represent in
comparison to the business as a whole.
Confirm plans for moving vehicles currently held in the depots in Scotland.
Obtain details and inspect correspondence with agents for evidence that the marketing of the
depots is due to start in May/June only.
Ascertain how fair value was assessed and review any valuation reports prepared by independent
valuers.
Agree remaining useful lives of the Scottish depots with the company’s stated depreciation policy.
Discuss with the directors the extent of any impairment reviews performed by them and any follow
up on any steps identified but not yet taken.
Obtain details of the value in use for the Scottish depots and review the basis of these calculations.
Acquisition of Loucamion
The figure for intangibles (nearly £12 million) that appear to have been recognised on the acquisition
of Loucamion is high, and there is a risk that some of the intangibles, especially any value allocated
to customer relationships, may not meet the recognition criteria of IFRS 3, Business Combinations
and IAS 38, Intangible Assets. The overriding requirements are that it is probable that future
economic benefits will flow to the entity and that the cost can be reliably measured.
In the case of an acquisition, the key issue to determine is whether other intangibles can be
identified separately from goodwill. IFRS 3, Business Combinations gives some illustrative examples
and these include customer lists and customer contracts and the related customer relationships. For
the customer lists of Loucamion to be recognised they must meet the contractual-legal criterion or
the separability criterion. Loucamion does not appear to have any legal rights to protect or control
the relationship it has with its customers or their loyalty therefore the lists do not satisfy the
contractual-legal criterion. IFRS 3 states that a customer list acquired in a business combination does
not meet the separability criterion if the terms of confidentiality or other agreements prohibit the
entity from selling, leasing or otherwise exchanging information about its customers. This appears to
be the case with Loucamion’s customer list. On this basis the customer list should not have been
recognised as a separable asset but should have been subsumed within goodwill. This error should
be corrected and the amortisation charged for the year reversed as follows:
DEBIT
Goodwill
£4,000,000
CREDIT
Intangible assets
£3,600,000
CREDIT
Profit or loss (4,000,000/10)
£400,000
There may be unrecognised impairments of goodwill and other assets by the year end.
The other newly acquired intangible assets may not be amortised over a realistic useful life.
It is essential we obtain details of the amortisation schedules and review these closely.
Audit procedures
Obtain a breakdown of the allocation of the purchase consideration and determine how much has
been allocated to the other intangibles. Confirm that items recognised in other intangibles meet the
criteria to be recognised separately.
Obtain details from the auditors of Loucamion about the nature of the customer relationships to
confirm that no legal relationships exist and that the confidentiality terms are in place.
Ascertain how management have assessed the useful lives of the other intangibles for the purpose of
amortisation and consider whether this is reasonable.
Ascertain how the fair values of the assets and liabilities of Loucamion were assessed and review any
valuation reports prepared by independent valuers.
Obtain the consolidation schedules to review whether Loucamion has been correctly consolidated,
including only post-acquisition results.
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Review the disclosures relating to the acquisition to ensure that all the requirements of IFRS 3 have
been met.
All relevant exchange rates should be recorded in the audit file so that we can ensure the subsidiary’s
financial statements are translated from its functional currency to the presentation currency of the
group ie, £.
We need to consider the arrangements for the audit of Loucamion. It may not be cost-effective for us
to visit the company ourselves. We will need to ensure that we are satisfied by the assurances
provided by any local audit firm. Presumably this will not be too great a problem because the
company already has a range of operations throughout Europe.
We will also need to consider whether any issues relating to the valuation of goodwill and intangibles
require disclosure as Key Audit Matters.
Interest rate swap
This appears to be the first time that Hillhire has used derivatives in this way, which increases the risk
that the treatment is incorrect. There is a risk that the swaps do not meet the criteria for hedge
accounting as set out in IFRS 9. We need to confirm that:
•
the hedging relationship consists only of eligible hedging instruments and eligible hedged items;
•
at the inception of the hedging relationship there is formal designation and documentation of the
hedging relationship and the entity’s risk management objective and strategy for undertaking the
hedge; and
•
the hedging relationship meets all of the hedge effectiveness requirements of IFRS 9, namely
(IFRS 9, para 6.4.1(c):
– there is an economic relationship between the hedged item and the hedging instrument;
– the effect of credit risk does not dominate the value changes that result from that economic
relationship; and
– the hedge ratio of the hedging relationship is the same as that actually used in the economic
hedge.
The condition that the hedge should be highly effective appears to be met as the hedge is a perfect
match in terms of currency, maturity and nominal amount.
There is a risk that hedging may be applied from the wrong date. Whilst the interest-rate swap was
acquired on 1 April 20X7 it was only designated as a hedge on 1 May 20X7. In accordance with IFRS
9 hedge accounting may only be applied prospectively, from the later of the date of designation and
the date that the formal documentation was prepared. We would need to check the date of the
documentation but based on information currently available hedge accounting can be applied no
earlier than 1 May 20X7.
These risks are exacerbated by the fact that the company is highly geared. The directors have an
obvious incentive to manipulate the manner in which this swap is accounted for so as to minimise the
volatility associated with any changes in interest rates or the values of any assets or liabilities.
The change in fair value up to the year end should be recognised as other comprehensive income
and accumulated in equity.
Interest for the period 1 October 20X7 – 31 March 20X8 has not been accounted for.
The £9.5 million (£200m × 6/12 × (7.5% + 2%)) variable interest for the six months to 31 March 20X8
is charged to profit or loss and is accrued until payment is made.
The net settlement on the interest rate swap of £1.5 million (£200m × 6/12 × (9.5% – 8%)) received
from the swap bank as a cash settlement reduces the £9.5 million variable rate interest expense to £8
million. This is equivalent to the fixed rate cost (£200m × 6/12 × 8%).
The following adjustments are required:
DEBIT
CREDIT
DEBIT
CREDIT
ICAEW 2022
Profit or loss – interest expense
£9.5m
Interest accrual/cash
Cash
Profit or loss – interest expense
£9.5m
£1.5m
£1.5m
Audit and integrated 1
381
Audit procedures
•
Review board minutes documenting the decision to enter into the swap and the strategic reason
for this ie, to confirm that there is formal designation of the hedge.
•
Review and recalculate the effectiveness of the hedge.
•
Confirm that documentation is adequate for IFRS purposes. This must include:
– identification of the hedging instrument ie, interest rate swap
– the hedged item or transaction ie, interest payments
– nature of the risk being hedged ie, changes in interest rates
– details of calculation of hedge effectiveness
– statement of entity’s risk management objective and strategy
•
Confirm date of preparation of the documentation to determine the date from which hedge
accounting should be applied.
•
Verify that adjustments already reflected in the draft financial statements have been calculated
from the correct date and that hedge accounting has not been applied retrospectively.
•
Seek specific assurances about the credit rating of the counterparty to the swap.
•
Confirm basis on which the fair value of the hedge has been determined and assess whether this
complies with IFRS 9.
•
Confirm that adjustments required for interest to 31 March 20X8 as outlined above have been
made.
Controls review on new online ordering system
Risk
The new system has been piloted at quite a large number of depots during the current year. There is
a risk that any errors in the system will have affected the recording of transactions during the year.
This is a highly sensitive system. It raises transactions involving payments from business customers
and credit card companies. It can instigate the transfer of vehicles between branches. The whole
point of piloting is the recognition that new systems frequently contain errors.
Breakdowns in the system could have led to vehicles being transferred for fraudulent purposes. It is
unlikely that staff would steal a commercial vehicle, but it might have been possible to ‘lose’ a vehicle
in the system and hire it out for cash. Apart from the loss of revenue, that could have led to exposure
to claims if the unauthorised use meant that the company’s insurance policy did not cover any claims
for damages in the event of an accident.
Ideally, the pilot testing will have been controlled by a parallel run of the existing system at the
branches. In practice, it is unlikely that resources would permit this to happen.
It is worrying that the company has only engaged our IT specialists at this stage. That might suggest
that there was no independent, expert oversight of the piloting process or that the consultant
providing any such support has been sacked or has chosen to withdraw from the engagement. At
best, this suggests some recklessness in terms of the manner in which the pilot process was
managed. At worst, management may be planning to implement a system that has been found to be
defective.
Audit procedures
The new system needs to be documented and control risk assessed.
Management should be asked to provide detailed information about the errors that were uncovered
in the course of the pilot testing and the steps that have been taken to correct them, both in terms of
adjusting the system and correcting the underlying records that were affected by the errors.
The proposal to roll the system out will also have implications for future audits. We will have to take
great care over the audit of the system testing phase and the implementation phase. The transfer of
standing data and the reconstruction of the vehicle register should both, ideally, be checked
clerically and the results retained for us to review.
Share options
IFRS 2, Share-based Payment requires that the share options are reflected as an expense in profit or
loss.
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We need to assess the assumption that 10% of senior employees will leave and therefore forfeit the
shares.
Assuming the forfeiture of 10% is accurate, the expenses reflected in each of the three years from
20X8 should be as follows:
Expenses
Cumulative
expenses
£
£
31 March 20X8 (50 × 100 × 90% × £10 × 1/3)
15,000
15,000
31 March 20X9 (50 × 100 × 90% × £10 × 2/3) – 15,000
15,000
30,000
31 March 20Y0 (50 × 100 × 90% × £10) – 30,000
15,000
45,000
£
£
Year ending
The adjustment for 20X8 should be:
DEBIT
Profit or loss
CREDIT
15,000
Equity
15,000
Ethical points arising
The firm needs to consider whether the potential assurance assignment relating to the new system
may pose a threat to objectivity in respect of the audit.
There appear to be a number of threats.
Firstly, we need to remain vigilant to any increase in our evaluation of global inherent risk. If the
company’s profitability and financial position are deteriorating then management might be tempted
to distort the financial statements. That will lead to an increased risk that we will be blamed for some
alleged audit failure. If we see any clear evidence that the financial statements are being manipulated
then we should consider resigning the appointment in order to protect our reputation.
We would need to clarify the exact nature of the additional service to be provided by our IT
specialists. In accordance with FRC Revised Ethical Standard our firm would be prohibited from
designing and implementing financial information technology systems due to Hillhire being listed
and as such a public interest entity (para 5.40 and Appendix B part (e)). Even if the nature of the
service is such that the prohibition does not apply, we need to manage the perception that there
could be a self-interest threat. We might be accused of being prepared to compromise on our audit
opinion in order to win this consultancy business.
Looking ahead to future years’ audits, if Barber and Kennedy provide assurance relating to the
controls over the system it could amount to both a self-review and management threat, especially if
in future years the firm was to place reliance on controls in gathering their audit evidence.
20 Maykem
Scenario
Requirement
Skills
Review of assistant’s work: key weaknesses
Write in a clear and concise style appropriate to
a file review.
Identify weaknesses in assistant’s work.
Link large number of invoices with low GRNI
provision.
Identify there is insufficient evidence on the
audit file to determine the work performed on
GRNI and other accruals.
Identify that the financial controller is not the
best source of audit evidence (eg, for
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383
Requirement
Skills
confirmation of legal provision).
Identify potential creative accounting – window
dressing re invoices in transit.
Additional audit procedures
Identify practical solutions in terms of additional
audit work to address the identified
weaknesses.
Financial reporting issues
Write in a clear and concise style appropriate to
a file review.
Derivatives
Identify the financial reporting issues relating to
derivatives and possible treatments.
Claim from MegaCo plc
Assimilate facts relating to likelihood of claim
and outline potential treatments.
Contract liability
Link change in revenue policy with potential for
warranty provision.
Identify inappropriate revenue recognition
treatment.
Disposal
Highlight potential irrecoverable receivables
from the disposal of the business.
Identify potential need for dilapidations.
Accounting treatment of pension scheme
Adjustment required to proposed treatment.
Calculation of amounts to be presented in the
statement of financial position and of profit or
loss and other comprehensive income.
Audit issues
Evaluate the key issues including the impact of
the departure of the responsible accountant
and materiality.
Ethics
Evaluate with reference to ICAEW Code.
Marking guide
Marks
Review of assistant’s work: key weaknesses
Additional audit procedures
Financial reporting issues
Derivatives
Claim from MegaCo plc
Contract liability
Disposal
Accounting treatment of pension scheme
Audit issues
11
8
Ethics
Marks Available
5
45
3
2
3
3
7
3
Maximum
40
Total
40
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Corporate Reporting
ICAEW 2022
Review points on procedures performed
Trade payables
Explanation for decrease in payables seems odd as comments on commission imply high trading in
last month of year. Are we sure there is no cut-off error here?
Debit balances within trade payables ledger – what are these? What have we done to ensure that
they are recoverable? How do we know it is appropriate to classify them as trade receivables?
How were balances chosen for supplier statement reconciliation? Should select based on
throughput rather than year-end balance as key risk is understatement.
Work on invoices in transit is not adequate. Need to determine when goods were received rather
than when invoice was posted. If goods were received pre year end then should have an accrual
within goods received not invoiced (GRNI). This needs to be checked.
Large number of invoices in transit and significant balance in GRNI accrual suggest a risk of a cut-off
error so need to do careful work here.
May be other balances denominated in foreign currency – where are FX rates used to translate these
considered?
Not clear what procedures if any have been done on GRNI accrual – would expect it to be tied into
detailed listing which has been reviewed for unusual items, debit balances, old items etc.
Also needs to be tested for completeness by reference to procedures on supplier statements, cut-off,
accruals etc.
Review for any intra-group balances that may need to be disclosed as related party transactions or
may not be at arm’s length. (Consolidation schedules may also later require identification of such
balances in group financial statements.)
Accruals
Exceptionally high May sales increase risk of cut-off errors and fraud. Need to ensure adequate
procedures performed on sales cut-off.
Procedures performed on bonus are inadequate – need to understand basis on which accrual made
and bonuses to which staff are contractually entitled. Also need to determine what authorisation is
required from parent company for element payable to directors. May need to wait and see amounts
actually paid/authorised.
Procedures on general and admin accruals are not adequately documented – need analysis on file so
can see exactly what vouching was done.
In addition, the direction of testing does not address risk that accruals are incomplete. We need to
look at post year end payments and invoices and ensure that all items relating to pre year end
purchases have been accrued in year end financial statements.
The financial controller is not the right person to discuss the legal claim with – need to talk to
whoever has been handling discussions and also seek direct input from the legal firm involved
through circularisation.
Need to examine and file copies of all relevant correspondence.
May also need expert input re validity or otherwise of patent claim from a technological point of
view.
Should also consider whether legal firm was qualified to give an opinion in such a specialised area –
fees seem quite low for expert advice against a large corporation which may have far more in-house
expertise and expert lawyers.
See also points re related financial reporting issue below.
ICAEW 2022
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385
PAYE/NI
No procedures documented – what has been done on this?
Would expect agreement to payroll and post year end payment. Also important to discuss the
outcome of any PAYE/NI inspections and whether any additional amounts of penalties are likely to be
payable.
Contract liabilities
Cross reference to work carried out on revenues in audit file.
See comments below re change in allocation between product and revenue.
Given that there is a one year warranty period – seems odd that there is no warranty provision in
current liabilities.
Surplus property provision
Again seem to rely on discussion with financial controller – not appropriate as she did not calculate
provision.
Need to determine what advice was taken in determining two year period for provision – would
expect them to have taken advice from estate agents etc.
See also issues identified below.
General
No taxation payable shown – where are such balances and what work has been done on them?
No balances due to other group companies?
Potential financial reporting issues and adjustments identified
Accounting for derivatives
Comment on Metallo balance makes it clear that there is a derivative in the form of a forward
exchange contract. Accounting for this needs to be in line with IAS 32/IFRS 9. Will need to look
carefully at whether it qualifies for hedge accounting. Fair value of derivatives should be shown
within statement of financial position. If qualify for hedge accounting then gain/loss on the hedging
instrument will be taken to profit or loss in same period as item which was hedged. This will depend
on when inventory from Metallo is used. If does not qualify for hedge accounting then gain/loss
should go to profit or loss. In either case, balance with Metallo should be translated at year end rate.
We can only use fair value hedge accounting if there was appropriate documentation in place at
inception of the contract. Could also use cash flow hedge as either FV or CF hedges are permissible
under IFRS 9 for foreign currency.
MegaCo claim
MegaCo royalty claim – position taken in the accounts is very different to that taken in the prior year
and we need to understand what has actually changed to justify the different treatment.
Any claim like this represents a contingent liability where the probability of a payment being made
needs to be assessed. Only if it is remote is there no provision or disclosure in the financial
statements. If it is not remote but not more likely than not then a disclosure must be made and if
possible quantified – quantification is clearly possible here as there must have been some basis for
prior year provision.
Letter was only sent to MegaCo a few months ago and the fact they have not yet responded is not
adequate evidence that claim has been dropped, particularly given their acknowledgement letter –
more likely that they are using the time to build a stronger case and possibly even a larger claim.
Contract liability
Revenue recognition change is inappropriate and contravenes IFRS 15, Revenue from Contracts with
Customers. Two performance obligations can be identified: the supply of a refrigeration unit and the
three-year maintenance contract. Per IFRS 15, transaction price is allocated to each performance
obligation in proportion to the relative stand-alone selling price of the goods or services provided
within each performance obligation.
Since Maykem do sell products separately, they have evidence of stand-alone selling price of
product by reference to what a customer will pay for it. The same is true of the additional amount a
customer chooses to pay for maintenance contract. To split on any other basis would not be
permitted.
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Corporate Reporting
ICAEW 2022
Changing allocation retrospectively in this way has resulted in a large release of revenue and
additional profit which has materially distorted the results for the year. At the very least it will require
disclosure and might be regarded as a change in policy (if valid at all).
There is no requirement that all elements of a multi-element sale should give same margin – what
matters is appropriate stand-alone proportions allocated to revenue.
Revenue from the sale of the refrigeration unit should be recognised on delivery of the unit
(performance obligation satisfied at a point in time).
The maintenance contract is a performance obligation satisfied over time. Time elapsed (an input
method) is an appropriate way to measure progress towards satisfaction of the performance
obligation, so spread evenly over the period of the contracts.
The revenue received in advance for the maintenance contract is a contract liability (consideration
received or due before a performance obligation is satisfied). As maintenance contracts are for three
years, surely part of the contract liability should be in payables falling due after more than one year.
Disposal of business
Seem to have considered only some of the costs. One might expect:
•
What about dilapidations for property as in bad state?
•
Do plant and machinery or leasehold improvements have a NBV which is impaired and should be
written down or even written off completely? What proceeds, if any, are expected for such items?
•
What has happened to any receivables balances relating to domestic customers? Have these all
been collected or is collectability in doubt given sale of business?
•
Does Maykem have any ongoing warranty or other obligations under terms of deal which should
be provided for?
Need also to consider whether domestic market is a separate business segment and therefore
should be disclosed as a discontinued operation within the accounts.
May also be assets held for sale which should be reclassified.
Need to ensure gain or loss is properly described within statement of profit or loss and other
comprehensive income as should probably be regarded as an exceptional item.
Does sale of inventory suggest that other inventory provisions within Maykem might be inadequate?
Need to understand more fully what profit or loss was made on sale of inventory.
Should consider discounting in calculating surplus property provision.
Pension scheme
The directors are not correct. The contributions to the scheme are not recognised in profit or loss but
are treated as a debit to plan assets. The accounting entries relating to the contributions should be:
DEBIT
Plan assets
CREDIT
£306,000
Cash
£306,000
According to IAS 19, Employee Benefits, gains or losses on remeasurement of the net defined
benefit asset/liability (actuarial gains or losses) must be recognised in other comprehensive income
in the year in which they arise.
The full accounting treatment is as follows:
Amounts recognised in the statement of financial position
Present value of obligation
Fair value of plan assets
Net liability
ICAEW 2022
31 May 20X8
31 May 20X7
£’000
£’000
4,320
3,600
(4,050)
(3,420)
270
Audit and integrated 1
180
387
Expense recognised in profit or loss for the year ended 31 May 20X8
£’000
Current service cost
360
Net interest on the net defined benefit obligation: (5% × 3,600) – (5% ×
3,420)
9
Net expense
369
Loss recognised in other comprehensive income for the year ended 31 May 20X8
£’000
Actuarial loss on obligation
(522)
Return on plan assets (excluding amounts in net interest)
495
Net actuarial loss
(27)
Change in the present value of the obligation
£’000
Present value of obligation at 1 June 20X7
3,600
Interest cost on obligation (5% × 3,600)
180
Current service cost
360
Benefits paid
(342)
Loss on remeasurement through other comprehensive income (residual)
Present value of obligation at 31 May 20X8
522
4,320
Change in the fair value of plan assets
£’000
Fair value of plan assets at 1 June 20X7
3,420
Interest on plan assets (5% × 3,420)
171
Contributions
306
Benefits paid
(342)
Gain on remeasurement through other comprehensive income (residual)
Fair value of plan assets at 31 May 20X8
495
4,050
Audit issues
•
We need to determine where the information in Exhibit 2 has been obtained from in order to
evaluate the integrity of the data. This is a particular issue as the accountant normally responsible
for pensions has left.
•
We need to consider the implications for the audit of the involvement of experts ie, actuaries.
•
We need to ask why the accountant responsible for pensions has left and assess the
consequences of this on our risk assessment and on other areas of our audit.
•
Materiality must be evaluated. The net effect on profit or loss is a reduction of profit of £63,000
(369 – 306). This in itself is not material (based on the materiality level of £250,000) but there are
also consequences of the revised treatment in the statement of financial position and in other
comprehensive income. The proposed treatment would also be inconsistent with the previous
year therefore we should request that the financial statements are revised so that they are in
accordance with IAS 19.
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Corporate Reporting
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Ethics: Sophie’s investment
We have a responsibility to consider any possible or actual conflicts of interest.
In this case, there is a threat of self-interest arising, as a member of the audit team (Sophie) has an
indirect financial interest in the client’s parent company. The fact that the parent is listed on Euronext
rather than the London Stock Exchange does not reduce the risk.
The relevant factors from the ICAEW Code of Ethics (section 510) are as follows:
•
The interest is unlikely to be material to the client or to Sophie, as the investment is in a tracker
fund rather than shares and, therefore, the value of Maykem will only have a small influence on the
value of Sophie’s total investment.
•
Sophie is a junior member of the audit team and so her role is not significant in the sense that she
will not be making audit conclusions or be substantially involved in areas of high audit risk.
•
The investment is in ParisMet, the parent, rather than in Maykem itself.
The risk that arises to the independence of the audit here is not considered to be significant.
It would be inappropriate to require Sophie to dispose of her investment. It is also unnecessary to
remove Sophie from the assignment.
21 Tydaway
Marking guide
Marks
Follow up work from inventory count
Audit work arising from concerns and need to address financial statement assertions
Financial reporting effects of four hedging options
Explanation and comparison of the alternative financial reporting treatments
12
13
10
4
Documentation required for audit purposes
Marks Available
4
43
Maximum
40
Total
40
Questions and follow up work on inventory count attendance notes
Counting procedures
It appears that counters had access to the quantities shown on the system as they counted. This is not
best practice and can lead to a tendency to ‘count’ what should be there, as possibly illustrated in the
mezzanine area discrepancies.
You need to determine whether this was in fact the case and then to evaluate whether we can still
rely on the count. If they did have access to quantities then you will need to raise a management
letter point in this area.
In addition, investigating only differences greater than 10% tolerance level may be insufficient given
the level of materiality and significance of the inventory balances.
Overall count difference
No mention in your notes of what the overall count difference was – important to know this both to
evaluate accuracy of count and to assess what work is necessary on roll-forward of count quantities to
year end.
Audit sample count sizes
How were audit sample sizes for both raw materials and WIP determined? Important to know this so
we can assess adequacy of work done and also understand how to evaluate the potential impact of
errors identified. If errors are to be extrapolated into the population as a whole then we need to
make sure a representative sample has been chosen.
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389
Whether this is the case is not clear from documentation at present. WIP sample size is very low at
only five and unlikely to be representative unless number of WIP items is very low. You need to find
out and clarify this.
Weigh counting method for WIP
What value of total inventory was counted using weigh counting? 5% error rate is only acceptable if
this is clearly immaterial when applied to the whole relevant population.
You need to clarify whether weigh counting differences noted all went in one direction or whether
there were unders and overs as would be expected. 5% error rate does seem quite high unless value
of items involved is clearly immaterial.
Inventory controller – discussion on paint and chemicals
We cannot rely on discussion with controller to evaluate whether the approach taken on paint and
chemicals is reasonable. Again you need to determine the total value of such items and to estimate
what total possible mis-statement could be from the approach taken. If potentially significant then
additional work and analysis will be necessary at the year end.
Errors in mezzanine area – need for additional year end procedures
Although specific differences noted in the mezzanine area have been corrected, the fact that two
differences were noted in the same area may be indicative that counters in that area were not
accurate enough. You should ideally have performed additional counts in the areas that team had
counted to determine whether errors were indeed isolated or whether the whole area should be
checked and recounted. However you cannot now do that but, depending on the significance of
inventory counted by that team, we will need to consider additional procedures at year end, possibly
including a year-end inventory count.
It is important to understand fully the nature of the errors and inventory items on which they arose as
it may be possible to isolate the risk of similar errors to part of the population and thus either
determine that any misstatement cannot be material or limit additional procedures to the relevant
part of the overall population. As the errors went in both directions this suggests that there is both
overstatement and understatement risk. You need to determine the nature of the errors and the
inventory items which were miscounted.
No work on finished goods
No work appears to have been performed on finished goods quantities – were there any at inventory
count date? We might have expected some from the management accounts analysis which showed
goods made for Swishman.
Old or damaged inventory
Was any old or clearly damaged inventory noted during the count? We need details of this to ensure
adequately provided at year end.
Consignment inventory
Do you have any further details of how inventory sent on consignment to subcontractors is
accounted for? We would expect it to remain within inventory records but notes from count imply
that it is booked out and then booked back in again when it is received back. This might result in
under-recognition of inventory and a grossing up of revenue and cost of sales entries.
You need to understand and document fully the arrangements with the subcontractors and to review
all accounting entries. There may also be more inventory at the subcontractor which we need to
consider. In addition there is a question as to how inventory received back should be accounted for –
as raw materials or as WIP. It is also important to understand and document where subcontractor
costs are recorded in profit or loss so appropriate amount is inventorised but there is no double
counting.
Cut-off at count date
There is no evidence that you have tested the accuracy of cut-off entries at the inventory count date.
You need to do this so that the comparison of book to physical quantities is accurate as books have
been updated for all physical transactions before the count and post count transactions are not
included.
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Financial statement assertions – concerns or issues and key audit procedures
Introduction
Inventory is a material debit balance and audit work would be expected therefore to focus on the
assertions of existence, accuracy, valuation and allocation, and rights and obligations (ownership).
Each of these is considered below.
Within the statement of profit or loss and other comprehensive income the inventory balance is a
credit element of cost of sales and so it is also important to ensure that it is not understated.
Work on existence of inventory
Roll forward – work on book inventory
The count at the South London factory was on 30 June, one month before year end; we will need to
perform work on inventory movements over the last month to ensure that the year-end inventory at
that factory exists and has been accurately recorded. This might include test counts and cut off work
at year end or detailed work on completeness and accuracy of movements recorded within the book
stock records.
Also need to make sure that the count data tested at the inventory count has been tied into the
system and that the physical inventory count (including any book to physical adjustment) has been
recorded accurately in the accounting records.
Woodtydy – not included in count?
Inventory at Woodtydy does not appear to have been included in the 30 June count – we will need to
make arrangements to attend a count at this site and to perform appropriate audit tests of the
accuracy and completeness of this count. If the count is not at year end then we will also need to rollforward procedures as above. Will also need to address risk of incorrect cut-off on inventory
transferred between the two sites.
Work on accuracy, valuation and allocation of inventory
The fact that differing methods are used to value inventory at the two sites is not necessarily an issue,
providing both result in a reasonable approximation to actual cost of inventory held. However the
different approaches mean that there will be two separate populations for audit testing and that the
testing will need to be tailored for each site.
Purchase price variance
Tydaway’s inventory is valued at standard cost which has proved to be a reasonable approximation to
actual cost in the past. However purchase price variances are much higher in the 10 months to 31
May 20X1 than in the equivalent prior year period and might well need to be taken into account in
determining the actual cost of inventory held at year end.
•
Audit work should include testing a sample of individual raw material costs, comparing the actual
cost to the standard cost and ensuring that the difference has been posted accurately to the
purchase price variance account.
•
Purchase price variances (PPV) should then be reviewed for any significant one-off items such as
that already identified in the commentary on the management accounts. Such items should be
excluded from any adjustment made to inventory if, like the £25,000 in the commentary, they
relate to purchases of inventory which has been sold prior to year end.
•
We will then need to determine whether any adjustment has been made by management to
include a proportion of PPV in inventory and thus adjust the raw material inventory valuation to a
closer approximation to actual cost. An independent assessment of the reasonableness of this
adjustment should then be made. Calculations to assess the appropriateness of the PPV add back
could include:
– extrapolating the difference between actual and standard costs noted in the sample testing
and comparing this to the add back made;
– calculating the ratio of PPV to raw material purchases (excluding in both cases the one off items
identified above);
– applying this percentage to the raw material element of inventory; and
– considering PPV over the period of average inventory turn and ensuring after adjustment for
one off items that the amount added back is equivalent to PPV over the period in which
inventory was acquired.
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The change between old and new standard costs may have been posted to PPV when standard costs
were changed on the first day of the financial year. If it was, then this would need to be excluded
from the PPV add back calculation.
No PPV add back should be applied to £60,000 of components which were purchased in the
previous year. However, we will need to look at whether the standard cost for these was increased at
the beginning of year and to reverse that entry as the correct cost is cost components that were
actually purchased in prior year.
Freight costs
Freight is added to standard cost at 1.5% whereas actual costs are running at around 3.2% of raw
materials (£77,000/£2,431,000). It is not clear where the variance has been accounted for. It may
have been taken into account in variances already considered. In any case the amounts which might
potentially be included in inventory are not material so are not considered further. However should
note that % in 20X0 was 1.4% so may be exceptionally high costs in 20X1 which should not be
included within inventory valuation.
Overheads
Overheads included in inventory need consideration as these are based on May figures and could
well be material. You should obtain client calculation of the amount to be included in year-end
inventory and perform the following procedures:
•
Consider whether the assumption that WIP is on average 50% complete is reasonable – this may
involve an inspection of the WIP on site at year end.
•
Verify accuracy of calculations and agree amounts to expenses tested in statement of profit or loss
and other comprehensive income testing or other supporting evidence.
•
Agree overheads included are all items that can be included within inventory valuations. As they
appear to include delivery costs this may well not be the case as such costs are selling costs and
should not be inventorised.
•
Consider whether levels of activity through the factory have been normal as it would be
inappropriate to include in inventory excess levels of overhead arising from idle time or inefficient
production. There are some indications that this may have arisen as sales are at around 75% of
prior year level and direct production costs are also lower (despite higher unit costs for materials)
but overheads have remained at around the same level.
•
Ensure both finished goods and WIP are included in the calculation.
Woodtydy’s inventory
Work will also be necessary on Woodtydy’s inventory valuation. In designing this work we will need
to consider the extent to which audit work has been completed in the past as Woodtydy was only a
division. Work may also be required on opening balances.
•
In addition, the description of the inventory records implies that they may be manual in which
case additional work may be needed to ensure internal consistency and clerical accuracy.
•
Raw materials are valued at the latest invoice price and the accuracy of this can be tested by
taking a sample and agreeing the value to an invoice for the last transaction.
•
We also need to consider whether latest invoice price is appropriate as this may result in inventory
which was purchased earlier in the year being included in inventory at a price which is higher or
lower than actual cost. If differences are significant then additional testing may be necessary to
determine error over whole population. It would normally be more appropriate to use FIFO
pricing and although latest invoice can be an estimate of this, it is not always an accurate one.
•
To test overheads we will need to look at actual hourly rates and compare to the £30 rate used to
include overhead in inventory. Also we need to ensure that hours included on each job card
appear reasonable and are consistent between similar jobs. Information available to test this is not
clear at present so further investigation will be necessary. As for Tydaway we need to look at the
nature of costs included and whether overheads are for normal level of production.
•
No obvious freight costs are included in the value at Woodtydy so we need to discuss whether
freight and other purchasing costs are included and if not, whether the effect could be material.
•
Woodtydy’s inventory is also likely to include components purchased from Tydaway as there are
sales between the factories. We will need to ensure that any interdivisional profit is eliminated in
the company accounts.
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•
To the extent that any issues are noted with valuation of Woodtydy inventory, we will need to
consider whether there is any impact on fair values recorded at the time of Woodtydy acquisition.
In addition, we need to consider any pre-existing supply contract between Tydaway and
Woodtydy and assess whether the fair value of this needs to be taken into account.
Provisions
We will need to do work on inventory provisions at both sites. The provision at Tydaway appears not
to have been reassessed since the last year end and looks very low compared to the level of
inventory, the slower stock turn and the provision made by Woodtydy which is in a similar business.
It seems likely that a specific provision will be required against the finished goods made for
Swishman as the margin (11%) possible on any sales is unlikely to cover the rework costs and may
also only be able to sell repainted units at a lower price.
We also need to consider whether any contingent asset should be recognised re: claim against
Swishman. Swishman has agreed to pay an immaterial amount £6,000, which prima facie can be
shown as an asset – however financial position of Swishman means it is unlikely to be able to pay. The
same consideration applies to any further amounts claimed from Swishman and we would need to
be virtually certain that the additional claim would be upheld to meet the criteria for recognition of a
contingent asset.
•
We need to consider whether there is any risk of further order cancellations from other customers.
•
Old components still in stock but purchased in a prior year may also need a provision as they are
clearly very slow moving. Need to discuss this with management.
•
Work done should include understanding and assessing the appropriateness of the provisions
that have been made but also considering whether the provisions are complete. This will mean
following up on potentially obsolete items noted at stock count; considering data available which
will allow us to identify slow moving items; and looking at the margins made on individual
product sales (including post year-end sales of WIP held at year end) to determine whether there
are low margin items or items sold at a loss where a provision may be necessary.
Overhead costs which are not included in standard costs at Tydaway, selling costs and any rework
costs should all be considered in this analysis. In addition a sample of high value items should be
reviewed to ensure that there are no NRV issues, that the items are being used in current production
and that there is no excess inventory.
Tutorial Note
Credit should also be awarded for answers that discuss the impact of ISA (UK) 540 (Revised)
Auditing Accounting Estimates and Related Disclosures in relation to complexity, subjectivity and
estimation uncertainty, as well as the controls in place at this client leading to a separate
assessment of audit risk for these categories of balances.
Work on rights and obligations (ownership) of inventory
•
Testing of value will ensure agreement to valid purchase invoices. However, testing is also
required around cut-off to ensure that inventory is only included where either it has been paid for
or a creditor recorded and where the delivery was received before the year end.
This will involve testing the last few deliveries before year end to ensure both inventory and creditor
included and the first few post year end to ensure that goods not delivered until after year end have
not been booked into year-end inventory.
•
We will also need to test sales cut-off to ensure that goods shipped to a customer before the year
end are not also included in inventory. This will involve detailed testing but also enquiry as to any
goods held at year end on behalf of customers.
Consignment stock sent to subcontractors will need more consideration as highlighted under stock
count queries as this may well be owned stock not included at present.
Understatement of inventory
Much of the work outlined above will be two directional – for example the detailed sample testing of
valuation. In addition, cut-off testing will test for understatement as well as overstatement, as will
stock count work.
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Work on PPV add back and freight will involve an expectation/calculation which is also two
directional. Work on provisions will need to be extended to ensure that provisions made are on a
valid basis and not overstated.
Impact of Chinese transaction on the financial statements
No hedging
In the absence of hedging there is no recognition of the purchase of the metal in the financial
statements for the year ending 31 July 20X1 as there has been no physical delivery of the inventory,
so it is unlikely that control has passed from the seller to Tydaway. The firm commitment would not
therefore be recognised.
On 15 December 20X1, the purchase takes place and the transaction would be recognised at the
exchange rate on that day at a value of £354,409 ($500,000/1.4108) as follows:
DEBIT
Inventory
CREDIT
£354,409
Cash
£354,409
This cost of inventory (which is £44,004 greater than at the time the contract was made) would then
be recognised in cost of sales and impact on profit in the year ending 31 July 20X2.
Hedging with forward contract – but no hedge accounting
At 31 July 20X1:
DEBIT
Forward contract – financial asset
CREDIT
£20,544
Profit or loss
£20,544
To recognise the increase in the fair value of the forward contract (ie, a derivative financial asset) and
to recognise the gain on the forward contract in profit or loss.
At 15 December 20X1:
DEBIT
Forward contract – financial asset
CREDIT
£23,450
Profit or loss
£23,450
To recognise the further increase in the fair value of the forward contract (ie, a derivative financial
asset) and to recognise the gain on the forward contract in profit or loss.
DEBIT
CREDIT
Cash
£43,994
Forward contract
£43,994
To recognise the settlement of the forward contract by receipt of cash from the counterparty.
DEBIT
CREDIT
Inventory
Cash
£354,409
£354,409
Being the settlement of the firm commitment (ie, the purchase of inventory) at the contracted at the
spot rate on 15 December 20X1 ($500,000/1.4108).
Fair value hedge
A hedge of a foreign currency firm commitment may be accounted for as a fair value hedge or as a
cash flow hedge (IFRS 9 para 6.5.4) at the choice of the entity.
If the hedged risk is identified as the forward exchange rate, rather than the spot rate, then it could
be assumed to be perfectly effective.
The value of the transactions are as follows:
At 15 July 20X1
$500,000/1.6108 = £310,405
At 31 July 20X1
$500,000/1.5108 = £330,950
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Difference = £20,545 is almost identical to the movement in the fair value of the forward at £20,544
and is clearly therefore highly effective:
Similarly, at 15 December 20X1
$500,000/1.4108 = £354,409
Difference = £23,459 which is almost identical to the movement in the fair value of the forward at
£23,450 and therefore remains highly effective.
Cash flow hedge
At 15 July 20X1
No entries are required at this date as the firm commitment is unrecognised. The forward contract is
potentially recognised, but it has a zero fair value and there is no related cash transaction to record.
At 31 July 20X1:
The increase in the fair value of the future cash flows (the hedged item) of £20,545 is not recognised
in the financial statements. However, as it exceeds the change in the fair value of the forward (the
hedging instrument) it is fully effective.
DEBIT
CREDIT
Forward contract – financial asset
£20,544
Other comprehensive income
£20,544
To recognise the increase in the fair value of the forward contract (ie, a derivative financial asset) and
to recognise the gain on the forward contract in other comprehensive income.
At 15 December 20X1:
DEBIT
CREDIT
Forward contract – financial asset
£23,450
Other comprehensive income
£23,450
To recognise the increase in the fair value of the forward contract financial asset and to recognise the
gain on the forward contract in other comprehensive income. It is recognised in its entirety in other
comprehensive income (ie, no part is recognised in profit or loss) as there is no ineffectiveness as the
increase in the fair value of the forward contract (the hedging instrument) is less than the change in
the fair value of the future cash flows (the hedged item) (IFRS 9 para 6.5.8).
DEBIT
CREDIT
Cash
£43,994
Forward contract
£43,994
To recognise the settlement of the forward contract at its fair value by receipt of cash from the
counterparty.
DEBIT
CREDIT
Purchases
£354,409
Cash
£354,409
Being the settlement of the firm commitment (inventory purchase) at the contracted price of
$500,000 at the spot rate on 15 December 20X1 ($500,000/1.4108).
DEBIT
CREDIT
Other comprehensive income
Purchases
£43,994
£43,994
To remove the firm commitment from other comprehensive income and adjust the carrying amount
of the inventory resulting from the hedged transaction.
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Discussion of financial reporting differences
Year ending 31 July 20X1
No hedge
No hedge
accounting
Fair value
hedge
Cash flow
hedge
£
£
£
£
–
20,544
20,544
–
SPLOCI
Profit or loss
(20,545)
Other comprehensive income
–
–
–
20,544
Financial asset
–
20,544
20,544
20,544
Inventory
–
–
–
–
Cash
–
–
–
–
Retained earnings
–
20,544
–
–
Hedging reserve
–
–
–
20,544
Firm commitment
–
–
20,545
–
SOFP
Year ending 31 July 20X2
No hedge
No hedge
accounting
Fair value
hedge
Cash flow
hedge
£
£
£
£
–
23,450
23,450
–
SPLOCI
Profit or loss
(23,459)
Other comprehensive income
–
–
–
Note (2)
SOFP
Financial asset
Inventory
Cash
–
354,409
(354,409)
Note (1)
Note (1)
Note (1)
354,409
354,409
(44,004)
(43,994)
(354,409)
(354,409)
(354,409)
43,994
43,994
43,994
354,409
Retained earnings
–
43,994
–
–
Hedging reserve
–
–
–
Note (2)
Firm commitment
–
–
44,004
–
(44,004)
Notes
1
The financial asset increases to £43,994 before being settled for cash.
2
Other comprehensive income and the hedging reserve each increase to £43,994 before being
recycled into inventory.
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Tutorial Note
The notes below are more detailed than would be expected from even the best candidates.
The purpose of hedging is to enter into a transaction (eg, buying a derivative) where the derivative’s
cash flows or fair value (the hedging instrument) are expected to move wholly or partly, in an inverse
direction to the cash flows or fair value of the position being hedged (the hedged item). The two
elements of the hedge (the hedged item and the hedging instrument) are therefore matched and
are interrelated with each other in economic terms.
Overall, the impact of hedge accounting is to reflect this underlying intention of the matched nature
of the hedge agreement in the financial statements. Hedge accounting therefore aims that the two
elements of the hedge should be treated symmetrically and offsetting gains and losses (of the hedge
item and the hedging instrument) are reported in profit or loss in the same periods. Normal
accounting treatment rules of recognition and measurement may not achieve this and hence may
result in an accounting mismatch and earnings volatility, which would not reflect the underlying
commercial intention or effects of linking the two hedge elements which offset and mitigate risks. For
example, typically, derivatives are measured at fair value through profit or loss; whereas the items
they hedge are measured at cost or are not measured at all (eg, a firm commitment in the case of the
Chinese contract).
Hedge accounting rules are therefore required, subject to satisfying hedge accounting conditions.
In the case of the Chinese contract, the forward rate hedge attempts to lock Tydaway into the
contractual price of £310,405 ($500,000/1.6108). This reflects the US$ price at the exchange rate at
the time of the contract at the spot rate at the original contract date.
In the absence of hedging, the inventory cost would be higher at £354,409 ($500,000/1.4108)
reflecting the movement in the spot rate by the settlement date (according to the scenario in the
working assumptions). This would be reflected in a higher cost of sales in the year ended 31 July
20X2 and therefore lower reported profit, due to the exchange loss, than would have been the case
with hedging.
With hedging, but without hedge accounting, the inventory would still be recognised at £354,409,
but there would now be a gain on the forward contract derivative. This overall gain of £43,994 would
be recognised through profit or loss entirely separately from the inventory purchase contract without
trying to match the two elements of the hedge transaction in the same period. The gain on the
derivative is split between the two accounting periods according to when the gain arose (£20,544 in
the year ending 31 July 20X1; and £23,450 in the year ending 31 July 20X2). The earnings therefore
would be inflated in the year ended 31 July 20X1 by the £20,544 gain. Earnings would be deflated in
the year ended 31 July 20X2 as the higher inventory cost of £44,004 in cost of sales would only be
partially offset by the derivative gain of £23,450, resulting in earnings volatility.
Fair value hedge accounting attempts to reflect the use of the forward rate derivative (the hedging
instrument) to hedge against fair value movements in inventories arising from foreign exchange
movements (the hedged item). To do this, movements in the derivative, in the year ending 31 July
20X1, go through profit or loss and are recognised in the statement of financial position as a financial
asset. The treatment of the firm commitment (the hedged item), in order to match the treatment of
the hedging instrument, is also recognised through profit or loss and as a liability in the SOFP in
order to avoid a mismatch. (A firm commitment would not, in the absence of hedge accounting,
satisfy normal recognition criteria and so would not normally be recognised.) The small ineffective
element for Tydaway represents the net difference in the movements of the fair values of the hedged
item and the hedging instrument and is recognised through profit or loss in accordance with IFRS 9
para 6.5.8. On settlement, the firm commitment is offset against the inventory cost to reflect the
inventory price that the futures contract originally tried to lock in.
Cash flow hedge accounting attempts to reflect the use of the forward rate derivative to hedge
against future cash flow movements from inventory purchases arising from foreign exchange
movements. To do this, movements in the derivative, in the year ending 31 July 20X1, which would
normally go through profit or loss, are recognised in other comprehensive income. The other
comprehensive income balance (including further movements in 20X2 in the forward exchange
derivative) is recycled to profit or loss in the same period in which the hedged firm commitment (the
Chinese contract) affects profit or loss. (This may be regarded as superior to fair value hedge
accounting as it avoids the need to recognise a firm commitment, which would not be recognised in
any other circumstances.) In this case, this is in the year ending 31 July 20X2 when the contract is
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settled and the hedging gain is recognised as part of the inventory assets (basis adjustment) which in
turn affects cost of sales and profit in the period. The offset against the carrying amount of the
inventory resulting from the hedged transaction is to reflect the inventory price and ultimate cash
flows that the futures contract originally tried to lock into.
Note that under cash flow hedge accounting, the increase in the fair value of the future cash flows
(the hedged item) of £20,545 is not recognised in the financial statements. However, as it exceeds
the change in the fair value of the forward (the hedging instrument) it is fully effective (IFRS 9 para
6.5.11). This is because the separate component of equity associated with the hedged item is limited
to the lesser of: the gain/loss on the hedging instrument; and the change in fair value of the hedged
item (IFRS 9 para 6.5.11).
Documentation
For audit purposes and to meet the requirements of IFRS 9, we would expect the following
documentation to be available:
•
Details of the risk management objectives and the strategy for undertaking the hedge
•
Identification and description of the hedging instrument (forward contract)
•
Details of the hedged item or transaction (payable settled in $)
•
Nature of the risk being hedged (exchange rate changes £:$)
•
Description of how Tydaway will assess the hedging instrument’s effectiveness
22 Wadi Investments
Marking guide
Report describing, explaining and quantifying required accounting treatment of:
Acquisition of Strobosch
Additional audit procedures
Change of use of asset
Audit procedures
Points for instruction letter
Loan to Strobosch
Hedging of net investment
Marks Available
Marks
7
5
6
5
8
4
8
43
Maximum
40
Total
40
Report: Audit of Wadi Investment Group
Audit of parent company
Acquisition of Strobosch
We need to consider whether Strobosch is a subsidiary. The acquisition of an 80% stake in the equity
of Strobosch strongly suggests that Wadi has control of the entity, and provided there are no
indications to the contrary as listed in IFRS 10, Consolidated Financial Statements the investment
should be treated as a subsidiary. On this basis the purchase consideration will be accounted for in
accordance with IFRS 3, Business Combinations.
Cost of investment in the books of Wadi
The cost of the investment does not appear to have been calculated correctly. IFRS 3 requires that
the initial investment in the subsidiary is recorded in Wadi’s statement of financial position at the fair
value of the consideration transferred.
•
Under IFRS 3 costs relating to the acquisition must be recognised as an expense at the time of
the acquisition. They are not regarded as an asset. The RR23 million legal costs and the £2 million
internal costs incurred by Wadi’s M&A team must therefore both be expensed. The RR23 million
should be translated at the rate ruling at the date of acquisition.
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•
IFRS 3 requires that costs of issuing debt or equity are to be accounted for under the rules of IFRS
9, Financial Instruments. The £6 million transaction costs associated with the issue of the
debentures must therefore be written off against the carrying amount of the debentures and
expensed over the life of the debentures using the IRR%.
Based on the above the investment should initially have been accounted for as follows:
£m
DEBIT
Consideration transferred (675 + 360)
1,035
DEBIT
Profit or loss for the year (2 + (23 × 0.45))
12
£m
CREDIT
Cash (675 + 2 + 6 + (23 × 0.45))
693
CREDIT
Non-current liability: Debentures (360 – 6)
354
The following journal is therefore required to correct the investment:
£m
DEBIT
Profit or loss for the year
12
DEBIT
Non-current liability: Debentures
6
CREDIT
Investment in Strobosch
£m
18
At the year end, the debentures must be measured at amortised cost (W1).
•
The interest expense of £16 million, determined by the IRR of 4.42%, should be charged to profit
or loss for the year.
•
The coupon of 4% for the six-month period is the amount actually paid.
•
The debenture is therefore recognised at £356 million.
The following adjustment is required:
£m
DEBIT
Interest expense
£m
16
CREDIT
Cash
14
CREDIT
Debenture
2
Audit procedures
The following additional procedures are required:
•
Details of the consideration paid for the investment should be agreed to the purchase
agreement.
•
The purchase agreement should also be reviewed to determine that there is no additional
consideration to be paid.
•
The number of shares purchased should be agreed to the sale agreement to confirm the 80%
holding and the details should be reviewed to determine that Wadi does have control of
Strobosch.
•
Ownership of the shares should be confirmed by examination of share certificates.
•
Confirm the nature of costs detailed as issue costs of the debenture to ensure that they should not
be written off to profit or loss.
•
Confirm where the IRR of 4.42% has been obtained from and the basis on which it has been
calculated.
•
Discuss with management the way in which the costs of the internal team have been allocated to
the acquisition to agree appropriate treatment is applied.
•
Agree legal costs to invoices.
•
Discuss adjustments required to the investment and the debenture with management to
determine whether they will be made.
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Change of use of non-current asset
IAS 40, Investment Property requires that property that is held to earn rental or capital appreciation or
both, rather than for ordinary use by the business, must be recognised as investment property.
Hence the head office in London must be reclassified from Property, plant and equipment to
Investment property in the statement of financial position.
The asset must be accounted for under IAS 16, Property, Plant and Equipment up to the date of
change in use, and any difference between its carrying amount and its fair value at this date must be
dealt with as a revaluation in accordance with this same standard.
The carrying amount of the asset at 15 March 20X9, the date of change in use, was £108 million
(W2a), hence the £16 million uplift to its fair value of £124 million at this date should have been
recognised in OCI and as a revaluation surplus.
The accounting treatment of the asset from this date is governed by IAS 40 and, as the company
applies a fair value policy to its investment property, no further depreciation should have been
charged on this asset from 15 March 20X9. At the year end, the £4 million uplift to the new fair value
of £128 million (W2a) should have been credited to profit or loss for the year.
By continuing to record the asset in Property, plant and equipment, the asset has continued to be
depreciated and hence excess depreciation of £1 million (W2b) must be added back to the group’s
profits. The revaluation surplus of £21 million (128m – 107m, W2b) has been recognised in the
revaluation reserve, meaning that profit for the year is understated by £5 million (21m – 16m). A
further adjustment must be made to recognise the gain on remeasurement of £4 million.
Audit procedures
•
Agree original cost and confirm depreciation policy.
•
Check that fair values have been calculated in accordance with IFRS 13.
•
Check basis on which the fair values have been calculated. Current prices in an active market
should be available for this type of asset.
•
Agree valuations to valuer’s certificates.
•
Confirm the date that the office was vacated.
•
Review details of the rental agreement to confirm terms ie, occupier is not a company connected
to Wadi and rent has been negotiated at arm’s length.
•
Reperform calculations to confirm the net book value at the date of change of use.
•
Discuss adjustments required to remove the asset from property, plant and equipment with
management to determine whether management is willing to make these.
•
Confirm that disclosure is adequate ie, disclosure of the policy and a reconciliation of the carrying
amount of the investment property at the beginning and end of the period.
Audit of the consolidation
Points to be included in the letter of instruction
The following points should be included:
Matters that are relevant to the planning of the work of Kale & Co:
•
A request that the component auditor will cooperate with our firm.
•
Timetable for completing the audit.
•
Dates of planned visits by group management and our team, and dates of planned meetings with
Strobosch’s management and Kale & Co.
•
The work to be performed by Kale & Co, the use to be made of that work and arrangements for
coordinating efforts.
•
Ethical requirements relevant to the group audit, particularly regarding independence.
•
Component materiality and the threshold above which misstatements cannot be regarded as
clearly trivial.
•
A list of related parties.
•
Work to be performed on intra-group transactions and balances.
•
Guidance on other statutory reporting responsibilities.
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Matters relevant to the conduct of the work of Kale & Co:
•
The findings of our tests of control of a processing system that is common for all components, and
tests of controls to be performed by Kale & Co.
•
Identified risks of material misstatement of the group financial statements, due to fraud or error,
that are relevant to Kale & Co’s work, and a request that Kale & Co communicates on a timely
basis any other significant risks of material misstatement of the group financial statements, due to
fraud or error, identified in Strobosch and Kale & Co’s response to such risks.
•
The findings of internal audit.
•
A request for timely communication of audit evidence obtained from performing work on the
financial information of Strobosch that contradicts the audit evidence on which the team originally
based the risk assessment performed at group level.
•
A request for a written representation on Strobosch’s management’s compliance with the
applicable financial reporting framework.
•
Matters to be documented by Kale & Co.
Other matters:
•
A request that the following be communicated on a timely basis:
– Significant accounting, financial reporting and auditing matters
– Matters relating to going concern
– Matters relating to litigation and claims
– Significant deficiencies in internal control and information that indicates the existence of fraud
We should also request that Kale & Co communicate matters relevant to our conclusion with regard
to the group audit when they have completed their work on Strobosch.
Loan to Strobosch
The loan to Strobosch represents an intra-group item. On consolidation the non-current liability must
be cancelled against the matching financial asset of Wadi. The intra-group loan of £200 million must
be translated into RR at the spot rate. It has been recorded as a non-current liability in the books of
Strobosch at RR444 million (£200m/0.45). As a monetary liability, retranslation to the closing rate at
the year end is required to give a liability of RR426 million (£200m/0.47) and an exchange gain in the
books of Strobosch of RR18 million.
We must confirm that the financial statements of Strobosch included in the consolidation schedule
reflect the adjustments above. We should confirm that the intra-group balances agree and that the
cancellation has been reflected in the adjustments column of the consolidation schedule.
Hedging of net investment
There is a risk that hedging provisions have been adopted inappropriately. IFRS 9, Financial
Instruments states that the use of a foreign currency loan to hedge an overseas investment can only
be used where strict conditions are met:
•
The hedging relationship consists only of eligible hedging instruments and eligible hedged items
– we could seek the services of a suitably qualified expert in this field to ensure this condition has
been met.
•
At the inception of the hedging relationship there is formal designation and documentation of the
hedging relationship and the entity’s risk management objective and strategy for undertaking the
hedge. We would need to confirm that the hedge has been formally designated as such and
check that the following have been documented:
– Identification of the hedging instrument ie, the loans.
– The hedged item ie, the net investment in Strobosch.
– Details of how hedge effectiveness is to be determined.
– Statement of the entity’s risk management objective and strategy for undertaking the hedge.
ICAEW 2022
Audit and integrated 1
401
•
The hedging relationship meets all of the hedge effectiveness requirements of IFRS 9, namely
(IFRS 9 para 6.4.1(c)):
– there is an economic relationship between the hedged item and the hedging instrument;
– the effect of credit risk does not dominate the value changes that result from that economic
relationship; and
– the hedge ratio of the hedging relationship is the same as that actually used in the economic
hedge.
– Based on the information there does appear to be an economic relationship.
– The gain on the translation of the net investment in Strobosch is 80% × 41m = £33 million (W3).
– The exchange loss on the hedging loans is £36 million.
Hence the hedge is effective and hedge accounting rules may be applied provided that the other
conditions have also been met.
Assuming the conditions have been met we must confirm that the following accounting treatment
has been adopted:
•
The portion of loss on the loans that is determined to be an effective hedge, £33 million, should
be recognised directly in equity to offset the gain on the translation of the subsidiary.
•
The ineffective portion of the exchange difference on the loans, a loss of £3 million, should be
recognised in profit or loss for the year.
If we conclude that the hedging provisions of IFRS 9 have not been met an audit adjustment will be
required. The exchange loss on the loans would be charged to profit or loss for the year and the gain
on the subsidiary to the foreign currency reserve.
WORKINGS
(1) Debenture
£m
Initial measurement (360 – 6)
354
Interest for 6 months @ 4.42%
16
Coupon paid (8% × 360 × 6/12)
(14)
Year end balance
356
(2) Correction of investment property
Correct treatment
Date
3 April 20X6
30 June 20X7
30 June 20X7
30 June 20X8
15 March 20X9
15 March 20X9
£m
Initial measurement
Depreciation (90 × 15/600)
30 June 20X9
402
Corporate Reporting
(2.250)
Carrying amount
87.750
Revaluation to FV
112
Depreciation (112 × 12/585)
(2.297)
Depreciation (112 × 8/585)
(1.532)
Carrying amount
Gain on revaluation (OCI and revaluation surplus)
15 March 20X9
90
108.171
15.829
Revaluation to FV
124
Gain on remeasurement (profit or loss)
4
Revaluation to FV
128
ICAEW 2022
Current treatment
Date
£m
15 March 20X9
30 June 20X9
Carrying amount
108
Depreciation (112 × 4/585)
30 June 20X9
(1)
Carrying amount
107
Gain on revaluation (to revaluation reserve)
30 June 20X9
21
Revaluation to FV
128
(3) Foreign currency reserve
£m
Opening net assets:
RR1,865m
@ Closing rate 0.47
877
@ Opening rate 0.45
839
38
Retained earnings:
280 + gain on loan 18 =
RR298m
@ Closing rate 0.47
140
@ Average rate 0.46
137
3
Gain on retranslation of Strobosch
41
23 Lyght
Marking guide
Concerns of ethics partner
New IT system
Inventories
Sale of tyres
Leased buildings
Asset treated as held for sale
Receivables
Marks Available
Marks
8
8
5
6
6
7
7
47
Maximum
40
Total
40
To:
Gary Orton
From:
A Senior
Date:
11 May 20X8
S