business reporting july 2010 marks plan

7/30/2019 Business Reporting July 2010 Marks Plan

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TI BR Advanced Stage J uly 2010

The Institute of Chartered Accountants in England and Wales 2010 1

MARK PLAN AND EXAMINERS COMMENTARY TI Business Reporting July 2010

This report includes:

A summary of the scenario and requirements for each question

the technical and skills marks available for each part of the requirement

a description of how skills should be demonstrated

detailed points for a full answer examiners commentary on candidates performance

The information set out below was that used to mark the questions. Markers were encouraged to usediscretion and to award partial marks where a point was either not explained fully or made by implication..

BR Question 1 Flynt

Scenario

The candidate is in the role of a newly appointed financial controller who is asked to adjust a consolidatedstatement of comprehensive income in respect of three technical issues. Share options, defined benefitscheme and lease of surplus machinery. The candidate is also asked to calculate the EPS and diluted EPStaking into account the adjustments to the consolidated statement of comprehensive income.

Available Marks

Requirement Technicalmarks

Skillsmarks

Skills

1. Redraft consolidated statementof comprehensive income

15 6 Identify the treatment of share options isincorrect

Evaluate the lease to determine correctaccounting treatment

Appreciate impact on different elements ofthe statement of comprehensive income

Explain the difference between definedcontribution and benefit schemes

Produce revised statement of comprehensiveincome in an appropriate format

2. Calculate EPS and diluted EPS 3 1 Summarise the impact of adjustments on

EPS and diluted EPS

Identify the impact of adjustments on EPS

Total marks 18 7

Maximum marks 25


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1. Flynt

To: [email protected]: [email protected]

Re: Finalisation of financial statements for year ended 31 May 2010.

I would respond to your email as follows:

Share Option Scheme

Shane Pontings treatment of the option scheme is incorrect. IFRS2, Share Based Payment, should havebeen applied as follows:

The fair value of the options at the grant date should be treated as an expense in the income statement andspread 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 priceand continuing employment.

The fact that the share price has increased since the grant date is ignored when determining the charge tothe income statement. 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 financialposition date, which in this case is for 16 executives to be employed at the vesting date.

The charge to the income statement is therefore 378,000 (10,000 x 16 x 12.60 x x 9/12). This willreduce profit after tax and therefore EPS.

In addition this sum is also credited in the statement of financial position to equity. IFRS2 does not statewhere in equity this entry should arise, and many companies add it to retained earnings.

When calculating diluted EPS it will be necessary to take into consideration the number of free shares being

allocated to executives assuming the whole scheme will vest. (see appendix for calculations)

Lease of machinery

Shane Pontings analysis of the agreement as an operating lease is incorrect. This would appear to be afinance lease because:

(a) the lease term and useful life of the asset are the same

(b) the present value of the lease payments received, plus the residual value guaranteed by Prior plc cometo 606,381, 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 leasereceivable and will therefore be recognised in the income statement over the lease term as part of interestreceivable.

The rental income of 150,000 is removed from the income statement. Interest receivable of 61,000 iscredited to the income statement (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 2010 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.


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Dipper Pension Scheme

The accounting treatment for a defined benefit scheme is considerably different to that of a definedcontribution scheme. It is therefore necessary to remove the charge of 480,000 made by Shane Pontingand replace it with the following.

The income statement charge is split into three elements:

(a) Service cost, this is the pension earned by the employees of Dipper in the year, and is an operatingcost. This means that operating costs will rise by a net 80,000 after deducting the contributions paidinto the scheme that have been incorrectly charged by Shane Ponting.

(b) Return on assets: This is the expected investment income on the equities, bonds and other investmentsowned by the pension fund. This works out as 55,000 (5% x 2.2 million x 6/12). IAS19 does notspecify where this should appear in the income statement. I have treated it as investment income but itwould not be incorrect to offset it against operating costs.

(c) Discount rate for obligations: This is the unwinding of the present value of the pension liability due toemployees who are one year closer to retirement at the end of the accounting period. A charge of52,000 (4% x 2.6 million x 6/12) should therefore be made in the income statement. Because it

relates to a present value, I have added this to finance costs, but once again IAS19 is silent on theissue.

The actuarial difference reflects that some of the above figures are estimates, and also the increase in thenet liability in the pension fund to 670,000. (2.75m - 2.08m). This figure will appear in the statement offinancial position as a liability.

Per appendix 5 there is a net actuarial difference of 193,000. IAS 19 allows a number of methods of dealingwith gains and losses. Dippers accounting policy in relation to pensions is to recognise immediately gainsand losses. IAS 19 permits immediate recognition in both profit or loss and as other comprehensive income.

Goodwill impairment

The goodwill impairment should be charged to the income statement rather than other comprehensiveincome. This will impact on EPS

Summary of adjustments

As a result of these adjustments EPS has increased from 1.21 to 1.41 per share from the previous year.The diluted earnings per share is 1.38, and therefore should be disclosed as lower than basic. EPS.


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Append ices

Append ix 1

Flynt plc: Revised statement of comprehensive income for year ended 31 May 2010

2010 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) (3,631)

Goodwill impairment (400) (400)

Other operating income 150 (150) 0

Operating profit 4,129 3,244

Investment income 39 61 55 155

Finance Costs (452) (52) (504)

Profit before tax 3,716 2,895

Taxation (1,003) (810)

Profit after tax 2,713 2,085

Other comprehensiveincome

Actuarial loss on pension (193) (193)

Goodwill impairment (400) 400 0

(400)

2,313

(193)

1,892

Append ix 2: PV of lease agreement at 10%

YearCash Flow

000PV

000

1 150 136

2 150 124

3 150 113

4 150 103

5 211 131

Unguaranteed 5 9 6

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/f000

InterestIncome000

Installment000

At 31 May000

1 J une 2009 613 61 (150)

1 J une 2010 524 52 (150)524426


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Append ix 4: Pens ion Calcu lations

Asset Obligation

'000 '000

Balance at Acquisition 2,200 2,600

Return on asset 55Unwinding of discount(interest cost) 52

Service cost 560

Contributions 480

Pension Paid (450) (450)

Expected closing bal 2,285 2,762

Actual closing balance 2,080 2,750

Actuarial difference (205) 12

Net actuarial difference (193)

Appendix 5: Basic EPS

2010 2009

'000 '000

Profit after tax 2,085 1,699

Shares at start and end of year *1,475 1,400

Basic EPS 1.41 1.21

*6/12 x 1,400,000 = 700,0006/12 x 1,550,000 = 775,000

1,475,000


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Append ix 6: Di luted EPS

Diluted EPS Earnings Shares

'000

Basic 2,085 1475

Share Options (see below) 36

Total 2,085 1511Diluted EPS 1.38

Share Options '000

Maximum cash raised from shares

(19 x 10,000 x 39) 7,410

Shares issued at average price in year 000

(7.41m/48) 154

Maximum shares issued (7.41/39) 190

Free' shares 36

*Tutorial Note* IAS33 does state that the dilution in relation to the shares should be treated as if issued atthe beginning of the year or (if later) the date of issue of the financial instrument concerned. If this is thecase there is an argument for saying the number of free shares should be 36 x 9/12 =27. Equal credit wasgiven in the marking guide for both approaches.

Examiners comments

This question was generally well answered with the majority of candidates displaying a sound technicalknowledge. Answers were, in the majority of cases, well structured and clearly laid out following thestructure of the question. It was rare that candidates omitted complete sections of the question and most

candidates achieved a pass on this question.A majority of candidates were able to give correct explanations for the treatment of the three issues. Inaddition the calculations for the share option and pension schemes were mostly accurate with mostmistakes being due to carelessness rather than errors of principle

The standard of the revised statements of comprehensive income was more mixed with many candidatesnot correctly adjusting against the appropriate headings, although at least in most cases they did makesome attempt to do so. Almost all candidates correctly identified the goodwill adjustment.

A surprising number of candidates were unable to calculate the correct number of shares required in thebasic EPS computation. Hardly any students correctly calculated the number of free shares for the dilutedEPS, although quite a few made a reasonable attempt. Many students did not attempt this part.

A weak aspect of the candidates performance in respect of this question was in summarising and

concluding the impact of the adjustments on the EPS.


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BR Question 2 - Pepper Art

Scenario

The candidate is in the role of a member of a tax department advising a client Pepper Art. The key skills inthis question required of the candidate are reviewing, assimilation and judgement in providing advice to the

client regarding the clients tax liabilities. In terms of skills the candidate needs to identify errors in a taxcomputation provided by the client and identify potential VAT liabilities arising from the application of capitalgoods scheme to the potential acquisition of a building. The question includes two ethical issues, anincorrect repayment issued by HMRC and an unsupported payment for software support of 50,000. A goodanswer to the ethics section should include considerations of the implications for the firm and also theconsequences of making hasty accusations of inappropriate behaviour.

Available Marks


Skillsmarks

Skills

1. A revised calculation of thecorporation tax liabilitycorrecting any errors youidentify

2 1 Identify that errors have been made andprovide a corrected computation

2. Brief notes to explain anyerrors made by the internaltax department and youradjustments

7 3 Identify that impairment provides a largertax deduction and conclude that this ispotentially a preferred option

Evaluate the use of group losses andconclude that further information needed toassess optimum use

Link the add back for legal fees to thechargeable gain computation

Identify the opportunity for rollover reliefagainst the purchase of plant andmachinery by DeliverUK

3. A note of any additionalinformation you require tocomplete your review

2 1 Adopt sceptical attitude in respect ofsoftware costs and identify that furtherinformation required

4. VAT implications ofacquisition of Star House bySpaceway

3 1 Assimilate information from past transactionto identify current tax liability and impact onacquisition price

5. Ethical implications of J ims

email

5 Appreciate ethical implication for the firm

with respect to need for professionalsceptism and extent of reportingrequirements

Identify and explain the consequences ofreacting inappropriately to accusations

Appreciate money laundering requirements

Provide clear advice on what steps the firmmust take in respect of each issue

Total marks 14 11

Maximum 25


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Draft email reply to:J im J onesDate: 27 July 2010

Subject: revised adjustment of Profit Computation year ended 30 June 2010

Please find attached a revised corporation tax calculation, together with notes identifying the errors I havefound, explanation of my adjustments and detail of any further information to complete the review.

(Attachment 1)

I also attach a note setting out the VAT implications of the acquisition of Star House by Spaceway(Attachment 2)

At tachment 1

Pepper Art - Revised corporation tax calculation 000 000Profit before taxation per the accounts 802Add back

Software supportLegal feesDepreciation and other disallowable

503575

160962

LessProfit on sale of Prospect HouseDividend from SpacewayTax repayment

58555

207

(847)Less capital allowances (52)

Trading profit 63

Chargeable gain (Note 3) 400

463

Group relief from Spaceway (200)

Taxable profits 263

3 associated companiesTherefore marginal companyPCTCT @ 28% 73,640

Less 7/400 (500,000 263,000)(4,148)

Revised corporation Tax liability 69,492

Brief notes explaining errors and adjustments

Identification of errors

1. Legal fees have been correctly disallowed. However they could potentially be allowed against thedisposal of the building for chargeable gains calculation.

2. The chargeable gain has been calculated incorrectly.3. Foreign exchange losses have been incorrectly disallowed. Foreign exchange losses on settled

transactions are deducted for tax purposes.4. The calculation of corporation tax must take into account associated companies. Pepper Art now has

three associated companies.5. Goodwill 4% WDA claimed (see below)


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Explanation of adjustments

Impairment charge on goodwill

Goodwill represents a new intangible asset. Since 2002 the tax and accounting treatments of intellectualproperty are aligned. This means that the accounting entries for intellectual property such as goodwill aregiven tax relief or are taxable. Therefore it would appear to be more beneficial in this instance to follow the

accounting treatment as this results in a larger tax deduction in the current financial year.

The 4% per annum deduction is given only if an election (which is irrevocable is made). It is unlikely anelection had been made by J uly 2010. Therefore the tax computation has incorrectly added back theimpairment charge and allowed the 4% deduction. However this is a matter which would need to beconfirmed. (see later additional information)

Software Support Charges

For an expense to be allowable for tax purposes it should be wholly and exclusively for the purposes of thetrade. Provided there is evidence of this in terms of work performed and payment made the expense couldbe allowed. Clearly this is a substantial potential deduction and therefore the supplier should be requestedagain to produce an invoice. However, at the moment this expense has been disallowed until further

evidence is supplied.

Chargeable gain - Sale of Prospect House

The chargeable gain has been incorrectly calculated by the client.

A deduction for allowable cost, legal fees and indexation is permitted.

The acquisition of Spaceway by Pepper Art means that Pepper Art now forms a capital gains tax group withSpaceway and its 100% subsidiary DeliverUK. DeliverUK plans to invest 900,000 in fixed plant andmachinery which will enable Pepper Art to rollover the gain on the disposal of Prospect House against thepurchase by DeliverUK of plant and machinery.

As only part of the proceeds is being reinvested some of the gain will become chargeable in the currentperiod.

000

Disposal Proceeds 1,335

Less CostLegal fees

(500)(35)

Indexation allowance215-166.6 /166.6 =0.291 x 500,000

(145.5)

Indexed gain 654.5Rollover relief 254.5

Proceeds not reinvested=Chargeable gain 400

Spaceway potential group relief claim

Group relief available240,000 x (1.8.09 31.5.10)

10/12200

Group relief could be claimed in respect of the period from 1 August 2009 (the date of acquisition ofSpaceway by Pepper Art. However as the accounting periods are different only the period matching to theaccounting period of Pepper Art can be used as group relief.

Spaceway could carry the unused surplus management expenses forward against future profits.


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Given no further information a group claim would appear to be effective since Pepper Art is paying at themarginal rate of tax.

Addi tional information required to complete the review

Confirmation that claim for 4% WDA on goodwill has not been made

There may be acquisition costs in respect of Prospect House which would be allowed as a deduction in

calculating the chargeable gain. More detail on the future profits of Spaceway to assess whether claim for group relief is more or less

effective than a carry forward of the loss.

Software support charges need to obtain evidence of this expense.

We will need to review the capital allowances computation and review tax sensitive accounts such asrepairs and renewals, legal expenses etc.

At tachment 2

VAT implications of purchase of Star House by Spaceway

It is important to examine the tax history of this building to appreciate whether there are any future liabilitiesfor Spaceway.

Star House was a newly constructed property and CartoonGo would have suffered input VAT of 210,000.The recoverability of this input VAT would have been determined by the initial use of the building which wasexclusively business.

Therefore CartoonGo would have recovered 210,000 input VAT.

However, as the building cost more than 250,000, it will be subject to the capital goods scheme.

No capital goods scheme adjustments would be required for the year ended 31 May 2007 or 2008 since theuse remained business.

However an adjustment, i.e. repayment of input tax to HMRC, would be required for the year ended 31 May

2009 of 210,000/10 x (33 - 100%) =14,000.

The same adjustment will be made for the year ended 31 May 2010 and a further 14,000 would be payableto HMRC by CartoonGo.

If Spaceway buys the property with tenants occupying the property, it will constitute a transfer of a goingconcern (TOGC). The property is commercial (not residential) and more than three years old and no optionto tax was made by CartoonGo Therefore there is no requirement for Spaceway to opt to tax for the propertyto be included in the TOGC (i.e. the transfer is not subject to VAT).

Spaceway is not occupying the premises for its own business purposes. The rental charges to CartoonGoand the Insurance company will be exempt supplies. Therefore the adjustment for each of the remaining 6intervals will be:

210,000/10 x (0% x 100%) =21,000

Therefore a total payment to HMRC of 21,000 x 6 =126,000 will be made by Spaceway over theremaining 6 years.

Spaceway needs to consider this potential liability in negotiating the price for Star House.


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Briefing note to Tax Partner

Subject: Ethical implications for the firm arising from J im J oness email

Over repayment by HMRC of tax of 207,000

As the engagement letter has been revised in the current year, there appears to be no authority to adviseHMRC of the error without the clients consent. Professional accountants are advised to include the right tocommunicate with HMRC in their engagement letters with clients.

It is important to establish the facts of this apparent error as making unsubstantiated accusations could haveconsequences both for our firm and for the employee who has informed us of the managing directorsattitude towards the repayment. This may be an attempt to discredit the managing director and we shouldtherefore not rely on this account by the employee in the internal tax department but establish his claim forourselves

The first step is to examine the correspondence regarding the repayment and to establish that HMRC was infull possession of the facts and has made an error. If this is the case, as the error is clearly substantial, weshould:

ask the client to give us authority to advise HMRC of the error warn the client of the possible legal consequences a deliberate attempt to benefit from an error made

by HMRC may constitute a criminal offence under the Theft Act 1968.

advise the client that we will cease to act if consent to disclose is not given.

This advice must be recorded in writing and a copy of the meeting notes given to the client.

If a crime is committed, (i.e. non-disclosure of the error) there are additional responsibilities for the firm underanti money laundering legislation. A suspicious activity report will be required to SOCA and care should betaken that the firm is not responsible for tipping off the client as this is itself a criminal offence under thePOCA. Advising the client to stop breaking the law does not constitute tipping off.

Software support payment of 50,000

In order to determine whether there is an ethical issue for our firm with respect to this payment, moreinformation is required regarding the nature of the work performed. The amount appears unusually large forthe services provided. It is extremely unusual for no invoice to be supplied for such a large amount. This hasimplications for both direct taxes and VAT. We need to confirm that no claim for VAT has been made withoutan invoice displaying the VAT number of the registered trader.

The client may inadvertently be party to a money laundering transaction and this may require a suspiciousactivity report by our firm.

However, again care should be taken to establish the facts without tipping off the client.The firms money laundering officer must be informed of both transactions and legal advice and advice fromICAEW should be obtained.

Further points

If we conclude that the managing directors attitude to tax compliance appears to be very cavalier.Professional skepticism should be adopted in respect of any information provided to us by the client and itmay therefore be inappropriate for our firm to be associated with this client in future.


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Examiner comments

This question was again generally well answered with candidates adopting a structured approach toanswering the question. Although this was the question where candidates were most likely not to attempt apart of the question. For example, the provision of additional information was often omitted. The VAT

subsection was sometimes well answered with many candidates going beyond the requirements of thequestion to consider future tax planning in relation to the potential option to tax. Even if the numbers werenot always correct if was pleasing to see that the issues were understood. Certain aspects of thecomputation were done well for example foreign currency and goodwill. The weaker candidatesdemonstrated poor assimilation skills in terms of not identifying opportunities for rollover relief and lossrelief. Candidates were reasonably good at describing errors and saying how these should be corrected butactually redrafting the computation was sometimes beyond the weaker candidates.

Performance on ethics elements of this question:

A common weakness was to identify only one of the two ethical issues. Also very few candidates appliedjudgement to the source of the information to question the accuracy of J ims assertions regarding themanaging director. Many candidates proposed very radical approaches to the ethical implications for the

firm on the basis of unsubstantiated information.

.


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BR Question 3 Ed Holdings

Scenario

The candidate has recently assumed responsibility for the audit of Ed Holdings and its consolidated

financial statements. Ed Holdings heads a group of companies which supply IT goods and services to theeducation sector. It has a tight deadline for completion of the group accounts. The audit work on thesubsidiaries is largely complete and an assistant has completed work on the parent company andconsolidation. The candidate is asked to brief the audit manager on the status of the audit work, issuesarising and additional information required either from the client or from subsidiary auditors. This scenariotests the application of practical auditing skills to a complex scenario and includes a number of financialreporting issues, including issues associated with acquisition accounting, pensions and consolidationentries. A successful candidate will understand fully the principles and mechanics of a consolidation and beable to identify issues from the information provided. The scenario also tests the candidates ability todetermine what is significant to a group (as opposed to an individual subsidiary) audit and to consider widerimplications across the group of issues identified at a particular subsidiary. In addition, the requirement toassess the adequacy of a report from a subsidiary auditor tests the candidates knowledge of reporting andtheir ability to assess whether it is appropriate to rely on another firm.

Available Marks


Skillsmarks

Skills assessed

Identify and explain any known andpotential issues which you believemay give rise to material auditadjustments or significant audit riskin the group accounts.

6 10 Linking issues with audit risk e.g. no fair valuereview, growing business leads to potentialundervalue of other intangibles

Appreciate potential difference betweenRuritanian accounting standards and IFRSand impact on group accounts

Identify potential risk from use of overseasauditors

Identify potential non compliance with IFRSimpacts on group accounts (e.g. IAS 19)

Identify lack of fair value adjustment andimplications for accounts

Identify that goodwill adjustments will bematerial

Outline for each issue the additionalaudit procedures, if any, required to

enable us to sign our audit opinionon the group accounts.

4 5 Ascertain gaps in work performed andrecommend appropriate audit work

Identify the need for tax expert to determineadjustment to the group accounts

Identify need for expert advice in respect offair value adjustments and IAS 19

Appreciate inadequate work simply to agreeto bank statement

Identify appropriate audit tests

Total marks 10 15

Maximum marks 25


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BR3 Ed Holdings

Issues identified which may give rise to an adjustment or an indication of a significant audit risk inthe group accounts and additional audit procedures to enable sign of f of group accounts

Bhagats results are very significant to the group and reliance has been placed on other auditors to auditthis entity. Need to assess their competence by reviewing size, reputation, experience, client base etc of

the firm.Addi tional audit procedure

A formal confirmation of their independence will be required and this is not covered in the clearancesupplied.

The audit of Bhagat has been conducted under Ruritanian Standards of Auditing which may not beequivalent to IAS. Need to assess adequacy of work performed,

Addi tional audit procedure

This could be achieved by asking them to complete a questionnaire based on IAS or by asking for aclearance under IAS if they have the experience and training to supply this.

Bhagat has prepared financial statements under group accounting policies supplied by group financial

controller. There is a risk that these are not compliant with IFRS or that they are incomplete localpolicies have been used where group policies silent and this appears to included potentially materialareas such as pension fund accounting.

Additional audit procedures

Need to obtain either opinion based on IFRS (assuming local audit firm has the training and competence tosupply this) or to conduct a very detailed review of completeness and appropriateness of policies supplied.As Bhagat is in a different business to UK entities, there may well be omissions, such as the treatment ofsoftware development costs (not clear where these are classified at present).

Comment in clearance from Bhagat implies that the company has a defined benefit pension plan andthat this has not been accounted for under IAS-19. It also implies that the plan may have a significantdeficit which should be reflected on the group balance sheet. This could be a very significant

adjustment.Additional audit procedures

Need to determine the nature of the scheme and how accounted for at present. If it is a defined benefitscheme then will need an actuary to assess the liability to be recognised under IAS-19. Will also need toperform work on the existence and valuation of pension scheme assets. Knowledge of both IFRS and thelocal Ruritanian employment and investment markets is likely to be required.

Bhagat appears to have an investment which has not been considered further. Amount is immaterialbut need to determine whether this is a trade investment or an investment in a subsidiary or associatewhose results should be included in the group accounts.


Further information on the nature of this investment and the results of any subsidiary / associate are requiredso that the need for and materiality of any adjustment can be fully assessed.

UK subsidiaries

Aducit comment on obsolescence provision is potentially concerning as this is a policy which haspresumably been applied across the group. If a similar error rate applied to the provision in the othergroup companies, then the total error would be 225,000 which is material. Need to consider the natureof inventories in each entity and to evaluate further any potential error which may arise. Bhagat auditorshave not raised this as an issue but that may be because their audit work has not gone beyond ensuringcompliance with group policies. Could however be because Bhagat is not facing the same issues.


Need to discuss with management and other audit teams and determine extent to which additional analysis

is required based on actual post year end sales and sales forecasts rather than historic data. Adjustmentidentified in Aducit is not material but should be considered along with any other unbooked adjustments atsubsidiary or group level. An overall group adjustment schedule should be maintained.


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Confirmations of all intercompany balances are not required, providing the balances eliminate onconsolidation there is in fact a difference and this is discussed below

Warranty provision - Although the balance is not material, the key audit consideration here will bewhether it is complete and understatement could potentially be material.

Additional audit procedure

Need to assess provision based on the number of months warranty given, historic experience of warranty

claims and any known issues or problems with IT equipment supplied.

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 firstinstallment of 1 million on long term debt is due in 4 months time on 1 November 2010 and Aducit hasvery high trade payables.

Although companies are profitable, there are also signs (comment on inventory provision) that trading isdifficult. In addition, significant proportion of profit is generated abroad and there may be issues inrepatriating the cash to the UK to repay the loan.


Need to consider carefully cashflow forecasts and ability of company to repay its debts as they fall due. Inaddition, terms of the loan agreement need to be reviewed and covenant compliance assessed both nowand over the next year as any breach of covenant might render the entire debt repayable immediately.

Should also chase bank letter in Aducit even though bank balance is not in itself material. Bank letter alsoprovides details of any loan accounts and other arrangements and is an important piece of audit evidence.

Tax position on Aducit looks incorrect as no tax credit recognised at present. Would expect there to begroup relief and company has also clearly been profitable in the past so there may be the opportunity tocarry back losses. Need to investigate but would expect credit of around 28% - ie243,000 which is potentially material.


Need to enquire further as to tax position, obtain draft computations and determine to involve a tax expert asnecessary.

Ed Holdings

Agreeing investment of this size to bank statement alone is clearly inadequate


Need to review sale and purchase agreement for Bhagat to ensure no additional consideration payable,adjustments to consideration, warranties etc which need to be considered. Also need convincing evidence ofownership of shares through share certificates etc. Important to check that ownership is 100% as has beenassumed in consolidation entries.

Need to enquire as to how any costs related to the acquisition of Bhagat have been treated as these do notappear to have been included within the investment value.

Need to ensure that Ed Holdings has not issued any shares in year through review of minutes and of

documents filed at Companies House. Review of Board minutes and legal correspondence for the holdingcompany are important tests which do not appear to have been performed / documented.

Installment of long term debt repayable in November 2010 should be reclassified to current liabilities.Amount to be reclassified is 1million (959,000 after adjustment below for loan issue costs).

No documentation of work on Ed Holdings to ensure completeness of liabilities.


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Would expect at least a review of post year end bank statements for items which relate to pre year end.

No loan interest has been accrued on the long term loan and the loan arrangement fee of 200,000appears to have been treated incorrectly as an administrative expense. Under IAS39, it should insteadhave been deducted from the loan balance outstanding and charged over the loan period in proportion

to the outstanding balance on the loan. Correct income statement charge would be interest and financecharges of 262,000 (8million @ 6% for 6 months =240,000 +(on straight-line basis) 0.5 x200,000/8 =12,500. Tutorial note other possible answers would include a sum of digit calculationfor the allocation of the loan arrangement fee.

Consolidation entries

Need to investigate further the difference on intercompany balances as current treatment may beincorrect.

Given that all group companies operate in similar sectors, seems unlikely that only intercompany tradingis management recharges so consolidation entries may well be incomplete. Need to enquire further intothis.

Consolidation entries for acquisition of Bhagat seem very simplistic and may not comply with IFRS. Nofair value exercise appears to have been carried out at the date of acqu isition and the differencebetween the net assets in Bhagat and the acquisition price has all been posted to goodwill. May well beelements which should be allocated to intangibles which should then be amortised through the incomestatement.

In addition, costs and revenues for Bhagat have been assumed to occur evenly throughout the year whichmay well not be the case, especially as Bhagat is clearly a growing company. Given materiality of Bhagatresults and goodwill balance, adjustments here could clearly be material.


An expert valuer may be required to assess this unless an exercise was carried out at the time of theacquisition May well also be fair value adjustments to values of non current assets. Need to determine natureof these assets and whether any independent valuation was carried out. Also need to consider whether

adjustments should be made at the acquisition date for the application of group policies (clearance indicatedthat this effect has been posted to the income statement at present).

Need to obtain management accounts or other evidence which give a more precise analysis of the splitbetween pre and post acquisition results. Likely to be significant additional work to do in auditing this oncecompany has prepared it

Consolidation schedules are at summarised level. Will also need to complete work on detailed disclosureswithin group accounts.

Work done on consolidation adjustments comprises largely a description of the adjustment. Need to ensurethat the amounts of the adjustments and the financial statement captions to which they have been postedhas been substantiated by agreement to individual company results or other supporting documentation.

Also need to ensure that completeness of the consolidation entries has been considered by comparison toprior year and our knowledge of the way the companies trade and interact.


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Examiners comments

Certain subsections of this question were answered well.The issues relating to Bhagat, and the going concernproblems with Aducit demonstrated judgment and assimilation skills. Relatively fewer candidates spotted thepensions aspect of Bhagat, but many got the point about the differences between Ruritanian and international

standards and the points relating to reliance on other auditors' work and Ruritanian auditing standards.

Aspects of the question, which were done less well, were relating to consolidation. Few candidates made thesubstantive point that the audit work done on the consolidation schedules was completely inadequate. Very fewappreciated that the calculation of goodwill involved the identification of fair values on acquisition. Mostcandidates betrayed a scanty knowledge of accounting for groups.

Overall it was disappointing to see that students in most cases were focussed solely on the implications of theissues at the individual company level rather than considering the wider implications for the group accounts. Thiswas particularly the case in respect of the going concern and the obsolescence issue.

Many candidates demonstrated a familiar obsession with foreign currency translation, and this was quite often

the only contentious issue identified in relation to the consolidation schedule.

The quality of the audit work suggested varied but overall candidates were probably more specific in the nature ofthe work suggested than in past sittings.


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BR Question 4 - Precision Garage Access p lc

Scenario

The scenario is a listed company, PGA, which manufactures and installs garage doors for private residences.

There are two types of garage door produced which have different prices and margins. The candidate is asenior working for PGAs auditors and is currently supervising the planning and interim audit work. As part ofthe planning process, an audit junior has completed some initial analytical procedures on the interim 9months management accounts. The analysis by the audit junior is inadequate and the candidate is requiredto carry out more detailed analytical procedures with supporting calculations. The candidate is also requiredto outline the audit risks that arise from the patterns and trends identified in the analytical procedures and setout the audit procedures. Finally the candidate is asked to identify the financial reporting issues that arisefrom the audit issues identified in respect of both the 9 month interim financial statements and the full yearfinancial statements.

Available Marks


Skillsmarks

Skills assessed

1. Carry out revised analyticalprocedures identifying anyunusual patterns and trends inthe data which may requirefurther investigation.

7 6 Comparison of actual and imputedfigures based on data provided.

Use of judgement in interpreting dataand offering potential reasons forvariances

Correct analysis and treatment ofstaff bonus

Appropriate calculation andinterpretation of working capital

ratios.

2. Outline the audit risks that arisefrom the patterns and trendsidentified in the analyticalprocedures and set out the auditprocedures you would carry out

3 3 Structuring of presentation of auditwork to link into each analysis foreach audit area

Use of data to identify risks andidentification of appropriate audittests

3. Set out the financial reportingissues that arise from the aboveaudit work

3 3 Identification of key financialreporting issues.

Specify correct financial reportingtreatment

Total marks 13 12

Maximum marks 25


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To: Gary Megg, Audit ManagerFrom: A. SeniorDate: 26 J uly 2010Subject: PGA audit

1. Analytical procedures

1.1 Income statement

9m to30/6/2010

9m to30/6/2009

Note

Revenue:MontyGold

7,50014,000

9,60028,800

Note 1

Cost of sales:MontyGold

(6,700)(15,500)

(7,800)(23,400)

Note 2

Gross (loss)/profit (700) 7,200

Fixed administrative anddistribution costs (1,200) (1,200)

Exceptional itemsStaff bonus scheme (450) - Note 3

(Loss)/Profit before tax (2,350) 6,000

Income tax expense 0 (1,680)

(Loss)/profit for the year (2,350) 4,320

Note 1 Revenues

Revenue of the Monty has declined by 21%.Revenue of the Gold has declined by 51%.

The predicted values of revenue for each of the products are as calculated below. These are based onactual volumes sold (from the inventory records) x list prices.

Monty

9,000 units x 840 =7.56 m

The actual revenue for sales of Monty is 7.5m which is extremely close to the predicted level and thereforeprovides some assurance.

Gold

6,000 units x 2,520 =15.12m

The actual revenue for sales of Gold is 14m which is a difference of 8% and may represent a risk ofmaterial understatement of sales (eg through significant and inappropriate discounting of sales, or errors inrecording of sales.)

Audit work

Verify the data provided by Claire which was used to make the predictions in the analytical procedures

Agree standard prices to price lists and time of price change.

Test standard prices against sample of invoices

Review inventory records against inventory count information or continuous inventory records


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Enquire whether significant discounts have been made which may explain the shortfall. Determineconditions for discounting and relevant authorization enquiries from invoice sample.

70% of sales are overseas and denominated in euro. The standard price is fixed in euro at thebeginning of the year as equivalent to the , but exchange rate movements during the year may havecaused a change. As a consequence, the actual revenue may have moved out of line with the predictedrevenue based in s. Review exchange rate movements and examine whether the translation is at the

actual or average /euro exchange rate. (This test also applies to each category of cost.)

Note 2 - Cost o f Sales

Cost of sales of the Monty declined by 14%.Cost of sales of the Gold declined by 34%.

Using the quantity data provided by Claire, a significant fall in cost of sales would have been anticipated dueto reductions in total variable costs. The reduction in cost of sales would however be expected to be smallerin percentage terms than the reduction in revenues as this is a manufacturing company and hence somecosts are fixed. This fixed element of costs therefore does not change despite the fall in volumes.

The predicted values of cost of sales are:

Monty

(4m x 9/12) +(9,000 units x 840 x 50%) =6.78m

The actual cost of sales of Monty is 6.7m which is extremely close to the predicted level and thereforeprovides some assurance.

Gold

(12m x 9/12) +(6,000 units x 2,520 x 50%) =16.56m

The actual cost of sales of Gold is 15.5m which is a difference of 6.8% and may represent a risk of material

understatement of cost of sales if the understatement is due to errors and omissions. It is not clear from thedata whether the cost saving arises from lower variable cost per unit or fixed costs savings but this requiresfurther investigation.

Audit work

While the percentage difference is smaller for cost of sales than for revenue it may be more concerning asexchange rates do not appear to an explanatory factor as manufacturing is in the UK. However installationcosts and the sales network are incurred in euro so the exchange rate effect is not entirely to be ignored. Ascost of sales and revenues are both lower than anticipated this may be a consistent explanation.

Agree the total fixed costs being incurred against budget assumptions

Review the method of allocation of fixed production costs as given the seasonal nature of the

businesses then if the allocation is on a time basis, rather than a normal usage basis, this may distortthe costs allocated to cost of sales and inventory.

Similarly, the large fall in volumes compared to previous years may not represent a normal usage basisin allocating fixed production costs to units of output

An alternative explanation for the increase may be that there are fewer economies of scale arising fromthe smaller production runs from the lower volumes. Variable cost per unit may therefore have risen.

As we are relying on budget data, review of the budgeting process and its historic accuracy

A key audit concern is that the analysis implies there is a risk that revenue and cost of sales of the Gold mayboth be materially understated.


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Gold based on results for 9 months to 30.6.09

Actual gross loss (1,500)Revenue difference 1,120COS difference (1,060)Imputed loss from analysis (1,440)

Overall the possible indicated misstatement is quite small at 60,000 as the two differences are largelycompensatory. Nevertheless individually they are of concern and need investigating.

Summary analysis

There has been a 25% reduction is sales volumes of Monty and a 50% reduction in sales volumes of Goldcompared to the 9m period last year. Given the high fixed costs, then cost of sales has not fallen in line withrevenues and a gross loss has been made.

As the business is seasonal then further losses are anticipated in the fourth quarter as revenues will be lowand fixed costs will be high, being recognised on a time basis.

Note 3 Staff Bonus

The full year bonus is potentially 600,000. An accrual of 9/12 of this amount (i.e. 450,000) appears to havebeen made for the three quarters interim accounts. However this is not appropriate as the business isseasonal as: Sales volumes in the final quarter of the year ending 30 September 2010 are expected to bethe same as the final quarter of the year ending 30 September 2009.

On this basis revenue will be:

9 months to 30 J une 2009 38,400Y/e 30 Sept 2009 41,600Final quarter y/e 30 Sept 2009 3,200

Price increase 5% 3,360

9 months to 30 J une 2010 21,500Projected revenue y/e 30.9.2010 24,860

This is lower than 26 million threshold thus the bonus should not be recognised. (See financial reportingbelow).

Audit work

Review the sales budgets for the final quarter up to the year end to assess whether the threshold level ofsales to trigger the bonus has been achieved. For the final audit this figure will be known but for the purposeof reviewing of the interim final statements a combination of the latest actuals and the budget would beneeded.

Examine the terms of the bonus agreement and of any announcement or other undertakings with staffregarding the possible payment of the bonus.

1.2 Statement of financial position

1,2,1 Receivables

9 months to 30 June 2010

Receivables days = (2,400/21,500) x 270 days

= 30 days


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= 30 days

Y/e 30 Sept 2009


= 8.7 days

Alternatively use last quarter:


= 28 days

Superficially it may seem that receivables have fallen substantially from 4.3m to 2.4m. On closerinspection however the reduction is in line with the fall in sales and the receivables days are more or less the

same.

Conversely, it may seem the receivables at 30 September 2009 are very low using the first calculation of 8.7days. However receivables reflect sales in the most recent month(s) before the statement of financialposition is drawn up, rather than the average for the year. Given the seasonality of PGA then the final quartersales are low and therefore the year end receivables are expected to be low. This is reflected in thealternative calculation of 28 days.

1.2.2 Inventories

Superficially it may seem there has been little movement in inventories and thus it is low risk. However theinventory days shows significant movement:


Inventories days = (3,500/22,200) x 270 days

= 43 days


Inventories days = (3,500/31,200) x 270 days

= 30 days

The significant increase in inventory days shows that inventory remained constant but the expectation was

that it should have fallen as the cost of sales has reduced through a lower level of commercial activity.

Audit work

Analytical procedures shows a low level of risk for receivables as the receivables days (30 days) isconsistent both with the previous period and with the credit terms extended.

Inventories are more concerning as we would have expected them to fall and they have not. The key testsare to look at older inventory to see if there is a problem with quality, settlement or ability to sell.

It may also be worth looking at whether there has been a large increase in finished goods (eg cancelledorders in a recession). If this is the case, then an impairment of such inventories should be considered.


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Financial reporting issues

Revenue

There is a risk from revenue recognition policy as it may not be appropriate to record the sale of garagedoors until the installation complete unless two elements are separable.

Foreign cur rency translation

According to IAS21 sales should be translated at the date of the transaction (or the average rate as anapproximation). Given that sales are seasonal in the full year then there is a risk that the average rate maynot be at an appropriate rate

Staff bonus

The bonus should only be recognised according to IAS19 when there is a constructive or legal obligation tomake a payment. In this case, the full years revenue on which the bonus is based is expected to fall below26m in the full year (see note 3 above) thus no bonus should be recognised in the interim or the final fullyear financial statements.

Impairments of PPE

The Gold product looks to be performing poorly in making losses and the estimate is that Sales of Golddoors are not expected to increase in the foreseeable future.

Gold doors production seems likely to be a cash generating unit as the asset to make the Gold doors areseparately identifiable from the Monty assets. Similarly, the revenue streams are also separately identifiable.

As a consequence the value in use of the PPE used on the Gold production line (and other PPE specificallyassociated with the Gold product) seems likely to be low.

Also the fair value less costs to sell also seem to be low as the Production equipment is specialised andhighly specific to each of the separate production processes.

In such circumstances the sharp downturn in Gold sales could represent an impairment event and thereforean impairment review of the Gold assets should be carried out.

Receivables

The amount for receivables is a monetary asset and so should be translated at the year end exchange rate.

If in the recession bad debts are increasing then an impairment change should be considered.

Examiners comments

There were some excellent answers which really used the information given in the question to produceexpected revenue and cost of sales figures and receivable and inventory ratios. Having produced thefigures the audit issues were then relatively easy to identify and these candidates were able to score highmarks.

The weaker answers were those which made little attempt to use the figures given in the question, or onlyin a very basic way and answered the question using very basic presumptions. For example there is astaff bonus scheme therefore revenue must be overstated; or revenue has declined therefore there is acut off error; or cost of sales is understated therefore there is a foreign exchange error.

Very few candidates appreciated the significance of the fact that we were only 3/4 of the way through theyear, so the inventory and receivables calculations were often incorrect.


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It was not uncommon for students to ignore the financial reporting requirements of the question. Wherecandidates tackled the financial reporting properly, they often did well in identifying appropriate issues,although less well in describing the accounting.

There were also some excellent answers to this question, but those candidates who were not prepared toget into the numbers in the question and use them to identify audit issues did not achieve a pass on thisquestion

business reporting july 2010 marks plan

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