Question Bank

The Institute of Chartered Accountants in England and Wales
Corporate Reporting
Question Bank
For exams in 2023
icaew.com
Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-0355-0184-7
Previous ISBN: 978-1-5097-3990-5
e-ISBN: 978-1-0355-0653-8
First edition 2014
Tenth edition 2022
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© ICAEW 2022
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 Time Page

Marks allocation
(Mins) Question Answer
Financial reporting 1
1 Kime 30 63 1 305
2 Billinge 30 63 4 312
3 Longwood 30 63 5 315
4 Upstart Records 30 63 8 319
5 MaxiMart plc 30 63 10 326
6 Robicorp plc 30 63 13 329
7 Gustavo plc 30 63 15 334
8 Inca Ltd 30 63 19 341
9 Aytace plc 30 63 21 347
10 Razak plc 30 63 24 352
11 Kenyon 30 63 27 357
Audit and integrated 1
12 Dormro 40 84 31 361
13 Johnson Telecom 40 84 35 368
14 Biltmore 40 84 39 374
15 Hillhire 40 84 42 379
16 Maykem 40 84 46 385
17 Tydaway 40 84 50 391
18 Wadi Investments 40 84 54 401
19 Lyght 40 84 57 406
20 Hopper Wholesale 40 84 58 413
21 Button Bathrooms 40 84 60 418
22 Jupiter 30 63 64 425
23 Poe, Whitman and Co 30 63 66 432
24 Precision Garage Access 30 63 71 441
ICAEW 2023 Contents iii

Title Time Page
Marks allocation
25 Tawkcom 30 63 74 447
26 Expando Ltd 30 63 77 451
27 NetusUK Ltd 30 63 80 456
28 Verloc Group 30 63 84 459
29 KK 30 63 88 468
30 UHN (July 2014) (amended) 45 95 90 474
31 Couvert (November 2014) 40 84 94 482
32 ERE (November 2014) 34 71 98 489
Real exam (July 2015)
33 Congloma 40 84 103 499
34 Heston 30 63 106 506
Real exam (November 2015)
35 Larousse 40 84 111 515
36 Telo 30 63 115 524
37 Newpenny (amended) 40 84 118 530
38 Earthstor 40 84 123 539
39 EyeOP 30 63 126 548
40 Topclass Teach 30 63 129 556
41 Zego 40 84 133 563
42 Trinkup 32 68 137 571
43 Key4Link 28 58 140 577
44 Konext 40 84 145 585
45 Elac 30 63 149 595
46 Recruit1 30 63 151 600
47 EF 40 84 157 609
48 Wayte 30 63 160 616
49 SettleBlue 30 63 163 623
iv Corporate Reporting ICAEW 2023

Title Time Page
Marks allocation
50 EC 40 84 169 629
51 Raven plc 30 63 172 636
52 MRL 30 63 175 645
53 Zmant plc 42 88 181 653
54 Chelle plc 30 63 184 662
55 Solvit plc 28 59 187 669
56 Vacance plc 40 84 191 675
57 JKL plc 30 63 194 685
58 Roada Ltd 30 63 197 692
59 Your Nature plc 45 95 201 699
60 RTone plc 30 63 205 708
61 Gentri plc 25 52 208 716
Real exam (August 2020)
62 HC plc 40 84 213 723
63 React Chemicals plc 30 63 216 731
64 Hyall and Forbes 30 63 220 739
65 SSD 42 88 225 749
66 Beta World 30 63 230 758
67 GlamFood 28 59 233 766
68 Panther Metals Ltd 40 84 240 773
69 E-Van Ltd 30 63 244 785
70 Hughes Watson LLP 30 63 247 794
71 Llama Ltd 40 84 254 801
72 Eastoak plc 30 63 258 811
ICAEW 2023 Contents v

Title Time Page
Marks allocation
73 Circeon plc 30 63 261 822
74 Gazelle Ltd 40 84 271 831
75 FB plc 30 63 273 843
76 Spycit Ltd 30 63 276 850
Data Analytics Software practice questions
77 Practice Question 1 45 95 280 859
82 Practice question 6 40 84 296 884
vi Corporate Reporting ICAEW 2023

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-our-
qualifications/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 2023 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 2023

Question Bank
x Corporate Reporting ICAEW 2023
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 Debit Credit
£m £m
Land 1 30.5
Buildings – cost 132.7
Buildings – accumulated depreciation 82.5
Plant and equipment – cost 120.0
Plant and equipment – accumulated
depreciation 22.8
Trade receivables 2 174.5
Cash and cash equivalents 183.1
Ordinary share capital (£1 shares) 100.0
Share premium 84.0
Retained earnings at 1 July 20X1 102.0
Long-term borrowings 80.0
Deferred tax liability at 1 July 20X1 3 33.0
Trade and other payables 54.9
Sales 549.8
Operating costs 322.4
ICAEW 2023 Financial reporting 1 1

Additional
£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
Cost:
At 1 July 20X1 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
Accumulated depreciation:
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
Carrying amount:
At 30 June 20X2 30.5 50.2 80.7
At 30 June 20X1 34.0 33.6 67.6
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 2023

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:
Accumulated
depreciation at
Cost of land Cost of buildings 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 40-
year 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.

(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 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
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.
3 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.
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

Carrying
amount
£m
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 9.90
Total liabilities and equity 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.
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 Temporary Deferred tax

amount Tax base difference 30%
£m £m £m £m
Property, plant and equipment 18.92 13.78 (5.14) (1.54)
Investments in equity
instruments (note) 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
(1.09)
Deferred tax liability (1.86)
(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.
(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 straight-
line basis on purchased goodwill.
Requirement
Prepare the information required by the finance director.
Total: 30 marks
4 Upstart Records
Upstart 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

(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.

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
Finance income 890 180
Finance cost (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
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.
5 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.

From: [email protected]
To: [email protected]
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 £1.8m 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 30 September 20X1, 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 that date.
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
should be accrued in the financial statements for the year ended 30 September 20X1 as a ‘valid
expectation’ has been created.
6 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
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 £21m

CREDIT Cash £21m
DEBIT Cash £75m

CREDIT Revenue £75m
DEBIT Cost of sales £33m

CREDIT Cash £13.2m
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 Finance costs £0.9m

CREDIT 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-for-
share 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.
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).
7 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
interests.
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

Exhibit 1: Extracts from the draft financial statements for year ended 30 September 20X6
Gustavo Taricco Arismendi

£’000 £’000 Kr’000
Revenue 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)
Profit from operations 9,300 1,824 7,366
Finance income 580 108 –
Finance costs (2,450) (660) (1,456)
Profit before taxation 7,430 1,272 5,910
Income tax expense (2,458) (360) (2,240)
Profit for the year 4,972 912 3,670
Retained earnings
At 1 October 20X5 11,720 4,824 14,846
Profit for the year 4,972 912 3,670
Dividends paid (1 July) (3,000) (600) ––––––
At 30 September 20X6 13,692 5,136 18,516
Other financial information

Ordinary share capital (shares of £1/Kr1) 10,000 2,000 5,000
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 interests 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 impairment losses 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.

Gustavo would like to adopt the fair value method to measure the non-controlling interests. 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

8 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 interests.
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 interests
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 interests in Excelsior at
their 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.
Total: 30 marks

Exhibit 1: Draft statements of financial position at 30 April 20X1
Inca Excelsior
£m CUm
Non-current assets
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
Current assets
Inventories 9.8 16.6
Trade receivables 17.4 35.2
Cash 1.6 12.8
Total current assets 28.8 64.6
Total assets 97.6 135.6
Equity and liabilities
Share capital £1/CU1 4.0 10.0
Share premium account 12.0 16.0
Retained earnings 41.6 48.0
Non-current liabilities
Deferred tax 12.0 4.4
Loans 5.8 48.0
Current liabilities 22.2 9.2
Total equity and liabilities 97.6 135.6
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.

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.
9 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).

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) 1, 2
Operating profit 4,620
Income from associate 867 4
Other finance income 310
Finance costs (1,320)
Profit before tax 4,477
Tax (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).

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)
Other finance income 240
Finance costs (720)
Tax (300)
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

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.
10 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.

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 interests.
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
Non-current assets
Property, plant and equipment 3,460 3,210
Current assets
Inventories 610 580
Receivables 400 280
Cash at bank 70 90
Total assets 4,540 4,160
Equity
£1 ordinary shares 500 500
Retained earnings 2,740 2,540
Loan from Razak plc 800 800
Current liabilities
Trade payables 290 240
Tax payable 210 80
Total equity and liabilities 4,540 4,160
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.

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.

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.
11 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;
and
(2) 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

Exhibit 1: Financial statements
Kenyon plc: Statements of financial position as at 31 October
20X1 20X0
£m £m
ASSETS
Non-current assets
Property, plant and equipment 381 346
Investment in associate (see Exhibit 2) 56 –––
437 346
Current assets
Inventories 86 40
Receivables 72 48
Cash and cash equivalents 3 60
161 148
Total assets 598 494
EQUITY AND LIABILITIES

Equity
Share capital (50 pence shares) 150 150
Share premium 50 50
Retained reserves 265 223
Total equity 465 423
Pension liability (see Exhibit 2) 38 5
Current liabilities
Trade and other payables 95 66
Total liabilities 133 71

Total equity and liabilities 598 494
Kenyon plc: Statements of profit or loss and other comprehensive income for the year ended 31
October
20X1 20X0
£m £m
Revenue 663 463
Cost of sales (395) (315)
Gross profit 268 148
Distribution costs (27) (20)
Administrative expenses (28) (17)

20X1 20X0
£m £m
Share of profit of associate (see Exhibit 2) 7 –
Finance income 1 6
Profit before tax 221 117
Income tax expense (45) (24)
Profit for the year 176 93
Other comprehensive income (not re-classified to P/L):
Remeasurement loss on pension assets and liabilities (see Exhibit 2) (48) (10)
Tax effect of other comprehensive income 14 2
Other comprehensive income for the year, net of tax (34) (8)
Total comprehensive income 142 85
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.

12 Dormro
Note: For formatting reasons it is recommended that this question is done as home study/in a paper-
based 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 2023 Audit and integrated 1 31

Exhibit 2: Dormro: consolidation schedules for the year ended 30 April 20X2
Statement of financial position
Dormro Secure CAM Adjs. Note Group

£’000 £’000 £’000 £’000 £’000
ASSETS
Non-current assets
Property, plant and
equipment 45 2,181 788 3,014
Goodwill – – – 9,490 1 6,251
(3,239) 2
Investments 10,180 – 15 (10,010) 1 185
Current assets
Inventories – 3,380 2,947 6,327
Trade receivables 4,292 4,849 9,141
Intercompany receivables 2,045 – 1,474 (3,519) 3 –
Cash and cash equivalents 567 (706) 382 –––––– 243
Total assets 12,837 9,147 10,455 (7,278) 25,161
Equity
Share capital 200 10 510 (520) 1 200
Retained earnings at 1 May
20X1 4,523 973 1,758 (1,758) 2 5,496
Profit/(loss) for the year 54 (867) 2,962 (100) 3 568
(1,481) 2
Long-term borrowings 8,000 – – 4 8,000
Current liabilities
Trade and other payables 37 5,702 4,513 10,252
Intercompany payables – 3,329 90 (3,419) 3 –
Current tax payable 23 – 622 645
Total equity and liabilities 12,837 9,147 10,455 (7,278) 25,161
Statement of profit or loss
Revenue 767 23,407 28,097 (14,049) 2 37,455
(767) 3
Cost of sales – (19,703) (19,455) 9,727 2 (29,431)
767 3
Administrative expenses (740) (4,532) (4,688) (100) 3 (6,949)
2,344 2

Dormro Secure CAM Adjs. Note Group
£’000 £’000 £’000 £’000 £’000
Finance income/(cost) 50 (39) 31 (15) 2 27
Profit/(loss) before tax 77 (867) 3,985 (2,093) 1,102
Income tax expense (23) –––––– (1,023) 512 2 (534)
Profit/(loss) for the year 54 (867) 2,962 (1,581) 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 interests 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.

Klip – Statement of financial position as at 30 April 20X2
H$’000
ASSETS
Non-current assets
Current assets
Inventories 2,100
Trade receivables 600
Cash and cash equivalents 40
Total assets 4,680
Equity
Share capital 200
Retained earnings at 1 May 20X1 1,200
Profit for the year 500
Long-term borrowings 1,400
Current liabilities
Trade and other payables 1,380
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

13 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
Financial assets
Investments in equity 485 321
Derivatives 98 102
Debt investments 143 143
726 566
Financial liabilities
Loan note 2,000 2,000
2,000 2,000
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
£’000 £’000 £’000
Cole plc (50,000 shares) 163 230 –
Routers plc (16,000 shares) – – 93

Valuation at 31 Draft at 31
Historical cost December 20X6 December 20X7
£’000 £’000 £’000
International Energy plc (30,000 shares) 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.

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

Exhibit 2: Journal entries in respect of investments
Cole plc
£’000 £’000
DEBIT Cash 242
CREDIT Investment 230
CREDIT Profit or loss 12
Being the disposal of the investment in Cole plc
Routers plc
£’000 £’000
DEBIT Investment 93.28
CREDIT 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 Cash flow (5% ×

Period ended balance Interest at 5.73% 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
Journal entries in respect of the bonds
£’000 £’000
DEBIT Debt investment 1.2
DEBIT Cash 7.0
CREDIT Finance income 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 £’000
DEBIT Cash 83
CREDIT Debt investment 83

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 £’000
DEBIT Profit or loss – Interest expense 150
CREDIT Interest accrual 150
DEBIT Interest accrual 150

CREDIT Cash 150
DEBIT Cash 10
CREDIT Profit or loss – Interest expense 10
DEBIT Equity 8
CREDIT Derivative asset 8
14 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
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
Revenues
Rental income 500 – 300
Gains on investment properties 100 80 50
Operating costs
Depreciation of property (2) – (1)
Administration (12) (8) (9)
Finance costs (140) (50) (25)
Net profit 446 22 315

Summarised statements of financial position as at 31 December 20X8
Biltmore plc Subone plc Subtoo plc

£m £m £m
Property, plant and equipment (excluding
investment properties) 38 – 19
Investment properties 1,000 850 510
Investments 2,000 –––– ––––
3,038 850 529
Current assets 3 2 1
3,041 852 530
Equity 1,539 351 279
Non-current liabilities 1,500 500 250
Current liabilities 2 1 1
3,041 852 530
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 200
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.
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 250
value remains at £220 million.
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

Biltmore plc Present
carrying
amount
£m
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 300
small suite of management offices on the site. The complex cannot be sold separately.
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 150
20X9. The portfolio’s value was estimated at £120 million at that time.
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 850
£170 million was spent on the work done during the year ended 31 December 20X8.
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 360
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.
15 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.
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 20X7 Audited

£’000 £’000 £’000 £’000
Revenue 283,670 257,850
Cost of sales (187,220) (167,900)
Administrative expenses
(excluding amortisation) (35,020) (34,610)
Amortisation (1,960) (970)
Total administrative expenses (36,980) (35,580)
Profit from operations 59,470 54,370
Finance costs (17,750) (15,910)
Taxation (10,090) (9,270)
Profit for the year from continuing
operations 31,630 29,190
Loss for the year from
discontinued operations (4,390) ––––––––

Statement of financial position at 31 March
20X8 Draft 20X7 Audited

£’000 £’000 £’000 £’000
ASSETS
Non-current assets
Goodwill 12,000 5,000
Other intangible assets 40,680 28,740
Financial non-current assets 10,260 6,130
515,070 474,380
Current assets
Inventories 4,280 3,820
Receivables 86,430 78,160
Cash and cash equivalents 19,540 15,910
110,250 97,890
Non-current assets held for sale 40,130 –––––––
Total assets 665,450 572,270
Equity
Share capital 10,900 10,900
Share premium 63,250 63,250
Revaluation surplus 30,900 30,900
Reserves 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
Current liabilities
Bank overdraft 11,160 10,270
Trade and other payables 32,810 33,950
Tax liabilities 6,470 5,130
50,440 49,350
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
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.
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.
16 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
Exhibit 1: Maykem Ltd – Audit – 31 May 20X8

Work performed on current liability balances
Current liabilities are analysed as follows:
20X8 20X7
£’000 £’000
Trade payables 13,342 15,208
Accruals 5,749 4,579
Indirect taxes 2,625 2,302
Payroll taxes 1,214 1,304
Contract liabilities 15,435 18,167
Surplus property provision 500 ––––––
38,865 41,560
Trade payables
This balance is made up as follows:
20X8 20X7
£’000 £’000
Trade payables ledger 11,023 12,586
Goods received not invoiced 2,319 2,622
13,342 15,208
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 Payments in transit Invoices in transit Balance per

Supplier ledger (note 1) (note 2) Other statement Note
£’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 3
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
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.
(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
Commission 235 150 1
Bonus 4,000 2,300 2
General and administration 1,504 1,895 3
Legal fees 10 – 4
Royalties payable –––– 234 4
5,749 4,579
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.
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.
17 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 (
Exhibit 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.
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 Notes
£’000 £’000
Revenue generated by South London factory
External customers 4,282 5,912
Sales to Woodtydy 135 ––––– 1
4,417 5,912
South London factory costs
Raw materials at standard cost 2,431 3,197
Purchase price variances 296 (10) 2
Other purchase costs, including freight 77 45
Movement in inventory at standard cost (99) 20
Total raw material cost of goods sold 2,705 3,252
Movement in inventory provision – 5
Labour 873 869

10 months to 31 May
20X1 20X0 Notes
£’000 £’000
Overheads and delivery costs 345 354
Total factory cost of goods sold 3,923 4,480
Margin as a percentage of total revenue 11% 24%
31 May 31 May
20X1 20X0 Notes
£’000 £’000
Inventory analysis
Raw materials 340 270 3
Raw material element of work-in-progress 131 157
Raw material element of finished goods 55 –––– 4
526 427
Inventory provision (20) (20)
506 407
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.
(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)
At 15 December 20X1
Spot £1 = $1.4108
Fair value of forward contract £43,994 positive (ie, in favour of Tydaway)
18 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.
(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.
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
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.

19 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.
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.
(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.
20 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
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.

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.
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.
The fair value of the options has been estimated as follows:
1 January 20X8 £12
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).
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%.
21 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).
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.
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
Revenue
Showrooms 30,000 60,000
Online sales 33,000
Cost of sales (49,000) (42,000)
Less
Administration expenses (5,000) (5,000)
Distribution costs (5,000) (6,000)
Marketing costs for website (1,000)
Website development cost – amortisation (100)
Reorganisation costs (1,500)
SupportTech fees (1,800)
Premises costs (2,500) (3,000)

Years to 30 June 20X1 20X0
£’000 £’000
Pension contributions (192)
Profit on sale of eight small showrooms 4,000 ––––––
Profit 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.
(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 <[email protected]>

From: Andrew Brown <[email protected]>
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?
22 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
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

£’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
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 1 2 3 4 5 6
£’000 £’000 £’000 £’000 £’000 £’000
Future cash flows 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
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.
23 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 <[email protected]>
From: Margaret Fleming <m.fl[email protected]>
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.
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.
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 UK-
produced 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 straight-
line 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.fl[email protected]>

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.
(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%.

24 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

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
Draft 9 months to 9 months to 30 Year ended 30

Notes 30 June 20X6 June 20X5 Sept 20X5
£’000 £’000 £’000
Revenue: 1
Monty 7,500 9,600 10,400
Gold 14,000 28,800 31,200
Cost of sales: 2
Monty (6,700) (7,800) (9,200)
Gold (15,500) (23,400) (27,600)
Gross profit/(loss) (700) 7,200 4,800
Fixed administrative and
distribution costs (1,200) (1,200) (1,600)
Exceptional item
Staff bonus scheme 3 (450) –––––– ––––––
Profit/(loss) before tax (2,350) 6,000 3,200
Income tax expense –––––– (1,680) (900)
Profit/(loss) for the period (2,350) 4,320 2,300

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 9 months to 30 Year ended 30 Sept

June 20X6 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).

• 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
25 Tawkcom
Note: For formatting reasons it is recommended that this question is done as home study/in a paper-
based 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

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 Leasehold Network Fixtures and Investment

and buildings improv. assets equipment property Total
£’000 £’000 £’000 £’000 £’000 £’000
Cost/valuation
Brought forward at 1
October 20X8 32,000 4,160 162,831 19,255 0 218,246
Additions 0 3,409 34,391 2,406 0 40,206
Disposals (6,550) (102) 0 (508) 0 (7,160)
Transfer from assets held

for sale 0 0 0 0 3,936 3,936
Carried forward at 30
September 20X9 25,450 7,467 197,222 21,153 3,936 255,228
Accumulated
depreciation
Brought forward at 1
October 20X8 476 882 38,697 14,577 0 54,632
Charge for the year 0 298 2,875 4,051 0 7,224
Disposals (95) (98) 0 (129) 0 (322)
September 20X9 381 1,082 41,572 18,499 0 61,534
September 20X9 25,069 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.
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.

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.
26 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.

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.

Exhibit 2: Summary draft statement of profit or loss and other comprehensive income and
statement of changes in equity
30 June 20X7 30 June 20X6

Year ended (draft) (audited)
£’000 £’000
Revenue 4,430 3,660
Less operating expenses (3,620) (2,990)
Operating profit 810 670
Finance cost – Note 2 above (260) (200)
Taxation (91) (141)
Other comprehensive income:
Gain on property revaluation 1,000 –––––
Total comprehensive income for the year 1,459 329
Revaluation
Statement of changes in equity 30 June 20X7 (extract) Retained earnings surplus
£’000 £’000
Balance at 1 July 20X6 713 –
Total comprehensive income for the year 459 1,000
Balance at 30 June 20X7 1,172 1,000
Exhibit 3: Summary draft statement of financial position

Period end date (draft) (audited)
£’000 £’000
Non-current assets
Land 5,000 4,000
Premises – Note 4 above 125 –
Plant and machinery 2 2
Investments – Notes 3, 5 above 650 –
Current assets 2,155 520
Current liabilities
Taxation (91) (141)
Other (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

Period end date (draft) (audited)
£’000 £’000
Share capital 86 86
Share premium 100 100
Revaluation surplus – Note 1 above 1,000 –
Retained earnings 1,172 713
Equity 2,358 899
27 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.

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 Distribution Administrative Total year to Total year to

sales costs expenses 30 June 20X9 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
Temporary staff 5,690 0 2,451 8,141 1,065
Employee expenses 341 287 2,074 2,702 2,396
Total staff costs 94,819 46,568 43,049 184,436 157,591
Summary of staff cost related balances in the statement of financial position at 30 June 20X9

£’000 £’000
Current liabilities
Employment taxes 6,903 6,287
Employer’s pension contributions payable 2,397 1,484

£’000 £’000
Accruals
Temporary staff 204 119
Commission payable on June sales 454 429
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

Exhibit 3: Journals dashboard
COMPANY: NETUSUK 01.07.X8 – 30.06.X9
Journals
Dashboard Automated vs Manual
440 Value
Total no. of journals 25%
£3,874,000
75%
Total value of journals
£8,805
Average value of journals
Volume
10
Number of users
60% 40%
Automated Manual
Top 10 users
Value £000 × Volume Value Volume
Creator ID Department 38
36
900
850 34
Andrews Finance 800 32
750 × 30
Conway Finance 700
650 ×
28
26
Dalton Finance 600

550
× × 24
22
(financial 500
450 ×
20
18
controller) 400 × × 16
350 14
Edwards Finance 300 × 12

250 10
Farley Finance
200
150
× 8
6
100 4
Lyndon Sales 50
× 2
Ridley Finance
s
ay
ds
ey
as
g
ew
le
to
do
ng
on
om
w
dl
ar
Singh Finance
al
Fa
dr
on
W
Si
n
Ri
w
D
Ly
Th
Ed
An
Thomas Finance
Average £17k £12k £53k £8k £13k £5k £15k £18k £18k £2k
Wong Sales

28 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
Revenue 6,720 6,240 5,280
Cost of sales (3,600) (3,360) (2,880)
Gross profit 3,120 2,880 2,400

Verloc Winnie Stevie
£’000 £’000 £’000
Administrative expenses (760) (740) (650)
Distribution costs (800) (700) (550)
Interest income 80 – –
Finance costs (360) (240) (216)
Profit before tax 1,280 1,200 984
Income tax expense (400) (360) (300)
Profit for the year 880 840 684
Other comprehensive income (not reclassified to P/L):
Remeasurement gains on defined benefit pension plan 110 – 40
Tax effect of other comprehensive income (30) ––––– (15)
Other comprehensive income for the year, net of tax 80 ––––– 25
Total comprehensive income for the year 960 840 709
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 non-
controlling interests 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.

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)
Income tax expense (400 + (360 × 5/12) + 300) (850)

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 interests (W1) 513
1,715
Total comprehensive income for the year attributable to:
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

PFY TCI
£’000 £’000
NCI share (NCI in TCI is the same as Winnie has no OCI) × 20%
= 68 = 68
Stevie
As stated in Attachment 1 684 709
× 65% × 65%
= 445 = 461
Total NCI 513 529
(2) Goodwill (Winnie) (to calculate impairment loss allowance for year)
£’000 £’000
Consideration transferred 2,800
NCI at proportionate share of fair value (20% × 3,210) 642
Less net assets at acquisition:
Share capital 200
Reserves 2,050
(2,250)
Goodwill 1,192
Impairment loss allowance (10%) 119
(3) Goodwill (Stevie)
£’000 £’000
Consideration transferred 980
Less net assets acquired:
Share capital 100
Reserves 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 735

(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.
29 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.

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 – 30%
Monica Orchard Non-executive director –

(appointed by Yissan plc)

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.
30 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

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 56,900
Exceptional item (Issue 1) 5,040

£’000
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
Share capital – ordinary £1 shares 1,000
Share premium 15,000
Total equity 17,500
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) 12,350
Short-term provision (Issue 4) 740
Total current liabilities 13,090
––––––

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 8,000
Less carrying amount at 31 March 20X4 (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

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.
31 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

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
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%

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 20X4 20X3

Actual Budget Actual
C$m C$m C$m
Revenue 305.4 358.6 350.4
Other income 4.8 –––––– ––––––
310.2 358.6 350.4
Change in finished goods and WIP 5.9 (8.3) (18.6)

Raw materials and consumables used (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)
Finance costs (5.1) (5.0) (5.0)
(Loss)/profit before tax (50.2) 32.0 31.1
Tax –––––– (10.0) (9.3)
(Loss)/profit after tax (50.2) 22.0 1.8

Ectal: Statement of financial position at 31 August 20X4
20X4 20X4 20X3

Actual Budget Actual
C$m C$m C$m
Property, plant and equipment 551.3 622.5 603.7
Inventories 98.0 90.0 92.1

Trade receivables 50.7 55.0 57.0
Cash 1.5 15.0 10.1

Current assets 150.2 160.0 159.2
Total assets 701.5 782.5 762.9
Ordinary share capital 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

Short-term borrowings 2.8 – –
Current tax payable –––––– 10.0 9.3
Current liabilities 101.5 106.0 108.7
Total equity and liabilities 701.5 782.5 762.9
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) 604
Fair value of plan assets at 1 March 20X4 8,062

£’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:
1 April 20X4 31 August 20X4

Market price of one share in Brattle £6.00 £5.90
Value of put option contract £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.
32 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
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.

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
(1) Audit procedures for trade payables

Trade payables comprise:
20X4 20X3
£’000 £’000
Trade payables ledger balances 11,820 12,036
Add: Debit balances 345 52
Add: Goods received not invoiced 1,544 2,540
Total trade payables 13,709 14,628
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.

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
% of trade payable ledger balances 44.6 14.7 30.5
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 (72)
Year-end balance 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.

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:
20X4 20X3
£’000 £’000
Legal fees (see above) 100 –
Provision for restructuring:
Redundancy payments 270
One-off payments to employees for relocation costs 50
Costs of removing plant and machinery 400
720 –
Lease cost of factory 1,100 –

Payroll and other current taxes 200 200
Other accruals 500 350
Total 2,620 550
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.

(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.

33 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 2023 Real exam (July 2015) 103

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 non-controlling interests 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 interests 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.

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 interests 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 interests (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.

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
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.
34 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.

(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
ASSETS
Development costs 10,380 10,380
Trade and other receivables 36,100 30,400
(Overdraft) / Cash (8,400) 5,600
184,040 189,980
Long-term borrowings 22,000 39,000
Current tax payable 4,420 6,060
Provision for redundancy costs 3,800 –––––––
184,040 189,980

Draft financial information for the statement of profit or loss for the year ended 30 June
20X5 20X4
£’000 £’000
Revenue 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)
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
Revenue 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
Income tax credit/(charge) 2,600 (1,400)
(Loss)/profit after tax (11,284) 5,800
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.

An analysis of the property, plant and equipment figure in the draft financial statements is as follows:
Plant and
Land Buildings equipment Total
£’000 £’000 £’000 £’000
Lawn Mower Division:
Cost at 30 June 20X4 and 30 June 20X5 5,600 6,000 12,000 23,600
Accumulated depreciation at 1 July 20X4 – (960) (3,400) (4,360)
Depreciation charge for the year ended
30 June 20X5 ––––– (120) (860) (980)
Carrying amount at 30 June 20X5 5,600 4,920 7,740 18,260
Continuing activities:
(ie, the other three divisions)
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
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.

35 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
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 2023 Real exam (November 2015) 111

(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
35.1 Respond to the instructions in Hal Benny’s email.
35.2 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. Note Group
£m £m £m £m £m
Revenue 56.5 12.0 16.0 84.5
Cost of sales (33.3) (7.5) (12.5) (53.3)
Administrative expenses (8.3) (1.5) (1.5) (1.0) 4 (12.3)
Selling and distribution costs (4.7) (0.7) (1.4) (6.8)
Finance costs (1.6) –––– ––––– ––––– (1.6)
Profit before tax 8.6 2.3 0.6 (1.0) 10.5
Income tax expense (1.7) (0.5) (0.2) ––––– (2.4)
Profit for the year 6.9 1.8 0.4 (1.0) 8.1
Non-current assets
PPE 38.0 10.8 16.0 64.8
Goodwill – HXP – – – 2.6 1 5.6
Goodwill – Softex – – – 2
Investment in HXP 12.0 – – (12.0) 1 –

Investment in Softex 22.0 – – (22.0) 2 –
Current assets
Inventories 9.2 1.9 1.7 12.8
Trade receivables 10.8 2.0 2.1 14.9
Cash and cash equivalents – 0.6 2.0 2.6
––––– –––– ––––– ––––– –––––
Total assets 92.0 15.3 21.8 (28.4) 100.7

Larousse
plc HXP Softex Adjs. Note Group
£m £m £m £m £m
Share capital 10.0 4.0 5.0 (4.0) 1 10.0
– – (5.0) 2
Share options – – – 1.0 4 1.0
Retained earnings at 1 October
20X4 35.8 7.4 14.0 (7.4) 1 35.8
(14.0) 2
Profit for the year 6.9 1.8 0.4 (1.0) 4 8.1
Non-current liabilities 28.4 – – 2.0 1 30.4

Current liabilities
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
––––– –––– ––––– ––––– –––––
Total equity and liabilities 92.0 15.3 21.8 (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.

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 20% 25%

Larousse plc’s inventories at 30 September 20X5
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.

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.
36 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 expense 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

Exhibit: Draft trial balance at 31 August 20X5 − prepared by John Birch
Additional
£’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 –
Other income: property letting – 70
Current tax expense 350 –
Ordinary share capital – 60
Trade receivables 2 3,281 –
Trade payables – 3,965
Current tax payable – 350
Cash 82 –
Retained earnings at 1 September 20X4 – 5,051
Revaluation surplus at 1 September 20X4 3 – 971
Property at 53 Prospect Street 3 3,335 –
Computer and office equipment – at cost 242 –
Computer and office equipment – depreciation
at 31 August 20X5 – 110
Deferred tax at 1 September 20X4 4 – 243
––––– –––––
26,500 26,500
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.

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

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.
37 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.

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.

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).

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
Test Outcome Frequency of value of individual

orders for John Fuller for the year
Average value per individual order £3,246
35%
Average value of monthly totals of £64,379 30%
25%
orders
20%
% of individual orders exceeding £4,000 35% 15%
10%
% of individual orders in last three days 27% 5%
0%
of the month
00
0
00
00
00
00
10
£2
£3
£4
£5
Frequency of John exceeding £90,000 7
-£
1-
1-
1-
1-
£0
00
00
00
00
of orders in a month
£1
£2
£3
£4
One manufacturing manager, John Fuller, was identified as an outlier showing the following data:
Test Outcome
Frequency of value of
Number of manufacturing managers 30 individual orders for the year
Average value per individual order £2,343 2500
2000
Average value of monthly total orders £45,864 1500
per manager 1000
500
Frequency of managers exceeding 16 0
£90,000 in any one month 00
0
00
00
00
00
10
£2
£3
£4
£5
-£
Frequency of managers exceeding zero

1-
1-
1-
1-
£0
00
00
00
00
£100,000 in any one month (requiring
£1
£2
£3
£4
approval from senior manager)
Test 2: DAACA system – data dashboard

Top 4 suppliers
Average no of days
Test Outcome delivery terms exceeded
Number of orders matched 13,546

with GRN Wilson
Number of unmatched orders 1,175 Man Inc

Number of unmatched orders 22
over 2 months old UUP Ltd
Number of unmatched GRNs 17
Jones plc
-5 0 5 10

38 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 in-
formation for these transactions, but Greg had concerns about whether the financial reporting treat-
ment 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
ASSETS £’000
Non-current assets
Intangible assets – website development costs 31,300
Financial asset – investment in TraynerCo 8,000
Current assets
Inventories 144,380
Trade and other receivables 22,420
Cash and cash equivalents 71,139
Total assets 333,548

ASSETS £’000
Equity
Ordinary share capital (£1 shares) 10,000
Translation reserve (TraynerCo) (1,500)
171,862
Non-current liabilities 12,175
Current liabilities 149,511
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.

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
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.

39 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)
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)

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 £m
DEBIT Cash 9.0
DEBIT Receivables 27.0
CREDIT Revenue 36.0
DEBIT Cost of sales 13.2
CREDIT Inventories 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.

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)
Finance costs (5.5)
Income tax (2.3)
Other comprehensive income for the year ––––––
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.
40 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.

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 Assets under Fixtures, fittings

and buildings construction and equipment Total
£m £m £m £m
Cost or valuation
At 1 September 20X5 129.5 2.8 29.5 161.8
Additions – 21.8 4.1 25.9
Assets coming into use 13.5 (13.5) – –
Disposals –––––– ––––– (1.5) (1.5)
At 31 May 20X6 143.0 11.1 32.1 186.2
Depreciation
At 1 September 20X5 6.1 – 15.4 21.5
Charge for the period 2.4 – 2.8 5.2
Disposals –––––– ––––– (0.9) (0.9)
At 31 May 20X6 8.5 ––––– 17.3 25.8
Carrying amount
At 1 September 20X5 123.4 2.8 14.1 140.3
At 31 May 20X6 134.5 11.1 14.8 160.4

The forecast for the three months ending 31 August 20X6 includes movements in PPE as follows:
Freehold land Assets under Fixtures, fittings

and buildings construction and equipment Total
£m £m £m £m
Cost or valuation
At 31 May 20X6 134.5 11.1 14.8 160.4
Additions – 8.0 0.5 8.5
Depreciation charge for the
period (0.8) – (1.0) (1.8)
Revaluation gain 40.0 –––– –––– 40.0
At 31 August 20X6 173.7 19.1 14.3 207.1
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.

• 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.

41 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
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.

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 Forecast
Ph244 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
Depreciation (0.5) (0.7) (0.5) (0.4)
Balance at 31 October 7.1 11.5 5.8 10.0
Intangible asset: research and development (R&D)
20X6 20X6 20X5 20X5

Forecast Forecast Other
Ph244 R&D Ph244 Other R&D
£m £m £m £m
Balance at 1 November 7.2 8.2 – 7.9
Additions – 1.6 7.2 2.3
Amortisation (1.2) (1.8) ––– (2.0)
Balance at 31 October 6.0 8.0 7.2 8.2
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.

(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
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
Revenue 24.8 31.4
Cost of sales (15.2) (18.8)
Gross profit 9.6 12.6
Operating expenses (7.2) (8.8)
Operating profit 2.4 3.8
Finance costs (1.8) (1.4)
Profit before tax 0.6 2.4
Income tax ––––– (0.6)
Profit for the year 0.6 1.8
Zego Ltd: Statement of financial position at 31 October 20X6
20X6 20X5
£m £m
ASSETS
Non-current assets
Intangible asset: R&D 14.0 15.4
32.6 31.2
Current assets
Trade receivables 4.6 5.8
Cash and cash equivalents ––––– 3.6
16.6 17.2
Total assets 49.2 48.4
Ordinary share capital 4.0 4.0
Retained earnings 17.0 16.4
21.0 20.4

20X6 20X5
£m £m
Long-term liabilities: borrowings 20.6 22.4
Deferred tax 0.6 0.6
21.2 23.0
Current liabilities
Trade payables 3.8 4.4
Tax payable – 0.6
Overdraft 3.2 ––––
7.0 5.0
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
Adjustments for:
Depreciation 1.2 0.9
Amortisation 3.0 2.0
Finance costs 1.8 1.4
6.6 6.7
Change in inventories (4.2) 0.4
Change in trade receivables 1.2 (0.7)
Change in trade payables (0.6) 0.9
Cash generated from operations 3.0 7.3
Interest paid (1.8) (1.4)
Tax paid (0.6) (0.7)
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)
Cash flows from financing activities
Loan (repayment)/financing (1.8) 13.0
Net change in cash and cash equivalents (6.8) 1.2
Opening cash and cash equivalents 3.6 2.4
Closing cash and cash equivalents (3.2) 3.6

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.
42 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 interests.

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 expenses 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)
Other operating income 2 15.7 –
Operating expenses 2 (35.0) (188.8)
Profit/(loss) before tax 45.9 (48.4)
Tax 3 (9.0) ––––––
Profit/(loss) for the year 36.9 (48.4)
Other comprehensive loss 4 –––––– (56.6)
Total comprehensive income/(loss) for the year 36.9 (105.0)
Draft statements of financial position at 30 September 20X6
Notes Trinkup ZCC

£m Km
Non-current assets
Property, plant and equipment 6 127.3 244.5
Financial asset – investment in ZCC 64.8 –
Amount owed by ZCC 5 36.4 –
Net current assets 1 30.8 101.0
259.3 345.5

Notes Trinkup ZCC
£m Km
Equity
Share capital 150.0 50.0
Retained earnings at 1 October 20X5 52.8 240.5
Pension reserve 4 ––––– (56.6)
239.7 185.5
Deferred tax 19.6 –
Long-term loan owed to Trinkup 5 ––––– 160.0
259.3 345.5

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.

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
43 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) 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.
(2) 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

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 Number of £1

Key4Link 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.

Balance per Included in Balance per
Supplier Note purchase ledger accruals Difference 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 100,000
Anticipated redundancy costs 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
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.

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.

44 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).”
“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 Year ended 31 Dec

Revenue Notes 20X4 20X3 20X3
£’000 £’000 £’000
Customised mobile
devices 1 30,300 20,700 51,700
Software services 1 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.

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
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 pre-
tax 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 900
Defined contribution scheme 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.
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.
45 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.
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 Fenner to 30
information May 20X7 June 20X7
£m £m
Revenue 1,855.4 382.4
Cost of sales 1 (1,482.9) (272.0)
Finance income 2 3.6 –
Profit/(loss) before tax 95.9 (58.5)
Income tax (19.1) 12.0

Draft statements of financial position
Elac: consolidated
Additional (excluding Fenner) to 31 Fenner to 30
information May 20X7 June 20X7
£m £m
Non-current assets
Tangible assets 1,799.7 1,180.0
Investments 456.0 –
Suspense account 350.0 –
Current assets
Trade receivables 1 238.9 88.8
Cash 16.4 ––––––
Total assets 3,104.8 1,312.0
Equity
Ordinary share capital (£1 shares) 150.0 10.0
Reserves 2,255.4 208.4
Long-term liabilities 388.3 1,003.2
Current liabilities
Trade payables and accruals 305.6 65.6
Provisions and borrowings 1 5.5 24.8
Total equity and liabilities 3,104.8 1,312.0
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) Finance income
Finance 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.
46 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

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).
(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 £850,000 UK audit team

company
UK subsidiaries Materiality will be determined UK audit team

separately for each.
R1-Arca This entity is not required to issue Hind audit team in Arca to
Results are expected to be audited financial statements and so perform audit procedures
material to the Recruit1 work will be performed using
component materiality of £300,000

Entity Level of component materiality Audit procedures to be
performed by Hind
group. (A$600,000 as at 31 December

20X6).
Other non-UK subsidiaries £500,000 UK audit team to perform

(including R1-Elysia) review procedures for
Results are not expected to be unexpected fluctuations
material to the Recruit1 or material balances
group.
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 R1-
Arca 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) Agreed to draft tax computation prepared by R1-

Arca’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%.
Retained earnings at 1 May 4,238 Reconciled to prior-year financial statements. Retained

20X6 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 6,469

20X7

Account A$’000 Notes on audit procedures and matters arising
Property, plant and 1,065 In accordance with group policy, property, plant and
equipment 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 592 No audit procedures carried out as below component
prepayments materiality of A$600,000.
Cash and short-term 4,143 Agreed to bank statements or investment

investments 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 6,469

20X7
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.

The carrying amounts of the property and the loan in the consolidation reporting pack at 30 April
20X7 are as follows:
Property Loan
E$’000 E$’000
Initial purchase transaction on 30 September 20X6 6,000 6,000
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 500 –––––
Carrying amounts in the consolidation reporting pack at 30 April

20X7 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

47 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.

• 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
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.

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 Year ending Year ended

30 September 20X7 31 December 20X7 31 December 20X6
Actual Updated forecast Actual
£m £m £m
Revenue 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
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 10-
year lease with a tenant for the third floor, at an annual rental of £40,000. EF continues to occupy
the other two floors.

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.
48 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.

(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
Cash generated from operations 6,320 3,990
Extracts from statement of financial position at 30 September
20X7 20X6
£’000 £’000
Total liabilities 8,490 8,730
Equity 27,180 24,830
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%

Exhibit 2: Wayte draft statement of cash flows for year ended 30 September 20X7 – prepared by
Jenny
20X7 20X6
£’000 £’000
Cash generated from operations (Note) 6,320 3,990
Tax paid (810) (790)
Net cash from operating activities 5,510 3,200
Cash flows from investing activities

Dividends received 30
Purchase of PPE (2,408) (2,656)
Purchase of financial asset (192) (430)
(2,570) (3,086)

Dividends paid (3,000) –
Directors’ interest-free loan accounts repaid (1,000) ––––––
(4,000) ––––––
Net change in cash and cash equivalents (1,060) 114

Cash and cash equivalents brought forward 610 496
Cash and cash equivalents carried forward (450) 610
Note: Reconciliation of profit before tax to cash generated from operations
Finance income (30) –
Depreciation charge 1,100 690
Decrease (increase) in inventories 250 (400)
Decrease (increase) in trade receivables 330 (360)
Increase in trade payables 230 20
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.

• 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 expense. Tax is
charged at 20%.
49 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.

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

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 Cost of sales £610,000

CREDIT 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.

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 £290,000

CREDIT 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. Owen-
Grey’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 10 20 30

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
Frequency of order value

for MAK Ltd
40%
35%
30%
25%
20%
15%
10%
5%
0%
0
0
70
40
10
80
50
-£
1,
2,
2,
3,
-£
-£
-£
-£
£0
01
01
01
01
£7
,4
,1
,8
£1
£2
£2

50 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.

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:
Factory Office
(including (including Plant and
land) land) equipment
£’000 £’000 £’000
Cost at 31 May 20X7 and 31 May 20X8 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)
Carrying amount at 31 May 20X8 3,563 3,680 2,578

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 31,170
Income tax expense (Note 1) (380)
Profit from continuing operations 1,516
Discontinued operations
Loss from discontinued operations (Note 2) (1,250)
Profit for the year 266
(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.

• No tax relief is given for a depreciation expense or an impairment loss 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.
51 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
51.1 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.
51.2 Prepare revised financial statement extracts which include your adjustments.
Note: Ignore current tax and deferred tax
Total: 30 marks

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
Other comprehensive income −
Extracts from statement of financial position at 30 April 20X8
(see Exhibit 2) £’000
Non-current assets
Property, plant and equipment 3 and 4 53,860
Suspense account − one 1 6,757
Financial asset 1 706
61,323
Current assets 20,859

Total assets 82,182
Equity
Share capital (£1 ordinary shares) 200
Revaluation reserve 3 and 4 6,200
Cash flow hedge reserve 1 706
Other reserves 600
33,626
Loans 18,650
Pension – net defined benefit liability 5 136
Suspense account − two 4 10,000
28,786
Current liabilities 2 19,770

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.

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) 8,771,930
CREDIT Cash 8,771,930
DEBIT Cash 2,015,173

CREDIT 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 Cost of sales 12,000
CREDIT Trade payables 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.

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.
52 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.

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.
10 months to 10 months to
£’000 £’000
Wages and salaries for administrative staff 2,324 2,159
Other staff expenses 495 540
Insurance, electricity, gas and other utilities 1,140 1,275
Depreciation of office equipment 180 200
Movement in allowance for receivables 80 200
Profit on sale of branch office (300) –
Legal and professional fees 210 50
Movement in provision for claims and other legal matters 40 180
Start-up costs for MP Ltd 230 –
Other administrative expenses 76 63
Total operating expenses 4,475 4,667

MRL’s operating expenses have fluctuated over the 10 months to 30 June 20X8, as shown in the chart
below:
Operating Operating expenses by month
expenses
£’000
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 £50,000

CREDIT Accruals £50,000
Half-year bonus for MRL executive team.

(2) In May 20X8:
DEBIT Other staff expenses £9,000

CREDIT Cash £9,000
New tablet computers for finance team.

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.

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.

53 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 interests in KJL.

(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.

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
Equity
Retained earnings at 1 October 20X6 9,200 45,000
21,400 85,000
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

The journal is:
DEBIT KJL Retained earnings O$8,229,375

CREDIT Inventory 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.
54 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.

(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
Revenue 30,600 31,800 35,700
Cost of sales (22,803) (23,044) (25,444)
Gross profit 7,797 8,756 10,256
Operating costs (8,235) (7,904) (6,996)
Finance costs (500) (617) (609)
(Loss)/profit before tax (938) 235 2,651
Tax 178 (47) (530)
(Loss)/profit for the year (760) 188 2,121
Other comprehensive income –––––– (273) 46
20X7 20X6 20X5

Earnings per share To be calculated 1.9p 21.2p
Dividend per ordinary share Nil 1p 2p
Chelle share price at 31 October 980p 1139p 1711p
£1 = 100 pence (p)
Draft statement of financial position
20X7 20X6 20X5

Draft Final Final
£’000 £’000 £’000
Non-current assets
Property, plant and equipment 53,675 51,497 48,574
Financial asset 1,503 1,503 1,776
55,178 53,000 50,350

20X7 20X6 20X5
Draft Final Final
£’000 £’000 £’000
Current assets
Inventories 2,770 2,910 3,307
Trade receivables 7,710 7,503 7,997
Tax asset 178 – –
Cash ––––– 525 2,273
10,658 10,938 13,577
Total assets 65,836 63,938 63,927
Equity
Share capital (£1 shares) 10,000 10,000 10,000
Other components of equity 1,416 1,416 1,689
Retained earnings 37,294 38,054 37,966
48,710 49,470 49,655
Long-term liabilities (5% convertible bonds) 9,603 9,603 9,486

Current liabilities
Trade payables 6,304 4,818 4,256
Tax payable – 47 530
Bank overdraft (limit £5 million) 1,219 ––––– –––––
7,523 4,865 4,786
Total equity and liabilities 65,836 63,938 63,927
Extracts from draft statement of cash flows
20X7 20X6 20X5

Draft Final Final
£’000 £’000 £’000
Net cash inflows from operating activities 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)
Change in cash (1,744) (1,748) 1,854
Cash brought forward 525 2,273 419
Cash carried forward (1,219) 525 2,273
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

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.
55 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
Total: 28 marks

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.

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.

56 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
(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
losses. 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.

Extract from the financial statements for the year ended 31 May 20X1
Land and hotel Investment

Property buildings properties
£’000 £’000
Cost
At 1 June 20X0 100,500 –
Additions –––––– 24,550
At 31 May 20X1 100,500 24,550
Land and hotel Investment

Depreciation buildings properties
£’000 £’000
At 1 June 20X0 2,585 –
Provided in the year 80 –
At 31 May 20X1 2,665 –
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.

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 20X2 20X3 20X4

MYR million MYR million MYR million
Forecast rental income with full occupancy 4.0 4.0 4.5
Disposal proceeds 50.0
20X2 20X3 20X4

Expected occupancy rates:
No airport expansion 32% 20% 20%
With airport expansion 55% 80% 85%
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

‘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 £’000
DEBIT Cash 20,000
CREDIT Non-current liabilities 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
57 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 interests 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:

“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
Revenue 200.1 60.9
Cost of sales (128.7) (31.7)

JKL: consolidated
(excluding MiTek) MiTek
£m £m
Income tax (2.9) (1.2)
Other comprehensive income for the year –––––– –––––
Total comprehensive income 14.1 6.0
Attributable to:
Equity holders of the parent 14.1
Non-controlling interests ––––––
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 expense 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
Benefits paid to pensioners 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.

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.
58 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.

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:
Pott Other Total

£m £m £m
Certified work and agreed variations 15.6 40.2 55.8
Uncertified work 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

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
August 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
Total 114.60 (11.25) 15.45 118.80
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.

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.

59 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 AIM-
listed 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 interests 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.

Requirements
59.1 Prepare the working paper requested by the audit engagement partner, Kirsty Fox.
59.2 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
YN BBO YN Group
£’000 £’000 £’000
Profit for the year 18,000 5,000 23,000
Attributable to:
Equity holders of the parent 21,500

Non-controlling interests 1,500
23,000
Summary forecast statement of financial position at 31 December 20X6
YN BBO Journals YN Group

£’000 £’000 £’000 £’000
Property plant and equipment 56,500 16,600 73,100
Brand name – Nature&U 8,500 8,500
Financial asset – investment in BBO 13,800 Dr 150 13,950
Current assets 50,600 20,800 71,400
Total assets 129,400 40,400 169,950
Equity (£1 ordinary shares) 15,000 10,000 25,000

FVOCI reserve 300 Cr 150 450
Retained earnings 52,100 17,400 Dr 1,500 68,000
Non-controlling interests Cr 1,500 1,500
Non-current liabilities 25,000 25,000
Current liabilities 37,000 13,000 50,000
Total equity and liabilities 129,400 40,400 169,950
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.

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 £’000
DEBIT Investment 150
CREDIT 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 interests in BBO. The fair value of the non-
controlling interests 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 20X7 20X8 20X9

£’000 £’000 £’000
Future divisional cash inflows 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.

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 bio- Total materials used Bio-degradable

degradable materials (tonnes) 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%.

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 Actual Staff

turnover turnover
% %
20X4 15 20
20X5 12 14
20X6 10 9
The target for 20X7 is 5% and the target for 20X8 is 4%.
60 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, H-
Sound 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.”

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
Lease rentals – retail properties 1,737 –
Depreciation 100 279
Directors’ salaries 140 550
Finance costs 30 407
Equity: Share capital and retained earnings 15,691 6,855

Net debt 608 5,892
Dividends paid in the year 2,000 –
Key ratios
RTone H-Sound
Return on Capital Employed (ROCE) 38.5% 38.5%
Gearing 3.7% 46.2%
Revenue per employee £311,770 £328,073
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.

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 H-
Sound. 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
Depreciation/Amortisation
At 1 October 20X2 100 261
Charge for the year 179
Property 40
Equipment 60 ––––
At 30 September 20X3 200 440
Carrying amount at 30 September 20X3 7,300 2,960
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.

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.
61 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.

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)
Investment in CarNation (Note 1) 100 –

Inventories 47 41
Cash 154 34
Loan (Note 2) (60) –
Taxation payable (15) (14)
Deferred taxation (6) –
Other assets and liabilities (109) (56)
Net assets 264 150
Share capital 200 70

Retained earnings 64 80
264 150

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.
Audit procedures on taxation
I am concerned about the extent of our audit procedures on taxation. Gentri plc’s tax expense 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.

• 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 expense for Gentri plc and the Gentri Group.
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.
• 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
Year ended 30 September £m £m
Cash flows from operating activities:
Profit before taxation 187 208
Add:
Depreciation 21 20
Decrease in inventory 5 6
Increase in creditors and provisions 7 18
Impairment of property – 15

20X8 20X7
Year ended 30 September £m £m
Deduct:
Profit on disposal of PPE – (4)
Increase in accounts receivable (3) (10)

217 253
Net cash flows from taxation:

Current taxation paid (41) (25)
Net cash flows from investing activities:

Purchase of PPE (53) (95)
Proceeds from disposal of PPE ––– 5
(53) (90)
Net cash flows from financing activities:
Repayment of loan – (10)
Dividends paid (40) (35)
(40) (45)
Net cash inflow 83 93

Cash at beginning of year 105 12
Cash at end of year 188 105

62 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.
ICAEW 2023 Real exam (August 2020) 213

Corporate loans are measured initially at fair value plus directly attributable transaction costs and
thereafter at amortised cost less impairment losses. 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
Other comprehensive income - -
Extract from statement of financial position as at 31 May 2020
HC plc (parent)
2020 2019
Financial assets £’000 £’000
Equity investments (shares)
Investments in subsidiary companies 5,000 5,000
Other investments in equity instruments 43,150 10,000
48,150 15,000
Other financial assets
Corporate loans 9,840 15,390
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
Alma plc (800,000 shares) - 10,000 6,000
VLA plc (320,000 shares) 18,150 - 18,150
Investment 25,000 ––––– 25,000
43,150 10,000
The investments in shares in Alma plc and VLA plc represent less than 10% of the share capital of
those companies.

• 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
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

• 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 £’000
DEBIT Cash 6,000
CREDIT 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 loss allowance 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.
63 React Chemicals plc

You are Alan Khan and you work as a financial accountant at React Chemicals plc (React), an AIM-
listed 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.

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 expense 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.

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 2020 2021 2022

Profits increase by - 12% 18%
Price per share £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)
Finance costs (125)
Tax (to be completed) (x)

Forecast summary statement of financial position as at 31 July 2021
£’000
Non-current assets
TOTAL ASSETS 47,814
Equity
Share capital (£1 shares) and other reserves 11,810
29,100
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 21,777
Tax base of plant and equipment (14,813)
6,964
Deferred tax liability at 25% 1,741

• 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.
64 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:
• 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).

(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
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
Operating
Notes Product Revenue profit/(loss)
£’000 £’000
Manufacturing divisions 1
UK Exhausts 4,061 51
India Tyres 4,801 1,680
Total manufacturing 2 8,862 1,731
Retail divisions 2
UK Exhausts 2,051 428

Tyres 2,135 320
India Exhausts 723 291

Tyres 2,692 807
France Exhausts 626 234

Tyres 448 120
Germany Exhausts 253 27

Tyres 1,239 (35)
Sweden Exhausts 477 97

Tyres 1,354 203

Operating
Notes Product Revenue profit/(loss)
£’000 £’000
Other: 8 small divisions 3 Exhausts 1,093 208

Tyres 3,466 520
Total retail 16,557 3,220
Total retail and manufacturing 25,419 4,951

Less:
Inter-division revenue 1 (8,862)
Less:
Head office costs (2,303)
Total 16,557 2,648
Summary by product:
Exhausts 5,223 1,336
Tyres 11,334 3,615
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 3 2,182
Head office 263
Total 14,026

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.

65 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
65.1 Respond to the audit engagement partner’s instructions.
65.2 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 intangible
assets Development costs Total
£m £m £m
Cost
At 1 October 2019 350 140 490
Additions 97 117 214
At 30 September 2020 447 257 704
Accumulated amortisation
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
Accounting policy note for intangible assets

• Recognition and measurement
Purchased intangible assets include licences, patents and databases, and are stated in the statement
of financial position at cost less accumulated amortisation.
Development costs comprise internally developed intangible assets 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
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 intangible assets 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.
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 £m
DEBIT Cash 20.15
DEBIT Profit or loss 0.10
CREDIT Non-current liability 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%.
The SSD financial controller has recorded this as follows:
£m £m
DEBIT Cash 40
CREDIT PPE 30
Being recognition of profit on disposal of building
£m £m
DEBIT Leased asset 27.8
CREDIT 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.
66 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).
“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 interests 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.
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 interests.
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
Revenue 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) –––––––
Tax (19,600) (16,000)
Other comprehensive income ––––––– –––––––
Total comprehensive income for the year 83,800 72,500
Other financial information
Retained earnings
As at 30 September 2019 180,600 173,800
As at 30 September 2020 264,400 246,300
Ordinary share capital
£1 shares (see Exhibit 1) 140,000
A$1 shares 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.
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.
67 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.
(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.
Analysis of revenue entries
Source of entry
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
5782 5820
6000
5021 4987 5137
5000
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
180 153
160 150
140 112 119
120 110
100
80
60
40 12
20 5
0
Mon Tue Wed Thu Fri 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 Cash £2 million

CREDIT Deferred income £2 million
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.

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: www.icaew.com/examresources
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.

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 Alain Smith Julie Lao

Sales ledger – Accounts assistant – Accounts assistant –
resigned February 2020 resigned August 2020 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 Bank– 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
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 bill-
and-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.

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 Description Debit Credit Account Effective User IDs

ID code dates
131735 Cancel 324,000 0 4000 01/03/2020 Alain

proforma
invoices
In June 2020:
Transaction Description Debit Credit Account Effective User IDs

ID code dates
134203 Cancel 145,551 0 4000 01/06/2020 Alain

proforma
invoices
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 bill-and-hold 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.
68 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.

“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
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 San Diego on 27
December 2020.

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 Account Prior Year Current % change Brief comments

Code Description £ Year prepared by Jason
£ Green
4000 Nickel Based 6,041,028 12,178,537 102%

Alloys
4002 Cobalt Based 1,516,635 2,357,616 55%

Alloys
4003 Nickel (73,923) 337,199 556% Movement already

explained by Audit
issue 1
4004 Other Raw 292,047 296,846 2% Consistent with

Materials 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
£342,556 on a ‘bill-
and-hold’
arrangement
4013 Molybdenum 3,495,861 5,511,292 58% Per Paul, Panther

accountant, sales of
molybdenum have
increased following

Account Account Prior Year Current % change Brief comments
Code Description £ Year prepared by Jason
£ Green
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 10,440 – (100)%

8 Sales)
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 351,045 257,740 (27)%

Sell
4030 MP35N 194,941 64,763 (67)%
4031 Refine/Reclaim – 1,941 N/A
4040 Sales – 166,316 161,789 (3)%

Processing
Total revenue 29,682,894 35,310,842
Totals subject to roundings

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:
Cost price Inventory

Quantity per tonne cost
Tonnes £ £
Estimated nickel alloy in inventory at 30 September 2021 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.
69 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.

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
69.1 Prepare the working paper requested by Hanna Sennhauser.
(22 marks)
69.2 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

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
Total assets 147,400

£’000
Equity
Ordinary share capital (£1 shares) 50,000
Other reserves 5,000
67,600
Net defined benefit pension liability (Exhibit 2, note 3) 54,000
Non-current payables and provisions 7,000
61,000
Current liabilities 18,800
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 8
Residual value as % of cost 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.

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:
Fair value of Present value Net defined benefit

plan assets of obligation pension liability
£’000 £’000 £’000
At 1 July 2020 16,000 (67,000) (51,000)
Interest 2% 320 (1,340) (1,020)
Contributions paid 3,500 3,500
Current service cost (2,000) (2,000)
Less: Benefits paid to retired members (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.
70 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.

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.
• Two 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 three-
year 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.

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 1.5
Other 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 100
Non-controlling interests – 20% of $5 million, translated at exchange
rate of £1 = $0.8 1 1,250
Total consideration 10,750

Notes £’000
Less: net assets
As reported in the Localex draft financial statements at 30 June 2021 2 5,000
Fair value adjustments:
Contractual right to supply power and equipment in Utopia 3 1,600
Provision for UK patent costs 4 (125)
Total net assets 6,475
Goodwill 4,275
Notes
(1) It is Numilla group policy to value the non-controlling interests 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.

Advance Information
Assume the date is 1 October 2021
Llama Ltd
The Advance Information relates only to Question 1 of the Corporate Reporting examination.
• this document, which includes the scenario, background information (Exhibit A) and audit
planning notes (Exhibit B); and
• the nominal ledger data for Llama Ltd (Llama) for the 11 months ended 31 May 2021, contained
within the data analytics software: www.icaew.com/examresources
Examination
In the Corporate Reporting examination, you will be provided with the nominal ledger data for Llama
for the full 12 months ended 30 June 2021 contained within the data analytics software. You will
need to address the new data for the month of June 2021 and to consider the data, patterns and
trends for the year ended 30 June 2021 as a whole.
The data for the 11 months to 31 May 2021 remains valid for the exam and will be unchanged.
However, in the exam, you will not be able to access the data analytics software for the 11 months to
31 May 2021 made available in the Advance Information or any notes you have made in the data
analytics software for the 11 months to 31 May 2021.
Scenario
You are an audit senior working for Morton LLP, a firm of ICAEW Chartered Accountants. Morton is
the auditor of Llama and it has a team working on the audit for the year ended 30 June 2021.
Llama prepares its financial statements in accordance with IFRS® Standards. In September 2021, an
audit plan was prepared by an audit manager who has now left the firm. The audit manager was
assisted by Ben Boreham, an audit assistant. You have just been assigned as the audit senior on the
audit of Llama and receive the following email from the new audit engagement manager, Fran
Farmer:
From: Fran Farmer
Date: 1 October 2021
To: Audit Senior
Audit planning for Llama was carried out during September 2021. Llama’s management provided
Morton with nominal ledger data for the 11 months ended 31 May 2021. This was imported into the
data analytics software used by Morton to carry out the audit.
The final audit of Llama for the year ended 30 June 2021 will commence in late October 2021.
The previous audit manager prepared some background information (Exhibit A). Ben Boreham
prepared audit planning notes containing matters he discussed with the client (Exhibit B).
Audit materiality has been set at £65,000.
Before the final audit commences, I would like you to familiarise yourself with Llama by reviewing:
• the background information (Exhibit A) and the audit planning notes (Exhibit B); and
• the nominal ledger data for Llama for the 11 months ended 31 May 2021, contained within the
data analytics software.

Exhibit A: Background information – prepared by previous audit manager,
September 2021
Company ownership
Concepts in Catering Cuisine Ltd (CCC) owns 100% of the ordinary shares of Llama.
On 1 August 2020, the entire ordinary share capital of CCC was acquired by a private equity fund.
Business and operations
Llama operates three restaurants in the UK which provide high-quality dining, drinking and
entertainment for its customers.
Llama One and Llama Two have been open for several years. Llama Three opened to customers in
November 2020.
Each restaurant operates from leasehold premises. The existing leases for Llama One and Llama Two
were extended with effect from 1 July 2020. Llama also signed a lease on a new restaurant (Llama
Three) on 1 July 2020. I have requested these lease contracts from the client.
Llama Three began trading and welcomed its first customers in November 2020. However, between
July 2020 and November 2020, the leasehold property had required considerable investment. CCC
provided funds to make this investment possible.
Finance
At 31 May 2021, Llama owed significant amounts to CCC arising from loans and other transactions.
Following a post-acquisition review, CCC’s new owners have now made it clear that they intend to
make Llama operate autonomously and become more financially independent of CCC. This includes
Llama being required to refinance its existing parent company loans from CCC using external
finance. Therefore, Llama is in negotiation with various banks and the Llama directors hope for a
favourable loan decision in January 2022.
In initial discussions, bank lending officers have indicated that they will need to inspect Llama’s
audited financial statements before they can approve a loan. They have also indicated that to make a
favourable loan decision they expect to see improvements in Llama’s financial performance for the
year ended 30 June 2021 compared with the year ended 30 June 2020.
Although Llama’s internal accounting records show a loss for the 11 months to 31 May 2021, the
directors are optimistic that the financial statements for the year ended 30 June 2021 will report a
profit.
Members of the accounting department at Llama and their roles
Pierre Delvenne
Finance director
Susan Chu
Financial accountant
Dianna Stevens Ahmed Hayat Gary Porter

Accounts assistant Accounts assistant Accounts assistant
Joined November 2020 Joined November 2020
and left December 2020

Pierre Delvenne – Finance director
Pierre is an ICAEW Chartered Accountant and has worked at Llama since 2016. Pierre has overseen
the new restaurant project, Llama Three. He was closely involved with each aspect of the project
including negotiating the price for works with the contractors. As Llama is a small company, he
records all types of transactions on a day-to-day basis. Pierre delegates the preparation of quarterly
management accounts to Susan Chu, who also assists him with the preparation of the year-end
financial statements.
Susan Chu – Financial accountant
Susan has worked for Llama for two years. She previously worked in the sales ledger department for
a large manufacturing company. She reconciles the bank statement monthly. Susan prepares the
quarterly management accounts and is assisted by Dianna Stevens who processes the month-end
accruals and prepayments.
Dianna Stevens – Accounts assistant
Dianna is competent at basic bookkeeping. She reconciles the cash takings at each of the three
restaurants and processes month-end journals for accruals and prepayments, as instructed by Susan.
She manages the purchase ledger and prepares monthly supplier statement reconciliations, assisted
by Ahmed Hayat.
Ahmed Hayat – Accounts assistant
Ahmed joined Llama in November 2020. He works with Dianna on the purchase ledger and petty
cash postings. He also has a wide range of roles including property maintenance, health and safety
training and hiring bar staff.
Gary Porter – Accounts assistant
Gary joined in November 2020. He did not settle into the team and so he left in December 2020. He
has not been replaced.
Information about Llama’s property, plant and equipment (PPE)
PPE includes:
• Account code 0010 – Leasehold property improvements
This account includes the costs of refitting restaurants. These costs include fees for surveying and
compliance with planning regulations, together with contractor costs for building works.
Depreciation for leasehold improvements has been recognised in Account code 0011.
• Account code 0040 – Furniture and fixtures
Each restaurant is furnished to a high specification. Costs in the furniture and fixtures account include
design fees, furniture, kitchen and bathroom fittings, kitchen, bar and cocktail equipment.
Depreciation for furniture and fixtures has been recognised in Account code 0041.
• Account code 0055 – Computer equipment
Costs in the computer equipment account include office computers, sound systems, cash registers
and tablet devices for taking customer orders. Depreciation for computer equipment has been
recognised in Account code 0056.
The company policy is to capitalise items which have a useful life of more than 12 months and to
expense all other items.

Exhibit B: Audit planning notes – prepared by Ben Boreham, September
2021
I have raised the following matters with Susan Chu:
Matter 1: Account code 0010 − Leasehold improvements
At 31 May 2021, Leasehold improvements (0010) has increased by 45% and leasehold
improvements depreciation (0011) by 49%.
I have analysed the Account codes 0010 and 0011 using the data analytics software.
0010 0011
Leasehold
improvements depreciation
£ £
Opening balances agreed to the financial statements
at 30 June 2020 1,889,145 (183,511)
Manual journals to record depreciation costs (89,526)
Purchase invoices 841,231
Manual journals for accruals and correction of
misposted transactions 19,042 –––––––
Balance at 31 May 2021 2,759,418 (273,037)
Note: Susan showed me the budget for the refitting of the Llama Three restaurant. I reviewed the
invoice list totalling £841,231 and this total figure for purchase invoices is less than the total
budgeted expenditure for leasehold improvements. So, I think this account is low audit risk.
Matter 2 Account 0040 – Furniture and fixtures
I reviewed the transactions in Account code 0040 – Furniture and fixtures using the large value
function in the Detect module. I noted the following, which is the largest debit transaction in this
account:
Transaction ID £ Effective date User Description
41825 101,116 12/7/2020 Susan Chu CCC lease contract –

Furniture and fixtures
Note: Susan told me that this transaction is connected with the new project to refit the Llama Three
restaurant and Pierre told her how to record it. Susan provided an internal purchase order as
supporting evidence.
71 Llama Ltd
Assume the date is 1 November 2021
The final audit visit for Llama started recently and you have just joined the audit.
The engagement manager for the Llama audit, Fran Farmer, gives you the following briefing:
“You, as audit senior, will have reviewed the background information prepared by the previous audit
manager and the audit planning notes prepared by the audit assistant, Ben Boreham. You will also be
familiar with the data for Llama for the 11 months ended 31 May 2021.
“Data for June 2021 has been imported into the data analytics software from Llama’s nominal ledger,
so the data for the full year ended 30 June 2021 is now available.
“Ben has performed audit procedures on additions to property, plant and equipment (PPE) and the
depreciation charge (Exhibit 1). Ben has also carried out audit procedures on the transactions and
outstanding balances with CCC (Exhibit 2).

“Llama has provided information about the lease agreements for the properties occupied by Llama’s
three restaurants, Llama One, Llama Two and Llama Three (Exhibit 3).
“I have set out my instructions for you in a separate document (Exhibit 4).”
Requirement
Respond to the audit engagement manager’s instructions (Exhibit 4).
Total: 40 marks
Exhibit 1: Audit procedures for additions to PPE and the depreciation charge for the year –
prepared by Ben Boreham
Audit procedures on additions to PPE
My lead schedule for PPE shows the following balances at 30 June 2021 for the three PPE asset cost
accounts.
Current
Account Prior Year Year
Code Account Description 2020 2021 Change
£ £ £ % change
0010 Leasehold improvements 1,899,145 2,755,180 856,035 45%
0040 Furniture and fixtures 918,684 1,535,414 616,730 67%
0055 Computer equipment 51,434 121,396 69,962 136%
Total of cost accounts 2,869,263 4,411,990 1,542,727 54%
I have carried out the following audit procedures on additions to PPE:

• Asset additions in Account code 0010 – Leasehold improvements
I think the additions to this account should be assigned a low audit risk because I compared the total
of the purchase invoice additions to the capital expenditure budget during my planning visit.
I have analysed the purchase invoice additions to this account as follows:
Purchase invoices posted by:
£
Pierre 675,452
Dianna 161,719
Ahmed 2,658
Susan 1,402
Total 841,231
I have calculated that 80% of the invoices, by value, included in this Account code have been posted
by Pierre Delvenne, the finance director.
I have used the data analytics software to identify four large transactions posted by Pierre. These are
four ‘Interim application’ invoices which represent progress payments for the refit of the Llama Three
restaurant.
I agreed each of these four amounts to an interim valuation from Llama’s surveyor. The four invoices
represent expenditure of £571,400, 84.6% of the invoices processed by Pierre to this account.
I was provided with a copy of the contract with the construction company for the entire refit project
and I noted that the contract was not signed by the contractor.
• Asset additions in Account code 0040 – Furniture and fixtures
I identified the largest transaction for £101,116 posted to this account in my audit planning notes.

I have investigated a further large transaction, which should be recorded as a leasehold
improvement and not as an addition to furniture and fixtures.
Transaction ID £ Effective date User Description
49545 43,000 1/11/2020 Susan Interim application No 1

Chu
I have asked Susan to adjust this transaction and to record £43,000 as an addition in account 0010.
Most of the other transactions included in Account code 0040 are small in value and therefore I have
not carried out any further procedures.
• Asset additions in Account code 0055 – Computer equipment
I reviewed this account and there are no material transactions, so I have not completed any audit
procedures for additions to this account code.
I therefore conclude that additions to leasehold improvements, furniture and fixtures and computer
equipment are fairly stated.
Audit procedures for the Account code – 008000 Depreciation
My lead schedule for PPE shows the following balances at 30 June 2021 for the three PPE
accumulated depreciation accounts.
Current
Account Prior Year Year
Code Account Description 2020 2021 Change
£ £ £ % Change
0011 depreciation (183,511) (284,009) (100,498) 55%
Furniture and fixtures
0041 depreciation (201,208) (348,629) (147,421) 73%
Computer equipment
0056 depreciation (13,151) (33,395) (20,244) 154%
Total of accumulated depreciation

accounts (397,870) (666,033) (268,163) 67%
I compared the depreciation charge of £268,824, recorded in Account code – 008000 Depreciation,
with the £268,163 change in the total of all the accumulated depreciation account codes noted
above. The difference is not material.
I obtained a schedule of the asset useful lives used to calculate depreciation for the year ended 30
June 2021. All assets are assumed to have a nil residual value and depreciation is calculated using
the straight-line method.
Leasehold improvements 25 years

Furniture and fixtures 10 years
Computer equipment 4 years
I recalculated the depreciation charge using the asset lives and found no material differences.
I discussed the asset useful lives with Pierre, who told me that there was a change in accounting
estimates from 1 July 2020. Until that date, the useful lives for leasehold improvements and furniture
and fixtures were 15 years and 8 years respectively.
Pierre’s justification of this change was that Llama has the right to extend the term of its leases for all
three restaurant properties (Exhibit 3).
In my opinion the depreciation charge is fairly stated.

Exhibit 2: Audit procedures on the transactions and outstanding balances with CCC – prepared by
Ben Boreham
I have performed audit procedures for intercompany balances. These balances are the amounts
owed by Llama to its parent company, CCC.
My lead schedule shows the following amounts owed to CCC at 30 June:
Prior year Current year

2020 2021
Account code Account description £ £
2103 CCC – Intercompany loans 1,067,332 2,166,548
2118 CCC – Intercompany trade creditor 765,351 926,151
1,832,683 3,092,699
I reviewed the loan agreement between Llama and CCC and established that:
• there is no fixed repayment date for amounts outstanding; and
• interest is chargeable at 8% per annum.
In my view, this is a low-risk account as amounts are owed to the parent company and there is no
fixed repayment date. Pierre told me that it is highly unlikely that repayment of the loan will be
demanded by CCC.
In my opinion intercompany balances are fairly stated.
Exhibit 3: Information for the property lease agreements

Each restaurant operates from leasehold premises. The leases for Llama One and Llama Two were
extended with effect from 1 July 2020. A single lease for both properties was signed on 1 July 2020.
The lease for the new property, Llama Three, was entered into on 1 July 2020.
Llama has exclusive use of the three properties for the duration of the lease terms.
At the end of the lease terms, Llama does not have a legal option to purchase the properties.
However, Llama has the right to extend the term of its leases for all three restaurant properties.
The annual lease payments have been recorded in Account code 007100 – Rent as follows:
Implicit annual
£ Lease term interest rate
Llama One
4 quarterly payments of £13,512 54,048
Llama Two
4 quarterly payments of £16,125 64,500
Total annual payments under extended lease 118,548 15 years 8%
Llama Three
12 monthly payments of £20,833 249,996 10 years 8%
Other costs included in Account code 007100 are:
£
Legal fees for Llama One and Llama Two lease 6,443
Legal fees for Llama Three lease 2,738
Annual maintenance charge for Llama Three 8,836

Exhibit 4: Audit engagement manager’s instructions – audit of Llama for the year ended 30 June
2021
(1) In respect of the audit of each of: (a) additions to PPE; and (b) the depreciation charge:
• identify and explain any weaknesses in the audit procedures performed by Ben Boreham (Exhibit
1); and
• set out and explain the key audit risks and any additional audit procedures we should perform to
address each risk. Use the data analytics software to identify specific key transactions which
require further investigation.
(2) Set out and explain the key audit risks, including inherent risks, arising from transactions and
(3) Using the information about property lease agreements (Exhibit 3):
• set out and explain the appropriate financial reporting treatment for the property leases in Llama’s
financial statements for the year ended 30 June 2021;
• prepare correcting adjusting journal entries; and
• summarise the impact of your adjustments on Llama’s profit or loss for the year ended 30 June
2021 as shown in the data analytics software.
Ignore any further adjustments for current tax and deferred tax.
72 Eastoak plc
Eastoak plc is an AIM-listed company that manufactures building products for the construction
industry.
Eastoak has a 30 September year end. It does not have any subsidiary companies. Its functional
currency is the £.
Eastoak has three divisions which each produce a separate product line:
• Ventilation division (based in UK)
• Lighting division (based in UK)
• Insulation division (based in France).
Shareholders have been concerned for some time about the results of Eastoak. After extended
discussion, the Eastoak board decided to close the Insulation division. The division was closed on 1
July 2021.
Despite the closure, shareholders remained concerned and, following a board meeting in
September 2021, the finance director and CEO resigned.
On 1 October 2021, Buzz Jones was appointed as the new Eastoak CEO. Eastoak advertised for a
new finance director, but the position is as yet unfilled.
You work for a firm of ICAEW Chartered Accountants. You have been seconded to assist Buzz with
the preparation of the Eastoak financial statements for the year ended 30 September 2021. Eastoak
is not an audit client of your firm.
Buzz called to give you the following briefing.
“A junior member of the Eastoak finance team, Georg May, has been helping me to put together the
Eastoak financial statements for publication, but we need your technical expertise. Georg has
prepared draft financial information for the year ended 30 September 2021. He has identified three
financial reporting issues which may require adjustment (Exhibit 1).
“The year ended 30 September 2021 was a challenging year for the business. As part of its
management commentary in the financial statements, the board wants to include a review of the
impact of the decision to close the Insulation division and of the performance of the two remaining
divisions. Therefore, I asked Georg to prepare a draft analysis of the overall performance of Eastoak
and its divisions which can be used as the basis of the management commentary (Exhibit 2).
However, I believe this analysis needs further consideration because I do not think his interpretation
is appropriate or that his analysis is complete.

“I would like you to prepare a working paper for me in which you:
(1) Set out and explain, for each of the three issues in Exhibit 1, your recommended financial
reporting treatment in Eastoak’s financial statements for the year ended 30 September 2021.
Include correcting journal entries.
(2) Prepare a revised statement of comprehensive income for Eastoak for the year ended 30
September 2021 (Exhibit 1), suitable for publication, which includes your adjustments from 1
above. Show your workings.
(3) Evaluate Georg May’s draft analysis of Eastoak’s overall performance and its divisions (Exhibit 2).
Include any relevant additional analysis. Use your revised statement of comprehensive income.”
Requirement
Prepare the working paper requested by Buzz Jones.
Note: Ignore any adjustments for current tax and deferred tax.
Total: 30 marks
Exhibit 1: Draft financial information for Eastoak, prepared by Georg May

Eastoak: Draft statement of comprehensive income for the year ended 30 September
2021 2020
£’000 £’000
Revenue 385,000 376,000
Cost of sales (283,388) (263,200)
Gross profit 101,612 112,800
Administrative expenses (92,120) (82,720)

Closure costs (2,000) -
Operating profit 7,492 30,080
Finance costs (500) (1,100)
Income tax expense (1,328) (5,506)
Other comprehensive income - -
Total comprehensive income 5,664 23,474

The above statement of comprehensive income includes the following amounts in respect of the
Insulation division, which was closed on 1 July 2021:
2021 2020
£’000 £’000
Revenue 76,600 99,416
Cost of sales (52,088) (69,591)
Administrative expenses* (24,357) (21,872)
Closure costs** (2,000) -
–––––– ––––––
Operating (loss)/ profit (1,845) 7,953
Income tax credit/(expense) 351 (1,511)
(Loss)/Profit after tax (1,494) 6,442
*A share of the total administrative expenses for the year ended 30 September 2021 has been
allocated to the Insulation division in the same proportion as for the year ended 30 September 2020
(ie, £92,120 × (£21,872/£82,720) = £24,357).
** The closure costs comprise redundancy costs of £1,200,000 and a provision for £800,000 in
respect of estimated costs to retrain staff who have relocated from the Insulation division to the
Ventilation and Lighting divisions.
(1) Closure of Insulation division
The Insulation division operated from a factory in France and 90% of its sales were invoiced in €. On
1 July 2021, operating activities ceased. On the same date, the Eastoak board instructed an agent to
advertise the division’s assets for sale as soon as possible at a realistic price.
The carrying amounts of the Insulation division assets held for sale, as they are currently recognised
in Eastoak’s statement of financial position at 30 September 2021, are:
Plant and
Land Buildings equipment
£000 £000 £000
Carrying amount at 30 September 2020 5,000 5,880 8,600
Depreciation charged for the year ended 30
September 2021 - (140) (1,290)
The Insulation division did not buy or dispose of any assets in the year ended 30 September 2021.
Eastoak uses a revaluation policy for land and buildings but recognises plant and equipment at cost.
Shortly after the assets were advertised, a property developer in France offered to buy the land and
buildings for €14 million. A competitor of Eastoak offered €9.7 million for the plant and equipment.
Selling costs are expected to be €500,000 for the land and buildings and €100,000 for the plant and
equipment. Both disposals are likely to complete by 31 December 2021.
The exchange rate at 1 July 2021 and 30 September 2021 was £1 = €1.1
(2) Refinancing arrangement
On 1 October 2015, Eastoak borrowed £20 million from its bank. The fees and transaction costs were
minimal. The loan is repayable on 1 October 2025.
Until 1 October 2020, interest of 5% per annum was paid annually in arrears.

Immediately after the interest had been paid on 1 October 2020, Eastoak renegotiated the terms of
the loan agreement with its bank as follows:
• No further annual interest payments will be made.
• The loan will be settled by Eastoak paying £30 million to the bank on 1 October 2025.
The new loan has an effective interest rate of 6% per annum which was the market rate for this type of
loan at 1 October 2020. The fair value of the loan at this date was £22.418 million (excluding fees).
The fees paid to the bank for the refinancing arrangement were £500,000 and have been included in
finance costs in Eastoak’s statement of profit or loss.
(3) Share-based payment scheme
On 1 October 2020, in order to improve employee performance, Eastoak decided to introduce a
share-based payment scheme for the employees of the Ventilation and Lighting divisions.
No adjustments have been made in the Eastoak financial statements for this scheme.
On 30 September 2024, the vesting date, each employee can choose to receive either:
• 2,000 shares in Eastoak, which cannot be sold until 12 months after the vesting date; or
• a cash amount equal to the value of 1,700 shares in Eastoak.
The market price of an Eastoak share was £4.00 on 1 October 2020. On 30 September 2021, the
market price was £4.50. The fair value at 1 October 2020 of the right to receive one share under the
scheme (after taking into account the selling restriction) was £3.50.
Vesting is conditional on being continuously employed by Eastoak over the period 1 October 2020
to 30 September 2024. On 1 October 2020, Eastoak expected that 700 employees would meet the
vesting condition. At 30 September 2021, Eastoak revised its estimate of the number of employees
expected to meet the vesting condition to 600.
Exhibit 2: Draft analysis of the overall performance of Eastoak and its divisions – prepared by Georg
May
Overall company revenue has increased by 2.4% however this includes a 23% fall in revenue from
the Insulation division and an increase of 11.5% in the revenue for the Ventilation and Lighting
divisions.
The revenue for the Ventilation and Lighting divisions has increased as a result of a 15% increase in
sales volumes for these products compared with the year ended 30 September 2020.
Although sales volumes of the Insulation division’s products remained constant, exchange rate
fluctuations caused a 20% reduction in its revenue in £ compared with the year ended 30 September
2020.
The impact of currency movements on revenue for the Insulation division has contributed to a fall in
the gross profit for the company from 30% to 26.4%. The Insulation division has made a loss for the
year ended 30 September 2021 of £1,494,000 compared with a profit of £6,442,000 for the year
ended 30 September 2020.
73 Circeon plc
You are Alex Baura, an audit senior at Helio Zena (HZ), a firm of ICAEW Chartered Accountants.
You are planning the audit of Circeon plc and the Circeon Group for the year ending 31 December
2021.The engagement manager provides you with the following briefing note.
Briefing note
Circeon plc is the parent company for a group which develops and sells innovative medical products.
It has a number of wholly-owned subsidiaries, including Thetaron Ltd. Thetaron was incorporated in
January 2019 to research and develop BSM49, a device for managing diabetes.

Thetaron’s results were immaterial to the Circeon Group in both 2019 and 2020. Its financial
statements for those years were not audited by HZ. However, HZ has been appointed as Thetaron’s
auditor for the year ending 31 December 2021, replacing the current auditor. The Circeon finance
director, Max Omicon, is pleased that we are now the auditor for Thetaron.
Although the Circeon board has confidence that BSM49 is commercially viable, it has other strategic
priorities and is therefore considering whether to sell its shares in Thetaron.
Yesterday, Max informed me that Circeon has received two alternative offers for either 100% or 40%
of the shares it owns in Thetaron. If the Circeon board decides to accept either offer, the completion
date will be 31 December 2021.
Max provided information about Circeon’s investment in Thetaron shares and the two alternative
offers received (Exhibit 1). I have forwarded this to you, together with Thetaron’s most recent
summary forecast for the year ending 31 December 2021 (Exhibit 2). The forecast was prepared by
Sam Heran, the Thetaron CEO, an ICAEW Chartered Accountant. It includes significant research and
development expenditure.
One of my friends plays squash with Sam. My friend sent me an email including some information
about Thetaron (Exhibit 3), which we will need to consider carefully.
Instructions
What I need you to do is:
(1) Explain the financial reporting treatment for the year ending 31 December 2021 of the disposal
of shares in Thetaron (Exhibit 1) for each of:
(a) offer 1; and
(b) offer 2,
for each of:
– the separate company financial statements of Circeon plc; andthe consolidated financial
statements of the Circeon Group.
– the consolidated financial statements of the Circeon Group.
For each offer (a) and (b), include relevant calculations and assume that the disposal of the
shares takes place on 31 December 2021 and that Thetaron’s results are in line with the forecast
provided (Exhibit 2).
(2) In respect of HZ’s audit of Thetaron’s financial statements for the year ending 31 December
2021:
(a) explain the key audit risks to be addressed; and
(b) set out the audit procedures for research and development costs.
Assume the completion date is 31 December 2021.
(3) Explain the ethical issues for both HZ and Sam that arise from the information in the email I have
received (Exhibit 3). Set out any actions that HZ should take.
Requirement
Respond to the engagement manager’s instructions.
Total: 30 marks

Exhibit 1: Information about Circeon’s investment in Thetaron and the two alternative offers
received – provided by Max Omicon, Circeon finance director
Circeon plc’s investment in Thetaron
Thetaron was incorporated on 1 January 2019. On incorporation, it had a share capital of 1 million £1
ordinary shares, all of which were issued at par to Circeon plc.
Circeon plc measures investments in subsidiaries at cost and has not recorded any impairment in
respect of its investment in Thetaron.
On 1 January 2020, Circeon plc made a loan of £3 million to Thetaron to fund Thetaron’s
development work on BSM49. The interest on the loan is at the market rate of 5.5% per annum and
the principal is repayable on 31 December 2025. Thetaron has the right to repay all or part of this
loan early, without penalty.
Two alternative offers
Circeon plc has received two alternative offers for its shares in Thetaron, both of which assume a
completion date of 31 December 2021.
Offer 1
An offer to Circeon plc from a management buyout (MBO) team for the entire issued share capital of
Thetaron comprising:
• Initial cash consideration of £1.7 million payable immediately on completion. This offer assumes
that Thetaron’s net assets (excluding the loan from Circeon plc) will have a carrying amount of
£1.2 million. The initial consideration will be adjusted £1 for £1 if the statement of financial
position at the completion date shows a higher or lower carrying amount for net assets. For
example, if the statement of financial position shows net assets (excluding the loan) of £1.1
million, the initial consideration will be reduced by £100,000 to £1.6 million.
• Additional consideration equal to 1% of revenues earned by Thetaron from sales of BSM49 in the
three years from 1 January 2022. The first sales of BSM49 are expected in 2022. The additional
consideration is payable on 31 March 2025 and its fair value at 31 December 2021 has been
calculated as £400,000.
The MBO team comprises the Thetaron CEO, Sam, and three other Thetaron board members.
Venture Capital funding has been arranged.
If Circeon plc accepts the MBO offer, its existing loan of £3 million will be repaid in full by Thetaron
on the completion date. Thetaron will finance this loan repayment by borrowing from a consortium of
UK banks.
Offer 2
An offer to Circeon plc from Sam (acting alone rather than as part of an MBO) for 40% of the issued
share capital of Thetaron, comprising cash consideration of £700,000.
The consideration will be adjusted if the net assets in the statement of financial position at the
completion date (excluding the loan from Circeon plc) are more or less than £1.2 million, the
adjustment in this case being 40% of the difference. For example, if the statement of financial
position shows net assets (excluding the loan) of £1.1 million, the consideration will be reduced by
£40,000 to £660,000.

If this offer is accepted, Thetaron will not make early repayment of the £3 million loan from Circeon
plc.
The board’s request
The Circeon board would like to understand the impact of each offer on the separate financial
statements of Circeon plc and the consolidated financial statements of the Circeon Group. Circeon
measures non-controlling interests using the proportion of net assets method.
Exhibit 2: Thetaron summary forecast for the year ending 31 December 2021, provided by Sam
Heran, Thetaron CEO
Summary forecast statement of profit or loss for the year ending 31 December 2021
Note £’000
Revenue −
Costs of research and development 1 (1,950)
Other operating costs (260)
Loan interest (165)
Loss before taxation (2,375)
Tax credit 2 475
Net loss for the year (1,900)
Summary forecast statement of financial position as at 31 December 2021
Note £’000
Cash 840
Other current assets 4 480
Current liabilities (220)
Net current assets 1,100
Non-current liabilities (Circeon plc loan) (3,000)
Net liabilities (1,800)
Share capital 1,000
Retained earnings (2,800)
(1,800)
Notes
1 Research and development costs relate wholly to the development of BSM49. They comprise
staff costs, consumables and an allocation of utility and other costs.
2 The tax credit has been prudently estimated and represents group relief receivable for the
surrender of some of Thetaron’s tax losses to other group companies.
3 Property, plant and equipment comprises IT equipment, fixtures and fittings.
4 Other current assets comprise the estimated receivable for group relief and sundry prepayments.

Exhibit 3: Extract from email received by audit manager from a friend
When I saw Sam last night, he could not wait to tell me that he and his MBO team have made offers
to Circeon plc for its shares in Thetaron. He is clearly excited about becoming a Thetaron shareholder
and he mentioned some very encouraging results from initial marketing of BSM49. These results
have generated significant attention from potential customers.
Sam asked me to keep quiet about these encouraging results, because only he and his MBO team
know about them, but I thought you would like to know. He said he is close to doing a deal with at
least one potential customer, but that he had suggested waiting until after any share transaction is
complete, so the customer could deal with the new owners.

Advance Information
The Advance Information relates only to Question 1 of the Corporate Reporting examination.
• this document, which includes the scenario, notes of a meeting with Paula Elliott, Gazelle Ltd’s
finance director, (Exhibit A) and a working paper prepared by an audit assistant working for MFE
(Exhibit B); and
• the nominal ledger data for Gazelle for the 11 months ended 30 November 2021 contained
Examination
In the Corporate Reporting examination, you will be provided with the nominal ledger data for
Gazelle for the full 12 months ended 31 December 2021 contained within the data analytics
software. You will need to address the new data for the month of December 2021 and to consider
the data, patterns and trends for the year ended 31 December 2021 as a whole.
The data for the 11 months to 30 November 2021 remains valid for the exam 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 2021 made available in the Advance Information nor any notes you have made in the
data analytics software for the 11 months to 30 November 2021.
Scenario
Assume the date is 20 June 2022
You are an audit senior working for MFE LLP, a firm of ICAEW Chartered Accountants.
You have been assigned to the audit of Gazelle for the year ended 31 December 2021. Gazelle
prepares its financial statements in accordance with IFRS. You receive the following email from the
audit engagement manager, Sam Kota:
From: Sam Kota
Date: 20 June 2022
To: Audit Senior
In April 2021, MFE was appointed as Gazelle’s auditor. Shortly after, I had an introductory meeting
with Paula Elliott, Gazelle’s finance director. I have summarised for you my notes from this meeting,
which include background information about Gazelle and its business (Exhibit A).
Gazelle has been slow to provide nominal ledger data. Therefore, the audit for the year ended 31
December 2021 is scheduled for July 2022.
In May 2022, MFE started planning the Gazelle audit for the year ended 31 December 2021. An MFE
audit assistant prepared a working paper using some information from the year ended 31 December
2020. He also included information about the current members of the Gazelle finance team and their
roles (Exhibit B).
Gazelle’s management has now provided MFE with the nominal ledger data for the 11 months
ended 30 November 2021. This has been imported into the data analytics software that MFE uses to
carry out its audit procedures.
The nominal ledger data for the full year ended 31 December 2021 will be available for the final
audit visit in July 2022.
Before the final audit visit, I would like you to review:
(a) the notes of my introductory meeting with Paula Elliott prepared in April 2021 (Exhibit A) and the
working paper prepared by the MFE audit assistant in May 2022 (Exhibit B); and
(b) the nominal ledger data for Gazelle for the 11 months ended 30 November 2021, contained

Exhibit A: Notes of introductory meeting with Paula Elliott – prepared by

Sam Kota, April 2021
Business and operations
Gazelle is a recruitment agency for clients in the science, clinical and engineering sectors.
The services Gazelle offers are:
• permanent job recruitment services in the UK
• supply of temporary contractors (temps) in the UK and in the rest of Europe
Permanent job recruitment services (UK only)
Clients approach Gazelle when they need a permanent employee. Gazelle advertises the job and
identifies and shortlists applicants according to the client’s job specification.
Gazelle charges each client a fee based on a percentage of the successful applicant’s starting salary.
A sales invoice is prepared for each fee. These sales invoices are recorded in the following Account
codes, based on the client sector:
Account code Account description
4001 Perms – Science
4006 Perms – Clinical
4013 Perms – Engineers
Revenue is recognised when the applicant commences employment with the client. As part of the
terms of business, Gazelle offers a full refund if, within three months of appointment, the applicant
leaves the client’s employment. This happens rarely as Gazelle is very experienced in recruitment.
In early April 2021, Gazelle appointed Geri Kyle as a new director and head of permanent
recruitment. Paula told me that the board expects Geri to introduce some changes to the contracts
with clients for permanent job recruitment services. As a result, revenue may increase in the year
ending 31 December 2021.
Supply of temporary contractors (temps) in the UK and the rest of Europe
Clients approach Gazelle when they need staff on a short-term basis. Gazelle has responsibility for
providing a suitable temp to the job specification approved by Gazelle’s client. Gazelle provides
temps to clients under the following methods:
• Method 1: Temps employed by Gazelle (UK only)
• Method 2: Company temps (UK and the rest of Europe
Method 1: Temps employed by Gazelle (UK only)
• The temp is employed by Gazelle for the duration of their work for Gazelle’s client. Gazelle
provides all payroll and human resources (HR) functions relating to the temp.
• The employed temp submits a weekly/monthly online timesheet to Gazelle, which sets out the
hours worked for Gazelle’s client. The timesheet is authorised by Gazelle’s client before
submission to Gazelle.
• Gazelle pays the employed temp an agreed wage, net of all relevant taxes and other deductions.
The gross wage cost is recorded in Account code 6002 Temps costs – UK.
• Gazelle’s accounting system generates a sales invoice when the employed temp submits their
online timesheet. The accounting system uses agreed fees per hour for the services provided to
the client by the employed temp. The sales invoice is recorded in Account code 4000 Temps – UK.

Method 2: Company temps (UK and the rest of Europe)
• A company temp is an individual that provides their services to Gazelle through their own limited
company. The company temp’s limited company has responsibility for paying all relevant taxes to
the tax authorities and undertakes any necessary HR functions.
• The company temp’s limited company submits a weekly/monthly invoice to Gazelle for the
services that the company temp has provided to Gazelle’s client. Gazelle records the purchase
invoice in Account code 6002 Temps costs – UK or Account code 6007 Temps costs – Europe.
• Gazelle prepares a sales invoice to its client for the services provided to its client by the company
temp, at an agreed fee per hour/day.
• The sales invoice is sent to Gazelle’s client for approval.
• The sales invoice is recorded in Gazelle’s accounting records when it has been approved by
Gazelle’s client. Sales invoices are recorded in Account code 4000 Temps – UK or Account code
4007 Temps – Europe.
• Occasionally Gazelle’s clients are slow to approve sale invoices for payment in respect of services
provided to them by company temps. If clients are slow to approve the invoice, Paula Elliott
prepares a manual journal each month to accrue for unapproved sales invoices as follows:
DEBIT Account code 2109 Accrued income
CREDIT Account code 4000 Temps – UK
When the sales invoice is raised and processed, Paula enters a reversing journal entry to remove the
accrued income.
Exhibit B: Working paper prepared by MFE audit assistant in Mat 2022

Gazelle – Average number of employees for the year ended 31 December
In addition to employing temps for its clients, Gazelle has its own core staff (including directors) for
recruitment, finance and administration. The total number of employees is as follows:
2021 2020
Gazelle core staff members (including directors):
• Recruiters for permanent jobs 9 10
• Recruiters for temps 20 18
• Finance and administration 14 14
43 43
Employed by temps 207 198
250 240
Calculation of gross profit for UK temps

I have prepared the following analysis using information from the data analytics software for the year
ended 31 December 2020. The analysis shows how the revenue and costs for UK temps are recorded
in Account codes 4000 and 6002 respectively and identifies gross profit for the supply of employed
temps and company temps.

Employed Company
Account code temps temps Total
£’000 £’000 £’000
Account code 4000 Temps – UK
Sales invoices and credit notes 8,116 – 8,116
Sales invoices and credit notes – 7,655 7,655
8,116 7,655 15,771
Account code 6002 Temps cost – UK
Total payroll cost for employed temps and Gazelle
core staff (7,933) – (7,933)
Company temp purchase invoices, purchase

credit notes and manual journals for accrued
income – (7,546) (7546)
Less:
Manual journal transfers to Account code 7003
Core staff salaries 2,033 – 2,033
(5,900) (7,546) (13,446)

Gross profit 2,216 109 2,325
Members of the Gazelle finance team
Paula Elliott
Finance director
Arianna Oliver Leo Neom

HR and payroll manager Accountant
Melissa Woodward
Trainee accountant
Paula Elliott – Finance director

Paula is an ICAEW Chartered Accountant and has worked at Gazelle since 2010. She is head of the
finance function. Paula is responsible for the production of the financial statements and quarterly
management accounts. She processes all types of accounting entries but mainly manual journals for
accrued income to the receivable account – Account code 2109 Accrued income. She also posts
manual journals for accruals and prepayments for expenses.
She sometimes helps Leo Neom to post company temp sales invoices and credit notes in Account
codes:
4000 Temps – UK
4007 Temps – Europe
Melissa also posts invoices for permanent job recruitment services in Account code 4001 Perms –
Science.

Arianna Oliver – HR and payroll manager
Arianna has worked for Gazelle for many years. She is experienced in payroll preparation and all
aspects of HR. Arianna processes the payroll for both employed temps and Gazelle’s core staff.
Arianna records the wages journals and posts the gross pay for employed temps and for Gazelle’s
core staff in total to Account code 6002 Temps costs – UK.
Arianna does not process any sales invoices.
Leo Neom – Accountant
Leo joined Gazelle in December 2019.
Leo generates and posts sales invoices for permanent job recruitment services and is responsible for
credit control for receivables.
Leo is responsible for processing and paying purchase invoices received from company temps.
These invoices are recorded in Account code 6002 Temps costs – UK or Account code 6007 Temps
costs – Europe.
Leo also processes sales invoices to Gazelle’s clients for services provided by company temps. Sales
invoices for company temps are recorded in Account code 4000 Temps – UK or Account code 4007
Temps –Europe.
Gazelle recognises that there is an internal control weakness as Leo is responsible both for the
recording of company temp purchase invoices and for generating and processing sales invoices to
Gazelle’s clients. Paula Elliott has oversight of this process and in a small company such as Gazelle, it
is not always possible to achieve segregation of duties.
On a monthly basis, Leo Neom transfers an amount representing the cost of Gazelle’s core staff from
Account code 6002 Temps cost – UK to Account code 7003 Core staff salaries.
Melissa Woodward – Trainee accountant
Melissa process sales invoices for services provided to Gazelle’s clients by employed temps to
Account code 4000 Temps – UK. This provides segregation of duties as Arianna processes payroll
costs for employed temps.
From July 2021, Melissa helped Leo to post company temp purchase invoices to Account code 6002
Temps cost – UK.
74 Gazelle Ltd
Assume the date is 18 July 2022
You are an audit senior working for MFE LLP, a firm of ICAEW Chartered Accountants.
Sam Kota, the audit engagement manager, has asked you to assist with the audit for Gazelle.
Sam gives you the following briefing:
“You will have reviewed the notes of my introductory meeting with Paula Elliott, Gazelle’s finance
director, and a working paper prepared by an MFE audit assistant. You will also have familiarised
yourself with the data for Gazelle for the 11 months ended 30 November 2021.
“Data for December 2021 has now been imported into the data analytics software from Gazelle’s
available.
“Last week I met with Paula to discuss changes at Gazelle since our last meeting in April 2021. I have
summarised these for you (Exhibit 1).
“Paula has asked for advice about the financial reporting treatment of Gazelle’s investment in 30% of
the ordinary share capital of QM Ltd (Exhibit 2). MFE is not the auditor of QM.
“I have set out, in a separate document (Exhibit 3), instructions for the tasks I would like you to
perform.
“Audit materiality is £105,000.”

Requirement
Total: 40 marks
Exhibit 1: Changes at Gazelle since April 2021 – prepared by Sam Kota

Paula told me that there have been some changes at Gazelle with the aim of improving profit.
1. Permanent job recruitment services
On 1 May 2021, Geri Kyle, the new head of permanent recruitment, changed the contract terms for
permanent job recruitment. Contracts entered into from this date with Gazelle’s clients have the
following terms:
• Gazelle raises and recognises a sales invoice for 20% of the fee when suitable applicants are
shortlisted for interview. It invoices and recognises the remaining 80% of the fee when the client
appoints and employs a suitable applicant.
• Gazelle offers a full refund, if, within six months of appointment, the applicant leaves the client’s
employment.
2. Work in progress for permanent job recruitment
In December 2021, Leo posted a manual journal adjustment for work in progress for permanent job
recruitment. This is the first time that Gazelle has recognised work in progress. Leo said that this was
necessary because significant costs of recruitment are incurred before Gazelle places an applicant
with a client. These include costs of:
• Networking events and recruiter’s time on general background research to identify a central pool
of suitable candidates for each business sector.
• Advertising for specific permanent jobs together with identifying and shortlisting applicants,
according to the client’s job specification.
3. Bonus scheme for recruiting company temps
On 1 November 2021, Gazelle introduced a bonus scheme for core staff in the temps recruitment
team. Recruiters earn a one-off bonus when they place a new company temp with a Gazelle client.
The bonus is earned when the company temp commences work.
At 31 December 2021, Leo posted an accrual for his estimate of the total bonus earned.
Paula told me that this bonus scheme has had a positive effect on revenue, but that clients have been
slower at approving invoices. She is slightly concerned that, to maximise their bonus, recruiters have
targeted placing as many new company temps as possible with clients, rather than ensuring that the
company temp meets the client’s specification.
Exhibit 2: Information about Gazelle’s investment in QM – prepared by Paula Elliott

On 31 December 2020, Gazelle purchased 30% of the ordinary share capital of QM for £37,879 and
recorded this in Account code 0062 Investment in QM Ltd. Two directors of QM own the remaining
70% of the shares equally.
QM offers recruitment services to place applicants in permanent jobs in the education sector.
The terms of the contractual agreement between QM and Gazelle are:
• Each shareholder has the right to appoint one director to the QM board, which will have in total
three directors. I (Paula Elliott) have been appointed as the Gazelle representative director and
have been present at all QM board meetings to date.
• QM owns and controls all assets brought into the company.
• The shareholders liability to QM is limited to the extent of their respective investments in the
company.
• All key business decisions require the unanimous consent of the three directors.
• Gazelle recharges the services of its recruiters who have worked on QM’s clients. Gazelle charges
a mark-up of 50% on the recruiters’ salary costs. Recharges to QM are recorded in Account code
4101 QM Recharges.
• The profit or loss made by QM will be shared between the three shareholders in line with their
percentage shareholdings. Gazelle will therefore be entitled to 30% of any profit in addition to the
mark-up earned on the recharge of its services.

I am unsure how to account for this investment. QM made a loss of £85,500 after tax for the year
ended 31 December 2021.
Exhibit 3: Audit engagement manager’s instructions – prepared by Sam Kota

As part of our audit planning for Gazelle for the year ended 31 December 2021, I would like you to:
1. Using preliminary analytical procedures (see guidance below) and other information, identify and
explain the key audit risks for revenue and related costs. For each audit risk identified:
• Explain the appropriate financial reporting treatment for the year ended 31 December 2021.
• Identify any information and explanations that you require from management in respect of the
audit risks identified.
You should identify specific transactions in the data analytics software that represent items of
significant audit interest.
Guidance on preliminary analytical procedures
The relevant account codes for revenue and related costs are:
4000 Temps – UK
4001 Perms – Science
4006 Perms – Clinical
4007 Temps – Europe
4013 Perms – Engineers
6002 Temps cost – UK
6007 Temps costs – Europe
2. For Gazelle’s investment in QM (Exhibit 2):

• Set out and explain the financial reporting treatment in Gazelle’s financial statements for the year
• Set out key audit procedures that MFE should perform.
75 FB plc
Assume the date is 18 July 2022
FB plc is a listed company which makes steel structures for the building industry. It has several 100%
subsidiaries. The FB group has a 31 December year end and the £ is both its functional and
presentational currency.
The FB group manufactures its products in the UK and sells to customers in the UK and the rest of
Europe.
The FB group’s largest customer, Central Construction (CC), is a company located in the Netherlands.
CC has a 31 December year end and its functional currency is the €. UG Holdings Inc owns 100% of
the shares in CC.
CC has won a large contract to build industrial units on a site near the port of Rotterdam, in the
Netherlands. CC will start preparatory and design work on the Rotterdam contract in October 2022.
In accordance with IFRS 15, CC will correctly recognise revenue relating to the contract from January
2023 only, when work on the site commences. The FB group will sell and deliver the first
consignment of steel structures for this Rotterdam contract to CC in November 2022 and will receive
payment in December 2022. There will be no sales or deliveries to CC in December 2022.
CC needs additional finance to fulfil the Rotterdam contract and to achieve future ambitious growth
targets. However, its parent company, UG Holdings has told the CC board that it is unwilling to
provide a loan and that CC should obtain finance independently. UG Holdings has also indicated
that it wants to sell its investment in CC.

CC has approached the FB board for finance. After initial discussions between the finance directors
and CEOs of both CC and FB, two alternative methods for FB plc to provide financial support to CC
were presented to the FB board on 15 July 2022 (Exhibit 1).
You are a member of FB’s finance department, and you report to FB plc’s finance director.
You have been provided with extracts from the minutes of the FB board meeting on 15 July 2022
(Exhibit 1) and forecast financial information for the FB group (Exhibit 2) and for CC (Exhibit 3). This
forecast financial information does not include any adjustments for either of the two alternative
methods of financial support.
The finance director gives you the following briefing.
“The FB group reported profit after tax of £30 million for the year ended 31 December 2021. The FB
plc shareholders expect profit after tax to be maintained at this level for the year ending 31
December 2022. The FB board wants to understand how each method for FB plc to provide financial
support to CC, will change FB’s forecast consolidated profit after tax for the year ending 31
December 2022.
“I would like you to prepare a briefing note for the FB board in which you:
(1) For each of:
Method 1: Zero coupon bond
Method 2: Purchase of 100% of the shares in CC and intercompany loan
(a) Explain the financial reporting implications, including the current and deferred tax
implications, for FB’s forecast consolidated statement of profit or loss for the year ending 31
December 2022. Set out appropriate journals.
(b) Prepare a revised forecast consolidated statement of profit or loss for FB for the year ending
31 December 2022.
(2) Evaluate and contrast the impact of Method 1 and Method 2 on FB’s forecast consolidated profit
after tax for the year ending 31 December 2022.”
Requirement
Prepare the briefing note requested by the finance director.
Total: 30 marks
Exhibit 1: Extracts from FB board meeting held on 15 July 2022

Method 1: Zero coupon bond
The finance director presented Method 1 as the preferred method because it will have only a small
impact on FB’s results for the year ending 31 December 2022.
On 1 October 2022, FB plc will make a loan to CC of £18.4 million, which will be secured on assets
owned by CC. FB plc will incur legal fees of £500,000 in respect of the loan arrangement. The loan
will be redeemable on 30 September 2024 for £21.6 million. No cash interest will be paid. The
effective interest rate is 6.9%.
The finance director noted that, in the tax jurisdiction where FB plc operates, the accounting
treatment and the tax treatment of interest are the same.
Method 2: Purchase 100% of the shares in CC and intercompany loan
The CEO presented Method 2 as the preferred method, since FB plc will have control over CC’s
operations including the ability to appoint the CC board. He reminded the FB board that CC is a
major customer and that, in November 2022, the FB group will sell and deliver the first consignment
of steel structures with a sales value of £27 million to CC. This consignment is the first of a series of
very profitable sales to CC on which the FB group will achieve a gross profit margin of 33.33%.
The CEO provided details of the potential acquisition and intercompany loan as follows:
On 1 October 2022, FB plc will buy 100% of the ordinary shares in CC from UG Holdings for €10
million, which is equal to the fair value of CC’s net assets. CC will not pay dividends to FB plc.
Immediately after acquisition, FB plc will provide an intercompany loan to CC of €22.08 million
at an annual interest rate of 3%. The loan is redeemable at par on 1 October 2027,
The finance director said that exchange gains and losses on intercompany loans are not taxable or
deductible for tax purposes in any accounting period. He also said that, in the tax jurisdiction where
CC operates, the accounting treatment and the tax treatment of interest payable are the same.

Conclusion of the meeting
The finance director agreed to prepare a briefing paper. This paper will explain the financial
reporting implications of each method and evaluate and contrast the impact on FB’s forecast
consolidated profit after tax.
Exhibit 2: Forecast financial information for FB Group

FB’s forecast financial information includes £27 million revenue for the supply of steel structures to
CC in November 2022 and the related cash receipt in December 2022.
This forecast financial information was prepared before FB plc was approached to provide financial
support for CC. It does not include any adjustments arising from the two alternative methods of
financial support for CC.
FB’s forecast consolidated statement of profit or loss for the year ending 31 December 2022
£’000 £’000
Revenue 125,000
Net finance expense (2,000)
Current tax expense (7,000)
Deferred tax expense (3,000) ––––––
Total tax expense (10,000)
Profit after tax (33,900)
Tax rate 20%
Exhibit 3: Forecast financial information for CC

CC’s forecast financial information includes the purchase of steel structures from the FB group in
November 2022 and the related cash payment in December 2022. These steel structures are
included in CC’s forecast inventory at 31 December 2022.
This forecast financial information for CC does not include any adjustments arising from the two
alternative methods of financial support that FB plc may provide.
CC’s forecast statement of profit or loss for the year ending 31 December 2022
€’000 €’000
Revenue 42,200
Net finance expense (250)
Current tax expense (1,505)
Deferred tax expense (45)
Total tax expense (1,550)
Profit after tax 4,200
Tax rate 10%

Forecast exchange rates
1 October 2022 £1 = €1.20

31 December 2022 £1 = €1.10
Average rate for the period 1 October 2022 to 31 December 2022 £1 = €1.15
76 Spycit Ltd
You are an audit senior at Vallis LLP, a firm of ICAEW Chartered Accountants. You have recently been
assigned to the audit of Spycit Ltd for the year ended 30 June 2022. Spycit imports spices from
around the world, combines them to produce its own spice mixes and sells these mixes to catering
and retail customers in the UK. Spycit’s functional currency is the £.
The audit engagement manager, Bobbie Thom, has provided you with background information (
Exhibit 1) and gives you the following briefing:
“I want you to take responsibility for our audit procedures on Spycit’s prepayments and other
receivables. An audit assistant, Jo Smith, has obtained an analysis of these accounts and has
produced a working paper documenting the audit procedures performed to date (Exhibit 2). I
believe that Jo needs some supervision and guidance from you.
“I have also received an email (Exhibit 3) from Murray Evans, Spycit’s operations director, in which he
raises a concern about the behaviour of the finance director, Cary Komo.
“What I need you to do is:
(1) Review all the information provided and draft a briefing paper for Jo which, for each element of
prepayments and other receivables set out in Exhibit 2:
(a) identifies any financial reporting issues and sets out and explains the correct financial
reporting treatment in Spycit’s financial statements for the year ended 30 June 2022; and
(b) describes and explains the additional audit procedures that Jo should perform.
(2) Explain the ethical issues arising for the finance director, Cary Komo, from the matters disclosed
in Murray Evans’s email (Exhibit 3) and set out any actions that Vallis LLP should take.
Requirement
Respond to Bobbie Thom’s instructions.
Total: 30 marks
Exhibit 1: Background information – provided by Bobbie Thom, audit engagement manager

Until recently, Spycit was a traditional family company, owned and managed by members of the
Evans family. In October 2021, following the retirement of the CEO and finance director, Bryn Evans,
a number of family members decided to sell their shares to Dragon Investments (Dragon), a private
equity company.
Dragon appointed a new CEO, Kit Beard, and finance director, Cary Komo. Cary is an ICAEW
Chartered Accountant. The other members of the Spycit Board are Murray Evans, operations director,
who has worked for the company for many years; and Harry Wyvern, who is Dragon’s representative
on the board.
Spycit’s issued ordinary share capital is owned as follows:
Number of £1 ordinary shares

Dragon Investments 80,000
Murray Evans, operations director 6,000
Evans family members who do not work for the company 14,000
100,000
Dragon intends to hold its shares for about two years and then to exit by means of an AIM listing. Kit
Beard and Cary Komo both have generous bonus arrangements, contingent on Spycit’s profit after

taxation increasing annually by over 50% in each of the two financial years ending 30 June 2022 and
30 June 2023.
Kit and Cary have already changed the way in which Spycit carries out its operations – they have
brought in new suppliers resulting in increased revenues and higher profits. The draft financial
statements for the year ended 30 June 2022 show profit before tax of £1.2 million, compared with
£750,000 for the year ended 30 June 2021.
Based on the draft financial statements, audit materiality has been set at £60,000.
Exhibit 2: Working paper prepared by Jo Smith – audit assistant

The prepayments and other receivables in Spycit’s draft financial statements for the year ended 30
June 2022 are analysed in the table below, with prior year comparatives. The notes below the table
provide further information about each element of prepayments and other receivables. They also
document the audit procedures that I have performed.
30 June 2022 30 June 2021

Note £’000 £’000
Prepayments:
Insurance 1 483 231
Other prepayments 2 73 65
Other receivables:
Financial asset 3 192 -
Loan to Jarman 4 600 -
Rebates due from Jarman 5 72 -
Total 1,420 296
Notes
1 The insurance balance at 30 June 2022 includes £200,000 relating to an insurance claim made by
Spycit for a consignment of spices lost in transit from a supplier in West Africa. I agreed this
amount to a claim that Spycit submitted to its insurer on 28 March 2022.
2 Other prepayments represent the net effect of debit and credit balances, all of which have a
value of less than £10,000. No detailed audit procedures have been performed.
3 The amount of £192,000 recognised within other receivables as a financial asset is equal to the
net gain in the fair value of foreign currency forward contracts from inception to 30 June 2022.
Spycit enters into agreements each month with suppliers for the purchase of spices to be
delivered six months later. Each agreement specifies the quantity of spices to be delivered and
fixes the price to be paid in the relevant foreign currency. Each agreement gives rise to a foreign-
currency firm commitment for Spycit. Payment is made by Spycit to its suppliers on delivery.
The new finance director, Cary Komo, decided to hedge foreign-currency firm commitments for
future monthly consignments of spice purchases using foreign currency forward contracts. He
started by hedging the foreign currency risk on agreements made in January 2022 for spices to
be delivered in July 2022.
Each month from January 2022, Cary took out a forward currency contract and designated it as a
fair value hedge of the foreign-currency firm commitment made in that month. In all cases, the
forward-currency contract exactly matched the amount, currency and payment date of the
commitment made to purchase the spices. I confirmed this for a sample of contracts and noted
no exceptions.
The net gain of £192,000 in the fair value of forward currency forward contracts from inception to
30 June 2022 has been recognised in the statement of profit or loss. No entries have been made
in respect of the purchases of spices for delivery in July 2022 and beyond. I have checked the
calculation of a sample of gains and losses within this £192,000 and agreed the year end fair
values of the foreign currency forward contracts to market information.

As part of our audit, we have gained assurance that foreign currency amounts are translated at 30
June 2022 exchange rates.
4 In December 2021 Spycit agreed to purchase all packaging for retail spice mixes from a new
supplier, Jarman Ltd, from 1 April 2022.
To fulfil this supply contract, Jarman required new plant and equipment costing £540,000.
The receivable of £600,000 represents an interest-free loan made on 1 January 2022 by Spycit to
Jarman to finance Jarman’s investment in plant and equipment and to provide working capital.
The loan is repayable in annual instalments of £100,000, with the first instalment due on 31
December 2022.
I asked Cary for more details and he told me that Jarman could have obtained a loan from its
bank at an annual interest rate of 9%, but the Jarman directors were reluctant to provide the
personal guarantees that the bank requested.
5 The receivable of £72,000 represents rebates due from Jarman for packaging purchased by
Spycit during the three months ended 30 June 2022.
The supply contract with Jarman has the following terms:
(1) Packaging supplied by Jarman from 1 April 2022 to 30 September 2022 will be invoiced to
Spycit at prices that are 25% higher than those paid by Spycit to its previous supplier for
similar quality packaging. This initial price is to cover the set-up costs incurred by Jarman
and to provide it with adequate cashflow in the initial period of the contract.
(2) On 31 December 2022, Spycit may become entitled to a rebate from Jarman for purchases
made between 1 April 2022 and 30 September 2022. The rebate will be calculated as 20% of
Spycit’s total purchases from Jarman in that period if those purchases are £810,000 or more.
(3) From 1 October 2022, the rebate arrangement no longer applies and the prices for
packaging purchased from Jarman will be 5% lower than those paid by Spycit to its previous
supplier.
I obtained invoices for packaging delivered by Jarman between 1 April 2022 and 30 June 2022.
These totalled £360,000. The rebate recognised has been calculated as 20% of this amount,
which is in line with the agreement.
Exhibit 3: Email from Murray Evans, Spycit operations director
To: Bobbie Thom, Vallis LLP

From: Murray Evans, Spycit
Date: July 2022
Subject: Confidential
I am sharing this information with you because I believe that, as Spycit’s auditor, you have a right
to know.
The loan to Jarman and the contract for Jarman to supply packaging were approved in December
2021 by a majority of the Spycit board. In making its decisions, the board considered detailed
financial information prepared and presented by Cary Komo. I voted against both arrangements
because I was aware of bad publicity concerning Jarman’s environmental and employment
practices.
At the time I was prepared to accept the majority decision, but I have recently found out that
Cary’s wife is the sales manager at Jarman. Cary did not disclose this to the Spycit board. In
addition, the bad publicity about Jarman’s environmental and employment practices has resulted
in a significant reduction in Jarman’s revenue and it is now in financial difficulties. This suggests to
me that the financial information that we considered when we approved the loan and supply
contract may have been incorrect.
I tried to discuss these matters with my fellow directors, Kit Beard and Harry Wyvern. However,
they were not interested, saying only that the deal with Jarman was welcomed by Dragon, our
majority shareholder. Dragon owns 30% of the issued share capital of Jarman and is keen to see
Jarman increase sales to other companies in which Dragon has invested.

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 realistic
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 2023 you will not be able to copy
visualisations (or any other information) from the software into your script, so it is important that
you learn how to describe trends and transactions in sufficient detail as if you were preparing audit
evidence. The marker will not access the software during the marking process. 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.
ICAEW 2023 Data Analytics Software practice questions 279

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).
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.
77 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 mock-
ups (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:
Sample item A
Extracted from trade payables account:
Transaction 'PIN029525'
Transaction Id Account Code Amount Effective Date Document Type Journal Description User Id Line Description Created Date
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 lines 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'
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
Extracted form trade payables transactions:

Transaction 'PPY013791'
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
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 71,805 ( 9%)
Cost of goods sold 805,061 876,096 71,035 ( 9%)
Other cost of sales 4,599 5,368 769 ( 17%)
(2) Trade payables (from Financial Statement view)
Trade Payables 148,109 151,941 3,832 ( 3%)

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
77.1 In respect of the two sample items extracted by Brian, describe the audit procedures that
should be carried out.
(10 marks)
77.2 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)
77.3 Recommend and justify internal control improvements to address potential control
deficiencies.
(8 marks)
Total: 45 marks
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.

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 Amount Effective Document Journal description User ID Created

code date type date
51010 38,000 31/1/2019 SIN–Sales Reversal – Dec18 sales FWRIGH 15/2/2019

Invoice T
21010 –38,000 31/1/2019 SIN–Sales SIN001008 – Posting FWRIGH 15/2/2019

Invoice Run Control T

code date type date
51010 24,320 31/1/2019 SCR–Sales Hilditch Mobile refund TPOTTS 09/2/2019

Credit for October inv error
21010 –24,320 31/1/2019 SCR–Sales SCR000231 – Posting TPOTTS 09/2/2019

Credit Run Control

code date type date
72000 21,342 1/1/2019 PIN – Rent – Newcastle JSMITH 09/2/2019

Purchase 1/10/18 – 31/12/18
Invoice
31010 –21,342 1/1/2019 PIN – PIN002349 – Posting JSMITH 09/2/2019

Purchase Run Control
Invoice

code date type date
71080 18,982 22/2/2019 PIN – Invoice 23910 – JSMITH 13/1/2019

Purchase Executive Search Ltd
Invoice
31010 –18,982 22/2/2019 PIN – PIN004889 – Posting JSMITH 13/1/2019

Purchase Run Control
Invoice
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.

The following list of relevant account codes has been identified from Elephant’s accounting system:
Account name Account code
Receivables control account 21010
Overseas receivable 21020
Payables control account 31010
Domestic Sales 51010
Overseas Sales 51020
Other income 54800
Recruitment and selection 71080
Rent 72000
Suspense Account 990
Requirement
78.1 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)
78.2 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)
78.3 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)
78.4 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
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 National
Insurance (NI), a related tax cost) and an apportionment of Elephant’s central overheads.

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'
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
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
79.1 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.
(6 marks)
79.2 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.
(6 marks)
79.3 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.
(6 marks)
79.4 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

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 13000 Intangible assets (SOFP) £95,000

CREDIT 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 £18,236

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
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.

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
80.1 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)
80.2 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)
80.3 Identify and explain any audit quality management issues arising from Brian’s email.
(8 marks)
80.4 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 un-
invoiced 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 170,294 0 -170,294 100%
23040 – Pre-Payments Control A/C 51,066 300,000 248,934 487%
I am concerned that perhaps there might be a fraud here, so perhaps you should review my work.
Regards,
Brian

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.
ADVANCE INFORMATION: ELEPHANT LTD
This Advance Information relates only to Corporate Reporting Practice Question 5.
(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.
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.
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.
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)
• 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.
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 in 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
Jo Smith
Tanya Potts Andrea Bloggs Emma Davids

Accounts assistant Accounts assistant 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 day-
to-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.
Exhibition
Account code Contract sales 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
Less: direct payroll costs
62100 – Studio salaries (580)
62105 – Studio NI (49)
Total studio salary cost (629) (629)
62130 – Fitting salaries (18)
62135 – Fitting NI (2)
Total fitting salary cost (20) (20)
62120 – Sales salaries (356)
62125 – Sales NI (36)
Total sales salary cost (392) (392)
Total salary costs (629) (20) (392) (1,041)
Reallocate studio salary costs to:
*Exhibition salary costs 126 (126) -
**Other sales salary costs 94 - (94) -
Total direct payroll costs (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 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
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.
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
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 72,000 Monthly – 35 days after
development for 24 months period invoice
One-off fee in exchange for 18% discount on 228,000 Payable on 1 January 2021
services and goods supplied in the two financial
years ending 31 December 2019 and 31
December 2020.
Total 300,000
December 2018 was a very busy month and Frank told me that he did not get a 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 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
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.
The relevant account codes for revenue and direct payroll costs are:
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

82 Practice question 6
ADVANCE INFORMATION: ELEPHANT LTD
Assume that the current date is 15 December 2018.
This Advance Information relates only to Corporate Reporting Practice Question 6.
(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.
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.
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.
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.
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 (eg, 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
Organisation chart
Set out below are the members of the accounts department at Elephant and their roles.
Frank Wright
Finance director
Jo Smith
Tanya Potts Andrea Bloggs Emma Davids

Accounts assistant Accounts assistant Trainee
Joined March 2018

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 Holmes, 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.
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 Description Amount Account Created date Comment

£ (Effective date)
PIN29468 604000677 – 3 Night 3,200 61055 09/05/2018 Handwritten note

Holiday for two people to requesting payment
(03/05/2018)
Monte Carlo with from Jerry Holmes

Transaction Id Description Amount Account Created date Comment
£ (Effective date)
NOM60382 Premier Inn – JH/Private 154 61085 17/03/2018 No supporting

travel 11 April documentation
(11/03/2018)
available
NOM60367 Grange Holborn Hotel – 167 61085 12/03/2018 No supporting

JH/Grange Holborn Hotel documentation
186 61026 (06/03/2018)
– Private travel 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.
Transaction Id Description Amount Created date Account

£ (Effective date)
NOM063254 Weatherby MWSA – GM Nov Fuel 60 29/10/2018 26524

(23/10/2018)
Issue 3: Large item posted by trainee

Also, while looking at transactions in the nominal ledger I noticed the following transaction posted
by Emma Davids which seems to be rather large for someone so junior to be posting.
Transaction Id Description Amount Created date Account

£ (Effective date)
NOM063189 TFR 44,099 26/10/2018 20010,

20014
(20/10/2018)
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:
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
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).”
Requirement
Respond to the instructions from Emily.
Use your firm’s Data Analytics 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 March 2019, 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.
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 B) 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 (Matter 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.
Include journal entries.

Answer Bank
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 3
Sports stadium (IFRS 15) 6
FX House disposal 5
Estate agency buildings 4
Property management contract 2
Foreign currency receivable and forward contract 4
Taxation 3
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. 8
Marks Available 35
Maximum 30
Total 30
Response as follows:
To FD
From Jo Ng
Date 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

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)
Income tax expense (17.1 + 3.4) (20.5)
Cash flow hedge 1.3
Reclassification of cash flow hedge (1.3)
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
Share capital 100.0
Share premium 84.0
Retained earnings b/f 102 Profit for year 64.6 166.6

£m
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 judgemental 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.

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 Costs incurred basis Work certified basis

£m £m
Revenue 27.2 23.8
Cost of sales (18.0) (18.0)
Profit 9.2 5.8
Statement of financial position Costs incurred Work certified

£m £m
Gross amounts from customers
Costs incurred 18.0 18.0
Recognised profit 9.2 5.8
27.2 23.8
Progress billings (17.0) (17.0)
10.2 6.8
Receivables (£17.0m – £17.0m) 0 0

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 £10.2m

CREDIT Revenue £10.2m
Also I have reversed the additions to property, plant and equipment as follows:
DEBIT Cost of sales £18m

CREDIT 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 £21.5m

CREDIT Gain/loss on non-current asset disposal £21.5m
DEBIT Gain/loss on non-current asset disposal £5.8m

CREDIT 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:
Finance costs (reversing incorrect entry made by

DEBIT the assistant) £2m
CREDIT Non-current assets – net investment in lease £2m

To record interest income for 6 months to 30 June 20X2:
Non-current assets – net investment in lease (6/12

DEBIT of interest income at 10% on (£21.5m less £2m)) £975,000
CREDIT 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 £10m

CREDIT Trade receivables £10m
DEBIT Admin expenses (Gain on disposal) £8m

CREDIT Assets held for sale £8m
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 judgement 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 £m
DEBIT Trade receivables 1.3
CREDIT Profit or loss (other income) 1.3

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:

CREDIT 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 £1m

CREDIT 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 £17.1m

CREDIT Current tax obligation £17.1m
Being current tax adjustment – revised profit (85.1 – 14) × 24%
DEBIT Income tax expense: £14m × 24% £3.4m

CREDIT Deferred tax obligation £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 36.4

2 Billinge
Marking guide Marks
Explanations and calculations of deferred tax implications of: 1

Fair value adjustment 5
Share-based payment 6
Unrealised profit 5
Unremitted earnings 5
Lease 8
Marks Available 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.

(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)
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 2.000
Cumulative expense (1,000 × 500 × 75% × £5 at grant date × 2/3) (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.

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
expense 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)
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) 9.60
Deferred grant (£2m – £2m/5) (1.60) 8.00
Tax base (£12m – £2m) – [(£12m – £2m) × 25%] (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.

(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) 4.800
Lease liability (£6m + [8% × £6m] – £1.5m) (4.980) (0.180)
Tax base 0.000
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 expense is reduced representing
the tax recoverable in the future.
3 Longwood
Marking guide Marks
Change in tax rate 8

Revised tax losses adjustment 8
Fair value adjustments 7
Goodwill calculation 7
Deferred taxes, goodwill and share versus asset deals 8
Marks Available 38
Maximum 30
Total 30
(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.

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
Deferred tax liability (1.86) (1.43) 0.43
Deferred tax asset 0.77 0.60 (0.17)
(1.09) (0.84) 0.26
The resultant adjustments are:
Debit Credit
£m £m
Tax expense – 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.

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 £m
DEBIT Deferred tax asset 0.92
CREDIT Tax expense – 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.
Carrying Temporary Deferred tax

Fair value amount difference at 23%
£m £m £m £m
Property, plant and equipment 21.65 18.92 (2.73) (0.63)
Development asset 5.26 0.00 (5.26) (1.21)
Post-retirement liability (1.65) (0.37) 1.28 0.29
25.26 18.55 (6.71) (1.55)
Deferred tax liability (1.84)
(1.55)
The resulting consolidation adjustment is:
Debit Credit
£m £m
Goodwill adjustment 1.55

(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 73.91
Fair value of net assets acquired (16.24)
Goodwill 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

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.
4 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 non-
controlling interests. 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 interests, 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 interests.
Requirement Skills
Show and explain with supporting Apply technical knowledge to identify implications
calculations, the appropriate financial of crossing control threshold.
reporting treatment of goodwill and non- Apply technical knowledge to distinguish between
controlling interests for Liddle in Upstart’s and calculate the deferred and contingent
consolidated statement of financial position consideration.
as at 30 June 20X5. Use the proportion of
net assets method to determine non- Identify the incorrect treatment of the professional
controlling interests. 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.

Requirement Skills
Explain, with supporting calculations, the Apply technical knowledge to determine whether
appropriate financial reporting treatment for a provision should be recognised and calculate the
the restructuring plans and the share amount of the provision.
options. Appreciate that no provision should be made in
respect of the second proposal.
Identify that the share options represent an equity-
settled share-based payment.
Apply technical knowledge to account for the
share-based payment correctly.
Prepare Upstart’s consolidated statement of Assimilate adjustments and prepare revised

profit or loss for the year ended 30 June consolidated statement of profit or loss.
20X5, to include Liddle.
Explain (without calculations) the impact on Assimilate information, and apply technical
Upstart’s consolidated financial statements if knowledge to explain that NCI valuation would
the fair value method for measuring non- impact on goodwill.
controlling interests were to be used instead
of the proportion of net assets method.
Marking guide Marks
Appropriate financial reporting treatment of goodwill and non-controlling interests 16

Appropriate financial reporting treatment for the restructuring plans and the share
options 9
Consolidated statement of profit or loss 8
Impact of the fair value method 5
Marks Available 38
Maximum 30
Total 30
(1) Explanation of financial reporting treatment of goodwill and non-controlling interests
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

• 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 non-
controlling interests’ 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 350
DEBIT Profit or loss £350,000

CREDIT Current liabilities £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

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:

CREDIT 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)
Profit from operations 18,422
Finance income 905
Fair value gain on associate 326
Associate income 424
Finance cost (625 + 169 + 78 + 123 + 141) (1,136)
Taxation (3,700)
Profit for year 15,241
Profit attributable to:

Shareholders of the parent 13,901
15,241
(4) Fair value method implications

If the fair value method in relation to the non-controlling interests 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 interests (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 loss allowance, this
would decrease the NCI allocation in the consolidated statement of profit or loss.

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
30 Jun 20X5 1 Apr 20X5 1 Oct 20X4 1 Jan 20X3

£’000 £’000 £’000 £’000
Share capital 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) (40) –––––– ––––––
(1,600 × 1/20 × 9/12 and 6/12) 18,320 16,645 13,295 7,600
Movement 1,675 3,350 5,695
(3) Goodwill
Consideration: £’000
Shares issued (800,000 × £11.50) 9,200
Cash 01.10.20X4 2,000
2
Deferred cash (£3 million/1.09 ) 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 interests at 01.10.X4 3,989 (13,295 × 30%)
Less: Net assets at control (W2) (13,295)
Goodwill 13,077
£’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

£’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
Upstart Liddle (9/12) Adjust Group

£’000 £’000 £’000 £’000
Revenue 23,800 11,700 (1,080) 34,420
Additional depreciation (60)
Cost of sales (7,400) (4,050) 1,080 (10,640)
Unrealised profit (210) (W9)
Operating costs (3,500) (1,125) (5,358)
Professional fees (250)
Restructuring provision (350)
Share-based payment (133)
Finance income 890 135 (120) (W9) 905
Gain on previously held equity
investment (W8) 326 326
Associate income (6,780 × 25% ×
3/12) 424 424
Finance cost (520) (225) 120 (W9) (625)
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 (2,350) (1,350) (3,700)
Profit for year 9,676 5,025 15,241
NCI: (5,025 × 6/9 × 30%) 1,005

(5,025 × 3/9 × 20%) 335
Total 1,340

(6) Increase in investment in Liddle 1 April 20X5
£’000 £’000
CREDIT Cash 3,500
DEBIT NCI 1,665
DEBIT 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 finance 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

5 MaxiMart plc
Marking guide Marks
Share option scheme 7

Pension scheme 14
Reward card 5
Futures contract 7
Proposed dividend 5
Marks Available 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
Non-current assets
Defined benefit pension plan – 100
Defined benefit pension plan 40 –

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 30 September
20X1 20X0
£’000 £’000
Present value of defined benefit obligation 2,410 2,200
Fair value of plan assets (2,370) (2,300)
40 (100)
Defined benefit expense recognised in profit or loss for the year ended 30 September 20X1
£‘000
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
Interest on obligation (2,200 × 5%) 110
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 2,300
Interest on plan assets (2,300 × 5%) 115
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 £100m/£102m × £100m 98,039
Loyalty points £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
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.
6 Robicorp plc
Scenario
Requirement Skills
Recommend any adjustments, with Apply technical knowledge of IAS 38 to the

accompanying journal entries, that are required scenario to determine appropriate accounting
to make the accounting treatment comply with treatment of the application.
IFRS, explaining the reasons for your proposed Identify need for amortisation of development
changes. 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 Assimilate adjustments and prepare revised
(Exhibit 2) taking into account your adjustments profit after tax.
and calculate the diluted earnings per share. Calculate basic EPS and diluted EPS.

Marking guide Marks
Recommended adjustments 26
Revised earnings per share and diluted earnings per share 8
Marks Available 34
Maximum 30
Total 30
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 Profit or loss £6m

CREDIT 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).

CREDIT 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 Revenue (1,800 × £25,000) £45m

CREDIT Contract liability £45m
DEBIT Accrued expenses £19.8m

CREDIT 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
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 £2.478m

CREDIT Bond liability £2.478m
DEBIT Accruals £0.9m

CREDIT 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 £1.568m

CREDIT 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 Financial asset (shares in Saltor) £5.5m

CREDIT 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.

CREDIT Financial asset £700,000
The sales commission of 4 pence per share is ignored.

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 Loan £427,200

CREDIT Profit or loss – interest £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.
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 44,000,000
Development costs expensed (6,000)
Development costs amortised (500)
Revenue/costs not recognised (25,200)
Bonds instead of shares (4,000,000)
Interest expense (2,478)
Finance cost previously charged 900
Share option expense (1,568)
Fair value loss on Saltor (700)
Employee compensation (loan to employees) (880)
Interest on employee loan 427 ––––––––––
Revised totals 30,271 40,000,000
Basic EPS 75.7 pence

(3) Diluted EPS
£’000
Basic totals 30,271 40,000,000
Convertibles (see below) – –
Share options (free shares) –––––– 232,611
Total 30,271 40,232,611
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] (1,159,389)
 Number of shares treated as issued for nil consideration (free shares) 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.
7 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
interests and the impact of future changes in exchange rates on the consolidated statement of
financial position.

Marking guide Marks
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 27
Advise on the impact that any future changes in exchange rates will have on the
consolidated statement of financial position 7
Marks Available 34
Maximum 30
Total 30
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)
Gain on sale of subsidiary 13,340
Profit from operations 23,987
Share of profit of associate 160
Finance income 424
Income tax expense (2,974)
Exchange differences on translating foreign operations 7,369
(Restatement of goodwill 4,370
Exchange gain in year 2,999) ––––––

Owners of parent company 18,429
18,599
Total comprehensive income attributable to:
Non-controlling interests (W9) 1,644
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 interests (NCI) have a 25% share of profit of Taricco for the first six months of
the year until disposal takes place.
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
Taricco Arismendi
Gustavo 6 months 9 months Adjust Total
£’000 £’000 £’000 £’000 £’000
Revenue 35,660 14,472 7,225 57,357
Cost of sales (21,230) (11,082) (4,639) (37,221)
Depreciation (£14.4m/8 years ×
9/12)/5 (270)
Operating costs (5,130) (2,478) (1,481) (9,489)
Acquisition fees (400)
Gain on disposal (W4) 13,340 13,340
Share of associate’s profit (W6) 160 160
Finance income 580 54 – (210) 424
Finance cost (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

(2) Net assets of Taricco
On disposal At acquisition
£’000 £’000
Retained earnings b/f 4,824 2,400
Profits to disposal (6 months) 456
Dividend paid 0 –––––
Total 7,280 4,400
(3) Goodwill
Taricco
£’000
Cost to parent 15,000
NCI at acquisition (25%) 1,100
Less net assets (4,400)
Goodwill 11,700
impairment loss allowance (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) 720
At disposal 1,820
(6) Share of profits of associate
Taricco
35% × PAT × 6/12 160
(7) Goodwill of Arismendi
01.01.X6 30.09.X6
(Kr 6) (Kr 4)
Kr’000 £’000 £’000
Cost of investment 75,600 12,600 18,900
NCI at acquisition
12Kr × 5,000 shares × 20% 12,000 2,000 3,000
87,600 14,600 21,900
Net assets at Acquisition
Share capital 5,000
Three months to 1 January 20X6
3,670 × 3/12 918
Fair value adjustment
£2.4m × Kr 6 14,400
35,164 5,861 8,791
Goodwill 52,436 8,739 13,109
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)

£’000
Taricco
456 × 25% 114
Arismendi
281 × 20% 56
Share of goodwill restatement for Arismendi
4,370 × 20% 874
Share of exchange difference
2,999 × 20% 600
1,644

8 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 interests 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 12

The consolidated statement of financial position of Inca at 30 April 20X1 7
A calculation of NCI at fair value 5
Explain any ethical concerns 8
Marks Available 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 CU4.4 million 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 expense 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.
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.
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 finance cost 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 a finance cost 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 accounting
records 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.
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 interests at fair value
If non-controlling interests in Excelsior are valued at their 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%

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%
American loan US$m Rate CUm

Borrowed 15.0 3.2 48.0
Interest for year to income statement (10.91%) 1.6 3.0 4.8
Interest paid (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
Interest/
exchange Director’s
Draft PPE Dev costs Tax loss adj. loan Final
CUm CUm CUm 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
Current assets
Accounts receivable 35.2 (2.0) 33.2
Cash 12.8 12.8
Total current assets 64.6 62.6
135.6 133.6
Equity and Liabilities
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
Loss since acquisition (16.0) (1.2) (1.4) 2.0 (2.6) 6.4 (2.0) (14.8)
Deferred tax 4.4 1.2 1.4 (2.0) 5.0
Loans 48.0 2.6 (6.4) 44.2
Current liabilities 9.2 9.2
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
PPE 64 4.5 14.2
Intangible assets 7 4.5 1.6
Current assets
Inventories 16.6 4.5 3.7
Trade receivables 33.2 4.5 7.4
Cash 12.8 4.5 2.8
133.6 29.7
Share capital 10 5 2.0
Share premium 16 5 3.2
Retained earnings
Pre acquisition 64 5 12.8
Post acquisition (14.8) 4.8 (3.1)
Translation reserve (W1) 1.8
16.7
Non current liabilities: Deferred tax 5 4.5 1.1
Loans 44.2 4.5 9.8
Current liabilities 9.2 4.5 2.1
133.6 29.7
WORKINGS
(1) Translation reserve
Gain/(Loss)
£m £m
Opening net assets @ Closing rate 90 @ 4.5 20
Opening net assets @ Opening rate 90 @ 5 18 2.0
Loss for the year
@ Closing rate (14.8) @ 4.5 (3.3)
@ Average rate (14.8) @ 4.8 (3.1) (0.2)
Translation reserve for Excelsior 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

£m
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 120
NCI @ acquisition (90 × 20%) 18
NA: 10 + 16 + 64 (90)
Goodwill 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 120
NCI @ FV 20
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 interests (NCI) in consolidated statement of financial position
20% × 16.7 3.4
9 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 6
Marks Available 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.
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 Revenue £400,000

CREDIT 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
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

Pension scheme FV asset PV obligation
£’000 £’000
Opening balance 12,200 18,000
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)
Current service cost –––––– 1,200
Expected closing balance 12,732 19,604
Difference on remeasurement through OCI 768 196
Actual closing balance 13,500 19,800
The net actuarial gain of £572,000 (768,000 – 196,000), should be recognised in other
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 Operating costs £0.21m

CREDIT Accruals £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 (40% × (£4.8m – £3.4m))
Share of profit to 1 Sept 20X2 102 See above
2,962

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 3,800
Cost at 1 Sep 20X2 12,400
––––––
16,200
Less net assets at fair value (W1) 6,055
Goodwill 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:

Consolidated statement of profit or loss and other comprehensive income for year ended 31 May
20X3
Holiday Xema 9
Golf/TV Pension accrual Options mnths Total
£’000 £’000 £’000 £’000 £’000 £’000 £’000
Revenues 14,450 (400) 4,050 18,100
Operating costs (9,830) (1,050) (1,072)
(210) (360) (2,700)
––––– (152) (15,374)
Other operating income 838 838
Associate income 867 (765)* 102
Other finance income 310 180 490
Finance charges (1,320) (540) (1,860)
Profit before taxation

(ignore tax as
instructed) 4,477 2,296
Net gain on remeasurement in year 572
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 4,050
Costs (2,700)
Finance income 180
Finance costs (540)
990
Tax for nine months (225)
(765)

10 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 12
Purchase of the bond in Imposter plc and ethical issues 9
Razak’s consolidated statement of financial position at 30 September 20X2 9
Explain how to account for the proposed pension plan 9
Marks Available 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 interests 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

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
Goodwill 8,826 8,826 W3
Non-current assets
FV
Property, plant and adjustment
equipment 6,000 3,460 1,400 – 140 10,720
Investment in Assulin 9,325 (9,325)
Loan to Assulin 800 (800)
Other financial assets 1,193 (503) (W6) 690 W6
17,318
Current assets
Inventories 1,255 610 1,865
Receivables 960 400 1,360
Bank 0 70 70
2,215 1,080 – 3,295
Total assets 19,533 4,540 (542) 23,531

Razak Assulin Adjs. Consol.
£’000 £’000 £’000 £’000
Equity
£1 ordinary shares 2,800 500 (500) 2,800
Share premium account 7,400 7,400
(2,740)
Retained earnings 2,510 2,740 (529)(W5) 1,981 W5
Other components of equity 750 300 1,050 W5
NCI 2,012 2,012 W4
13,460
1,641 + 74
(unwinding
Contingent consideration 1,715 1,715 6/12 months)
Other 2,788 2,788
Loan from Razak 800 (800)
Current liabilities
Bank overdraft 1,220 1,220
Trade payables 865 290 1,155
Tax payable 1,200 210 1,410
3,285 500 – 3,785
Total equity and liabilities 19,533 4,540 (542) 23,531
Consolidated statement of financial position
£’000
Non-current assets
Goodwill 8,826
Other financial assets 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

£’000
Contingent consideration 1,715
Other 2,788
Current liabilities
Bank overdraft 1,220
Trade payables 1,155
Tax payable 1,410
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
Share capital 500 500
Fair value adjustment 1,400 1,400
Depreciation (six months) (140) ––––––
Total 4,500 4,440
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 8,826

£’000
At acquisition 2,000
Profit share of Assulin since acquisition (60 × 20%) 12
Total 2,012
(5) Reserves
Retained earnings
£’000 £’000
Razak per draft 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 (529)
Imposter – net adjustments (503)
–––––– –––––
Total 1,981 1,050
(6) Imposter bond

Loan receivables (gross carrying amount)
£
At 1 October 20X1 1,200,000
Finance income (7.5% × 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) 90,000
Finance cost (unwind discount) (7.5% × 7,000) (525)
Finance cost (increase in allowance) (592,475)
Net (503,000)

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.
11 Kenyon
Marking guide Marks
Financial performance discussion and ratios

Profitability 7
Earnings per share 6
Contingent liability 3
Pension 3
Financial position discussion and ratios
Liquidity 6
Working capital management 5
Conclusion and recommendation

Marking guide Marks
Contingent liability – impact on ratios 4

Contingent liability – further information 4
Marks Available 38
Maximum 30
Total 30
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).
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 finance 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.
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 Liability of £13m Liability of £7m

recognised recognised 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 (221 – 1 – 7) ÷ 663 = 32% (117 – 6) ÷ 462 = 24%

profit/Revenue
EPS = Profit for year/Weighted average no of 176/300 = 58.7p 93/300 = 31p

equity shares (Note: 50 pence shares)
P/E ratio = Price per share/EPS 490/58.7 = 8.35 280/31 = 9.03
Non-current asset turnover = Revenue/Non- 663/381 = 1.74 463/346 = 1.34

current assets
Quick ratio = (Current assets – (161 – 86)/95 = 0.79 (148 – 40)/66 = 1.64
Inventories)/Current liabilities
Inventory days = Inventory/Cost of sales × 86/395 × 365 = 79 days 40/315 × 365 = 46 days
365
Receivable days = Receivables/Revenue × 72/663 × 365 = 40 days 48/463 × 365 = 38 days

365
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 – (221 – 1 – 7 – 7) ÷ (465 – 7 + 38 –
56) = 46% 56) = 47%
Operating margin = Operating (221 – 1 – 7 – 13) ÷ 663 = 30% (221 – 1 – 7 – 7) ÷ 663 = 31%
profit/Revenue
EPS = Profit for year/Weighted average no of (176 – 13)/300 = 54.3p (176 – 7)/300 = 56.3p
equity shares
(Note: 50 pence shares)

12 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 20

Additional audit procedures 10
Revised consolidated statement of financial position including Klip 14
Marks Available 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.

• 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 intangible assets. There may be
consequential effects on performance for the year because of amortisation of the identified
intangible assets.
• 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)
• 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.

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)
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 Finance cost Interest payable

£ £ £ £ £
Year 1 7,800,000 521,040 (480,000) 7,841,040
Year 2 7,841,040 (1,000,000) 456,981 (480,000) 6,818,021
Journals required
£’000 £’000
DEBIT Loan 200
CREDIT Admin expenses 200
DEBIT Loan 480
CREDIT Accrued interest 480
DEBIT Finance costs 521
CREDIT Loan 521
DEBIT Loan – long term borrowings 1,000
CREDIT Loan – current liabilities 1,000

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
• 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 £1 million 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.

• 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.
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
• 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.
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.

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) 253
Total assets 25,920
Equity
Share capital 200
Retained earnings (W4) 5,766
Foreign exchange reserve (W6 and W7) 52
Non-controlling interests 22
Long-term borrowings (6,841 (see above) + 333) 7,174
Current liabilities
Loan 1,000
Trade and other payables (10,252 + 329 + 480) 11,061
*Current tax payable 645
*Further adjustments may be required to taxation

WORKINGS
(1) Translation of the statement of financial position of Klip
H$’000 H$’000 Rate £’000

ASSETS
Non-current assets
Property, plant and equipment 1,940 4.2 CR 462
Current assets
Inventories 2,100
Less write down at acquisition 1,000 1,100 4.2 CR 262
Trade receivables 600 4.2 CR 143
Cash and cash equivalents 40 4.2 CR 10
Total assets 3,680 877
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
Long-term borrowings 1,400 4.2 CR 333
Current liabilities
Trade and other payables 1,380 4.2 CR 329
Total equity and liabilities 3,680 877
(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 £’000
Non-controlling interests 775 × 10% 77
995
Less net assets of acquiree 775
Goodwill 220 HR 5.4 41
Exchange gain 11
Retranslated at closing rate 220 CR 4.2 52

(4) Consolidated retained earnings
£’000
Dormro (see below) 5,743
Adjustments
Share of Klip post-acquisition profits
3 months × 90% of Klip H$500,000 = 112.5 @AR 4.8 23
5,766
Retained earnings at 1 May 20X1 5,496
Add profit for the year 568
Add write back of arrangement fee on loan 200
Less finance charge on loan (521)
–––––
Revised retained earnings at 30 April 20X2 5,743
£’000
Closing net assets (37 + 107 + 71) 215,000 × 10% 22
(6) Exchange difference on retranslation of subsidiary
H$’000 £’000
Net assets at acquisition 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

13 Johnson Telecom
Marking guide Marks
Treatments
Disposal of Cole 3
Hedge re International Energy 5
Acquisition of Routers 4
Loan note and swap 2
Hedging
Explanation of hedging principles 4
Draft hedging documentation 3
Note independence issues 2
Key risks and internal controls
1 mark for each risk/control identified and explained 9
Audit evidence
1 mark for each piece of evidence 9
Marks Available 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 £’000
DEBIT Investment 12
CREDIT Other comprehensive income 12
Being revaluation of the investment in Cole plc at the date of disposal

The journal entries are as follows:
£’000 £’000
DEBIT Cash 242
Being the disposal of the investment in Cole plc

(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 £’000
CREDIT 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 £’000
DEBIT Investment 0.8
CREDIT 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 £’000
DEBIT Other components of equity 27

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 £’000
DEBIT Derivative asset 12
However, hedge accounting had been applied and the fair value gain recorded in other
comprehensive income/other components of equity:
£’000 £’000
DEBIT Derivative asset 12
CREDIT Other components of equity 12
Therefore, the journal required to reverse the hedge accounting is:
£’000 £’000
(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 £’000
DEBIT Cash 83
CREDIT Debt investment 72.2
The journal entry to adjust for this error is as follows:
£’000 £’000
DEBIT Debt investment 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.)

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.

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
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.

• 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 third-
party 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.)

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.
14 Biltmore
Marking guide Marks
Treatments
General 2
Harmony Tower 3 3
Grove Place 3
Head office 3
Northwest Forward 2
Teesside 3
Essex Mall 2
Subone Head Office 3
Coventry Building 3
Adjustments
1 mark for each journal entry, maximum of 8
Impact on the auditor’s report
Quantify the combined impact 4
Appropriate audit opinion and explanation, maximum of 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.

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.
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.
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.

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 £m
DEBIT Gains on investment properties 50
CREDIT Investment properties 50
Grove Place
Treat costs incurred as revenue:
£m £m
DEBIT Repairs 30

Cancel gain recognised for year:
£m £m
Reclassify building as non-investment property:
£m £m
DEBIT Property, plant and equipment 80
Charge depreciation on additional non-investment property:
£m £m
DEBIT Depreciation expense 4
CREDIT Property, plant and equipment 4
Northwest development
No adjustment required.
No adjustment required.

Essex Mall
Cancel gain recognised for year:
£m £m
Reclassify development as non-investment property:
£m £m
DEBIT Property under construction 770
Subone plc’s head office (consolidation adjustment only)

Reclassify building as non-investment property:
£m £m
Charge depreciation on additional non-investment property:
£m £m
DEBIT Depreciation expense 6
CREDIT Property, plant and equipment 6
(Book value throughout the year = £120m, divided by 20-year life = £6m.)
Transfer recognised gain to revaluation reserve:
£m £m
CREDIT 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 £m
Transfer property to inventory:
£m £m
DEBIT Inventory 345

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 Current Property under

properties PPE assets construction Total
£m £m £m £m £m
Draft 2,360 57 6 0 2,423
Harmony Tower 3 (50) (50)
Grove Place (30) (30)
Head office (100) 76 (24)
Essex Mall (850) 770 (80)
Subone Head Office (150) 150 –
Coventry building (360) 345 (15)
Revised 820 283 351 770 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

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.
15 Hillhire
Marking guide Marks
Key audit risks and financial reporting treatment

General 5
Discontinuation
Audit risk 3
Financial reporting treatment 4
Audit procedures 3
Acquisition 7
Swap
Audit risk 3
Audit procedures 3
New system 4
Share options 5
Ethical 4
Marks Available 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%.

Cost of sales
In 20X8 cost of sales has increased by 11.5% over 20X7, compared with a 10% increase in revenue.
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.

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
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 Profit or loss (44,520/25 × 3/12) £445,200
CREDIT 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.

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 intangible assets (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 intangible assets, 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 intangible assets 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 intangible assets. Confirm that items recognised in other intangible
assets 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 intangible assets 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.

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 intangible
assets 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 Profit or loss – interest expense £9.5m

CREDIT Interest accrual/cash £9.5m
DEBIT Cash £1.5m

CREDIT Profit or loss – interest expense £1.5m

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.

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:
Cumulative
Expenses expenses
Year ending £ £
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
The adjustment for 20X8 should be:
£ £
DEBIT Profit or loss 15,000
CREDIT 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.
16 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.

Requirement Skills
Identify that the financial controller is not the

best source of audit evidence (eg, for
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 11

Derivatives 3
Claim from MegaCo plc 2
Contract liability 3
Disposal 3
Accounting treatment of pension scheme 7
Audit issues 3
Ethics 5
Marks Available 45
Maximum 40
Total 40

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.

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.

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 £306,000

CREDIT 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
31 May 20X8 31 May 20X7

£’000 £’000
Present value of obligation 4,320 3,600
Fair value of plan assets (4,050) (3,420)
Net liability 270 180

Expense recognised in profit or loss for the year ended 31 May 20X8
£’000
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
Benefits paid (342)
Loss on remeasurement through other comprehensive income (residual) 522
Present value of obligation at 31 May 20X8 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) 495
Fair value of plan assets at 31 May 20X8 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.

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.
17 Tydaway
Marking guide Marks
Follow up work from inventory count 12

Audit work arising from concerns and need to address financial statement assertions 13
Financial reporting effects of four hedging options 10
Explanation and comparison of the alternative financial reporting treatments 4
Documentation required for audit purposes 4
Marks Available 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.

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 accounting
records have been updated for all physical transactions before the count and post count transactions
are not included.

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 roll-
forward 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.

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.

• 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.

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 £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 £20,544

CREDIT 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:

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 Cash £43,994

CREDIT Forward contract £43,994
To recognise the settlement of the forward contract by receipt of cash from the counterparty.

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
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.
However, the existence of the contract and associated risk would be disclosed from this date in
accordance with IFRS 7.
At 31 July 20X1


To recognise the increase in the fair value of the hedging instrument (which is the forward contract,
being a derivative financial asset) and to recognise the gain on the forward contract in profit or loss.

CREDIT Firm commitment £20,545
To recognise the increase in fair value of the hedged item liability (ie, the previously unrecognised
firm commitment) in relation to changes in forward exchange rates and to recognise a debit entry in
profit or loss, which offsets the profit previously recognised in respect of the gain on the derivative
financial asset (IFRS 9).
At 15 December 20X1

To recognise the increase in the fair value of the hedging instrument (which is the forward contract,

CREDIT Firm commitment £23,459
To recognise the increase in the fair value of the hedged item liability (ie, the firm commitment) and
to recognise a debit entry in profit or loss, which offsets the profit previously recognised in respect of
the gain on the derivative financial asset (IFRS 9 para. 6.5.13).
DEBIT Cash £43,994

To recognise the settlement of the forward contract by receipt of cash from the counterparty.

Being the settlement of the firm commitment (ie, the purchase of inventory) at the contracted price of
$500,000 at the spot rate on 15 December 20X1 ($500,000/1.4108).
DEBIT Firm commitment £44,004

CREDIT Inventory £44,004
To remove the firm commitment from the statement of financial position and adjust the carrying
amount of the inventory resulting from the firm commitment.
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.

CREDIT 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:

CREDIT 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 Cash £43,994

To recognise the settlement of the forward contract at its fair value by receipt of cash from the
counterparty.
DEBIT Purchases £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 Other comprehensive income £43,994

CREDIT Purchases £43,994
To remove the firm commitment from other comprehensive income and adjust the carrying amount
of the inventory resulting from the hedged transaction.
Discussion of financial reporting differences
Year ending 31 July 20X1
No hedge Fair value Cash flow

No hedge accounting hedge hedge
£ £ £ £
SPLOCI
Profit or loss – 20,544 20,544 –
(20,545)
Other comprehensive income – – – 20,544
SOFP
Financial asset – 20,544 20,544 20,544
Inventory – – – –
Cash – – – –
Retained earnings – 20,544 – –
Hedging reserve – – – 20,544
Firm commitment – – 20,545 –

Year ending 31 July 20X2
No hedge Fair value Cash flow

No hedge accounting hedge hedge
£ £ £ £
SPLOCI
Profit or loss – 23,450 23,450 –
(23,459)
Other comprehensive income – – – Note (2)
SOFP
Financial asset – Note (1) Note (1) Note (1)
Inventory 354,409 354,409 354,409 354,409
(44,004) (43,994)
Cash (354,409) (354,409) (354,409) (354,409)
43,994 43,994 43,994
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.
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
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

18 Wadi Investments
Marking guide Marks
Report describing, explaining and quantifying required accounting treatment of:

Acquisition of Strobosch 7
Change of use of asset 6
Audit procedures 5
Points for instruction letter 8
Loan to Strobosch 4
Hedging of net investment 8
Marks Available 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 accounting records 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.
• 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 £m
DEBIT Consideration transferred (675 + 360) 1,035
DEBIT Profit or loss for the year (2 + (23 × 0.45)) 12
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 £m
DEBIT Profit or loss for the year 12
DEBIT Non-current liability: Debentures 6
CREDIT Investment in Strobosch 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 £m
DEBIT Interest expense 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.
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.
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 accounting
records 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 accounting records 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
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.
• The hedging relationship meets all of the hedge effectiveness requirements of IFRS 9, namely
(IFRS 9 para. 6.4.1(c)):
relationship; and
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 £m
3 April 20X6 Initial measurement 90
30 June 20X7 Depreciation (90 × 15/600) (2.250)
30 June 20X7 Carrying amount 87.750
Revaluation to FV 112
30 June 20X8 Depreciation (112 × 12/585) (2.297)
15 March 20X9 Depreciation (112 × 8/585) (1.532)
15 March 20X9 Carrying amount 108.171
Gain on revaluation (OCI and revaluation surplus) 15.829
15 March 20X9 Revaluation to FV 124
Gain on remeasurement (profit or loss) 4
30 June 20X9 Revaluation to FV 128
Current treatment
Date £m
15 March 20X9 Carrying amount 108
30 June 20X9 Depreciation (112 × 4/585) (1)
30 June 20X9 Carrying amount 107
Gain on revaluation (to revaluation reserve) 21
30 June 20X9 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

19 Lyght
Marking guide Marks
Concerns of ethics partner 8

New IT system 8
Inventories 5
Sale of tyres 6
Leased buildings 6
Asset treated as held for sale 7
Receivables 7
Marks Available 47
Maximum 40
Total 40
To: Gary Orton

From: A Senior
Date: 11 May 20X8
Subject: Lyght plc – final and interim audit and ethical issues
Concerns of ethics partner
(1) Tender and low audit fee
Obtaining an audit by tender does not, of itself, give rise to ethical concerns. Similarly, the fact that
the bid was at a low price and will generate a substantial under-recovery does not constitute
unethical conduct. However there are a number of other potential threats to independence.
• Self-interest threat
One threat to independence is a ‘self-interest’ threat. This may occur as a result of any interest of
professional accountants that may conflict with their duty to report independently. In this case the
threat is that the low bid may have been made in the expectation of obtaining more profitable
non-audit work. As the other work has not yet been awarded, the client may pressurise us during
the audit by threatening not to award us the other work. If we are awarded the work, the client
may threaten during future audits to take it away from us. An alternative self-interest threat may be
to ‘reward’ us with unduly high fees for other tax and advisory work in return for us inappropriately
attesting the financial statements.
There is also a potential self-interest threat from doing inadequate amounts of audit procedures in
order to reduce the under-recovery. The audit plan should clearly require sufficient, relevant and
reliable audit evidence to support the audit opinion, irrespective of the fee.
• Self-review threat
If we are successful in gaining the other work there may also be a ‘self-review’ threat. This may
occur when a judgement needs to be re-evaluated during the audit by the professional
accountant who originally made that judgement.
• Non-audit services
Revised Ethical Standard sets out a clear general approach to non-audit and additional services.
Under the standard it would never be appropriate for the audit firm to undertake a management
role.
As Lyght is not yet a listed or public interest entity, tax work for Lyght would normally be
acceptable under the standard, but the materiality and risks involved in the work would need to
be considered on their merits.

The nature of other advisory work would also need to be considered on its merits (the potential
tender for the IT work is considered below). Where there is doubt, the Revised Ethical Standard
states that our firm should (para. 5.13):
– Identify and assess the significance of any related threats to the integrity or objectivity of the
firm.
– Identify and assess the effectiveness of the available safeguards to counter any threats (which
may include resignation or refusal to accept appointment as auditor or provider of the non-
audit services).
– Consider whether it is probable that an objective, reasonable and informed third party would
conclude that the proposed service would not impair integrity or objectivity.
The circumstances should also be communicated to those charged with governance and the
rationale behind the decisions taken should be documented.
According to the Revised Ethical Standard (para. 4.35 & 4.36) audit staff should not be assessed on,
or have their pay related to, their ability to cross-sell the firm’s products. The suggestion that
promotions may depend on selling the additional tax and advisory services to Lyght is ethically
inappropriate.
(2) Size of client
Lyght is a large client for a firm of our size. At the moment it appears the fees from Lyght (if we gain
the tax and advisory work) will make up about 8.8% (£0.5m/(£5.2m + £0.5m)) of our firm’s total fee
income. This is within the bounds set by the Revised Ethical Standard (para. 4.31) (15% of the firm’s
total fee income for non-listed client companies which are not public interest entities). However if
Lyght obtains a listing, our fee income would be likely to increase (eg, from acting as reporting
accountant) and the ethical limit according to the Ethical Standard (para. 4.27) would fall from 15% to
10%. We are therefore likely to breach the limits at this stage.
According to the Revised Ethical Standard (paras. 4.27 and 4.31), where fees amount to 5%–10% (for
a public interest entity or other listed clients) or 10%–15% (for non-listed clients that are not public
interest entities) the fact needs to be disclosed to the ethics partner and those charged with
governance at the client and appropriate safeguards adopted where necessary. This may include
declining some of the work.
The fee percentage limits in the Revised Ethical Standard are not however rigid. They are based on
expected regular levels of fee income and relate to situations where a ‘reasonable and informed
third party’ might consider the firm or the engagement partner’s objectivity to be impaired.
New IT system
(1) Ethical issues
According to the Revised Ethical Standard (para. 5.50), the firm should not undertake work on
computerised accounting systems on which the auditors would place significant reliance. The threat
to independence in this case is one of self-review, the auditors performing services for an assurance
client that directly affect the subject matter of the assurance engagement.
Auditor involvement in the design and implementation of IT systems that generate information
forming part of a client’s financial statements would therefore create a self-review threat. Here Budd
& Cherry would only be doing part of the work. It needs to be clearly established how the work
would impact upon the financial statements, as opposed to producing management information that
did not feed into financial statement disclosures. (The briefing notes state that the new IT system is ‘to
monitor the flows of goods across the globe and for management accounting purposes’.)
However, where the information provided by the new IT system is likely to have a significant impact
on Lyght’s financial statements, then the self-review threat is likely to be too significant to allow us to
provide such services. Appropriate safeguards would certainly be required, ensuring that Lyght does
the following:
• Acknowledges its responsibility for establishing and monitoring the system of internal controls
• Makes all management decisions with respect to the design and implementation process
• Evaluates the adequacy and results of the design and implementation of the system
• Is responsible for the operation of the system (hardware or software) and the data used or
generated by the system

Additionally the non-assurance services should be provided only by personnel not involved in the
financial statement audit engagement and with different reporting lines within the firm.
Nevertheless in spite of the safeguards, the self-review threat may still be considered to be so great
that we should not tender for this work.
(2) Audit issues
• Change of system
There are three key aspects that we will need to consider regarding the systems changes
implemented during the year.
– The operating effectiveness of the old system
As this is our first year as auditors we will need to document the old system and gain an
understanding of the way in which it operated including an understanding of internal control.
The fact that the system has been changed suggests that there may have been particular
problems with the old system which we should identify. We should review systems files and
interview IT personnel regarding specific deficiencies in the old system that the introduction of
the new system has attempted to address.
– The development of the new system including the changeover
A key risk is the potential loss or corruption of financial information. We will need to establish
whether appropriate security for the previous systems was maintained during the development
and installation of the new systems. This might have included for example appropriate access
controls and confidentiality relating to the new system developers and installers. We also need
to obtain details of the way in which data was transferred, details of the controls implemented
over the change-over and the extent and results of testing performed on the new system to
determine whether it is operating effectively.
– The operating effectiveness of the new system
Systems notes will need to be updated and we will need to ensure that we have a good
understanding of the way in which the new system operates including the internal controls
implemented by management. We will need to evaluate controls to determine our detailed
audit approach. However increased substantive testing of payables and receivables is likely to
be necessary due to the increased audit risk resulting from the fact that it is the first year of the
audit and systems changes have taken place.
• Provision of other services
The proposed project commencing in July 20X8 does not affect the current audit but does have
implications for future audits. Even if our staff members are not involved in development, as
auditors we should be consulted during it and carry out the following procedures:
– At the design stage, ascertain whether the systems specification appears to include appropriate
data security and authorisation processes.
– At the design stage, review plans to establish whether there are any obvious problems with
data collection, input, processing and output.
– Determine whether all aspects of the systems have been tested, and testing has been carried
out by users as well as developers.
– Either by carrying out procedures ourselves, or reviewing the results of internal tests, confirm
that controls over security and accuracy of data have been satisfactorily tested.
– Ascertain whether there is a full information trail for the design and development process.
– Confirm that new systems have been approved by management and users.
– Confirm that staff have been fully trained and user documentation is complete.
(3) Financial reporting issues
Hardware costs recognised as part of plant and equipment will include the purchase price plus the
costs directly attributable to bringing the assets to the location and condition necessary to be
capable of operating as intended. Installation costs would therefore be capitalised. Related revenue
expenditure eg, ongoing maintenance costs must not be capitalised but must be recognised in profit
or loss. The hardware should be depreciated over its estimated useful economic life from the point
that it is available for use.

The computer software should be recognised as an intangible non-current asset in accordance with
IAS 38, Intangible Assets. It is both identifiable as it is separable and under the control of Lyght. As
the software has been provided by an external contractor it should also be possible to measure the
software reliably based on the amounts invoiced and paid by Lyght in respect of this. Capitalised
costs may include the costs of testing the software prior to use on the basis that these costs are
directly attributable. The software should be amortised over its useful economic life commencing
when it is available for use.
Inventories
(1) Audit issues
Inventories at around £20 million are clearly material both in their impact on profit and on net assets.
Verifying inventories is therefore clearly necessary. If we can obtain sufficient evidence by alternative
procedures, then we may be able to give an unmodified audit report in spite of the fact that we have
not attended year-end inventory counts.
Alternative procedures may include the following:
• Attendance at physical inventory counts performed after the year end with a review of the ‘roll-
back’ reconciliation performed by management.
• Assess the effectiveness of internal controls and other management controls over inventory
amounts and movements.
• Undertake analytical procedures to assess the reasonableness of inventory amounts given the
levels of sales and purchases prior to year end. (This is most valid for sales of large numbers of
identical, small items – such as clothing and small appliances – where patterns in sales may be
more discernible than for large one-off sales.)
• Inspect purchase documentation and ultimate sales and receipt of cash documentation for dates
that straddle year end. (This is most valid for sales of large items – such as medical equipment and
military vehicles – where there may be third-party documented verification of dates.)
If we are unable to obtain sufficient appropriate evidence regarding the existence of inventory we
will need to consider issuing a modified audit opinion due to the limitation on scope of the work we
have been able to perform.
This issue of exchange rate volatility gives additional audit concerns. The dates of transactions in
foreign currencies need to be established in order to verify the amounts in the functional and
presentation currencies. The specific details are considered below under financial reporting issues.
• Foreign currency
According to IAS 21, The Effects of Changes in Foreign Exchange Rates an entity is required to
translate foreign currency items and transactions into its functional currency.
Lyght’s functional currency ‘is the currency of the primary economic environment in which it
operates’. The primary economic environment ‘is normally the one in which it primarily generates
and expends cash’. It is assumed that Lyght’s functional currency is sterling as it operates from the
UK.
Inventories are a non-monetary asset. Lyght therefore initially records both the inventory and the
associated liability at the exchange rate at the date of purchase (perhaps the £/€ rate if acquired
within the EU).
The inventory needs no further translating. Thus, while the exchange rates in customers’ countries
may vary substantially, this will not directly affect inventory values stated at cost. (Any outstanding
liability is a monetary item and should be retranslated at the reporting date. Exchange gains and
losses should be recognised in profit or loss.)
If however the exchange rate moves substantially post year end, then the recoverable amounts of
inventories may fall in sterling terms, and thus an impairment review may be required.
• Other issues
In accordance with IAS 2, Inventories, inventories must be valued at the lower of cost and net
realisable value. Net realisable value may be a particular issue here due to the ‘pre-used’ nature of
the items sold. Audit procedures should include a review of after date sales with a comparison to
cost.

Revenue recognition may also be an issue. Further details are required regarding the point at
which revenue is recognised and therefore inventory derecognised, particularly in respect of the
high value items where there is an identified buyer prior to the inventory being purchased.
Sale of tyres
• The purchase
Lyght bought a batch of tyres from a depot managed by Leslie Moore’s cousin. IAS 24, Related
Party Disclosures identifies key management personnel which includes directors, and ‘close family
members’ of key management personnel as related parties of an entity. Cousins are not
specifically identified in IAS 24 as ‘close family members’ but the depot manager may fall within
the more general description of ‘those family members who may be expected to influence, or be
influenced by, that individual in their dealings with the company’. The provision of gifts to the
depot manager could be a factor which indicates that the depot manager is influenced by Leslie
Moore or vice versa. Whether the purchase of the tyres represents a related party transaction
requires further investigation. If it is a related party transaction disclosure will be required in the
• The sale
As an associate company of VenRisk Lyght is a related party of VenRisk. Hott is also an associate of
VenRisk and therefore they are related parties, however, Hott is unlikely to be a related party of
Lyght, as the possibility of exercising significant influence, or having significant influence
exercised upon it, by another associate of VenRisk seems unlikely. More information on
governance structures and contractual rights would clarify this situation. The sale of the tyres is
thus not a related party transaction.
(2) Audit issues
• Related party transactions
Establishment of whether related party relationships exist is a key issue. Given that the directors
do not appear to have made all relevant information available in the first instance there may be a
high risk of further undisclosed transactions. Audit procedures need to be designed in this
context. The under-disclosure may be due to a lack of knowledge/awareness of the transactions’
nature or it may be deliberate concealment.
Audit procedures need to establish and evaluate the controls that exist to identify and approve
such transactions.
Audit procedures that may indicate the effectiveness of controls and reveal RPTs include the
following:
– Review the board minutes for transactions with other parties and evidence of influence.
– Review disclosures in previous year’s financial statements.
– Review RPT disclosures in the financial statements of entities suspected of being related
parties.
– Review large transactions, particularly loans and other financial transactions, for evidence that
they may not be on an arm’s length basis.
– Review legal correspondence for guarantees and other undertakings where no monetary
amount has been transferred.
– Examine shareholder records of group entities and, where possible, of entities suspected of
being related parties.
– Enquire of the directors the nature of the controls to identify and record RPTs.
• Unethical behaviour
There may have been fraudulent behaviour by Lyght and Leslie Moore. There is a risk that the
purchase of tyres by Lyght may be at a price significantly below their fair value. This may be either
as a favour to a cousin, or in return for a financial inducement from Lyght. Alternatively, it may be
that the purchase price is legitimate. The army may have wished to dispose of the tyres even at a
nominal price as it had no other means of distribution. As bulky items, the purchase cost may have
been small by comparison to the transport costs to be incurred, making the eventual sale price
reasonable. An explanation should however be obtained from Leslie Moore.

The invoice of £3,487 also requires further investigation. The gifts and entertainment may have
been provided in order to secure a reduced purchase price. Not only would this represent
unethical behaviour but could also be seen as a payment of a bribe in contravention of the
Bribery Act. This would be an offence for both the giver and receiver of the bribe. Reasonable and
proportionate hospitality would not be considered a bribe, however the ethical guidance on gifts
and hospitality would also need to be taken into account. Further information is required to
determine whether illegal acts may have taken place which we, as auditors, may be permitted or
required to disclose.
If unethical or illegal behaviour has taken place this also has implications for our assessment of
the integrity of management and may affect the extent to which we rely on responses provided by
them to other issues.
Leased building
Under IFRS 16, Leases, the distinction between operating and finance leases is not relevant to
lessees. With the exception of leases for less than 12 months or leases of low-value assets, all leases
must be recognised in the statement of financial position. A lease liability is recognised, together
with a right-of-use asset, being the lease liability plus the first payment in advance.
A lease liability for the present value of future lease payments has been correctly recognised.
However, the amount of the right-of-use asset is incorrect because this should be the lease liability
plus the first payment in advance: £950,000 + £150,000 = £1.1 million. £110,000 depreciation
(£1.1m/10) should have been recognised in profit or loss, rather than £95,000 (£950,000/10).
However, the difference of £15,000 is 0.125% of pre-tax profits of £12 million, which would not
normally be regarded as material.
(2) Audit issues
We would carry out the following audit procedures in connection with the lease to confirm it qualifies
as a right-of-use asset:
• Review the lease agreement and assess whether the terms appear to show that control has been
transferred to Lyght (for example is Lyght allowed to sublet the office space?).
• Assess the significance of arrangements at the end of the lease (in particular whether legal title
transfers to Lyght or whether Lyght has been granted an option to extend the lease so that it
could occupy the premises for all or a substantial part of its economic life).
• Examine invoices and other documents related to maintenance, insurance and other office costs
to assess the economic substance of the lease terms.
• Inspect the premises to confirm their existence and that they are used by Lyght.
If we conclude that the treatment as a right-of-use asset is correct, the following procedures would
be required:
• Confirm the calculation of the present value of lease payments, including confirmation that the
calculation is taken from the start of the lease date, and that the finance cost is being spread over
the lease term in a method that accords with IFRS 16.
• Agree payment figures and implicit interest rate used to lease agreement and reconcile payment
in advance of £150,000 to cashbook.
• Recalculate the depreciation charge and agree the calculation basis to the accounting policy
note.
• Confirm that disclosures of liabilities under the lease are in accordance with IFRS 16.
Asset treated as held for sale
Lyght has classified its head office as held for sale from 1 January 20X8 on the basis that
management made the decision to dispose of this asset on that date. However, in accordance with
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations certain conditions must be met
in order for this classification to be made.
These are as follows:
• The asset must be available for immediate sale in its present condition.
• Its sale must be highly probable.

For the sale to be highly probable:
• Management must be committed to the plan.
• There must be an active programme to locate a buyer.
• The asset must be marketed for sale at a price that is reasonable in relation to its current fair value.
• The sale should be expected to take place within one year from the date of classification.
• It is unlikely that any significant changes to the plan will be made or that the plan will be
withdrawn.
On the basis that Lyght is not planning to market the property until May 20X8 and there is no current
active programme to locate a buyer, all of the above conditions are not met. The asset should not
therefore be classified as held for resale but should be retained within property, plant and
equipment and should be depreciated for the remainder of the year. This would result in an
additional depreciation charge of approximately £33,000 (2,000,000/20 × 4/12).
On the basis that Lyght has treated the asset as held for sale the following adjustments would have
been reflected in the draft financial statements:
£’000 £’000
DEBIT Assets held for sale (1,600 – 20) 1,580
DEBIT Profit or loss 20
DEBIT Revaluation surplus 400
CREDIT Property, plant and equipment 2,000
These entries should be reversed on the basis that the treatment of the asset as held for sale is not in
Impairment of the asset should also be considered if its recoverable amount is less than the carrying
amount. See audit issues below.
(2) Audit issues
• Confirm with management that marketing is only going to commence on 1 May 20X8 ie, the asset
does not qualify as held for sale at the period end.
• Consider materiality. The treatment of the property as held for sale has resulted in a reduction in
net assets of 1.2% (420/36,000). However, if the property is deemed to have suffered an
impairment the difference in the financial effect of the two treatments may be negligible. Further
investigation is required. In this instance materiality also needs to be considered from the
qualitative aspect as well as the quantitative aspect. The classification adopted in the draft
financial statements results in the property being removed from non-current assets and being
disclosed separately immediately below current assets. This impacts on the perception of the
company’s liquidity.
• Confirm that the asset has been included in property, plant and equipment and that it has been
depreciated for the full year. The net impact of correcting the treatment of £13,000 (£33,000
additional depreciation – £20,000 estimated costs of disposal) is unlikely to be material however
the additional depreciation is consistent with continued recognition of the asset as part of
property, plant and equipment.
• Confirm whether the property has suffered an impairment. Its fair value is currently below its
carrying value. An assessment of the value in use of the asset should be made to determine
whether an adjustment is required. If the recoverable amount (higher of fair value less costs of
disposal and value in use in accordance with IAS 36) is less than the carrying amount the asset will
be impaired and should be written down to its recoverable amount. Any loss would initially be
treated as a revaluation decrease.
Receivables
• The requirements of IFRS 9, Financial Instruments apply.
• Interest on the trade receivable is £2,577,000 × 8% = £206,160.
• A loss allowance for the trade receivable should be recognised at an amount equal to 12 months’
expected credit losses.

• Although IFRS 9 offers an option for the loss allowance for trade receivables with a financing
component to always be measured at the lifetime expected losses, Lyght has chosen instead to
follow the three stage approach of IFRS 9.
• The 12-month expected credit losses are calculated by multiplying the probability of default in
the next 12 months by the lifetime expected credit losses that would result from the default. Here
this amounts to £376,440 (£1,505,760 × 25%).
• Because this allowance is recognised at 1 May 20X7, the discount must be unwound by one year:
£376,440 × 8% = £30,115.
Overall adjustment:
Finance costs (impairment of receivable)

DEBIT (376,440 + 30,115) £406,555
CREDIT Loss allowance £406,555
(2) Audit issues

We would carry out the following audit procedures in connection with the allowance:
• Review correspondence with Cristina and assess whether its commitment appears legally
binding.
• Obtain representations from the management of Lyght which confirm the decision to adopt IFRS
9 and the three-stage approach (this could be confirmed via board minutes).
• Review a sample of similar receivables to determine whether any further loss allowances should
be recognised.
• Evaluate the probability of external factors occurring which may result in the monies owed by
Cristina not being paid, such as a likely change of government in the next year.
• Recalculate the loss allowance using information obtained during the course of the audit.
• Confirm with management the basis on which the 8% interest rate and the 25% default rate have
been used to reflect the risks of Cristina.
• Review any significant changes in circumstances occurring between the interim audit and the final
audit.
20 Hopper Wholesale
Marking guide Marks
Inventory
Audit issues 5
Audit procedures 5
Financial assets
Audit issues 4
Audit procedures 4
Receivable
Audit issues 3
Audit procedures 3
Share option scheme
Audit issues 5
Audit procedures 4
Sustainability issues (including ethics) 10
Marks Available 43
Maximum 40
Total 40

Inventory
Audit issues
(1) Materiality
The option may be material to the statement of profit or loss and other comprehensive income
as the potential gain of £150,000 represents 5.5% of profit before tax.
(2) Risk
There is a risk that the option is incorrectly valued particularly as there is no directly comparable
instrument being traded on the open market at the period end and that any change in value is
incorrectly calculated.
If the underlying market price of flour has fallen as at 31 December 20X8 then the option’s
intrinsic value will increase by 20,000 multiplied by the difference between the market price of
flour and the strike price of £140 per tonne.
The fair value of the option will have to be determined. From the information provided, it does not
necessarily sound as if the original contract was determined by reference to a traded option that will
have a standardised set of terms and conditions and that will have an open-market, observable
market value. The £400,000 offered by the counterparty to the option will possibly constitute a
reasonable estimate of the fair value as at the reporting date, although the amount offered could be
significantly different from fair value. Sweetcall would have an incentive to offer less than the fair
value in order to be released from this potential commitment, but could just as easily offer more than
the fair value in order to resolve the significant uncertainty associated with the cost of having the
option exercised against it in June 20X9.
The option was recorded at cost of £250,000. If the £400,000 is regarded as a fair value, then the
gain of £150,000 on the option would be recognised in profit or loss for the year ended 31
December 20X8. If this is not deemed suitable as a fair value, then the difference between the
carrying value and any assessed fair value should be included as the gain (or loss – less likely).
There is a risk that the option may be incorrectly treated as a hedging instrument.
The directors might argue that the option is a hedging instrument because it was purchased with the
express intention of reducing risk arising from changes in the value of the inventory. The hedge
could be described either as a fair value hedge or as a cash flow hedge. However, to account for the
transaction as a hedge, the following requirements must be met:
• 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
hedge.
• The hedging relationship meets all of the hedge effectiveness requirements of IFRS 9, namely
(IFRS 9 para. 6.4.1(c)):
relationship; and
hedge.
Based on the information available, it would appear not all these conditions are met, specifically that
the documentation is not in place, and that the purchase was arguably opportunistic rather than a
part of a coherently planned risk management strategy and so it would be inappropriate to use
hedge accounting.
There is a risk that the price of flour could change in such a way that the option lost much of its value
(market risk). Prices do seem to change dramatically, as evidenced by the fact that the option was
purchased substantially out-of-the-money and three months later it is substantially in-the-money.
We need to consider the counterparty’s ability to honour the commitment imposed by the option
(credit risk). This should have been investigated before paying for the option, however even if this is
the case Sweetcall’s solvency will have to be reconsidered as at the reporting date.
There is a risk that any errors in the drafting of the contract could result in the option lapsing even if it
would have been in Hopper’s interests to exercise it (legal risk).

Disclosure may be inadequate. The option should be disclosed in accordance with IFRS 7 as a
derivative financial asset.
Review the option contract to determine that the contract exists and that the company has the rights
and obligations relating to the option.
Vouch the provenance of the contract by referring to correspondence with the counterparty and any
professional advisers.
Write to Sweetcall and ask for direct confirmation of the terms and conditions of the option.
Investigate whether there are any other contracts in existence which relate to this transaction.
Valuation and measurement will be a difficult area. Determine the basis on which management have
valued the option eg, Black-Scholes method.
Review the accuracy of any parameters that have been input into the model, such as the volatility of
flour prices, the strike price and the time left to run. Some simple sensitivity analysis would be
sensible in order to assess how suitable the valuation is.
Compare the results of that calculation with the £400,000 offered by Sweetcall to cancel the contract
and assess the implications of any difference.
Confirm the assessment of the creditworthiness of Sweetcall as the option will not be worth anything
if they default.
Confirm disclosures are in accordance with IFRS 7.
Financial assets
Audit issues
(1) Materiality
The financial assets are material to both the statement of financial position and the statement of
profit or loss and other comprehensive income. The amount recognised in non-current assets
amounts to 5% of total assets. The gain amounts to 19% of profit before tax and 2.4% of revenue.
(2) Risk
There is a risk that the investments have been incorrectly classified as a financial asset at fair
value through other comprehensive income. In accordance with IFRS 9, Financial Instruments, all
equity investments are measured at fair value in the statement of financial position, with value
changes recognised in profit or loss, except for those equity investments for which the entity has
elected to present value changes in ‘other comprehensive income’. The fair value through other
comprehensive income categorisation is only appropriate if:
(a) the equity investment is not held for trading;
(b) the entity has made an irrevocable election at initial recognition to measure it at FVTOCI
with only dividend income recognised in profit or loss.
There is a risk that the investments have been incorrectly valued. Financial assets at fair value
through OCI should initially be measured at fair value. At the end of each reporting period the
financial assets should be remeasured to fair value with any changes recognised in other
comprehensive income. This does appear to be the treatment adopted here and is therefore
correct provided that the categorisation is appropriate.
Obtain a schedule detailing the purchase price of the individual investments and their valuation at
the period end.
Agree initial recognition at fair value to the transaction price eg, statements from stockbrokers.
Obtain details of any transaction costs and confirm that these have not been included in fair value
but have been expensed.
Determine the means by which the period end fair values have been established. In this case shares
are listed therefore there should be a quoted market price and agree to schedule.
Obtain details and review the way in which the investments are managed to determine that they are
not held for trading eg, enquire of management that it is not their intention to sell in the short term
corroborated by a review of events after the end of the reporting period.

Review other information eg, notes of board meetings and ensure that discussion of investments is
consistent with their classification as being held for the short term.
Review the adequacy of the disclosure note in the financial statements and ensure that it is in
accordance with IFRS 7, Financial Instruments: Disclosures.
Receivable
Audit issues
(1) Materiality
The receivable represents only 0.08% of total assets and is therefore not material on a
quantitative basis. However, it is material due to the nature of the transaction ie, on a qualitative
basis, because it is a director-related transaction.
(2) Risk
There is a risk of non-compliance with IAS 24, Related Party Disclosures due to the lack of
disclosure as this transaction constitutes a related party transaction. We have been told that the
receivable is due from a company which is under the control of Jack Maddison, who is Hopper’s
Managing Director. Jack Maddison is in a position to control or significantly influence both
companies. The transaction may not be a normal commercial transaction and may be subject to
bias. A trade receivable with credit terms of 12 months would be unusual. However, a loan with
such terms would not.
Completeness is a high-risk assertion. Whilst we are aware of this transaction and can confirm
the details there may be other similar transactions which we are not currently aware of. Due to
the nature of related party transactions they may be difficult to identify.
There is a risk that the receivable may be overstated. If there is any doubt about the
recoverability of the debt then an allowance may be required.
The classification of the debt also needs to be considered. We have been told that it will be
repaid within the next 12 months. If this is not genuinely the case then the asset should be
disclosed as an asset recoverable after more than one year, in other words, a non-current asset.
Discuss the transaction with Jack Maddison to establish the nature and the purpose of the
transaction.
Review any documentary evidence of the transaction eg, invoice or loan agreement and confirm the
terms of the agreement, in particular the repayment terms and timing.
Review board minutes for authorisation of the transaction and any discussions regarding the purpose
of the transaction and its repayment. Also review the board minutes for evidence of any other related
party transactions.
Obtain evidence that Jack Maddison does control Bourne Ltd, eg review of Bourne Ltd financial
statements.
Review financial statements of Bourne Ltd to establish that it recognises that it has a liability to
Hopper and assess the ability of the company to repay the debt.
Obtain general representation from management confirming that they have disclosed all related
party transactions to us and that they are appropriately accounted for and disclosed.
Obtain further specific written representations regarding the receivable due from Bourne Ltd
including details of the control which Jack Maddison has over Bourne Ltd, confirmation that
management believes the debt to be recoverable and the date on which it will be repaid.
Share options
Audit issues
(1) Materiality
Profits are understated by £430,000 (700 – 270). This represents 15.6% of profit before tax and is
therefore material. As the share options are transactions with employees the transaction is likely
to be material from a qualitative as well as from a quantitative perspective.

(2) Risk
The key issue is that of inappropriate accounting treatment. In accordance with IFRS 2, Hopper
Wholesale Ltd is required to recognise the remuneration expense as the services are received,
based on the fair value of the share options granted.
In this case the fair value at the date the options were granted was £12. The calculation
performed by the entity currently uses the fair value at the end of the reporting period of £14.
The full expense has been recognised in profit or loss in the year of issue. In accordance with
IFRS 2, the cost should be recognised over the vesting period (in this case two years).
The calculation performed by Hopper Wholesale Ltd does not take into account the number of
options expected to vest but simply assumes that all will vest at the end of the period. IFRS 2
requires that the amount recognised take into account estimates of the number of employees
expected to leave.
The credit entry has been recognised as a long-term liability. This should be recognised as part
of equity rather than as a liability.
The expense should have been recognised as £270,000 (100 × 500 × 90% × 12 × ½).
Agree other contractual terms to legal document ie, number of shares awarded to each employee,
vesting terms and length of vesting period.
Enquire of directors regarding the numbers of employees estimated to benefit and the basis on
which the 10% leaving rate has been estimated.
Compare staffing numbers to forecasts and numbers of leavers to prior years.
Confirm that £12 is the fair value at the grant date by reference to documentation supporting the fair
value calculation.
Enquire of the directors as to the model used to estimate fair value. Consider whether this is in
accordance with IFRS 2 (eg, Black-Scholes) and that it is appropriate in the circumstances. (As the
company is not listed it is unlikely that a market value for shares will be available.)
Consider whether expert advice is required on the valuation.
Obtain representations from management confirming that the assumptions used are reasonable.
Social and environmental report
Requirement to publish information
The Companies Act 2006 requires quoted companies to include information on environmental,
employment and social issues as part of its strategic report. Quoted companies must also report on
greenhouse gas emissions in their Directors’ Report. As Hopper is not a quoted company these
requirements do not apply. However, companies are encouraged to provide this information
voluntarily therefore increasingly its inclusion is being seen as best practice.
Assertion 1
This will be a difficult statement for us to verify for the following reasons:
• The statement is dependent on the integrity of others and we will not have access to the records
of the suppliers.
• There may be some flexibility in the definition of child labour, eg, in terms of age and potential
hours worked.
Possible sources of evidence would include assertions by suppliers, inspection by auditors,
information available in the press.
Assertion 2
This assertion is more straightforward. The current minimum wage is set in law. A review of payroll
records should be performed targeting the lower paid workers in particular and comparisons made
with the minimum wage. A calculation would then be performed to ensure that the additional pay
rate does equate to at least 10% of the minimum wage.
Assertion 3
Again there should be evidence to support this assertion provided adequate payroll records are
maintained. Details of staff sickness rates for the current year and previous year should be obtained

from payroll records. A comparison should be made, and a calculation performed to confirm that
rate of decrease.
Assertion 4
Our ability to verify this statement will depend on the records on waste disposal maintained by the
company. For example, if disposal is conducted by a contractor, invoices for the cost of disposal
would provide evidence of the volumes of waste sent to landfill. A comparison with previous years
could then be made. If this is not the case, we would need to establish the basis on which the
management have made this claim. Specific procedures would then depend on the source
information available.
Assertion 5
The company should maintain a log of all accidents which take place in the workplace. Assuming that
these records are available we should be able to compare the number of recorded accidents which
took place in the current year, compare this with the number which took place in the previous year
and recalculate the percentage change.
What will be more difficult to confirm is that the reduction is due to improved health and safety
procedures. We may not have the expertise to determine whether procedures have improved (as
opposed to simply being different) unless they have been made in response to recommendations
made by experts in the health and safety field. If this is the case, we would be able to confirm that
procedures have been revised in accordance with those recommendations.
Professional considerations
We have not been involved in this type of work before, therefore we need to ensure that we have the
relevant expertise and resources to complete this assignment. The scope of this work is not set down
in statute so we would need to clarify precisely our responsibilities in an engagement letter. We also
need to clarify the purpose of our report and consider issues regarding any liability that we may have
to third parties. This exercise would also constitute the provision of other services, which is allowed
under ethical guidance. We would need to consider the fee that we will receive and ensure that we
are not economically dependent on this client.
In addition, the social and environmental report is expected to be included in the same document
that contains the audited financial statements. As such, it would form part of the other information
which we, as the statutory auditors, are required by ISA (UK) 720 (Revised November 2019) to read to
identify any material inconsistencies. If any of the proposed assertions are found to be inconsistent
with the audited financial statements and we conclude that there is a material misstatement in the
other information which management refuses to correct, we would need to consider what impact this
would have on the auditor’s report, and more generally, whether we should continue the audit
engagement. In the Other Information section of the auditor’s report we would be required to
provide a description of the material misstatement.
21 Button Bathrooms
Marking guide Marks
Financial reporting issues and key audit risks

Revenue recognition – FR and audit issues 9
Reorganisation – FR and audit issues 6
Website development costs – FR and audit issues 5
Pension 6
E-commerce and service provider – audit risks 7
Outsourcing of payables ledger 5
Response re cyber attack 4
40
Total 40

To: Carol Ying, Partner
From: A Senior
Date: 15 July 20X1
Subject: Button Bathrooms Audit
Audit junior’s points
(1) Revenue
Online sales
The timing of receipt of cash should not determine the timing of revenue recognition. In accordance
with IFRS 15, Revenue from Contracts with Customers, revenue should be recognised for the sale of
goods when the entity satisfies the relevant performance obligation, which is when control is passed
to the customer (IFRS 15: para. 32). This would normally occur on the passing of possession of the
goods (ie, physical delivery).
The key audit risk is therefore that revenue is inflated as being recognised when cash is received
from SupportTech rather than when the goods are delivered which may be up to four weeks later.
This would in turn inflate profits.
A key audit risk is also incorrect cut off, because if revenue is recognised then the cost of sales should
also be recognised.
There is therefore a risk that profit is significantly inflated by overstating revenue and failing to
recognise any cost of sales on items paid for by customers in June. There needs to be an appropriate
system for recording the delivery date in order to have control over the timing of revenue
recognition and cut-off.
Similarly, there needs to be a system for recording the nature and timing of returns. If returns are
significant consideration could be given to making a provision or even deferring revenue recognition
until after the end of the returns period.
A key legal issue is with which party is the customer’s contract. This could be SupportTech.
Alternatively, it may be that the contract is with BB and SupportTech is merely an agent. This could be
significant in the case of default.
As goods are delivered to order there is no material issue with inventories in this respect.
Audit procedures will include the following:
• Examining the dates of delivery to customers of sales recognised in June 20X1
• Examining the dates of delivery to customers of sales recognised in July 20X1
• Tracing the receipt of cash recognised as revenue in June to delivery dates to ensure that
recognition is not according to the cash receipt date
• Reviewing returns post year end to ensure revenue has not been inflated
• Confirming the need for a returns provision by examining returns ratios over the period online
sales have been in operation
Sales made on interest-free credit terms
The key issue here is that revenue would appear to be overstated as the full £520,000 has been
recognised as sales revenue. The revenue should be recognised at the fair value of the consideration
received. As an interest-free credit period has been given the revenue is effectively made up of two
elements:
• the fair value of the goods sold
• finance income
These two elements should have been accounted for separately. In order to calculate the fair value of
the goods sold the future cash receipts are discounted to present value at an imputed rate of
interest. The imputed rate of interest reflects the credit status of customers so in this case 10% should
be used.

Revenue should be recognised as follows:
£
Sale of goods
Deposit (£520,000 × 10%) 52,000
Balance (468,000 × 1/1.12) 386,777
438,777
Finance income (386,777 × 10% × 6/12) 19,339
Sales revenue is currently overstated by £81,223 (520,000 – 438,777). This represents 8.9% of net
profit as per the draft management accounts.
The net impact on profit is £61,884 (81,223 – 19,339). This is approximately 6.8% of the net profit as
per the draft management accounts. In both cases the adjustment is likely to be material.
A receivable would also be included in the statement of financial position of £406,116 (386,777 +
19,339).
Audit procedures
Audit procedures will include the following assuming that the adjustments above are made:
• Confirm total sales made on interest free credit.
• Inspect agreement details to confirm amount of deposit and interest free period.
• Agree deposits received to cash receipts and bank statements.
• Ascertain from management the basis on which the 10% interest rate reflecting the credit status of
customers has been calculated.
• Recalculate discounting of sale proceeds.
• Recalculate finance income and confirm disclosure as finance income (rather than sales revenue).
• Confirm that receivable balance is included in current assets and discuss any recoverability issues
with management.
(2) Disposal of showrooms
Held-for-sale classification
IFRS 5 requires that a non-current asset, such as BB’s unsold showroom, should be classified as ‘held
for sale’ when the company does not intend to utilise the asset as part of its on-going business but
instead intends to sell it. The showroom having been closed is therefore potentially in this category.
However to be classified as ‘held for sale’ the showroom should be available for immediate sale.
The likelihood of a sale taking place should also be considered to be highly probable and normally
completed within one year of the date of its classification.
The intended sale date of the Bradford showroom is in September 20X1 and there is a contract in
place. This showroom is therefore within the category of held for sale. It would therefore be
reclassified as a current asset and measured at the lower of its carrying amount and its fair value less
costs to sell at the date that it is deemed as held for sale. The current values will therefore need to be
reassessed at this date but the sale price of £1.15 million (less selling costs) would be a guideline.
The revalued amount less depreciation up to the time of the reclassification as held for sale should
therefore be the amount recognised.
The Leeds showroom is more uncertain in terms of the disposal date and the level of certainty. Audit
procedures should therefore review the probability of sale up to the audit completion date. In this
respect, the showroom must be actively marketed for sale by BB at a price that is reasonable in
relation to its current fair value. For a sale to be considered as highly probable there should be a
committed plan and BB management should be actively trying to find a buyer. The mere act of
advertising may not be enough in this respect and audit procedures need to obtain evidence of the
likelihood of sale. If the conditions are only met after the reporting date, there should be full
disclosure in the notes to the financial statements. Depreciation should cease when the held for sale
criteria are satisfied.

It should be considered whether the Leeds showroom should be revalued as the company has
adopted the revaluation model. However, as it was acquired ‘fairly recently’ the scope for revaluation
is likely to be somewhat limited.
Conversely, given that trade is difficult the fair values may have fallen and the issue of impairment
arises according to IAS 36. This raises the question of obtaining audit evidence in respect of whether
the showrooms are cash generating units. This is the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or groups
of assets. Each showroom appears to meet the criterion and should be reviewed for impairment on
this basis. As the showrooms have been closed they have no value in use hence the carrying amount
should be compared to the fair value less costs to sell.
Separate disclosure in the statement of profit or loss and other comprehensive income as
‘discontinued operations’ is also required when a company discontinues a ‘component’ of its
activities, which should have been a cash generating unit while held for use. The definition of a
discontinued operation is when it is classified as ‘held for sale’ or when it is sold and according to
IFRS 5 para. 32:
• represents a separate major line of the business or geographical area of operations;
• is part of a single coordinated plan to dispose of a separate major line of the business or
geographical area of operations; or
• is a subsidiary acquired exclusively with a view to resale.
Thus, in this case, IFRS 5 para. 32(b) may apply as the closure is part of the single coordinated plan to
withdraw from the showroom-based accessories products market.
A component of an entity comprises operations and cash flows that can be clearly distinguished
operationally, and for financial reporting purposes, from the rest of the entity and this seems likely to
include each individual BB showroom given the policy of managing performance on an individual
showroom basis. The question of whether the closure is a withdrawal from the market is however a
question of judgement as accessories products are now being sold online.
Revaluation
The revaluation reserve would become realised when the asset is sold but would not be affected by
being classified as held for sale. If there is an impairment loss that was a reversal of this previous
revaluation, then it would be a write down in the revaluation reserve rather than a charge to profit.
Audit procedures
• Confirm contract terms of the sale of the Bradford showroom.
• Inspect legal and other correspondence in respect of the sale of the Bradford showroom.
• Obtain an independent valuation of Bradford and Leeds sites.
• Evaluate the probability of sale of the Leeds site up to the audit completion date.
• Inspect advertising and any correspondence in response of this.
• Inspect reorganisation plan for evidence of a coherent and coordinated plan.
• Confirm impairment procedures and calculations for compliance with IAS 36.
(3) Website development costs
Website development costs may be treated as an internally generated intangible asset according to
IAS 38 if the appropriate conditions are satisfied. SIC 32, Intangible Assets – Web Site Costs, confirms
that internal costs of the development stage of a website are subject to IAS 38.
Conditions about feasibility have been satisfied as the site is operational. Similarly, the costs appear
to be able to be measured reliably at £1 million. There may be some question over whether there are
future economic benefits as while BB has made a profit this year this is only due to exceptional items.
Clearly this is for the business as a whole and online sales are not yet established, but there is doubt
over the future profitability of online sales and therefore whether the website development costs can
be recovered and thus over whether they should be capitalised.
According to SIC 32 internal costs incurred at the operating stage of a website (ie, once it is
completed), should be treated as an expense.

Audit procedures
• Given the possibility of future losses, the capitalised web site costs need to be evaluated for
impairment.
• Examine costs capitalised to ensure they are attributable to website development.
• Identify any overhead allocations in capitalised costs.
(4) Defined benefit pension plan
The key audit issue here is that the defined benefit plan does not seem to have been accounted for
in accordance with IAS 19, Employee Benefits.
The excess of liabilities over assets should be reported as a liability in the statement of financial
position. This is calculated as follows:
£’000
Present value of plan obligations 249.6
Less fair value of plan assets (240.0)
Plan deficit 9.6
Profit or loss for the year should include:
£’000
Net interest on net defined benefit liability
(38.4 – 19.2) 19.2
230.4
The charge recognised in profit or loss must therefore be increased by £38,400 (230.4 – 192). This
represents 4.2% of the net profit based on the draft management accounts, therefore may not be
material. Materiality would need to be reassessed however on the basis of other adjustments which
may be required eg, online sales recognition. Also as it relates to pensions (which affects employees)
it may be judged material in qualitative terms.
The remeasurement gain of £28,800 is then recognised in other comprehensive income (see below).
Remeasurement gain
PV of obligation Fair value of plan assets

£’000 £’000
B/f – –
Contributions paid 192.0
Interest on plan assets 19.2
Interest cost on obligation 38.4
Actuarial difference (bal. fig) ––––– 28.8
C/f 249.6 240.0
Audit procedures
Ask the directors to reconcile the scheme assets valuation at the scheme year end date with the fair
value of the plan assets of £240,000 at 30 June 20X1.
Obtain direct confirmation of the scheme assets from the investment custodians.
Consider the extent to which it is appropriate to rely on the work of the actuary eg, ascertain the
qualifications and experience of the actuaries.

Through discussion with the directors and actuaries:
• obtain a general understanding of the assumptions made;
• consider whether they are unbiased and based on market expectations at the year end; and
• consider whether assumptions are consistent with other information.
E-commerce
(1) Audit risks arising from use of external service provider
A key risk to BB of the new e-commerce strategy is that it is using an outside service provider.
ISA (UK) 402, Audit Considerations Relating to an Entity Using a Service Organisation provides
guidance on how auditors should carry out their responsibility to obtain sufficient appropriate audit
evidence when the audit client, which is a ‘user entity’, relies on such services.
In the case of BB the online sales are clearly material to the business as they make up around half of
revenue, even though they have only been launched for half a year. The service is also fundamental
in being a key element of the internal control systems for BB.
ISA 402 requires the auditor to understand how the user entity uses the services of the service
organisation. In the case of BB, this most significantly requires an understanding of the nature of the
services provided by SupportTech; the degree of interaction between the activities of BB and
SupportTech; and the nature of the relationship between the two companies, including the
contractual terms.
When obtaining an understanding of internal control we should:
• evaluate the design and implementation of controls at BB that relate to the services provided by
SupportTech; and
• determine whether this gives sufficient understanding of the effect of SupportTech’s operations
on BB’s internal controls in order to provide a basis for the identification and assessment of risks
of material misstatement.
If not, then we should do one or more of the following:
• Obtain a report from SupportTech’s auditors (either Type 1 or Type 2 depending on their scope).
• Contact SupportTech, through BB, then visit SupportTech and perform audit procedures that will
provide information about the relevant controls.
• Use another auditor to perform procedures that will provide information about the relevant
controls at SupportTech.
If proposing to visit SupportTech we should first determine whether sufficient appropriate audit
evidence concerning the relevant assertions is available from records held at BB. However, given the
extent of SupportTech’s activities this seems unlikely.
We should therefore perform further procedures including tests of controls.
Substantive procedures will include inspecting documents and records held by SupportTech (access
to records held by SupportTech may be established as part of the contractual arrangement with BB).
This could include the use of CAATs, if permitted by SupportTech.
Substantive procedures will also include obtaining confirmation of balances and transactions from
the service organisation where the user entity maintains independent records of balances and
transactions. This will include the cash balance outstanding paid by customers.
We may also perform analytical procedures on the records maintained by BB and SupportTech.
(2) E-commerce risks
Aside from the risks that arise because BB has used an external service provider there are additional
business risks that would arise from e-commerce even if it were operated internally by BB. These
include the following:
• Risk of non-compliance with taxation, legal and other regulatory issues
• Contractual issues arising: are legally binding agreements formed over the internet?
• Risk of technological failure (crashes) resulting in business interruption
• Impact of technology on going concern assumption, extent of risk of business failure
• Loss of transaction integrity, which may be compounded by the lack of sufficient audit trail
• Security risks, such as virus attacks and the risk of frauds by customers and employees

• Improper accounting policies in respect of capitalisation of costs such as website development
costs, misunderstanding of complex contractual arrangements, title transfer risks, translation of
foreign currency, allowances for warranties and returns, and revenue recognition issues
• Over-reliance on e-commerce when placing significant business systems on the Internet
An entity that uses e-commerce must address the business risks arising as a result by implementing
appropriate security infrastructure and related controls to ensure that the identity of customers and
suppliers can be verified, the integrity of transactions can be ensured, agreement on terms of trade
can be obtained, as well as payment from customers is obtained and privacy and information
protection protocols are established.
When auditing an entity that uses e-commerce, the auditor must consider in particular the issues of
security, transaction integrity and process alignment.
Therefore when examining the issue of security, we should carry out audit procedures to address the
following:
• The use of firewalls and virus protection software.
• The effective use of encryption.
• Controls over the development and implementation of systems used to support e-commerce
activities.
• Whether security controls already in place are as effective as new technologies become available.
• Whether the control environment supports the control procedures implemented.
When considering transaction integrity, we need to consider the completeness, accuracy, timeliness
and authorisation of the information provided for recording and processing in the financial records,
by carrying out procedures to evaluate the reliability of the systems used for capturing and
processing the information.
Process alignment is the way the IT systems used by entities are integrated with one another to
operate effectively as one system. We need to assess the extent to which SupportTech’s systems are
automatically integrated with the internal systems of BB and this may affect issues such as the
completeness and accuracy of transaction processing, the timing of recognition of sales and
receivables, and the identification and recording of disputed transactions.
A more general business risk also exists in that e-commerce sales may merely be displacing shop
sales. This may be indicated for BB by the fact that total sales in the year are similar to the previous
year.
Outsourcing of payables ledger accounts
Audit issues
Problems have been identified with controls in the past which increases audit risk in this area. Details
of these problems need to be clarified by reviewing the previous year’s audit file. The current year’s
procedures may have to be revised to address these.
Inherent risk is increased by the fact that the company has outsourced the payables ledger part-way
through the year. The transition may not have been well-managed. This risk is increased by the
historic in-house control issues as there may have been errors in the information initially transferred
to SupportTech.
There has been a high turnover in staff and staff who continued to work for BB after redundancy
notices had been issued. Disgruntled and/or inexperienced staff increases the risk of error.
We need to understand how SupportTech is being used by BB. This will include:
• the contractual terms;
• the nature of the relationship and the service provided by SupportTech. The Finance Director
authorises all invoices before they are paid. This means that a key control is maintained by BB,
although SupportTech is responsible for processing the invoices; and
• details of the information sent by BB to SupportTech and the level of detail in the schedule sent
back by SupportTech for approval by the Finance Director.
Other issues
Whilst purchase orders and delivery notes are maintained by BB, invoices are sent directly to
SupportTech. It is unlikely that sufficient evidence will be obtained from records maintained by BB

alone. However, the fact that records were maintained in-house for 10 months of the year increases
this possibility.
Effectiveness of controls over access to the portal. The system should operate such that the finance
director can view the payables accounts but not change them. If both SupportTech and BB can
update balances, there is an increased risk of duplication.
Results of enquiries of management, eg whether management is aware of any issues eg, uncorrected
errors made by SupportTech.
Points for inclusion in response to email
Consequences
• The consequences depend on the nature and extent of the breach. However, in the UK, the
Information Commissioner’s Office (ICO) could conclude that this is a breach of personal data
under the General Data Protection Regulation (GDPR) which requires the reporting of such a
breach within 72 hours of becoming aware of it. Significant fines could also be payable if GDPR
has been breached. Although the fault appears to have been at SupportTech’s end, personal data
relating to BB clients may have been lost, which could mean BB is liable. This should be
investigated as a matter of extreme urgency.
• It is possible that the hackers have accessed data relating to BB’s customers and suppliers which
could be used fraudulently.
• It would be advisable to obtain more information about this and assess the need to contact and
alert customers and/or suppliers where relevant so that they can take action if necessary.
• BB could suffer reputational damage. For example customers may be more reluctant to use the
website to make purchases if they have concerns over security of personal and/or banking details.
• There is the possibility that the portal between SupportTech and BB has allowed the hackers to
access BB’s own system. This should be investigated as a matter of urgency.
Future action
• BB should implement a formal system for managing cyber-security risk within the supply chain.
• Suppliers should be assessed using criteria relating to risk rather than spend ie, as SupportTech
has access to records and data there is a significant cyber-security risk irrespective of the level of
fees paid to SupportTech.
• BB should define who is responsible for supply chain cyber-security within the organisation eg, IT
department, operational department.
• Assurance should be obtained from suppliers when reviewing tenders for new contracts (possibly
through the use of questionnaires) but assurance should also be requested throughout the
period of the contract.
• Transparency regarding issues/breaches should be encouraged. (In this case it appears that
SupportTech has complied with this principle as BB has been notified of the breach.)
22 Jupiter
Scenario
Requirement Skills
Accounting treatment of development costs Consider how each development project meets
IAS 38 criteria for deferral.
Identify the inter-relationship of the two projects
and how a successful outcome of the engine
project could shorten the useful life of the fuel
converter.
Calculate the impairment loss allowance on the
conversion device development costs based on
the cash flow forecast.

Requirement Skills
Identify the implications of the competitor’s

development activity for the useful life and
carrying value of Jupiter’s intangible assets.
Identify the risk of the bank foreclosing on its
funding and how this may result in the write off
of all development costs.
Highlight how the combination of factors may
bring Jupiter’s going concern into doubt.
Audit issues Identify practical lines of inquiry to discuss with

directors.
Demonstrate professional scepticism towards
directors’ assertions.
Assess the possibility of mitigating factors such
as the existence of patents or other legal rights.
Identify how the work of internal audit could be
relevant, and discuss the procedures required
to evaluate whether the procedures of internal
audit can be used.
Demonstrate how the risks relating to going
concern should be explored.
Assimilate information that indicates an overall
risk of creative accounting.
Professional and ethical implications Identify ethical and legal implications of

industrial espionage to the company.
Demonstrate awareness of how the lack of
integrity of directors affects the auditor’s
position.
Audit of trade payables Identify practical alternative forms of evidence

in face of the inability to obtain confirmation or
statements from Myton.
Recognise the risk of dependence on Myton as
a supplier.
Identify the potential implications of the
retention of title clause.
Identify the risks arising from the non-
replacement of the clerk.
Demonstrate understanding of the risks relating
to overseas suppliers.
Identify practical level of testing for the other
balances.
Recognise the implication of debit balances
and the increasing level of goods received not
invoiced.

Marking guide Marks
Accounting treatment of development costs 11

Audit issues 11
Professional and ethical implications 4
Audit of trade payables 12
Marks Available 38
Maximum 30
Total 30
Memorandum: Jupiter Ltd – Development costs

I set out below my analysis of the position on the ongoing capitalisation of development costs. There
are also some associated professional and ethical issues which we will need to consider. These have
implications for our evaluation of inherent risk at the global level as well as at the level of
development costs. We may have to consider our position with respect to the continuation of this
appointment.
Treatment of development costs
The key audit issue is the risk of overstatement of intangible assets due to the inappropriate
recognition of development costs in the statement of financial position. There are two issues for
Jupiter Ltd concerning accounting for development costs.
(1) The device to convert vegetable oil to diesel was launched in 20X7. The development costs were
capitalised and are being amortised on a straight line basis over eight years. There is a carrying
amount of £3 million in the statement of financial position.
(2) A car engine, which runs on unconverted vegetable oil, is under development. Costs of £6
million were capitalised in 20X7 and further costs of £2 million that were incurred in 20X8 have
been capitalised.
Costs relating to internally developed intangible assets can only be capitalised when they are
incurred during the development phase of the project. According to IAS 38, the development phase
of a project occurs when the entity can demonstrate all of the following:
• Technical feasibility of completing the asset so it will be available for use or sale
• Intention to complete the intangible asset and use or sell it
• Ability to use or sell the intangible asset
• How the intangible asset will generate probable future economic benefit
• Availability of adequate technical, financial and other resources to complete the development
and to use or sell the intangible asset
• Ability to measure reliably the expenditure attributable to the intangible asset
Research phase costs must be expensed, as should development costs which do not comply with the
above criteria.
The vegetable oil conversion device
Even ignoring the threat posed by the competitor’s new car engine, Jupiter’s plan to launch its own
new engine is, in itself, a threat to the estimated commercial lifespan and viability of the conversion
device.
IAS 36, Impairment of Assets requires assets to be carried in the financial statements at no more than
their recoverable amount, which is the higher of their fair value less costs to sell and their value in
use. If there is any indication that the asset may be impaired, the recoverable amount should be
calculated. Should the recoverable amount of the asset be lower than the carrying amount, the
carrying amount must be written down to the recoverable amount. The impairment loss should be
recognised immediately in profit or loss.
In the case of the conversion device technology, it is not possible to calculate the fair value less costs
to sell. However, the internal auditors’ forecast provides a basis for determining the likely amount of
impairment loss. It should be noted that the additional threat posed by the competitor has not been

taken into account here. We will also need to consider whether the work of the internal auditors can
indeed be relied upon (see ‘Professional and ethical implications’ section below).
Year Future cash flows PV factor at 15% Discounted future cash flows
£’000 £’000
1 770 0.86957 670
2 700 0.75614 529
3 520 0.65752 342
4 350 0.57175 200
5 330 0.49718 164
1,905
The cash flow from the sixth year has not been taken into account. IAS 36 requires a maximum of five
years to be covered when calculating value in use, unless a longer period can be justified.
Based on this working, the recoverable amount for the asset is £1.9 million, lower than its carrying
amount of £3 million. This suggests that the capitalised development costs related to the conversion
device should be written down, and an impairment loss allowance of £1.1 million recorded. It is
worth noting that a larger impairment loss allowance may be required, as the competitor’s new
engine may further reduce the market for the conversion device.
In addition to the impairment, the launch of the car engine may have the effect of reducing the
expected useful life of the asset. Any change in the estimated useful life of the device to convert the
oil should be accounted for as a change in accounting estimate in accordance with IAS 8, Accounting
Policies, Changes in Accounting Estimates and Errors. For example, if the development costs are
determined to have a shorter useful life after the introduction of the alternative car engine, the
carrying amount should be written off over the current and remaining years. This will result in a
revised amortisation charge for the period, over and above the impairment loss.
The vegetable oil burning engine
If the rival company does launch its new engine, then it is possible that Jupiter’s engine will be
unsuccessful. Jupiter might decide not to keep developing their product and, even if they do
continue, demand could be lower than expected.
This raises the risk that the capitalised car engine development costs may be carried at greater than
the recoverable amount, and that an impairment should be reflected in the financial statements. The
capitalised development costs may need to be written down if the demand for the product is
expected to be lower than planned.
Alternatively, if Jupiter decides to discontinue the development of the engine, the £8 million will
need to be written off and expensed to profit or loss. This would likely be the case if the launch of the
competitor’s product makes the new car engine no longer commercially viable.
A full write-off would also be required if Jupiter no longer have funds available to continue with the
development. For example, given the level of Jupiter’s borrowings and the bank covenant in place,
the bank may withdraw its funding. That would mean that there would no longer be adequate
resources to complete the development of the engine.
Conclusion
Further audit procedures will need to be performed before we can reliably quantify the amount of
adjustment required to the financial statements.
The writing down of the conversion device development costs due to impairment is almost certainly
required, unless management can provide reliable evidence otherwise. The impairment or full write-
off of the car engine development costs needs to be determined. At this stage, it would seem that
the adjustment required in relation to the value of the capitalised development costs is between £1.1
million (impairment to the conversion device costs only) and £11 million (full write-off of all
development costs). Even if only the conversion device costs require writing down, this is likely to be
material to the financial statements.
We will also need to consider whether the company is in fact a going concern, given the gearing-
based bank covenant in place.

Audit issues and evidence
The prospects for both projects must be discussed with management. It may be that they have a
valid reason to believe that the diesel device project has not been impaired and that the expenditure
on the new engine still meets the criteria for a development project.
Diesel conversion device
We will need to make enquiries of management to understand:
• their assessment of the viability and expected useful life of the conversion device, in the light of
the threat posed by the competitor’s new engine; and
• their rationale for not writing down the capitalised development costs in spite of the evidence of
impairment provided by the cash flow forecast produced by the internal auditors.
Jupiter’s management may have valid reasons for believing that there is a viable future for the
conversion device. For example, there are many cars with conventional diesel engines that can run
on the fuel manufactured with this device. Demand for such cars may continue into the future
because there is a well-established infrastructure to buy fuel for diesel cars and to have them
maintained and serviced. The new engines might not be a direct replacement for all potential
markets. It may be, for example, that the new engines can only be built to power small cars.
If management maintains that no impairment write-down is required, we should obtain a revised
cash flow forecast to support this position. Management will need to be able to justify the changes
made to the internal auditor’s first forecast, and the underlying assumptions for these.
Management’s assessment of the conversion device’s future must be evaluated against an
understanding of the industry. If we do not have the expertise required to carry out the evaluation
within the audit team, it may be necessary to involve an auditor’s expert – either internal to our firm,
or external – to advise on this.
Vegetable oil burning engine
There may also be issues with the proposed competition for the new engine. There may be technical
problems to be overcome before the proposed launch date. The engine may be inferior to the
model that Jupiter proposes to launch.
We also need to consider the going concern implications of the possibility that the bank will
foreclose on the loan. We need to discuss the possibility of a major write-off with management. If the
write-off goes ahead then the resulting gearing figure will be a matter of simple arithmetic. However,
the fact that the bank would then be entitled to foreclose on the loan does not necessarily mean that
it will do so. The directors should be given the opportunity to indicate how they think the bank might
react.
The fact that the directors are prepared to exploit what amounts to a loophole in the rules on
reporting events after the reporting period is a matter of some concern. Arguably, the push to
publish the accounts before the announcement of the new engine is, at the very least, aggressive
and creative accounting.
Using the work of internal auditors
We should seek a copy of the internal auditor’s risk assessment, to determine whether there are any
other factors which may have an impact on the value of the capitalised development costs. As
discussed above, the cash flow forecast for the conversion device may provide a basis for
considering the need and the amount of impairment write-off. Before we make use of the internal
auditors’ work, however, we need to comply with the requirements of ISA 610 (UK) (Revised June
2013), Using the Work of Internal Auditors.
ISA (UK) 610 requires auditors to consider the following when determining whether or not the work
of the internal auditors can be relied upon:
• The internal audit function’s objectivity: whether the function’s organisational status and relevant
policies and procedures support a position of objectivity
• The level of competence of the internal audit function
• Due professional care: whether the internal audit function applies a systematic and disciplined
approach, including quality management
If any of the above is inadequate, we must not use the work of the internal audit function.
It appears that the objectivity of Jupiter’s internal auditors may be impaired. The finance director is
able to instruct the internal audit function to investigate ways to complete the preparation of the

financial statements before the competitor announces its new product. This implies that the internal
audit function may report directly to management, rather than those charged with governance. If this
is the case, the undue influence that appears to be exercised by the finance director increases the
risk that the internal auditor’s professional judgements may be overridden.
Indeed, the fact that management has overlooked the cash flow forecast prepared by the internal
auditors, providing evidence that the capitalised development costs for the conversion device need
to be written down, further highlights this risk.
Even if we do determine that the work of internal auditors can be used, we must perform sufficient
appropriate audit procedures on the work we plan to use. We must, in particular, evaluate whether:
• the work has been appropriately planned, performed, supervised, reviewed and documented;
• sufficient appropriate audit evidence had been obtained to enable the internal auditors to draw
reasonable conclusions; and
• the conclusions reached are appropriate in the circumstances, and the report prepared by the
internal auditors is consistent with the results of the work performed.
Professional and ethical implications
As auditors we have a clear duty to form and express an opinion on the financial statements. We have
become aware of some facts that not only cast doubt on the proposed valuation of major assets, but
also suggest that the directors have engaged in a form of industrial espionage that is, at best
immoral and unethical and, at worst, illegal.
The fact that the information was gathered in this way means that the directors do not wish to use it in
correcting the financial statements. While that is understandable, we are not bound by the same
considerations. The information that has been gathered by the directors indicates that the financial
statements may contain a material misstatement and we are obliged to take this into account in
forming our opinion. Once we have performed sufficient audit procedures to confirm the amount of
impairment that would be appropriate, we should ask Jupiter’s management to adjust the financial
statements to take account of the expectations concerning these two projects. If the management
refuses to amend the financial statements, we will need to issue a modified audit opinion.
The fact that we are aware that the financial statements will be used by the bank to enforce its loan
agreement creates a potential duty on our part. This is partly due to the precedent set by Royal Bank
of Scotland v Bannerman Johnstone Maclay and Others 2002. We are aware that the bank will use the
financial statements for this specific purpose and we will find it difficult to deny a duty of care if the
loan conditions are subsequently found to have been breached and we did nothing to warn this user.
The fact that Jupiter’s management has misled the competitor’s engineer points to a clear lack of
integrity. This, coupled with the apparent lack of objectivity of the internal audit function, will require
us to re-evaluate our risk assessment of the company and adjust our audit procedures accordingly.
The management’s unethical attitude also calls into question the reliability of any written
representations. It is important that the need to maintain a high level of professional scepticism
throughout the audit engagement is communicated to every member of the audit team.
While this potential breach of law does not have a direct effect on the financial statements, we will
need to determine whether the company is indeed in breach of the law – and if so, whether any
material fines or penalties are likely to arise. We should notify those charged with governance – the
audit committee, for example – of this non-compliance.
This matter, in itself, does not warrant our resignation on ethical grounds. However, we should
consider the need to seek legal advice, and reassess whether the directors have sufficient integrity
for us to be willing to continue to be associated with this company.

Notes for James Brown: Jupiter Ltd
Trade payables at 31 December 20X8
Audit issues
(1) Myton Engineering
Myton Engineering is a substantial payable balance representing 40% of the trade payable balance
but the company does not confirm balances or supply statements which would be used to confirm
completeness of the liability. The balance at the period end is exactly the same as it was in the
previous year which seems unusual and should be investigated. Circularisation is not possible but we
may be able to request the confirmation of specific invoices. We should also perform a review of
after-date cash payments and check individual invoices to GRNs, the GRNI accrual and the inventory
records. Old unmatched purchase orders should be investigated to confirm that they have not
resulted in unrecorded liabilities.
Myton Engineering is the sole supplier of a key component in the fuel converter. This heavy
dependence increases business risk and could potentially affect the viability of Jupiter if supply was
withdrawn. A new retention clause has been introduced this year which suggests a lack of stability
either in Jupiter or Myton Engineering. The reason for the retention clause being introduced should
be ascertained and the terms of the retention clause should be reviewed to ascertain the point at
which Jupiter is required to recognise liabilities for purchases made.
(2) Overseas suppliers
Control risk is increased by the failure to replace the clerk responsible for overseas accounts. This
balance has increased by 95% which suggests that the work of this clerk has not been reallocated.
This needs to be discussed with the finance director.
We also need to consider whether this balance includes any foreign currency transactions and
ensure that these have been accounted for in accordance with IAS 21. If there are foreign currency
balances we should reperform a sample of foreign currency translations and check that appropriate
rates are used. Logistical problems may make obtaining evidence in the short time scale more
difficult and there is an increased risk of late invoices. Cut-off will therefore need to be considered
carefully in respect of these accounts.
Recognition of the goods in transit should be investigated. Treatment will depend on the point at
which Jupiter Ltd obtains control of ownership either through transfer of legal title or in substance.
(3) Other balances
These represent 17% of total payables however each individual balance will be relatively small at
approximately 0.1% of trade payables. On this basis detailed testing of individual balances should be
limited. A small sample of the larger balances may be appropriate with analytical procedures on the
remainder.
The nature of the debit balances should be investigated. This may indicate further deficiencies in
controls. Debit balances may need to be reclassified as receivables.
(4) GRNI
This balance has increased significantly by 150%. This is likely to be as a result of the computer
problems at the period end which also increases control risk. Audit procedures on cut-off will be
particularly important. Cut off tests should be performed in conjunction with audit procedures on
inventory. The key risk is that the accrual is understated. Invoices received after the period end
should be reviewed to ensure that they have been accrued for where inventory has been received
before the end of the reporting period. Due to the computer problems experienced sample sizes
should be increased.
(5) Going concern indicators
We will need to remain alert to the issue of going concern throughout the audit. The company has
borrowed heavily to finance the development projects and it is possible that Jupiter will be in default
of the bank loan covenant. Trade payables have increased by 25% which may be indicative of
problems with cash flow. A major supplier has introduced a reservation of title clause which may
indicate a lack of confidence in Jupiter’s ability to settle liabilities.

23 Poe, Whitman and Co
Commedia Group
Background comments
The scenario in this question considers an independent television production company. At the
beginning of the period the company had two subsidiaries but it disposed of its majority
shareholding in one of these companies during the current year for an amount which included a
contingent consideration element. Other issues raised include: taking over from the previous auditor
who had resigned late into the relevant accounting period; changes in the funding basis for
commissioned productions; a provision in the company which is the subject of the partial disposal;
and possible impairment in the other subsidiary.
Candidates were required to identify audit risks and draft the audit procedures to mitigate these
events. They were also required to advise on financial reporting matters raised by a director.
The solution below provides significant detail, but it is sufficient for a good quality answer, that would
obtain a clear pass mark, to provide concise explanations of the following:
• Clear identification of the ethical issues of taking over from a resigning auditor and the practical
issues of late appointment, including the possible inability to obtain sufficient appropriate audit
evidence (limitation of scope) that may arise as a consequence of not being in office for the entire
accounting period.
• Identification of the risk and implications of the shift from a ‘funded commission’ to a ‘licensed
commission’ basis and an explanation of the associated audit work.
• Regarding the Scherzo subsidiary, there should be a clear identification of the valuation and
financial reporting risks associated with partial disposal. There should be particular emphasis on
the incentives given to directors to creatively account given the nature of the contingent
consideration contractual terms. The risks arising from the provision should also be identified and
explained together with the associated audit work.
• Regarding the Riso subsidiary, the key issue of impairment should be identified, quantified and
explained. This should include the appropriate financial reporting treatment.
Client: Commedia Group
Practical and ethical issues arising from late appointment
The unexpected resignation of the previous auditor could be as a result of an ethical or other
professional issue identified by that auditor. We must have already ensured that there were no such
issues preventing us from accepting the appointment as we have already been appointed.
We must have checked, prior to accepting the appointment, that adequate professional clearance
has been obtained from the previous auditor and that there are no matters of which we should be
aware.
We need to discuss the late resignation with the directors of Commedia to ensure there are no
matters such as a disagreement with the auditors that would have adverse implications for our firm’s
audit.
Before carrying out any work for Commedia we must ensure that satisfactory client identification
procedures have been performed (money laundering regulations).
We were not appointed as auditor until after the year end. Therefore, we may not be able to assess
adequately the stage of completion of the various commissions at 28 February 20X7 and the value of
work in progress at that date. If there are no other audit procedures that we can carry out to gain
sufficient audit evidence as to the value of work in progress at the year end, we may conclude that
the audit opinion will have to be modified. If the possible errors are considered to be material, this
may result in a qualified opinion (‘except for’). If the potential effect is pervasive, we may have to
issue a ‘disclaimer’ of opinion.
As the auditors of Scherzo, we will have access to confidential information which would be of use to
Commedia in assessing the probability of contingent consideration. This presents us with a conflict of
interest. We need to ensure that there are adequate procedures in place within our firm to ensure
that confidential information cannot be passed from one company to the other. Staffing a separate
team for the Scherzo audit is probably not feasible as we remain responsible for the Commedia
group audit and Scherzo probably remains as an associate company. The potential conflict of interest

must be disclosed to Commedia’s audit committee. It may be necessary to arrange independent
partner reviews of the Commedia group and Scherzo audit files.
Auditor’s responsibilities for initial engagements
The auditor must obtain sufficient appropriate audit evidence that the opening balances do not
contain misstatements that materially affect the current period’s financial statements. The auditor
must obtain evidence that the prior period’s closing balances have been brought forward correctly to
the current period or have been restated, if appropriate. The auditor should also obtain sufficient
appropriate audit evidence that appropriate accounting policies are consistently applied or changes
in accounting policies have been properly accounted for and adequately disclosed.
If this evidence cannot be obtained, the auditor’s report should include a modified opinion (inability
to obtain sufficient appropriate audit evidence) or a disclaimer of opinion.
If the opening balances contain misstatements that could materially affect the current period’s
financial statements the auditor must perform additional procedures to determine whether this is the
case. If the auditor then concludes that misstatements do exist in the current period’s financial
statements, the auditor should inform the appropriate level of management and those charged with
governance (ISA 510.7). The auditor should also request that the predecessor auditor be informed
(ISA 710.18). If the effect of the misstatement is not properly accounted for and disclosed, a qualified
or adverse opinion will be expressed.
If the current period’s accounting policies have not been consistently applied to the opening
balances and the change not accounted for properly and disclosed, a qualified or adverse opinion
will be expressed.
If the prior period’s auditor’s report was modified, the auditor should consider the effect of this on
the current period’s accounts. If the modification remains relevant and material to the current
period’s accounts then the current period’s auditor’s opinion should also be modified.
The auditor must obtain sufficient appropriate audit evidence that the comparative information
meets the requirements of the applicable financial reporting framework. Auditors must assess
whether:
• the accounting policies used for the comparative information are consistent with those of the
current period or whether appropriate adjustments and/or disclosures have been made; and
• the comparative information agrees with the amounts and other disclosures presented in the
prior period or whether appropriate adjustments and/or disclosures have been made. In the UK
this will include checking whether related opening balances in the accounting records were
brought forward correctly.
If the auditor becomes aware of a possible material misstatement in the comparative information
while performing the current period audit, then additional audit procedures should be performed to
obtain sufficient appropriate audit evidence to determine whether a material misstatement exists.
An Other Matter paragraph should be included in the auditor’s report in the case of the prior period
financial statements not having been audited at all, or having been audited by another auditor. This is
irrespective of whether or not they are materially misstated, and does not relieve the auditor of the
need to obtain sufficient appropriate audit evidence on opening balances.
Audit risks arising from specific events during the year
(1) Commedia Limited
Changes from a funded to a licensed basis
During the year ended 28 February 20X7 a number of the company’s commissions changed from a
funded to a licensed basis. This has the following implications for our audit:
• A funded commission entitled Commedia to invoice their customer in instalments as the
production progressed. Under the terms of a licensed commission, Commedia must wait until the
programme is delivered before they can invoice. This may cause cash flow shortages for the
company which, if not addressed through the securing of alternative funding, may cause going
concern issues. Licensed commissions generally attract a lower fee from the commissioning
broadcaster (due to the smaller bundle of rights attached to them). The costs of making the
programmes are, however, likely to remain the same, which again will have a probable negative
impact on company cash flow and profitability in the short term.
• The cost of making a licensed commission sometimes exceeds the value of the invoice to the
broadcaster. Where the cost of making the programme exceeds the value of the licensed

commission payment, the difference is carried forward as an intangible asset. The estimation of
future revenues from residual rights is an area of uncertainty with which Commedia’s
management may not be familiar.
• We will need to examine work in progress carefully as this is likely to be a material area. We will
need to examine the contracts with broadcasters to ensure the correct treatment. However, under
IFRS 15, Revenue from Contracts with Customers, costs incurred in relation to satisfied or partially
satisfied performance obligations (ie, costs related to past performance) must be expensed as
they are incurred. Therefore, once a performance obligation starts being performed, the costs will
be written off to the income statement as they are incurred (IFRS 15 para. 98).
Audit procedures
With respect to licensed commissions, where the costs exceed the initial fee from the originating
broadcaster we should consider the following:
• Examine a sample of the new licensed commission contracts to ensure the company is accounting
for them in accordance with their terms.
• Discuss with management the rationale for carrying costs forward where they exceed the value of
the broadcaster’s payment under the terms of the licensed commission as they may need to be
expensed instead.
• We need to examine management’s estimates of future revenues for a sample of such contracts to
ensure these exceed the costs carried forward.
• We should obtain documentation supporting the estimates of future income where possible. This
will include sales programmes.
– Any sales contracts for the exploitation of the rights to the programmes made to other
broadcasters.
– Agreements to make sales or the progress of negotiations to sell programmes.
– Any evidence of the popularity of the programme with the originating broadcaster.
Reviews of these factors should continue up to the date the financial statements are authorised for
issue.
We should review Commedia’s cash flow forecasts to identify the new funding requirements, if any,
arising from the change from funded to licensed commissions. This change in production funding
should be discussed with management to assess their view on its impact on the company’s cash flow.
Where gaps in funding are identified, discuss with management to assess what steps they have taken
to fill them. We also need to ensure management have considered the going concern status of the
company for the foreseeable future.
Disposal of Scherzo
The disposal by Commedia of part of its investment in Scherzo during the year also has audit risk
implications. The sales proceeds should include any contingent consideration payable even if, at the
date of acquisition, it is not deemed probable that it will be paid. Bob Kerouac of Commedia has
requested advice on the accounting treatment of the disposal in the financial statements. This shows
he is unfamiliar with such items and so increases the audit risk as this may have been accounted for
incorrectly. We need to examine the sale and purchase agreement for the disposal of the shares in
Scherzo to ensure that the disposal has been accounted for in accordance with its specific terms,
particularly to ensure that the transaction results in a loss of control. We should also:
• reperform management’s calculation of the profit or loss on disposal of the shares to ensure it is
accurate;
• review Scherzo forecasts as prepared prior to sale to support contingent consideration element;
• review management’s calculation of the fair value of the remaining investment in Scherzo and
check that any revaluation gain is included in the calculation of the gain or loss on disposal;
• review Scherzo year end financial statements (as provided by Commedia only and not as
obtained in our capacity as auditor of Scherzo) and assess whether the amount of contingent
consideration recognised is appropriate;
• ensure this figure is included in the calculation of the profit or loss on disposal; and
• consider the need to discount the future consideration, but given the short time period involved
the effect of this is not likely to be material.

A key issue with respect to the audit of the disposal of Scherzo is the audit of the net assets at the
date of disposal. Given that our firm was not appointed at this date, attesting the net assets
retrospectively is potentially a major problem where the information is no longer attestable and there
is thus a limitation of scope issue.
A related problem is ascertaining the pre disposal results. Time apportionment is unlikely to be
applicable in a business that is dependent on concerts and events that do not accrue evenly over the
year.
There is also an issue of auditing the relevant disclosures relating to the disposal under IFRS 5, Non-c
urrent Assets Held for Sale and Discontinued Operations. This might include attestation in the parent
and the group financial statements of:
• the date assets became held for sale
• impairment
• discontinued operations
(2) Scherzo Limited
Audit risks and contingent consideration
£5 million of the total possible £20 million share sale consideration payable by management is
contingent upon the results of the company for the year ended 28 February 20X7. Management
therefore have an incentive in this year to:
• suppress profits
• overstate costs
• understate income
in order to reduce the contingent sum payable. Management will want the profit for the year to be
below £3 million. Below this level, no further sums will be payable.
Every £1 of pre-tax profit for the year between £3 million and £5 million will result in £2.50 additional
contingent consideration which increases the risk of management manipulation of the figures. This
also increases our audit risk because a misstated profit figure may have a multiplied direct impact on
the sum receivable by Commedia for the shares in respect of the contingent consideration element.
Indeed, for every extra £1 profit earned between £3 million and £5 million there will be net loss to
Scherzo of £1.50.
Moreover, as the nature of the incentives for the new management of Scherzo is to engage in undue
prudence, this may be more difficult to argue against as auditors, given the inherently prudent nature
of many accounting principles.
In addition to excessive prudence concerning measurement, there are also incentives for the new
management of Scherzo to manipulate presentation, particularly in the classification of costs. The
contingent consideration contract terms suggest that exceptional items should be excluded. This
gives the incentive to classify any unusual income as exceptional but any unusual costs to be
presented as normal items (ie, not exceptional).
It should, however, be noted that the incentives may become redundant if Scherzo is making a profit
below £3 million. Any further downward manipulation would be pointless as it would give rise to no
further benefit as the contingent consideration would already be zero. Similarly, if the profit before
tax is significantly in excess of £5 million there is no benefit from small amounts of profit reduction. At
the audit planning stage, an assessment of the likely profit before tax (eg, from management
accounts) would help identify the key inherent risks with respect to managerial incentives to account
creatively.
Specific areas where management may seek to manipulate profits are as follows:
Collapsed stage
Provisions in connection with the collapsed stage. This is likely to be treated as an exceptional item
and therefore excluded from the calculation of pre-tax profit for these purposes. However,
management have an incentive to:
• classify some of the costs associated with the incident as ‘normal’ operating expenses and so
suppress the pre-tax profit figure used in the calculation of contingent consideration; and
• overstate any elements of the provision which are not to be classified as exceptional or understate
any that would be classified as exceptional.

Aside from the issue of the contingent consideration, the issue of the collapsed stage itself
represents an audit risk in that the provision for costs associated with the incident may be misstated
at the year end, particularly the provision for any potential litigation from members of the crew and
general public. If the company is found to have been negligent, this may result in criminal
implications for the company which may have going concern implications for the financial
statements. The incident will have no doubt caused adverse publicity for the company which may
adversely affect attendance at future events staged by the company.
A key issue is the role of Highstand to whom Scherzo subcontracted the erection of the stage. There
may be a contingent asset in respect of Scherzo taking litigation against Highstand. This would,
however, be an issue of disclosure rather than recognition. There should be no set-off between the
potential provision and the contingent asset.
The question of the probability of success of the litigation against Scherzo needs to be considered. If
it is possible, rather than probable, then this needs to be disclosed as a contingent liability rather
than recognised as a provision. This is a question of fact but also some legal judgement may be
needed.
No provision can be made in respect of anticipated future operating losses arising from the
reputational effects of the accident.
Audit procedures
• Request management provide you with a reconciliation of costs incurred on this exceptional item,
reconciling the charge in profit or loss with the closing provision in the statement of financial
position. This will enable you to ensure all costs have been appropriately recognised and
measured.
• Review legal documentation for the claims being made and the possibility of a counter claim
against Highstand.
• Inspect insurance documentation to assess the extent that any liability may be covered by
insurance.
• Evaluate any correspondence with insurers over whether any claims would be fully covered.
• Inspect any correspondence with the injured parties directly regarding any evidence of the fact,
nature and amount of any claims. Examine the level of complaints from customers and request to
see any additional undisclosed correspondence threatening litigation.
• Inspect any correspondence with Highstand directly regarding any evidence of the fact, nature
and amount of any claims and the ability of Highstand to pay any claim (eg, whether they have
insurance cover).
• Consider speaking or corresponding directly with the company lawyers to assess the extent, and
the probability of success, of legal proceedings.
• Obtain written representations from management on the level of claims included within the
financial statements and review any payments made in respect of the incident both before and
after the year end.
• Assess impact on company’s reputation from a review of reports in the media.
Directors‘ emoluments
Directors’ emoluments exceeding £350,000 are to be excluded from the calculation. Management
may seek to report a lower emoluments figure by excluding benefits in kind or use share-based
payments according to IFRS 2. Only those emoluments over £350,000 are to be excluded, therefore
management may defer payment of a portion of their salary below this figure until the following year
in order to reduce pre-tax profit. Similarly, any bonuses to which the directors are entitled may not be
provided for by management, or may be deferred or waived for this year.
Audit procedures
The major issue with respect to the directors’ emoluments is their impact on the contingent
consideration. The key risk therefore is the extent to which directors’ emoluments are understated
below the benchmark of £350,000 in year to 28 February 20X7.

Audit tests should therefore focus on this shortfall risk and may include the following:
• Assess whether there is a clear definition of ‘directors’ emoluments’ in the contingent
consideration contract. Areas of doubt may be the following:
– whether they are determined for the purposes of the contract on a normal IAS 19 accruals
basis;
– whether bonuses are included;
– whether share-based payments are included and if so whether they are measured for the
purposes of the contract on an IFRS 2 basis;
– assess the treatment under the contract of any other payments to directors (eg, pension
payments); and
– whether any actions by the new Scherzo directors are forbidden under the contract (eg,
waiving or deferring emoluments).
• Obtain a list of all directors and verify that both executive and non-executive directors are
included in the contract.
• Ascertain from the contract that all directors are included (ie, anyone who was a director at any
time during the year).
• Attest all payments made and owing to directors at any time during the year.
• Confirm that payments to the directors in the pre disposal period are included.
• Review the contract for any other terms relevant to the determination of directors’ emoluments for
the purposes of determining the contingent consideration.
• Compare the level of emoluments with prior years to review whether they are likely to be
understated, particularly benefits in kind.
• Examine directors’ service contracts to ensure emoluments are in line with these and that any
bonus entitlements have been provided appropriately.
Other audit procedures
We need to pay particular attention to revenue and purchases cut-off in Scherzo to ensure profits are
not understated. Any new provisions should be examined in detail to ensure they are fairly stated
and presented. Similar tests should be carried out with respect to impairments.
The purchase by management is likely to have been funded by external debt or equity coming into
Scherzo. If they are made available to us, examine the agreements for any such funding to ensure
appropriate treatment in the financial statements. We need to assess the ability of management to
fund any contingent consideration element, as any issues here could have implications for Scherzo’s
future activities. The debt element of any external funding introduced into Scherzo will need to be
serviced. This will place a cash flow strain upon the company and therefore we need to assess both
short and medium term serviceability of this debt (eg, from review of cash flow forecasts) to ensure
there are no adverse going concern implications for the company.
(3) Riso Limited
The company has lost a major customer accounting for approximately 35% of its revenue. It has not
as yet been able to find a suitable replacement customer for this lost studio time. This is partly due to
a surplus of studio space within the UK which is likely to make it harder for Riso to fill the spare
capacity within the studio. This gives rise to a going concern risk for Riso if its losses continue.
The loss during the year ended 28 February 20X7 and forecast cash outflows for the next two years
indicate that the value of the television production equipment may be impaired at 28 February 20X7.
Its carrying amount at that date was £5.6 million (£8m – (£8m – £2m) × 4/10) which was well in excess
of its fair value at that date of £4 million. It is therefore necessary to carry out an impairment review to
determine whether the value of the equipment needs to be written down. If this is not adequately
done, there is a risk of overstatement of non-current assets in the financial statements.
Audit procedures
Given the loss of a major customer during the year, we should assess the reasonableness of the
preparation of the financial statements on a going concern basis. This will include discussions with
management, review of profit and cash flow forecasts, and examination of new contracts to ascertain
whether the surplus capacity in the studio has been filled post year end.

We need to carry out a review of the client’s impairment review on the television studio equipment.
This will include the following procedures:
• Obtain a copy of the recent valuation of equipment and agree to the review.
• Evaluate the estimate of future cash flows prepared by management, ensuring they are based
upon reasonable assumptions.
• Evaluate the calculations of the possible impairment, including an assessment of whether the pre-
tax discount factor used is reasonable.
• Confirm any impairment identified is appropriately accounted for and disclosed in the financial
statements.
Notes in response to Bob Kerouac‘s email
Disposal of shares in Scherzo Limited
On disposal the assets and liabilities of Scherzo (including the goodwill) should be derecognised
and the fair value of the consideration recorded. The remaining investment in Scherzo should be
recognised at its fair value on the date the control was lost (30 April 20X6). Where there are any
assets held at fair value with movements as part of other comprehensive income then these other
comprehensive income amounts need to be transferred to retained earnings or profit or loss. Any
resulting difference is recorded in profit or loss and would be likely to be recognised as an
exceptional item.
After the disposal, Scherzo is no longer a subsidiary but rather an associate company of Commedia.
It will need to be accounted for in the consolidated financial statements under the equity method of
accounting. This involves including the fair value of the 30% retained interest in Scherzo on the date
control was lost plus 30% of its retained earnings since that date in the group’s consolidated
statement of financial position.
Television production equipment in Riso Limited
The company’s loss in the year ended 28 February 20X7 and anticipated future losses indicate that
the television production equipment may be impaired under IAS 36. An impairment review therefore
needs to be carried out. This involves a comparison of the carrying amount of the television
production equipment in the financial statements (net book value) at 28 February 20X7 with its
recoverable amount. For these purposes, recoverable amount is defined as the higher of (1) the fair
value less costs to sell and (2) the value in use. The fair value less costs to sell is (per IFRS 13) the
price that would be received to sell the equipment and other net assets (£4 million plus £0.25
million) in an orderly transaction between market participants at the measurement date, and value in
use equals the present value of expected future cash flows from the cash generating unit (‘CGU’)
where the impaired assets exist. These cash flows should be discounted at a rate the market would
expect for an equally risky investment. If the carrying amount is higher than the recoverable amount,
the difference should be written off in profit or loss for the year.
Because Riso’s sole activity is the operation of the television studio, it can be considered a CGU in
itself. From the information given to us by management the calculation will be as follows:
At 28 February 20X7:
Carrying amount of net assets
• Equipment £5.6m (£8m cost less £2m estimated disposal proceeds = £6m. Depreciation for four
years is therefore £2.4m on the depreciable amount of £6m)
• Other net assets: £0.25m
• Total: £5.85m
Fair value less costs to sell
• Equipment: £4.0m
• Other net assets (assumed): £0.25m
• Total: £4.25m

Value in use – cash flows Before discount £m After discount £m
Year 1 (0.1) (0.091)
Year 2 (0.05) (0.041)
Year 3 0.9 0.676
Year 4 1.375 0.939
Year 5 1.495 0.928
Year 6 2 + 1.695 2.086
Total discounted value in use 4.497
It is assumed all cash flows occur at year ends.

IAS 36.33(b) requires a justification of a period of over five years for value in use to be disclosed. The
validity of the disclosed explanation would need to be reviewed as part of the audit to ensure
compliance with IAS 36.
The value in use is higher than the fair value less costs to sell and therefore it is the former that needs
to be compared with the carrying amount to determine whether an impairment is necessary.
Comparing the two, there is a shortfall of £1.353 million that needs to be recognised (£5.85m less
£4.497m). This figure should be taken off the carrying amount of the television production
equipment.

24 Precision Garage Access
Marking guide Marks
Analytical procedures for further investigation 18

Audit work 8
Financial reporting issues that arise from the above audit work 8
Impact on profit of share option schemes and explain reasons for differences 8
Marks Available 42
Maximum 30
Total 30
Analytical procedures
Statement of profit or loss and other comprehensive income (in £’000)
9m to 9m to
30.06.20X6 30.06.20X5 Working
Revenue: 1
Monty 7,500 9,600
Gold 14,000 28,800
Cost of sales: 2
Monty (6,700) (7,800)
Gold (15,500) (23,400)
Gross (loss)/profit (700) 7,200
Fixed administrative and distribution costs (1,200) (1,200)

Exceptional items
Staff bonus scheme (450) –––––– 3
(Loss)/Profit before tax (2,350) 6,000
Income tax expense –––––– (1,680)

(Loss)/profit for the period (2,350) 4,320
WORKINGS
(1) Revenues
Revenue of the Monty has declined by 22%.
Revenue of the Gold has declined by 51%.
The predicted values of revenue for each of the products for the nine months to 30 June 20X6
are as calculated below. These are based on actual volumes sold (from the inventory records) ×
list prices.
Monty
9,000 units × £840 = £7.56m

The actual revenue for sales of Monty is £7.5 million which is extremely close to the predicted
level and therefore provides some assurance.
Gold
6,000 units × £2,520 = £15.12m
The actual revenue for sales of Gold is £14 million which is a difference of 7% and may represent
a risk of material understatement of sales (eg. through significant and inappropriate discounting
of sales, or errors in recording of sales).
Audit work
• Confirm the accuracy of the source 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.
• Compare inventory records with inventory count information or continuous inventory records.
• Enquire whether significant discounts have been given which may explain the shortfall.
Determine conditions for discounting and relevant authorisation enquiries from invoice
sample.
• 70% of sales are overseas and denominated in euro. The standard price is fixed in euro at the
beginning of the year as equivalent to the pound, but exchange rate movements during the
year may have caused a change. As a consequence, the actual revenue may have moved out
of line with the predicted revenue based in pounds. Review exchange rate movements and
confirm whether the translation is at the actual or average £/€ exchange rate. (This test also
applies to each category of cost.)
(2) Cost of 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 due to reductions in total variable costs. The reduction in cost of sales would
however be expected to be smaller in percentage terms than the reduction in revenues as this is
a manufacturing company and hence some costs are fixed. This fixed element of costs does not
change despite the fall in volumes.
The predicted values of cost of sales are:
Monty
(£4m × 9/12) + (9,000 units × £840 × 50%) = £6.78m
The actual cost of sales of Monty is £6.7 million which is extremely close to the predicted level
and therefore provides some assurance.
Gold
(£12m × 9/12) + (6,000 units × £2,520 × 50%) = £16.56m
The actual cost of sales of Gold is £15.5 million which is a difference of 6.4% 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 the data whether the cost saving arises from lower variable cost
per unit or fixed costs savings but this requires further investigation.
Audit work
While the percentage difference is smaller for cost of sales than for revenue it may be more
concerning as exchange rates do not appear to be an explanatory factor as manufacturing is in
the UK. However, installation costs and the sales network are incurred in euro so the exchange
rate effect is not entirely to be ignored. As cost 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
business then if the allocation is on a time basis, rather than a normal usage basis, this may
distort the costs allocated to cost of sales and inventory.

• Similarly, the large fall in volumes compared to previous years may not represent a normal
usage basis in allocating fixed production costs to units of output.
• An alternative explanation for the difference in costs may be that there are fewer economies
of scale arising from the 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 may both be materially understated.
Gold based on results for nine months to 30 June 20X6
£’000
Actual gross loss (1,500)

Revenue difference 1,120
COS difference (1,060)
Imputed loss from analysis (1,440)
Overall the possible indicated misstatement in overall profit or loss is quite small at £60,000 as
the two differences are largely compensatory. Nevertheless individually they are of concern and
need investigating.
Summary analysis
There has been a 25% reduction in sales volumes of Monty and a 50% reduction in sales
volumes of Gold compared to the nine month period last year. Given the high fixed costs, the
cost of sales has not fallen in line with revenues and a gross loss has been made.
As the business is seasonal, further losses are anticipated in the fourth quarter as revenues will
be low and fixed costs will be high, being recognised on a time basis.
(3) Staff bonus
The full year bonus is potentially £600,000. An accrual of 9/12 of this amount (ie, £450,000)
appears to have been made for the three quarters interim accounts. However this is not
appropriate as the business is seasonal as: “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.”
On this basis revenue will be:
£’000
Y/e 30 Sept 20X5 (10,400 + 31,200) 41,600
9 months to 30 June 20X5 (9,600 + 28,800) (38,400)
Final quarter y/e 30 Sept 20X5 3,200
Final quarter revenue adjusted for 5% price increase 3,360

9 months to 30 June 20X6 21,500
Projected revenue y/e 30 Sept 20X6 24,860
This is lower than the £26 million threshold thus the bonus should not be recognised. (See
financial reporting below.)
Audit work
Review the sales budgets for the final quarter up to the year end to evaluate whether the
threshold level of sales to trigger the bonus has been achieved. For the final audit this figure will
be known but for the purpose of reviewing the interim financial statements a combination of the
latest actuals and the budget would be needed.

Inspect the terms of the bonus agreement and of any announcement or other undertakings with
staff to determine the possible payment of the bonus.
Tutorial Note
The forecast revenue for the final quarter to 30 Sept 20X6 can also be calculated as follows:
Sales volumes expected in the quarter to 30 September 20X6 (in units)
Monty (13,000 – 12,000) = 1,000
Gold (13,000 – 12,000) = 1,000
Total revenue expected in the final quarter = (1,000 × £840) + (1,000 × £2,520) = £3,360,000

• Receivables
9 months to 30 June 20X6
Receivables days = (2,400/21,500) × 270 days
= 30 days
= 30 days
Y/e 30 September 20X5
= 8.7 days
Superficially it may seem that receivables have fallen substantially from June 20X5 to June 20X6,
from £4.3 million to £2.4 million. On closer inspection 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 that receivables at 30 September 20X5 are very low using the calculation
of 8.7 days. However receivables reflect sales in the most recent month(s) before the statement of
financial position is drawn up, rather than the average for the year. Given the seasonality of PGA,
the final quarter sales are low and therefore the year end receivables are expected to be low.
• Inventories
Superficially it may seem there has been little movement in inventories and thus it is low risk.
However, the inventory days show significant movement:
Inventories days = (3,500/22,200) × 270 days
= 43 days
Inventories days = (3,500/31,200) × 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 show a low level of risk for receivables as the receivables days (30 days) is
consistent 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 tests are 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,
cancelled orders). If this is the case, then a write-down of such inventories should be considered.

Revenue
There is a risk from the revenue recognition policy as it may not be appropriate to record the sale
of garage doors until the installation is complete unless the two elements are separable.
Foreign currency translation
According to IAS 21 sales should be translated at the date of the transaction (or the average rate
as an approximation). Given that sales are seasonal in the full year then there is a risk that the
average rate may not be at an appropriate rate.
Staff bonus
The bonus should only be recognised according to IAS 37 and 34 when there is a constructive or
legal obligation to make a payment. In this case, the full year’s revenue on which the bonus is
based is expected to fall below £26 million in the full year (see note 3 above) thus no bonus
should be recognised in the interim or the final full year financial statements.
Impairments of PPE
The Gold product looks to be performing poorly in making losses and the estimate is that “sales
of Gold doors are not expected to increase in the foreseeable future”.
Gold doors production seems likely to be a cash generating unit as the assets to make the Gold
doors are separately 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
specifically associated with the Gold product) seems likely to be low.
Also the fair value less costs of disposal also seem to be low as the “production equipment is
specialised and highly specific to each of the separate production processes”.
In such circumstances the sharp downturn in Gold sales could represent an impairment event and
therefore an 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 bad debts are increasing then an impairment charge should be considered.
Response to David May’s request
Proposal A – equity settled
Equity
Scheme Expense impact
commencing Computation of annual expense for each scheme each year each year
£ £
01.10.20X6 600 × £8 × 1/3 × (80 – [3 × 10]) 80,000 80,000
01.10.20X7 600 × £10 × 1/3 × 50 100,000 100,000
01.10.20X8 600 × £12 × 1/3 × 50 120,000 120,000
Year ending Year ending Year ending

Scheme commencing 30.09.20X7 30.09.20X8 30.09.20X9
£ £ £
1/10/20X6 80,000 80,000 80,000
1/10/20X7 100,000 100,000
1/10/20X8 –––––– ––––––– 120,000
Total expense 80,000 180,000 300,000

Proposal B – cash settled
Scheme commencing 01.10.20X6
Year ending 30 September Expense Liability

£ £
20X7 (600 × £10 × 1/3 × 50) 100,000 100,000
20X8 (600 × £12 × 2/3 × 50) – £100,000 140,000 240,000
20X9 (600 × £14.4 × 3/3 × 50) – £240,000 192,000 432,000

£ £
20X8 (600 × £12 × 1/3 × 50) 120,000 120,000
20X9 (600 × £14.4 × 2/3 × 50) – £120,000 168,000 288,000

£ £
20X9 (600 × £14.4 ×1/3 × 50) 144,000 144,000

Scheme commencing 30.09.20X7 30.09.20X8 30.09.20X9
£ £ £
01.10.20X6 100,000 140,000 192,000
01.10.20X7 120,000 168,000
01.10.20X8 ––––––– ––––––– 144,000
Total expense 100,000 260,000 504,000
Comparison – charge to profit or loss

30.09.20X7 30.09.20X8 30.09.20X9
£ £ £
Proposal A 80,000 180,000 300,000
Proposal B 100,000 260,000 504,000
Variation in profit
With the equity settled proposal the charge for each yearly tranche is constant over its life, as the fair
value is determined at the grant date and then apportioned evenly over the life of the scheme.
The total charge to profit or loss does however increase over the period with the equity settled
proposal for two reasons:
• The share price is projected to increase so the annual cost of later schemes is greater than earlier
schemes.
• There is a cumulative effect as in 20X7 there is only one scheme in operation, in 20X8 there are
two schemes and in 20X9 there are three schemes. In 20Y0 and beyond the cost will not however
continue to increase due to this cumulative effect, as there will only ever be three schemes in
operation in steady state.

The annual expense under the cash settled proposal will also increase due to the above effects but,
in addition, there is an annual increase for each individual scheme as the liability is recalculated each
year. Thus, as share prices rise, the charge will increase for this proposal and will include the
cumulative shortfall from previous years in respect of the increase. As a consequence, with rising
share prices the cash settled proposal will result in a higher charge to profit or loss than an
equivalent equity settled scheme.
In both cases there will, in reality, be volatility in the charge to profit or loss due to the actual number
of managers who leave and join in each year. This factor is not evident above due to the simplifying
assumption that 10 managers leave and join in each year. In addition the actual share prices at the
time of granting the cash settled items could vary significantly and this would be a further cause of
volatility.
25 Tawkcom
Marking guide Marks
Explanation of financial reporting and auditing issues arising from Jo’s work 16
Identification of additional steps required to complete audit procedures and to
support opinion on financial statements 9
Summarise where group audit team may provide useful information 5
Description of Key Audit Matters 5
Marks Available 35
Maximum 30
Total 30
Explanation of financial reporting and auditing issues

Prior year adjustment for repairs and maintenance costs
• Need to understand whether prior period audit adjustment of £1.3 million has been recognised
through pack in current year. If not then will give rise to an adjustment which, whilst not material,
is above the scope and should be reported to group.
• Also need to consider whether there are similar items which have been wrongly capitalised in the
current year. Procedures performed on additions to network assets are probably insufficient to
identify such items at present.
Sample sizes
• Unclear from work sent for review whether sample sizes for detailed testing have been calculated
correctly. Documentation on additions states that Jo has used group materiality rather than
performance materiality for PPE. Hence need to consider carefully whether adequate samples
tested for all areas.
Head office lease
• Now that IFRS 16, Leases is in force, the lease of the head office building will definitely need to be
recognised in the statement of financial position. More information will be required regarding the
lease in order to calculate the present value of the future lease payments at inception, which will
form the value of the right-of-use asset, together with accumulated depreciation, and the value of
the lease liability, both of which should have been recognised in the statement of financial
position.
• Given that lease of head office expires in 20Z5, should be depreciating leasehold improvements
over remaining 16/17 years. The depreciation charge for the year seems low and work on
depreciation and figures suggests that a life of 20 years is still being used even for additions in
the year. Unlikely to be material for group but is a clear error and could well be above reporting
scope, depending on timing of additions. Hence this needs to be evaluated and posted to the
schedule of adjustments. In addition, need to make sure that improvements are being
depreciated over no longer than their actual useful life, which may be shorter than lease term.

• Given major refurbishment of building, would expect much more significant disposals of
improvements capitalised in previous years (or perhaps significant expensing of expenditure if it
is not a true improvement).
Network asset additions
Appears from comments on additions that certain of the network assets are specific to particular
customers. If this is the case need to consider carefully the terms under which customers use them
and whether they are in substance leased to customer and, if so, how that lease should be accounted
for. Even if correct to continue to include the assets in PPE, the depreciation periods should not
exceed the expected life of the relationship with the particular customer which may well be less than
the 22-year depreciation period. Cannot at present evaluate the extent of this potential issue but
could be material given the size of the network assets.
Appears that rates used to capitalise labour and overhead may be inconsistent with prior year,
include an element of profit (as they are based on day rates for external customers) and were
increased at the request of group management. Effect is material and will affect both PPE and
Disposal of computer and office equipment
• Disposals of fixtures and equipment include a disposal of office equipment to a company owned
by friends of the FD. Whilst not a RPT for FR purposes, this transaction is large and clearly raises
questions of propriety, especially as the equipment was relatively new (since low accumulated
depreciation) and no proceeds were received. Need also to check on whether authority limits for
disposals followed.
Sale and leaseback
• Sale and leaseback transaction has been accounted for as a disposal of Glasgow House and a
profit of £1.295 million recognised. This is incorrect. Under IFRS 16, Leases only the gain on the
rights transferred may be recognised. In addition, need to determine whether this transaction
meets the criteria for a sale under IFRS 15. Further details are required. If not, continue to
recognise the transferred asset and also a financial liability equal to the transfer proceeds,
accounting for it using IFRS 9, Financial Instruments.
• Transaction was also concluded very close to year end which may be indicative of window
dressing. Transaction increases cash (ie, reduces net borrowings) and decreases PPE so may have
had an effect on critical ratio for covenants.
Sale of land
• It appears that the sale of land has been treated as an adjusting event after the reporting period.
Sale and profit have been recognised despite the fact that the sale was not completed at 30
September 20X9. This treatment is not correct in accordance with IAS 10, Events After the
Reporting Period as the sale in October does not provide evidence of circumstances which
existed at the reporting date as the contract was still conditional at that time. The profit on
disposal should therefore be reversed and the cost of land added back to PPE. If considered
material to the users the transaction could be disclosed as a non-adjusting event after the
reporting period.
• Consideration should be given as to whether the land meets the criteria to be classed as ‘held for
sale’ in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations. If
this were the case the asset would be measured at the lower of its carrying amount and its fair
value less costs to sell at 30 September 20X9. In this case the valuation would be at carrying
amount.
Valuation of freehold property
Last valuation of freehold properties was at 30 September 20X7. Given recent movements in
property market, that may be out of date. The client appears to have provided no documentation to
support keeping the valuation unchanged. Even if they can support the valuation remaining
unchanged, a depreciation charge should be made to profit or loss and a revaluation recognised
separately. The way they have accounted for it at present overstates profit which may affect bonus.
Revaluation entries should also result in reversal of accumulated depreciation. Amount is not material
to group but is above level which should be reported and is a clear error.
Investment property
• Investment property has been shown within PPE which is incorrect as it should be shown in a
separate asset category (as should related revaluation reserve). In addition, need to determine

group policy for investment properties and whether using cost or fair value model. Neither
applied at present as property is held at an out of date valuation. Given that sale fell through and
company has decided to postpone sale, seems likely that current market value has fallen and
reduction in value may be necessary.
• Also question as to whether the property is really an investment property at all as Tawkcom is
offering services as well as accommodation to the lessees. This would preclude classification as an
investment property unless such services are insignificant to the arrangement as a whole which
seems unlikely in the case of serviced offices. If classification is incorrect then depreciation should
be charged. However depreciation amount unlikely to be above scope for reporting to group.
Classification question and impairment question potentially more significant.
Useful life increase
• Increase in useful life by two years does not explain fully the very low depreciation charge for
network assets. A charge of around £7–8 million would have been expected based on a rough
calculation. It appears that an error has been made, perhaps by adjusting prior years’
depreciation through the current year charge. This is incorrect as any change in useful life should
be accounted for prospectively and the carrying value at the time of the change simply
depreciated over the remaining revised useful life. Initial indicators are that effect is material and
an adjustment will be required even if longer life can be justified.
• Will need input from head office team to determine whether longer useful life is reasonable for
core network assets. In addition, may well need input from auditor’s expert/specialist audit team
to consider evidence for the longer useful life and whether it is representative of reality.
Additional steps required to complete audit procedures
Group scope not entity level procedures performed
• Indication from additions testing in particular that procedures to date have been completed to
group scope only – procedures will need to be updated to take into account materiality for
individual statutory entity.
Procedures on impairment
• At present there is no consideration as to whether there are indications of impairment. Carrying
value of network assets in particular continues to grow and is very material to both group and
company figures. There will need to be consideration of whether impairment indicators exist
before we sign off to group. (Important to consider each asset separately for impairment). Likely
to be the case given the general economic climate. If indicators do exist then the recoverable
amount of the assets will need to be considered and evidence of external value or cash flow
projections obtained as necessary. As network supports all of company’s business, overall cash
flow projections obtained for going concern purposes will also be relevant here. However, this
work may not yet have been completed as typically left until the statutory accounts for the
subsidiary are signed off. Given that Tawkcom is a significant trading subsidiary of the group,
procedures performed on going concern at group level may be relevant.
Procedures on brought forward position
• No procedures appear to have been performed to verify the existence/ownership of brought
forward PPE balances and so test the completeness of disposals. Need to determine what work
the company/internal audit have done on this and to consider the extent to which such work can
be relied on as audit evidence. Will also need to do own testing. This is an important step given
the materiality of the balances involved.
Physical verification
• Physical verification of property should be possible, as should agreement to deeds or land
registry.
• Physical verification of fixtures and equipment should be possible although might be possible to
leave this for statutory work as balance (excluding additions in year which have been tested) is not
material for group purposes.
• Physical existence vouching should be possible for leasehold improvements although potential
issue has already been raised above. Therefore important that procedures done in this area reflect
the high risk of unrecorded disposals and consider specifically whether any previous
improvements have been disposed of or rendered redundant as a result of the work done in the
last two years.

• Physical existence procedures for network assets much more challenging as already highlighted
by procedures on additions. Need to look for evidence that network is still being used – perhaps
by review of sales/operational data; discuss with personnel outside of accounts whether there are
stretches of cabling which are redundant/little used or superseded by alternative routing;
consider whether additional cabling laid in year has rendered any existing cabling redundant.
May well need to involve a specialist. This review should consider additions in the year as well as
brought forward assets as work on additions has not been completed. Additional review of
customer specific assets also relevant – see below.
Capital/revenue?
• Need to look much more critically at nature of additions to network assets and consider carefully
whether there is evidence that any of the capitalised projects represent expense items such as
repairs and maintenance. This can be done through discussion of the nature of the projects with
the project managers or other personnel outside accounts. Also need to review procedures
performed on repairs and maintenance expense in the consolidated statement of profit or loss to
ensure that there is no evidence that this is lower than would be expected and therefore
potentially incomplete.
• Need to evaluate extent to which network assets relate to particular customers and compare
depreciation period to the life of the relevant customer relationship.
• Need to understand in much more detail the costs and any mark up included within the day rates
used to capitalise labour and overhead incurred on the creation of network assets. Important that
only the direct cost of bringing assets to working condition should be capitalised and this should
not include an allocation of administrative cost or a profit element. Costs should be vouched and
the hours/days incurred tied in to time reports (nature of projects already covered in proposed
work above). Material elements of additions should be vouched in the normal way – not clear that
this has been done.
Disposal to AR Hughes
• Need to understand rationale for disposal of assets to AR Hughes – ie, were assets surplus to
requirements? Why was their useful life so much shorter than that assumed in setting the
depreciation rate? Were other potential buyers considered? What was market value of similar
assets at time of sale?
Glasgow property
• Need to inspect the terms of the sale agreement with LJ Finance and also the lease agreement
before determining what the correct accounting treatment should be for both the disposal and
any subsequent lease. Confirmation of amounts involved via cashbook will then provide a starting
point for how to correctly record these events, including writing out the original transactions.
Sale of land
• Confirm details of the sale agreement to determine whether classification as held for sale is
appropriate.
Areas where group audit team may provide useful evidence
• Understanding extent to which procedures performed on going concern or impairment of
investments at group level may assist Tawkcom team in assessing impairment of PPE.
• Enquire as to procedures done on day rates for capitalisation of employees’ time as this has been
driven by a head office project. Would be useful to understand fully group policy and the
procedures performed at head office to validate the way in which rates are calculated.
• Discuss with group FD the disposal of assets to AR Hughes and his rationale for approving this.
• Obtain further information re Glasgow House transaction and consider fully the impact of this
transaction on compliance with the bank covenant.
• Understanding of group policy for investment properties.
• Background to and support for the group decision to increase the useful life for network assets.
Key audit matters
Key audit matters are defined as “those matters that, in the auditor’s professional judgement, were of
most significance in the audit of the financial statements of the current period. Key audit matters are
selected from matters communicated with those charged with governance” (ISA (UK) 701.8).

When determining key audit matters the auditor needs to take the following into account:
• Areas of higher assessed risk of material misstatement
• Significant auditor judgements relating to areas in the financial statements that involved
significant management judgement
• The effect on the audit of significant events or transactions that occurred during the period (ISA
(UK) 701.9)
These should be communicated in a separate section of the auditor’s report under the heading Key
Audit Matters. They should not be used as a substitute for expressing a modified opinion.
However, the scope of the standard needs to be taken into account. ISA (UK) 701 applies to audits of
complete sets of general purpose financial statements of listed entities. It can be applied in other
circumstances where the auditor decides that it is necessary. In the UK the ISA (UK) also applies to
the audits of other public interest entities and entities that are required, and those that choose
voluntarily, to report on how they have applied the UK Corporate Governance Code (ISA (UK) 701.5).
Tawkcom is not a listed entity and assuming that it does not meet the other criteria stated above a
Key Audit Matters section would not be required in the auditor’s report. As the parent company,
Colltawk plc is a listed entity, the parent company auditors would need to apply ISA (UK) 701. The
description of each key audit matter would need to address:
• why the matter was considered to be one of most significance in the audit; and
• how the matter was addressed in the audit together with a reference to any related disclosures.
In the UK in describing each of the key audit matters Colltawk’s auditor’s report would also need to
include:
• a description of the most significant assessed risks of material misstatement;
• a summary of the auditor’s response to those risks; and
• where relevant, key observations arising in respect to those risks (ISA (UK) 701.13-1).
26 Expando Ltd
Marking guide Marks
Explain FR treatment and audit procedures for the outstanding issues

Revaluation 5
Debenture loan 5
Acquisition of Minnisculio 4
Disposal of premises 5
Acquisition of Titch 3
Comment on procedures performed by the auditors of Titch 3
Provision of temporary staff 4
Complete the draft statement of profit or loss and other comprehensive income,
statement of changes in equity and statement of financial position 7
Marks Available 36
Maximum 30
Total 30
Revaluation of land
Accounting treatment
The basic treatment of the land adopted in the draft financial statements is correct. In accordance
with IAS 16, Property, Plant and Equipment there is no requirement to depreciate land. In addition,
the revaluation has been correctly recognised in the revaluation surplus and as other comprehensive
income. This gain is recognised but not realised therefore it will not be distributable.

Audit procedures
Verify valuation to valuation certificate.
Consider reasonableness of the valuation by reviewing the following:
• Competence, capabilities and objectivity of valuer
• The scope of their work and obtaining an understanding of it
• Methods and assumptions used
• Valuation basis is in line with IAS 16, as amended by IFRS 13, Fair Value Measurement (market-
based evidence of fair value)
Confirm that all assets within the same class as the land have been revalued (in accordance with IAS
16 if an asset is revalued the entire class to which it belongs must be revalued).
Confirm that disclosures are adequate in accordance with IAS 16 and IFRS 13. These should include
the following:
• Effective date of revaluation
• Whether an independent valuer was involved
• The methods and significant assumptions applied in estimating fair value
• The extent to which fair values were determined by reference to market transactions or other
valuation techniques
• The carrying amount that would have been recognised had the land not been revalued
• The change for the period in the revaluation surplus and the restrictions on the distribution of the
balance to shareholders
Debenture loan
In accordance with IFRS 9, Financial Instruments, a debenture should initially be measured in the
financial statements at the fair value of the consideration received net of issue costs. (The exception
to this is where the financial instrument is designated as at fair value through profit or loss.) The initial
treatment in Expando’s financial statements in this respect appears to be correct as the liability shows
an amount of £1,850,000 (£2,000,000 – £150,000).
However, the subsequent treatment of the debenture does not appear to be correct. Interest
recognised in profit or loss of £60,000 has been based on the coupon rate of 3% (£2,000,000 × 3%).
(The interest recognised in profit or loss is made up of this charge of £60,000 and the interest on the
6% bank loan of £200,000 (£3,333,333 × 6%)). The debenture should be measured at amortised cost
using the effective interest method. This means that the amount recognised in profit or loss should
have been based on the effective interest on the debenture of 7% amounting to £129,500 (7% ×
£1,850,000). The difference between the actual interest paid (£60,000) and the finance cost
(£129,500) represents a proportion of the premium at which the debenture will be redeemed. It is
therefore rolled up into the liability in the statement of financial position.
Audit procedures
• Confirm the details of the debenture to the debenture documentation ie, issue date, coupon rate,
premium.
• Confirm the receipt of cash to the cash book/bank statement.
• Evaluate the nature of the costs and confirm that they are directly attributable to the issue of the
debenture.
• Recalculate the effective interest rate ie, it should be the rate that exactly discounts estimated
future cash payments or receipts through the expected life of the debenture to the net carrying
amount of the financial liability.
• Confirm the change in the accounting treatment of the interest charge and the liability in the
statement of financial position with the client.
• Confirm the financial liability is adequately presented and disclosed in accordance with IAS 32,
Financial Instruments: Presentation and IFRS 7, Financial Instruments: Disclosures eg, qualitative
and quantitative disclosures about exposure to risk, carrying amount of the liability by IFRS 9
category, interest recognised in profit or loss.

Acquisition of Minnisculio
The purchase of the trade and assets of Minnisculio is currently represented as an investment at cost
of £250,000. This should be shown in the statement of financial position as inventories of £20,000
and an intangible asset of goodwill £230,000 as it is these assets which have been purchased as a
result of the business combination. In accordance with IFRS 3, Business Combinations the goodwill
should not be amortised, but should be subject to an impairment review. Whilst the basic provision
of IAS 36, Impairment of Assets is that an impairment review only needs to be conducted where there
is an indication that an asset may be impaired, goodwill acquired in a business combination is an
exception to this rule. In this instance IAS 36 requires an annual test for impairment irrespective of
whether there is any indication of impairment therefore the management of Expando must address
this. Provided that we are satisfied with the impairment review subsequently performed no further
adjustment will be required.
Audit procedures
• Confirm the purchase price of Minnisculio to the purchase documentation.
• Establish the basis on which the value of £20,000 has been attributed to the inventories (and
therefore the £230,000 to goodwill).
• Confirm that goodwill does not include any non-purchased goodwill or any identifiable intangible
assets.
• Discuss with the directors the need to perform an impairment review.
• Assuming this is carried out determine the means by which the goodwill impairment review has
been conducted eg, in accordance with IAS 36 has goodwill been allocated to the cash-
generating units expected to benefit from the synergies of the combination?
Disposal of premises
The premises would appear to be an asset held for sale in accordance with IFRS 5, Non-current
Assets Held for Sale and Discontinued Operations as its carrying amount is to be recovered
principally through a sale transaction rather than through continuing use. For this to be the case the
asset must be available for immediate sale in its present condition and the sale must be highly
probable. For the sale to be highly probable the following conditions must be met:
• Management must be committed to the plan.
• An active programme to locate a buyer and complete the plan must have been initiated.
• The asset must be actively marketed for sale at a price that is reasonable in relation to its current
fair value.
• Management should expect the sale to be completed within one year from the date of
classification.
• It should be unlikely that significant changes will be made to the plan or that the plan will be
withdrawn.
Assuming that these conditions are satisfied the asset should be classified as held for sale and
disclosed separately, in the statement of financial position. It should be measured at the lower of its
carrying amount and fair value less costs to sell. An impairment loss allowance should be recognised
where fair value less costs to sell is lower than the carrying amount. Until the date of reclassification
the asset should be depreciated as normal. An additional charge of £3,125 (£125,000/20 × 6/12) is
therefore required. The asset would no longer be depreciated from the date of reclassification even
if the asset remained in use.
Assuming that the asset does meet the criteria to be classified as held for sale the following
adjustment would be required:
£
Carrying amount at date of reclassification (125,000 – 125,000/20 × 6/12) 121,875
Fair value less costs to sell 115,000
Impairment loss allowance 6,875

Audit procedures
Confirm that the asset is held for sale by ensuring that the IFRS 5 conditions above are satisfied:
• Discuss with management their plans for the sale and marketing of the asset.
• Obtain evidence of management commitment eg, proposed sale should be minuted.
• Obtain evidence of an active programme for sale eg, property agents being appointed.
• Assess the market to determine the likelihood of the sale being completed within the one year
time frame.
• Recalculate current book value of the asset.
• Assess the means by which the fair value of the asset has been established and determine
whether this is reasonable.
• Obtain information about costs to sell to assess whether they relate directly to the disposal of the
asset.
• Confirm that separate disclosure of the asset has been made in accordance with IFRS 5.
Acquisition of 25% of Titch
Assuming that the 25% owned by Expando allows it to exert significant influence Titch will be treated
as an associate. As such the investment will be equity accounted as follows:
In the statement of profit or loss and other comprehensive income the group’s share of profit/loss
after tax is added to consolidated profit. This is normally achieved by adding the group share of the
associate’s profit/loss before tax and the group’s share of tax. In this case the tax has already been
dealt with. Therefore the adjustment required is as follows:
Share of loss of associate (350,000 × 9/12 × 25%) = £65,625
The group’s share of any other comprehensive income would also be included if relevant.
In the statement of financial position the group share of net assets is shown as a single item. This is
represented by the initial cost of the investment increased or decreased each year by the amount of
the group’s share of the associated company’s profit or loss for the year less any impairments in the
investment to date. In this case, the ‘Investment in associates’ will be £334,000 (£400,000 – £66,000)
to the nearest thousand.
Audit procedures
The audit of the financial statements of Titch is the responsibility of the auditors of Titch. We do not
have any direct responsibility for this. However, we are responsible for the audit opinion of Expando
even though the results will include information not directly audited by us. The amount of work we
will need to do depends on the extent to which we can rely on the component auditors and whether
Titch represents a significant component. At the planning stage we will have assessed the
competence and independence of the component auditors and will have requested a summary of
the audit procedures conducted. Therefore the following additional work needs to be performed:
• Review the summary of the audit procedures and assess whether the work is comprehensive
enough for our purposes.
• Identify any areas requiring special consideration and/or additional procedures.
• Consider the impact of any significant findings made by the component auditors.
If the component is not significant, analytical procedures at the group level may be sufficient for the
purposes of the group audit.
Once we have sufficient confidence in the individual financial statements of the associated company
audit work will be concentrated on the mechanics of the equity accounting as follows:
• Confirm the date of acquisition and that the shareholding is 25%.
• Inspect the shareholder agreement to verify that the relationship with Titch is that of ‘significant
influence’ – it could also be an interest in a joint arrangement, in which case we would see
evidence of ‘joint control’ as defined in IFRS 11, Joint Arrangements.
• Confirm the purchase cost of the investment to the purchase documentation.
• Recalculate the group’s share of the loss of the associate ensuring that only post acquisition losses
have been consolidated.

• Recalculate the statement of financial position balance to confirm that the cost has been reduced
by the appropriate share of losses.
• Confirm that any intra-group transactions have been identified and dealt with appropriately.
Provision of temporary staff
Despite the fact that Expando is a private company, the FRC Revised Ethical Standard does not allow
the provision of ‘loan staff’ (s. 2.36). However, the Standard (s. 5.120 & s. 5.124) does allow the
provision of accounting services by the audit firm, but only on the basis that the services:
• do not involve us undertaking part of the role of management;
• do not involve us initiating transactions;
• require little or no professional judgement; and
• are only of a routine or mechanical nature.
The duration of the role, the specific nature of the role and the accounting work to be performed by
the individual would therefore have to be assessed. The accounting records and financial statements
remain the responsibility of Expando’s management and any initiation work (such as originating
valuation decisions or taking sole responsibility for accounting entries such as journals) would not be
allowed (s. 5.125).
In addition, steps would have to be taken to reduce the potential self-review threat to an acceptable
level, such as the use of staff with no involvement in the Expando audit and review of both the work
and the accounting services engagement by a partner also not involved in the Expando audit (s.
5.127).
There are also practical issues to consider including whether we have sufficient staff available who
can be seconded and whether they have the relevant experience and expertise. There is a potential
for our reputation to be damaged if an unsuitable individual is sent.
Revised draft financial statements
Statement of profit or loss and other comprehensive income
Year ended 30.06.20X7 (draft) 30.06.20X6 (audited)

£’000 £’000
Revenue 4,430 3,660
Less operating expenses (3,620 + 3) (3,623) (2,990)
Operating profit 807 670
Finance cost (260 + 70) (330) (200)
Impairment loss on reclassification of non-
current asset as held for sale (7) –
Share of loss of associate (66) –––––
Taxation (91) (141)
Gain on property revaluation 1,000 –––––
Total comprehensive income for the year 1,313 329
Statement of changes in equity 30 June 20X7 (extract)
Retained earnings Revaluation surplus

£’000 £’000
Balance at 1 July 20X6 713 –

Retained earnings Revaluation surplus
£’000 £’000
Total comprehensive income for the year 313 1,000
Balance at 30 June 20X7 1,026 1,000
Period end date 30.06.20X7 (draft) 30.06.20X6 (audited)

£’000 £’000
Non-current assets
Land 5,000 4,000
Plant and machinery 2 2
Intangible assets: goodwill 230 –
Investment in Titch (400 – 66) 334 –
Current assets (2,155 + 20) 2,175 520
Asset held for sale 115 –
Current liabilities
Taxation (91) (141)
Other (300) (149)
6% bank loan (3,333) (3,333)
3% debenture (1,850 – 60 + 130) (1,920) ––––––
2,212 899
Share capital 86 86
Share premium 100 100
Revaluation surplus 1,000 –
Retained earnings 1,026 713
2,212 899
27 NetusUK Ltd
Marking guide Marks
FR advice 5
Summary of proposed audit work 12
Other comments – ethical issues 4
Explanation of data analytics and use in risk assessment 10
Marks Available 31
Maximum 30
Total 30

FR Advice
Pension should be accounted for in accordance with IAS 19, Employee Benefits. This means that the
net surplus/deficit on the pension plan will be recognised in the financial statements.
Harry needs to obtain details of the scheme assets and liabilities from the actuary and to record
entries in the financial statements:
• Record the opening balance on the scheme as shown in the prior year statutory accounts (gross
of deferred tax).
• Using details provided by the actuary, analyse the movement in assets and liabilities in the year
into the following and make the entries indicated below:
– Current service cost (as calculated by actuary). Will need to split between departments and
allocate between various statement of profit or loss and other comprehensive income captions.
Charge to operating profit.
– Interest on obligation (as calculated by the actuary). Forms part of finance cost in financial
statements.
– Interest on plan assets (as calculated by the actuary). Forms part of finance cost/income in
statement of profit or loss and other comprehensive income. It is netted off against the interest
on obligation to show ‘net interest on net defined benefit asset/liability’.
– Contributions paid – this will be the contributions paid in the year by employer and employee.
Employee contributions reduce current service cost (unless already netted off). Employer
contributions are what have already been charged to profit or loss. That entry needs to be
reversed so that profit or loss charge is only as specified above and amounts paid form part of
movement on deficit within statement of financial position.
– Remeasurement gains and losses (actuarial gains and losses) should be recognised
immediately in other comprehensive income.
• Closing deficit should then agree to amount advised by the actuary.
Schedule of audit procedures
Substantive analytical procedures are likely to be the most efficient and effective way to audit the
main payroll balances as headcount figures and details of pay increases are available. Such
procedures can also be used for commission as that would be expected to move in line with
revenue. Procedures for the first nine months should be as follows:
• Expectations for annual figures should be calculated and compared to actual. Any significant
variations should be investigated. Pension contributions can also be audited this way as the
relationship to main payroll cost is known.
• Sample of temporary staff costs should be agreed to invoices, timesheets and contracts for rates
of pay. Position re tax status of temporary staff should be considered, to address risk of
underpayment of income tax and NI via PAYE. Creditor balance should be discussed and basis for
calculation reviewed as creditor for temporary staff looks very low.
• Sample of employee expenses should be vouched to receipts/other documentation. Analytical
procedures should be performed for completeness of expense claims.
• Procedures should be performed to ensure that it is possible to audit year end pension figures on
a timely basis. We will need to ensure client understands entries to make and has made
arrangements with actuary/investment managers to get information in time (this may be
challenging given deadline). Discussions should have been held with the actuary at interim and
assumptions to be used in valuation of liabilities should have been reviewed at this stage and
discussed with management’s experts as appropriate. Circularisation letters can be sent to
investment managers and actuaries, backed up by discussions on how quickly information can be
provided. We must ensure Harry understands the entries he must make and where the
information can be sourced from. Entries to record correct opening position in the statement of
financial position should be determined.
• Obtain summary of pension balances to be included in the accounts from the actuary. Ensure
assumptions used to calculate actuarial liabilities are in line with those discussed at interim and
there are no market conditions which would make amended assumptions re discount rates etc
more appropriate. Ensure contributions shown by actuary agree to those in the accounting
records and tie in investment values to investment manager returns. Consider procedures

required on any other assets and liabilities within scheme and ensure that balances owed by
company to scheme are correctly eliminated when scheme deficit is included in the accounts.
• Liaise with auditors of parent company with respect to opening balances relating to pensions.
• Basis for bonus provision should be discussed, rules of bonus scheme reviewed and expectation
established for year-end accrual.
• Discuss with client why there is no holiday pay provision as would be expected. If provision is
recognised as a result of our query obtain support for the calculation and compare with
expectations.
• Perform work to check all payroll disclosures including those for pension scheme and directors’
remuneration.
Note: Credit should also be awarded for answers that discuss the impact of ISA (UK) 540 (Revised),
estimation uncertainty, as well as the controls in place at this client leading to a separate assessment
of audit risk and management bias, and the need for an auditor’s point estimate.
Other comments
• Level of temporary staff used in admin area may indicate issues with staffing and controls over the
course of the year – needs further investigation.
• Management’s attitude to controls is concerning – the tone at the top is a crucial element of entity
level control and it is difficult to rely on controls if this is not appropriate. Deficiencies in controls
have been an ongoing problem, and whilst management seem to be addressing the issue we
would want to see positive steps being taken in this respect as there is a poor track record of
dealing with our concerns.
• Full compliance with IFRS is required this year whereas some items were handled centrally last
year – may be other areas where this applies – need to consider more generally.
• Help in calculating entries for pensions – need to ensure that the threat of self-review – ie, auditor
auditing their own work is safeguarded. May do this by using people from outside the audit team
to assist, suggesting that parent company staff rather than audit firm provide assistance, ensuring
that CFO and his team take full managerial responsibility for all assumptions made, including in
particular judgemental assumptions for actuarial calculations and volatility assumptions etc in
share option valuation models. It is very important that these are not suggested by the audit firm.
• CFO’s general lack of expertise is concerning for such a large subsidiary. We need to be alert for
other more complex areas where he may not have the necessary financial accounting knowledge.
Data analytics
Data analytics involves the manipulation of complete sets of data eg, 100% of the transactions in a
population, thereby enabling conclusions to be drawn on the basis of the results. Results are usually
presented in a format which is easy to understand. The analysis is often presented visually eg, in the
form of graphs or pie charts. This allows data to be analysed to a greater degree of detail such that
the auditor can drill down into further detail at a granular level for specifically targeted areas.
Journals dashboard: use in risk assessment
• Journals exceed materiality threshold in total therefore would require investigation.
• Manual journals compared to automated journals seem high both in volume terms but
particularly in value terms.
• Manual journals in relative terms are greater than automated journals (£16,500 on average
compared to £3,670 for automated journals, see Working).
• These should be compared to data for the previous year to determine whether this is an anomaly
or whether this is the norm for this business.
• We need to further investigate how the system operates to determine the basis on which journals
are automated as opposed to those which are manually entered.
• The high level of manual journals could indicate that the system is not being operated effectively
ie, journals are being manually input which the system is capable of generating.
• Alternatively it could be an indication of fraud ie, the controls are being overridden to create
fictitious journals.

A number of issues can be identified from the analysis of the users as follows:
• Two individuals posting journals are from the sales department. Further investigation regarding
what these relate to would be required.
• 23 journals have been posted by Wong but the value in total is only £50,000. On average these
journals are for relatively small amounts but this could indicate a deliberate policy for individual
journals to fall below the point at which journals must be authorised. This is particularly relevant as
this user may be an ‘unexpected’ user.
• Similarly although only one journal has been posted by Lyndon this seems unusual and may
indicate that controls are being over-ridden. This is of particular concern in the light of our
previous issues with control deficiencies and the management’s attitude towards controls.
• Journals posted by Dalton are comparatively high, being £53,000 on average. This is significantly
more than other users including the FD, Thomas. We should clarify the nature of these and in
particular whether they have been authorised in accordance with company policy.
• It is notable that journals posted by Dalton exceed those posted by Thomas. It is possible that as
the financial controller he has been authorised by the FD to process significant journals on his
behalf. We need to obtain information regarding the authorisation process and authorisation
limits.
Further analysis
The following further analysis could be performed by the data analytics tool:
• Analysis of accounts to which journals have been posted both in terms of volume and value.
• Monthly analysis of volume/value of journals to identify trends (eg, year end journals) and in
particular unexpected peak months.
• Analysis of unexpected journals ie, highlighting unusual double entries. If significant these could
then be investigated further.
WORKING
Average value of manual journal = (75% × £3,874,000) ÷ (40% × 440) = £16,500 (rounded)
Average value of automated journal = (25% × £3,874,000) ÷ (60% × 440) = £3,670 (rounded)
28 Verloc Group
Marking guide Marks
Identify financial reporting issues, explain the correct accounting treatment and
describe audit response 14
Identify audit issues and describe the actions required 8
Draft revised consolidated statement of profit or loss and OCI 14
Marks Available 36
Maximum 30
Total 30

Based on the draft consolidated statement of profit or loss and OCI and the information provided
thus far, financial reporting issues can be identified as follows.
Part disposal of Stevie
Verloc Group has disposed of 40,000 shares in Stevie nine months into the year, which reduces its
shareholding from 75% to 35%. Assuming that the Group retains no special voting rights, its control
of Stevie has been lost. Stevie should therefore be accounted for as an associate instead of a
subsidiary for the last three months of the year.
The draft consolidated statement of profit or loss and OCI continues to treat Stevie as a subsidiary,
consolidating the full amount of Stevie’s revenue and expenses throughout the year. As a result, the

profit after tax generated by the group is currently overstated by £171,000 (£684k × 3 months/12
months), as well as a corresponding (as yet unquantified) overstatement in the consolidated
statement of financial position. This amount is both material in terms of its size, and also in terms of
its impact on the users’ understanding of the financial statements. We should therefore raise this
issue at our meeting with the Finance Director, and ask that the consolidated financial statements be
adjusted.
The revised consolidated statement of profit or loss, reflecting Stevie’s status as a subsidiary for the
first nine months of the year and as an associate for the last three months, is attached.
Other issues to consider during the audit:
• Confirm with the Finance Director the reason why Stevie has continued to be accounted for as a
subsidiary at the end of the year.
• If Stevie’s accounting treatment is due to an error, consider the technical competence of the
financial controller and assess whether this has any implications for the rest of the audit. Audit risk
may be deemed to be higher than previously assessed, and materiality may then need to be
adjusted accordingly.
• Inspect the contract for the disposal of the shares, to agree the proceeds from the disposal and
for any evidence that Verloc Group may have maintained a controlling interest in some form.
• Discuss with management and review supporting evidence for the determination of the value of
Verloc’s remaining shareholding. As Stevie is not listed, it would be important to understand how
the fair value has been determined and evaluate the appropriateness of the method used. This
will also affect the valuation of non-controlling interests at the time of the disposal.
Investment property
Issues to consider in relation to the property:
• The property is classified as investment property, and has been owned by Winnie for 10 years. To
understand whether the property has been correctly classified in accordance with IAS 40, we will
need to find out what the property is, and its current and future intended use.
• We will need to review evidence of the property’s uplift in value, by inspecting due diligence
reports or purchase documentation.
• The appropriateness of the assumption of 50 years useful life must also be considered – by
inspecting due diligence reports and asking group management to explain future plans relating
to the property.
Gains on investments in equity instruments
Under IFRS 9, Financial Instruments, all equity investments in the scope of IFRS 9 are measured at fair
value in the statement of financial position. Generally gains or losses arising on the subsequent
measurement of investments in equity instruments are recognised in profit or loss.
If an equity investment is not held for trading, an entity can make an irrevocable election at initial
recognition to measure it at fair value through other comprehensive income with only dividend
income recognised in profit or loss. The amounts recognised in other comprehensive income are not
re-classified to profit or loss on disposal of the investment although they may be reclassified in
equity.
However, the gains in question are on equity investments already held, and there is no evidence that
an irrevocable election to measure them at fair value through other comprehensive income has been
made. Therefore the default recognition rule applies.
The £46,000 gain on the investments in equity instruments should therefore be recorded in profit or
loss in the consolidated statement of profit or loss and other comprehensive income. As this has not
been done, the total consolidated profit or loss and therefore total comprehensive income for the
year is understated by £46,000. This is not material in itself, but needs to be added to the summary of
uncorrected misstatements which, in aggregate, may amount to a material difference. We should
therefore still request that an adjustment is made.
A separate issue is that some of the equity investments are unquoted equity. Under IFRS 9, unquoted
equity investments must also be measured at fair value. (This is a change from IFRS 9’s predecessor,
IAS 39, which allowed them to be measured at cost.) IFRS 13, Fair Value Measurement should be
applied, for example the market approach, using prices and other relevant information that have
been generated by market transactions that involve identical or comparable assets (IFRS 13 para.
B5).

Other issues to consider:
• Determine what other financial assets and liabilities are held by Verloc, and by the group, and
evaluate their current accounting treatment. The fact that the financial controller is unsure how to
account for the subsequent gain arising on the investments in equity instruments indicates a
higher risk of material misstatement in this area.
• Inspect the purchase contracts for the investments in equity instruments as well as other financial
assets, and discuss with management in order to understand the nature of the investment held.
Evaluate whether the financial assets have been classified correctly.
• For investments traded on an active market, obtain the quoted prices at the year end to verify
their fair value.
• For any investments not traded on an active market, assess the need for impairment by reviewing
the present value of the estimated future cash flows and comparing this to the investments’
carrying amount.
Loan from Inver Bank
Under IFRS 9, Financial Instruments, an entity should derecognise a financial liability when it is
extinguished ie, when the obligation specified in the contract is discharged or cancelled or expires.
An entity discharges its obligation by paying in cash, other financial assets or by delivering other
goods or services to the counterparty.
When a liability is extinguished, the difference between its carrying amount and the consideration
paid including any non-cash assets transferred and any new liabilities assumed is recognised in profit
or loss.
As a result of the transfer, Verloc should extinguish the liability but it should also recognise a gain of
£30,000 in profit or loss, arising from the difference between the carrying amount of the liability
(£800,000) and the value of the retail outlet (£770,000) that was transferred to the bank.
Other issues to consider:
• Confirm the existence of the arrangement with Inver Bank and the agreement to settle the debt
by transfer of the retail outlet to relevant documentation (such as legal correspondence, board
minutes, signed contracts etc).
• Review the draft financial statements to confirm the correct accounting treatment once completed
by the financial controller (as described above) within loans, non-current assets and profit or loss,
including any suitable disclosures.
• Recalculate the gain in profit or loss to ensure it matches the amounts specified in the
documentation from Inver Bank.
• Obtain representations from management and the company’s legal team that there are no
subsequent liabilities regarding the retail outlet (such as rent, rates, employment commitments
etc).
Audit issues
Time pressure
An unrealistically tight timescale increases detection risk. Procedures are likely to be rushed, resulting
in a lack of professional scepticism and misstatements going undetected.
Good audit planning, informed by meaningful risk assessment, will be essential here. The purpose of
the audit plan is not only to direct audit work to appropriate areas of the financial statements, but
also to decide on the resources and deadlines necessary to complete the audit satisfactorily.
At this stage, it is unclear whether risk assessment has been carried out adequately. Before
determining the audit strategy and audit plan, it is very important that robust risk assessment
procedures, including an evaluation of the group’s system of internal controls, have been performed
and documented. We might be able to roll forward some prior year documentation following
confirmation with the client, provided that adequate documentation had been maintained in prior
years. Even so, detailed risk assessment would still be required in relation to Winnie, which
represents a material acquisition during the year.
The tight timescale, and the heightened detection risk that this entails, means that appropriately
experienced staff need to be allocated to the engagement. We may need to consider whether
additional staff need to be brought on to the audit engagement team, to ensure that audit quality is
not compromised by the short turnaround.

The consolidated statement of financial position and statement of changes in equity have not yet
been provided. If the Finance Director does not supply them at the meeting as promised, we will
need to make very clear to him that the group audit cannot commence until a full set of draft financial
statements has been prepared. Any delays in providing supporting documentation to us will also
cause the audit completion date to be pushed back, as our audit opinion must be based on sufficient
appropriate audit evidence.
If, after considering the audit risk and resource allocation, it is determined that the audit requires
more time, we should request Verloc’s directors to push back the sign-off date. We need to explain to
the directors that without this, we would not be able to fulfil our responsibility as Verloc’s auditor and
perform the audit in accordance with the ISAs (UK).
Group audit arrangements
It is currently unclear who the auditor of Winnie is, or whether we will continue to act as auditor of
Stevie. The arrangements for this year, as well as for future years, need to be discussed with
management.
However, whether or not we act as statutory auditors of Winnie and Stevie, we remain the group
auditor of Verloc Group. The audit opinion on the group consolidated financial statements –
incorporating the results of Winnie and Stevie, insofar as they are consolidated in the group financial
statements this year – is therefore our responsibility.
From the information provided, Winnie is likely to constitute a significant component by virtue of its
size. On this basis, if we do not audit Winnie’s individual financial statements, we need to identify who
the component auditor is and evaluate the extent to which we can be involved in the component
auditor’s work.
To do so, we must first gain an understanding of the component auditor, taking into account the
component auditor’s level of professional competence, and whether they are independent from the
company.
Based on our understanding of the component auditor, and the assessment of material misstatement
in the group financial statements, the following will be required:
• Meeting with the component management or the component auditors to obtain an
understanding of Winnie and its environment, including:
– Winnie’s business activities that are significant to the group;
– the susceptibility of Winnie to material misstatement of the financial information due to fraud or
error; and
– identified significant risks of material misstatements. (This may take the form of review of a
memorandum containing the conclusions drawn by the component auditors.)
• Reviewing the component auditor’s overall audit strategy and audit plan.
• Performing risk assessment procedures to identify and assess risks of material misstatement at the
component level. These may be performed with the component auditor or by the group auditor.
It will be crucial to maintain communication with the component auditor of Winnie on a timely basis.
ISA (UK) 600 (Revised November 2019), Special Considerations – Audits of Group Financial
Statements (Including the Work of Component Auditors) requires us to set out for the component
auditor the work to be performed, the use we will make of the work and the form and content of the
component auditor’s communication with us (ISA (UK) 600.40-41).
Related party transactions
The audit manager described these as low risk, but they are material by nature. Not only are they
subject to specific disclosure requirements, they carry a high risk of manipulation.
There will also be additional reporting requirements should the company list on the stock exchange
during the coming year, which only increases the risk to the auditor.
Related party transactions should be considered at the risk assessment stage, with the following
audit procedures being performed:
• Discussion among the audit team of the risk of fraud-related misstatements
• Inquiries of management regarding related parties and associated transactions
• Obtaining an understanding of the controls in place to identify such related party transactions

Other procedures might include the following:
• Identification of excessively generous credit terms by reference to aged trade accounts receivable
analysis
• Identification of excessive discounts by reference to similar reports
• Review bank statements for evidence of payments made to directors or officers of the company
• Review of Board minutes for evidence of approval of related party transactions (directors are
under a fiduciary duty not to make secret profits)
• Written representations from directors to give exhaustive list of all actual/potential related parties
(that is, allow us to make the materiality assessment, not them)
• Review of accounting rewards for large transactions, especially near the year-end and with non-
established customers/suppliers
• Identification of any persons holding > 20% of the shares in the group by reference to the
shareholders’ register
Share capital
As the group is currently not listed, then share capital might be legitimately low risk. However, the
fact that the group is seeking a listing during the year means that share capital may change
significantly over the next 12 months. This is therefore an area which the audit team will need to bear
in mind and monitor for the purposes of next year’s audit.
Sampling method
ISA (UK) 530, Audit Sampling (Appendix 4) does allow samples to be selected haphazardly, which is
effectively the exercise of judgement which the manager appears to be advocating. However, several
points can be made against the manager’s advocacy of judgemental sampling.
Haphazard sampling requires the exercise of judgement which juniors are unlikely to possess in view
of the fact that their firm usually samples statistically. There is a risk that juniors will not understand
how to select samples in this way, and will simply select eg, large balances.
The previous audit manager’s claim that haphazard sampling is quicker is clearly incorrect. When
done properly, haphazard sampling requires the exercise of judgement and this takes time. Statistical
sampling is much quicker to implement as it is relatively mechanical.
In fact, the manager’s suggestion that this would save time amounted to an incitement to the juniors
to select the samples without due care, perhaps only picking the items that are close to hand. This is
a serious breach of the basic fundamental principles of the ICAEW Code of Ethics and the FRC
Revised Ethical Standard.
Unless evidence emerges during the audit planning stage to support the view that using haphazard
sampling is more appropriate and will result in lower detection risk than using statistical sampling,
the firm’s statistical sampling method should be applied.
Trade payables
It is acceptable for juniors to be involved in the audit of trade payables. However, the suggestion
appears to be that one junior has been made responsible for the whole of trade payables, with no
manager review: the results of the audit procedures were reviewed by another equally junior
member of staff. This is not acceptable, as the junior would possess neither the skills nor the time to
perform the work to a satisfactory standard.
Audit procedures performed by audit juniors must always be reviewed and signed off by the audit
manager.
Going concern
Going concern is a difficult area to audit as it usually involves making judgements about a business’s
future prospects, which requires substantial experience. Juniors are very unlikely to be able to do this
and so should not have been assigned to audit going concern.
A more senior member of the audit team should have been assigned going concern, such as the
audit manager or partner.
Taken together with trade payables, this reveals a disturbing failure of direction on the audit, which is
a key component of sound quality management.

Planned listing – events after the reporting period
Should Verloc Group become listed before the signing of the financial statements, the listing will
constitute a non-adjusting event. Although the financial statements for the year ended 20X9
(including share capital) will not be adjusted, the transaction will affect the decisions and evaluations
taken by the users of the financial statements, and therefore should be disclosed.
The audit team will need to review the disclosure and assess whether it is appropriate, and consistent
with the knowledge obtained by the audit team during the audit. It will be necessary to consider the
inclusion of an Emphasis of Matter paragraph in the auditor’s report, to draw the users’ attention to
the relevant disclosure of a significant uncertainty (not related to going concern).
Materiality
Last year’s materiality for the financial statements as a whole is relatively high, representing 1.6% of
revenue, 9.5% of profit before tax and 1.8% of gross assets. While this might have been appropriate
in the previous year, the group has gained in complexity this year, with the acquisition and disposal
of subsidiaries. The planned listing also increases the level of reliance that will be placed on the
financial statements going forward. There is therefore an argument for assigning a lower level of
materiality this year.
Subject to risk assessment procedures, lower performance materiality levels should also be set for
accounts at a higher risk of material misstatement. These should include accounts affected by the
acquisition and disposal of subsidiaries (investment in subsidiaries and associates, goodwill, non-
controlling interests) but should also cover investments in equity instruments, property, plant and
equipment and pension.
Attachment
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 × 9/12)) 13,280
Cost of sales (3,600 + (3,360 × 5/12) + (2,880 × 9/12)) (7,160)
Gross profit 6,120
Administrative expenses (760 + (740 × 5/12) + (650 × 9/12) + 23 (W3) + 10 (W5) – 30
(gain on liability extinguished (W9)) – 46 (gains on equity inv. (W10))) (1,513)
Distribution costs (800 + (700 × 5/12) + (550 × 9/12)) (1,504)
Gain on disposal of investment in Stevie (W6) 163
Finance costs (360 + (240 × 5/12) + (216 × 9/12)) (622)
Share of profit of associate (684 × 3/12 × 35%) 60
Income tax expense (400 + (360 × 5/12) + (300 × 9/12)) (775)

Items that will not be reclassified to profit or loss
Remeasurement gains on defined benefit pension plan (110 + (40 × 9/12)) 140
Tax effect of other comprehensive income (30 + (15 × 9/12)) (41)
Share of other comp. income of associates, net of tax (25 × 3/12 × 35%) 2
Other comprehensive income for the year, net of tax 101

£’000 £’000
Profit for the year attributable to:
1,929
Total comprehensive income for the year attributable to:
2,030
WORKINGS
(1) Group structure and timeline
Verloc
1.11.X6 Buy 75/100 = 75%
1.5.X9 160/200 = 80% 1.7.X9 Sell 40/100 = (40%)
Have left 35%
Winnie Stevie
Timeline
1.10.X8 1.5.X9 1.7.X9 30.9.X9
Winnie
Subsidiary – consolidate
5/12
Acquired
160,000 shares
= 80% of Winnie
Stevie
Subsidiary – 9/12 Associate –
3/12
Held 75,000 shares Sells 40,000 shares Equity

= 75% of Stevie = 40% account
Group gain in SOFP
on disposal (35% left)
Re-measure 35%
remaining to
fair value

PFY TCI
£’000 £’000
Winnie
Per Q (840 × 5/12) 350
Additional depreciation on fair value adjustment (W5) (10)
340
NCI share (NCI in TCI is the same as Winnie has no OCI) × 20%
= 68 = 68
Stevie
Per Q (684 × 9/12)/(709 × 9/12) 513 532
× 25% × 25%
= 128 = 133
Total NCI 196 201
(3) Goodwill (Winnie) (to calculate impairment loss allowance for year)
£’000 £’000
Less net assets at acquisition:
Share capital 200
Reserves 2,050
Fair value uplift on PPE (W5) 960
(3,210)
Goodwill 232
Impairment loss allowance (10%) 23
(4) Goodwill (Stevie) (to calculate group profit on disposal)
£’000 £’000
Less net assets acquired:
Share capital 100
Reserves 1,020
(1,120)
140

(5) Fair value adjustments (Winnie)
At acq’n 1.5.X9 Movement At year end 30.9.X9

£’000 £’000 £’000
PPE 960 (10) * 950
* 960/40 × 5/12 = 10
Note: 50 year total useful life but had owned for 10 years at acquisition so 40 years remaining
(6) Group profit on part disposal of Stevie
£’000 £’000 £’000

Fair value of consideration received 960
Fair value of 35% investment retained 792
Less share of consolidated carrying amount when control
lost
Net assets
Share capital 100
Reserves b/f 1,300
TCI to 1.7.X9 (709 × 9/12) 532
1,932
Goodwill (W4) 140
Less non-controlling interests (W7) (483)
(1,589)
163
(7) Non-controlling interests (SOFP)
£’000
NCI at acquisition (W4) 280
NCI share of post acquisition reserves to disposal
(25% × [(W6) (1,300 + 532) – 1,020]) 203
NCI at disposal 483

Decrease in NCI on loss of control (483)
0
(8) Intragroup dividend

Intragroup dividend income from Winnie = £100,000 × 80% group share = £80,000
Eliminate from ‘investment income’ bringing balance to zero.
(9) Loan from Inver Bank
Verloc recognises gain of £30,000 in profit or loss on extinguishing the loan to Inver Bank.
(10) Gain on equity investments
IFRS 9 requires that £46,000 gain arising on subsequent measurement of investments in equity
instruments is taken to profit or loss. The draft revised consolidated financial statements assume
that this is calculated correctly based on IFRS 9. This is subject to further review.

29 KK
Scenario
Requirement Skills
For each of the issues in Exhibit 2:

• describe the appropriate financial reporting
treatment in the KK consolidated financial
statements. 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; and
• explain the key audit issues and the audit
procedures to be performed.
(1) Seal sold £12 million of goods to Crag Assimilate information to evaluate the
relationship between KK and Crag.
Apply technical knowledge of IFRS 10 to the
scenario to determine that Crag is a subsidiary
of KK.
Identify that related party transaction exists if
Crag is a subsidiary.
Apply professional scepticism to the assertion
of fair value of the Crag shares.
Determine that Seal (KK associate) and Crag (KK
subsidiary) are related parties.
Explain the disclosure required according to
IAS 24.
Identify audit issue and provide appropriate
procedures.
(2) Sale of goods from Seal to Moose Apply technical knowledge of IFRS 10 to the
scenario to determine that Moose is an
associate of KK.
Determine that no related party relationship
exists between Seal and Moose as they are
associates of KK.
Apply scepticism to the nature of the
transaction to consider that a related party
transaction may be required to be disclosed.
procedures.
(3) Purchase of a company asset by a director Explain that director is related party and
requires disclosure.
Identify audit issues in relation to conflict of
interest and duty of directors.
Set out relevant audit procedures to address
audit issues.
(4) Loan from Yissan Explain related party transaction exists even
though loan repaid.
Identify audit issue and relevant procedures.

Requirement Skills
(5) Sale of goods from Crag to KK Determine that the sale of goods from Crag to
KK is an intragroup transaction with unrealised
profit.
Explain the consolidation adjustment required
in the consolidated financial statements.
Explain the disclosure required in the individual
financial statements according to IAS 24.
procedures.
Identify and explain the key audit issues which Identify and explain the key audit issues
arise from the acquisition by KK of shares and surrounding the acquisition of a controlling
options in Crag. interest in Crag during the year.
Explain the ethical implications for WJ of Mike’s Identify the issue as an advocacy threat arising
suggestion that WJ carry out review work in from the provision of non-audit services.
respect of the due diligence assignment Assimilate information to identify intimidation
performed by TE. and self-review threats.
Provide a recommendation of appropriate
action.
Marking guide Marks
Seal sold £12 million of goods to Crag 13

Sale of goods from Seal to Moose 7
Purchase of a company asset by a director 5
Loan from Yissan 3
Sale of goods from Crag to KK 7
Identify and explain the key audit issues which arise from the acquisition by KK of
shares and options in Crag 5
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 5
Marks Available 45
Maximum 30
Total 30
Note: It may be helpful to draw a diagram of the group structure before answering this question.
(1) Sales of goods by Seal to Crag
Financial reporting treatment
Determining the relationship between KK and Crag is crucial to determining whether this is a related
party transaction in the KK group financial statements.
Seal appears to be an associate of KK as there is a 40% direct shareholding and significant influence.
If Crag is a subsidiary of KK, then it is purchasing parts from a related party (per IAS 24 (revised) (a)
(vii) (Seal)).
If, however, Crag is an associate of KK, then Seal and Crag are not considered members of the same
group for related party purposes as they are only subject to significant influence from the same
investor.

Establishing the relationship between KK and Crag
A subsidiary is defined by IFRS 10, Consolidated Financial Statements as “an entity that is controlled
by another entity”.
In accordance with IFRS 10, an investor controls an investee when “the investor is exposed, or has
rights, to variable returns from its involvement with the investee and has the ability to affect those
returns through its power over the investee”.
Through its shareholding in Crag, it is clear that KK is exposed to variable returns dependent on the
performance of Crag. The key question is whether KK has the power to affect those returns, rather
than just influence decisions.
At the acquisition date and at the year end, KK can only vote with 45% of the ordinary shares. If it
were to exercise its options it would be able to vote with 60% of the ordinary shares and exercise
control.
IFRS 10 paragraph 12 states that “an investor with the current ability to direct the relevant activities
has power, even if its rights have yet to be exercised”. IFRS 10 paragraph B47 also requires an
investor to consider potential voting rights in considering whether it has control over another entity.
The potential voting rights are considered only if they are substantive ie, if the holder has the
practical ability to exercise the right.
Based on the information provided, the options appear to be ‘in the money’ as fair value per share
has risen by 13% since acquisition compared to a required exercise premium of 10% per share over
the price per share for the 45% shareholding. Consequently, the options seem likely to be exercised
and KK does have a ‘current’ ability to direct the activities of Crag, as it only requires the options to
be exercised (which it can do at any time up to the exercise date, it does not need to wait for the end
of the exercise period) to take control through a majority shareholding.
Consequently, Crag should be accounted for as a subsidiary of KK in the consolidated financial
statements.
Regardless of whether there have been transactions between a parent and a subsidiary, IAS 24
requires an entity to disclose the name of its parent and, if different, the ultimate controlling party.
Crag must therefore disclose the fact that KK is now its parent in its financial statements.
Treatment and disclosure of the goods sold to Crag by Seal
KK has significant influence over Seal and it is therefore a related party of KK. In accordance with IAS
24, Related Party Disclosures, disclosure of the aggregate amount of the transactions occurring
between Crag and Seal between 1 August 20X3 and 30 June 20X4 is required in the consolidated
financial statements of the KK group as they are related parties. (Crag is a subsidiary of KK and Seal
an associate of KK.) Disclosure is also required in the individual company financial statements of Seal
and Crag. No disclosure is required in KK’s individual company financial statements (even though
Seal and Crag are both related parties of KK) as the transaction does not impact on its individual
company financial statements.
Transactions before the acquisition date do not require separate disclosure in any company’s
financial statements as the parties were not related during this period.
Any outstanding balances and any bad or doubtful debts must also be disclosed in accordance with
IAS 24.
Audit issue
The key audit issue is the nature of the relationship between KK and Crag which determines whether
related party disclosures are required or not.
KK appears to have transactions with a number of related parties. Related party transactions are
particularly difficult to audit, not least because they depend upon management providing the auditor
with complete and correct information. This is an area that the audit team will need to focus on, both
to ensure that appropriate disclosure has been made in the financial statements, and as part of
considering the risk of fraud.
The auditors must remain alert for circumstances which might indicate the existence of related party
relationships or transactions. Where transactions outside the entity’s normal course of business are
identified the auditors must discuss them with management, in particular inquiring about the nature
of the transactions, whether related parties are involved and the business rationale (or lack of) of
those transactions.

Audit procedures
Sales transactions
• Agree the total of post-acquisition transactions to supporting sales and purchases records of the
two companies.
• Inspect a sample of delivery notes around acquisition date for cut-off to ensure consistency of
treatment between the two companies.
• Confirm amounts of intra group goods held in inventory at year end against inventory count
records.
Related parties
• Confirm shareholdings by inspecting share certificates and rights attaching to them.
• Inspect the contract for the options to verify the rights to exercise options.
• Review the assertion that fair value has increased by 13% since acquisition. Crag is a private
company so appropriate professional scepticism needs to be applied and management should
present evidence that the increase in sales represents an increase in the fair value of the shares
(eg, KK may have overpaid for the shares; or the sales increase may have been anticipated at
acquisition and already discounted into the price paid by KK at acquisition).
• Review the related party disclosure notes in Crag’s financial statements, to verify whether KK is
identified as Crag’s parent.
• Agree appropriate disclosure of each related party transaction in accordance with IAS 24. This
should include the following disclosures:
– nature of transactions
– amounts involved
– amounts due to or from the related party
– bad debt write offs to or from the related party
Note: The above answer depends upon the student correctly identifying that Crag is a subsidiary of
KK. If the student identifies Crag, instead, as an associate of KK, the answer would be marked on an
own answer basis, with follow-up marks being awarded for relevant discussion.
(2) Sale of goods – Seal to Moose
KK has a total (direct and indirect) shareholding of 54.5% in Moose. KK has a 35% direct holding in
Moose and also a 30% shareholding in Finkle which, in turn, has a 65% shareholding in Moose.
Through its shareholding in Finkle, it is thus clear that KK is exposed to variable returns, dependent
on the performance of Finkle. The key question here is whether KK has “the current ability to direct
the relevant activities” and in particular to direct the way Finkle exercises its shareholder voting
power with respect to Moose.
Given that one unrelated individual owns the other 70% of Finkle’s ordinary shares, it seems unlikely
that KK can exercise any more than significant influence over Finkle. As a consequence KK can only
exercise significant influence over Moose through its 35% direct shareholding, making Moose an
associate of KK rather than a subsidiary.
As Moose is an associate of KK and Seal is also an associate of KK, then in accordance with IAS 24,
Seal and Moose are not considered members of the same group for related party purposes so they
are not related parties. No separate disclosure of this transaction is therefore required.
Audit issue
If KK (or another related party of KK) actually influences the transaction then it could be regarded as
a related party transaction and therefore the audit issue is whether the disclosure of the related party
is not correct.
Audit procedures
• Confirm shareholdings by inspecting share certificates and rights attaching to them.
• Enquire of the directors whether actual influence existed which would require the transaction to
be disclosed as a related party transaction.

(3) Purchase of a company asset by a director
Financial reporting
A director is regarded as key personnel in accordance with IAS 24. Separate disclosure is therefore
required even if this transaction is not material to the company. This is because the transaction is
likely to be material to the director and therefore capable of influencing his decisions. The disclosure
will include the profit on disposal and the fair value attributed.
Audit issue
The audit issue in this case is that there is a potential conflict of interest between a director and the
body of shareholders in that a director may be benefiting from a transaction which is not at arm’s
length.
Directors have a fiduciary duty to act in the interests of all shareholders. Directors must not place
themselves in a position where there is a conflict of interest between their personal interests and
their duty to the company (Regal (Hastings) Ltd v Gulliver). In certain circumstances the company may
void such contracts. In statute law the duty to avoid conflict of interest has also been codified in
CA2006 – s.175.
More specifically, the audit issue in this case is that the price of £300,000 for the machine seems not
to be at an arm’s length compared to the fair value. Mike might therefore be exploiting his position
as director to gain personal advantage.
The Companies Act 2006 imposes restrictions on the dealings of directors with companies in order
to prevent directors taking advantage of their position. This applies even where the directors are
shareholders, but particularly where the interests of non‑controlling shareholders such as Yissan may
be damaged.
If there has not been knowledge and approval of the transaction by the board then there may be an
issue of false accounting by Mike.
Audit procedures
• Inspect provisions in Articles of Association and any shareholder agreement regarding directors’
contracts with the company to determine whether there has been any wrongdoing.
• Examine the terms of the contract(s) ascertaining whether there is any clause relating to purchase
of assets by directors.
• Ascertain whether any similar transactions have taken place in the past (review board minutes)
and at what prices (see evidence of such agreements where appropriate). The risk here is that
directors may be approving each other’s bargain purchases. Also, as Janet is Mike’s wife she is
also a de facto beneficiary of such a transaction and may have voted in favour.
• Ascertain whether the other directors were aware of the nature and extent of the sales contract
(eg, review correspondence; discuss with other directors) if they have approved it.
• Review board minutes to see if the contract has been considered and formally approved by the
board.
• Confirm the amounts to the underlying contract for sale of the machine to Mike.
• Confirm carrying amount from accounting records.
• Reconcile fair value to third party evidence (eg, trade guides if there is an active second hand
market).
• Determine whether the difference between fair value and price paid should be treated as a
benefit in kind for disclosed remuneration (also tax treatment to be considered later).
• Make enquiries to determine why Mike wanted an industrial machine. There is a risk he may be
acting in competition with KK which may be contrary to any exclusivity clause in directors’ service
contracts. Alternatively he may have sold it at a profit thereby making a personal gain from
company assets.
• Obtain written representations from management and, where appropriate, those charged with
governance that all matters related to this related party transaction have been disclosed to them
and have been appropriately accounted for and disclosed.
• Confirm the recognition of the excess of the payment over the carrying amount as a profit on sale
of PPE.

(4) Repayment of loan from Yissan
Financial reporting
KK is an associate of Yissan and therefore they are related parties.
Separate disclosure is required in accordance with IAS 24. This should include the existence and
repayment of the loan during the current period. Even though the loan is no longer outstanding at
the year end, it is a related party transaction during the reporting period, as is any interest charge on
the loan, even though no cash interest has been paid.
The nature and treatment of the loan would also be disclosed ie, the loan would be held at fair value
(discounted at a market interest rate with the PV unwinding over time. The unwinding of the discount
element is the related party benefit).
Disclosure of the trading between KK and Yissan should also be made.
Audit issue
As the loan is no longer outstanding the related party transaction could be missed.
Audit procedures
• Agree brought forward balance on the loan.
• Perform supporting calculations of implicit interest on the loan and confirm unwinding of the
discount is charged to profit or loss.
• Reconcile repayment to supporting documentation and accounting records.
(5) Financial reporting
As we have seen above, Crag is a subsidiary of KK. The sale of goods by Crag to KK for a profit of
£500,000 is therefore an intragroup transaction. While the revenue and cost of sales in Crag and KK
respectively cancel out, unsold inventory remains in KK at the year end.
As discussed above, effectively 40% of Crag is owned by Woodland plc. 40% of the unrealised profit
from this inventory therefore belongs to Woodland, the non-controlling interests, and cannot
therefore be consolidated into the group financial statements.
The adjustment for the unrealised profit is calculated as (£1,500,000 – 1,000,000) × ¼ = £125,000.
On consolidation, Crag’s post-acquisition retained earnings must be adjusted. 60% of Crag’s post-
acquisition retained earnings (including £75,000 of the £125,000 unrealised profit) will be
consolidated on the face of the group statement of financial position as part of the group’s retained
earnings. The remaining 40% must be presented as pertaining to non-controlling interests. An
adjustment of £50,000 must also be made to the profit attributable to non-controlling interests line in
the consolidated statement of profit or loss and other comprehensive income.
The details of the transaction must be disclosed in the individual financial statements of both KK and
Crag.
Audit issue
Subject to confirming that the relationship between KK and Crag is indeed that of a parent and its
subsidiary, the main audit issue here is ensuring the correct consolidation of Crag’s financial results
into the group financial statements. It is important to determine whether any non-controlling interests
have been correctly accounted for.
Audit procedures
• Reconcile the cost of the goods sold to KK to Crag’s inventory records.
• Confirm the consideration paid for the goods to both Crag’s sales ledger and KK’s purchase
ledger.
• Agree KK and Crag’s underlying records relating to the transaction to the consolidation schedule.
• Review the consolidation schedule to confirm whether the unrealised profit adjustment has been
calculated and recorded correctly.
• Agree Crag’s pre-acquisition retained earnings to the company’s management accounts for the
period up to KK’s acquisition of Crag’s shares.
Note: The above answer depends upon the student correctly identifying that Crag is a subsidiary of
KK. If the student identifies Crag, instead, as an associate of KK, the answer would be marked on an
own answer basis, with follow-up marks being awarded for relevant discussion.

Acquisition of Crag
As discussed above, Crag was effectively acquired on 1 August 20X3, when KK bought 45% of Crag’s
shares with an option to purchase an additional 15% at a future date. It is essential to confirm
whether the acquisition of a controlling interest in Crag is accounted for in accordance with IFRS. The
numbers and the disclosures relating to the acquisition are material, both from a quantitative and a
qualitative point of view.
• Valuation of assets and liabilities: These should be valued at fair value at the date of acquisition
in accordance with IFRS 13.
• Valuation of consideration: This should be at fair value and will include the option to acquire
further shares as a contingent consideration. KK should measure the contingent consideration at
its acquisition date fair value.
• Goodwill: This must be calculated and accounted for in accordance with IFRS 3. The amount of
contingent consideration should be included as part of the consideration transferred in the
goodwill working.
• Date of control: Crag’s results should only be consolidated from the date of acquisition, 1 August
20X3.
• Accounting policies/reporting periods: Accounting policies and reporting periods should be
consistent across the group.
• Consolidation adjustments: The KK group must have systems which enable the identification of
intra-group balances and accounts.
• Accounting policies: Accounting policies must be consistent across the group.
Ethics
The FRC’s Revised Ethical Standard addresses the issue of providing non-audit services to audit
clients in section 5.
In this case there is a potential advocacy threat in acting for an audit client in a legal dispute. A
potential advocacy threat arises where the assurance firm is in a position of taking the client’s part in
a dispute or somehow acting as their advocate.
While in principle the provision of other services is allowed, a threat of self-review must also be
considered, particularly where the matter in question will be material to the financial statements. WJ
acts as auditors covering the date of the acquisition so we have responsibility for that transaction
which may materially affect the financial statements for the year ended 30 June 20X4. In providing a
review of TE’s procedures there may therefore be conflict with WJ’s role in the audit engagement.
In addition, there may be a potential intimidation threat arising from Mike’s suggestion that a review
contract may only be awarded to WJ if he is happy with the audit. Mike himself is one of the key risks
identified in the interim audit (purchase of company asset). The suggestion that if there are no audit
issues raised about this, and other matters, there may be more work assigned to WJ is both an
intimidation threat and a self-interest threat since relating the outcome of the review to the
continuance as auditor has clear financial implications for WJ.
Also, it is the board rather than Mike alone who would determine whether we would be offered the
review work. The shareholders would decide whether we continue as statutory auditors.
The appropriate response is to complete the audit work as we see fit, ignoring the possibility of
further review work. It does not seem appropriate to accept the additional work given the advocacy
threat, the threat of intimidation and self-interest threat. At the completion of the audit, we need to
consider whether we should accept reappointment as auditors if offered this position.
30 UHN (July 2014) (amended)

Scenario
In this scenario the candidate is in the role of an audit manager being asked to take over in the final
stages of an audit of UHN. UHN is a manufacturing company which has survived the recession but is
still reliant on support from their bank which monitors performance against gearing and interest
cover ratios calculated on the year-end audited financial statements. The company is easily meeting
these ratios provided that the accounting policy choices of the directors are appropriate and the
accounting treatment of certain financial reporting issues is correct.

These financial reporting issues have been identified by the audit senior as areas which he believes
the board has exercised significant judgement in the choice of accounting policies. Issue 1 involves a
sale and leaseback arrangement – the leaseback is a matter on which the directors have not
complied with IFRS 16. Issue 2 involves an impairment charge on an overseas asset where the
accounting rules have been applied incorrectly. Issue 3, a hedge for delivery of titanium where the
directors have chosen (incorrectly) not to apply hedge accounting despite satisfying the conditions;
and Issue 4 where a liability has been treated incorrectly as a provision. The impact of the
adjustments for these issues is that the interest cover ratio is still met but the gearing covenant would
be breached.
The candidate is required to propose appropriate financial reporting treatments, adjust the financial
statements in order to recalculate the covenant ratios based upon their recommendations and to
identify the key audit risks arising from the review of the senior’s notes. The candidate is required to
exercise scepticism in their recommendations to distinguish accounting errors from areas where
judgement has been applied. In particular the candidate is required to recognise that although there
is potentially judgement to be exercised by the board, this is acceptable if the accounting policy
choices are within the substance of the relevant IFRS.
In addition the board is in disagreement about the business approach to cyber security. The
responsibility chain appears to end before board level and it appears to be a severe breach in risk
management and control. The operations director has suggested that a cyber-attack would be
catastrophic and there appears to be little board level discussion and agreement about this risk. The
issue creates audit risk, potential going concern risk and undisclosed liabilities.
The firm has been asked to tender for a one-off assignment on this matter. The candidate is asked for
a report on the ethical implications of this tender for the firm.
Marking guide Marks
Financial reporting issues 20

Impact of adjustments 6
Key audit risks 9
Cyber security 5
Ethical implications 5
45
Total 45
Working Paper – Prepared by Audit Manager

For the attention of Petra Chainey
I have examined the issues identified by the audit senior as follows:
Issue 1 – Sale and leaseback
The directors’ decision to charge the lease rental to profit or loss is incorrect under IFRS 16.
The asset was purchased in 20W4 and had a useful life at that date of 30 years. Therefore at 31 March
20X4 at the inception of the lease, the 20-year lease term is for the entirety of the asset’s remaining
useful life. We would need to consider if the assessment of useful life has changed but if not, this is
reasonably strong evidence that the lease term is for the entire useful life of the factory. Under IFRS
16, since the IFRS 15 criteria are met, the seller-lessee derecognises the asset sold, recognises a
right-of-use asset and 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 amortised using
the interest rate implicit in the lease.
The present value of discounted future lease payments relating to the factory is £611,120 × 20-year
annuity discount factor @ 8% ie, £611,120 × 9.818 = £6m.
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 £2,960,000 × (6,000,000 ÷ 8,000,000) = £2,220,000

The remaining carrying amount of £740,000 (2,960,000 – 2,220,000) represents the transferred asset.
The overall gain on disposal is £5,040,000. Only that part of the gain relating to the transferred asset
is recognised:
Gain relating to retained rights £5,040,000 × (6,000,000 ÷ 8,000,000) = £3,780,000
Therefore the recognised gain relating to the transferred rights is £1,260,000 (5,040,000 –
3,780,000).
At 31 March 20X4, the following entries are required:
DEBIT Right-of-use asset £2,220,000

DEBIT Bank £8,000,000
CREDIT PPE £2,960,000
CREDIT Gain on disposal £1,260,000
CREDIT Lease liability £6,000,000
The right-of-use asset is subsequently depreciated over the lease term of 20 years, therefore in the
year ended 31 March 20X5:
DEBIT Depreciation expense (£2,220,000/20) £111,000

CREDIT Right-of-use asset £111,000
The lease liability is amortised:
£
31 March 20X4 6,000,000
Interest at 8% 480,000
Lease payment (611,120)
31 March 20X5 5,868,880
Amortisation for the year ended 31 March 20X5 will be recognised by:
DEBIT Finance charge £480,000

DEBIT Lease liability £131,120
CREDIT Bank £611,120
Therefore £5,868,880 is non-current at 31 March 20X4 and £131,120 (repayment of capital) is

current.
Correcting journals:
£’000 £’000
DEBIT Exceptional item 5,040
DEBIT Right-of-use asset 2,220
CREDIT Gain on disposal 1,260
CREDIT Lease liability 6,000
Issue 2 – Impairment of service centre

The restrictions imposed by the government would indicate impairment and the directors have
correctly carried out an impairment review.

RUB
Cost 266
Depreciation 44
Carrying amount 222
Expressed in RUB, the asset is impaired because the recoverable amount, which is the fair value less
costs to sell of RUB204 million, is less than the carrying amount of RUB222 million.
However for the purpose of testing for impairment the carrying amount should be measured at the
normal historic exchange rate, but the recoverable amount should be determined at the closing
exchange rate.
Thus the carrying amount in £s is 222/53 = £4.189m
The recoverable amount in £s is 204/48 = £4.25m
Therefore no impairment charge is required.
£’000 £’000
DEBIT PPE 375
CREDIT Cost of sales 375
This is an error and must be adjusted.

Issue 3 – Hedge
The directors have not applied hedge accounting correctly and therefore an adjustment is required
to reflect the profit on the movement of the price of titanium held in inventory at 31 March 20X4. The
directors have already taken the loss to operating profit. However as hedging is applied a gain must
be recognised in profit or loss to reflect the movement in the value of the inventory.
£’000 £’000
DEBIT Inventory 2,000
680,000 kg × £15 = £10.2m – Cost £8.2m
CREDIT Income statement – Gain on inventory 2,000
The net gain recognised in profit or loss is £232,000.

Issue 4 – Provision for claim for damages
The provision should now be classified as a liability as the timing and amount are no longer
uncertain. It would therefore form part of the long-term borrowings of the company and be taken
into consideration when applying the bank gearing covenant. The provision stands at £9.26 million at
31.3.20X4 (£10m × 0.926 = £9.26m).
The liability has been agreed to be £9.1 million. 25% will be payable within the next 12 months =
£2.275 million. The balance will be due after more than 1 year and should be discounted for 1 year.
Short term Long term Total

£’000 £’000 £’000
Provision 740 8,520 9,260
6,825 × 0.926
Actual liability 2,275 = 6,320 8,595
(1,535) (665)

Provisions should be reclassified to liabilities and then
£’000 £’000
DEBIT Long term liabilities 2,200
CREDIT Profit and loss 665
CREDIT Short term liabilities 1,535
Recalculation of the gearing ratio and the interest cover ratio in accordance with the covenant with
the bank (Exhibit 1).
Statement of profit or loss for the year ended 31 March 20X4
Before Issue 1 Issue 2 Issue 3 Issue 4 After
£’000 £’000 £’000 £’000 £’000 £’000
Revenue (56,900) (56,900)
Operating costs 49,893 (375) (2,000) (665) 45,593
Gain on disposal (1,260)
Lease payment (remove)
Exceptional item (Issue 1) (5,040) 5,040 ––––––

Operating profit (12,047) (11,307)
Finance costs 2,200 2,200
Profit before tax (9,847) (9,107)
ASSETS
Non-current assets
Property, plant and

equipment (Issue 2) 20,040 375 20,415
Right-of-use asset 2,220 2,220
Current assets
Inventories (Issue 3) 21,960 2,000 23,960
Trade receivables 15,982 15,982
Equity
Share capital – ordinary £1

shares (1,000) (1,000)
Share premium (15,000) (15,000)
Retained earnings (1,500) 740* (760)
Total equity (17,500) (16,760)

Before Issue 1 Issue 2 Issue 3 Issue 4 After
£’000 £’000 £’000 £’000 £’000 £’000
Loans (20,000) (20,000)
Long-term liability – (Issue 4) (8,520) 2,200 (6,320)
Lease liability (5,869) (5,869)
Deferred tax liability (1,000) (1,000)
Total non-current liabilities (29,520) (33,189)
Current liabilities
Trade and other payables (12,350) (12,350)
Short-term provision – (Issue

4) (740) (1,535) (2,275)
Lease liability ––––––– (131) (131)
Total current liabilities (13,090) ––––– –––– ––––– ––––– (14,756)
Total equity and liabilities (60,110) – – – – (64,705)
*5,040 – 1,260 – 375 – 2,000 – 665 = 740

Conclusion
Therefore although the covenant in respect of the interest cover ratio is still satisfied, the impact on
the gearing ratio changes significantly and it is now breached.
Interest cover ratios
Before: 12,047/2,200 = 5.48 times
After: 11,307/2,200 = 5.14 times
Gearing ratio
Net debt defined as:
(Long-term borrowings and long-term payables (excluding provisions)) ÷ (Equity (Share capital and
reserves))
After
Loans 20,000
Long-term liability 6,320
Lease libaility 5,869
32,189
Equity 16,760 (32,189 ÷ 16,760) = 192%
Before
Loans 20,000
Equity 17,500 (20,000 ÷ 17,500) = 114%
The key audit risks to be addressed before signing our audit opinion on the financial statements
Inappropriate accounting treatments
The directors are under pressure to meet covenant requirements and although clearly the interest
cover ratio can be easily met, the gearing ratio covenant is encouraging the directors to be creative
in their judgements. This represents a key risk for the audit firm and would require the exercise of
professional scepticism in areas of judgement made by management. For example other areas of
judgement in this type of industry would be inventory, bad debt provisions and warranty provisions.

Note: Credit should also be awarded for answers that discuss the impact of ISA (UK) 540 (Revised),
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.
Correction of accounting errors
Whereas there is some judgement involved in the treatment of the sale and leaseback (issue 1), and
further discussion will be required with the directors over this matter, issue 2 the impairment of the
service centre and issue 4 the incorrect categorisation of the provision are less subjective and
adjustments should be proposed for correction of this accounting treatment. The outcome of these
issues would result in the gearing covenant being breached. Clearly with covenants in place, any
adjustment exceeds the materiality of £100,000. The materiality level should therefore be revisited
and other areas of the audit re-examined in the light of a recalculated materiality level.
Going concern
A key audit risk is therefore going concern. If the covenant is breached UHN will need to show the
loan as short term whether or not they are able to reschedule and the company does not have
sufficient cash to repay the loan if it is recalled immediately.
Consideration should be given to whether the going concern is affected by the breaching of the
gearing covenant. Initially we should discuss with management their relationship with the bank and
the probability of funding being withdrawn and their contingency plans to obtain an alternative
funding arrangement.
The effect of UHN being unable to meet its covenant does not necessarily mean that the entity is not
a going concern if the financial risk of this event can be counterbalanced by management’s plans to
reschedule its loan capital.
The directors are required to report that the business is a going concern with assumptions or
qualifications if necessary as part of their responsibilities under the UK Corporate Governance Code.
The listing rules also require auditors to review the annual statement by the directors that the
business is a going concern. As part of the audit we will have performed audit procedures to
examine the directors’ review of going concern to establish whether the use of this assumption is
appropriate. ISA (UK) 570 requires auditors to consider the same period used by management:
therefore in the first instance we will need to discuss with management their assessment of going
concern. We should ensure that management’s assessment considers the financial risk of the
withdrawal of the loan funding.
If there is adequate disclosure in the financial statements by the directors regarding the uncertainties
about going concern then an unmodified audit opinion with a ‘Material Uncertainty Related to Going
Concern’ section in the auditor’s report is likely to be sufficient. If the directors do not disclose going
concern uncertainties appropriately, however, it may be necessary to modify the audit opinion.
Audit quality
There is also a risk arising from the use of inexperienced audit staff on the assignment – additional
review procedures will be required to mitigate this risk.
Cyber security
There is an allegation that UHN’s systems were hacked causing the navigation system in a customer’s
cargo plane to fail. Although UHN strenuously denied the claim, the board appears not to be in
control of the issues relating to cyber security and the reporting chain and budget responsibility lies
with the IT manager who is not a board member. The risk of a cyber-attack could present a going
concern issue for Hartner to consider and also there may be further undisclosed liabilities to record.

Responsibility and accountability of the UHN board for cyber security and make appropriate
recommendations
It is clear that the board does not understand the risks of cyber security and have not linked up IT
and information risks with the management of business risks.
It is also apparent that the technical function of managing risk is separate from the business function.
There is no implication that the level of security and the handling of the risk of a cyber-attack is not
managed appropriately by the IT manager, however as the board is not involved or aware of the
processes, it is demonstrating a lack of accountability which is indicative of poor corporate
governance. The FRC risk guidance states that directors are responsible for appropriate risk
management and internal control; that they should also agree how principal risks should be
managed or mitigated. Cyber security should be seen as part of that responsibility which is currently
being delegated to sub board level management.
Recommendations for the board:
• Cyber security should become the responsibility of a board member – preferably part of the
responsibilities of a chief risk officer.
• Clear lines of responsibility and accountability for cyber security should be embedded in day-to-
day operational responsibilities and subject to board oversight.
• Develop a road map which defines critical business data and associated risks.
• Consider UHN’s participation in networks to share intelligence about attacks and attackers within
the industry.
• If in-house professionals are not available, the board should appoint external professionals to
communicate and articulate risk management and advise on the value of security spending.
• Ensure that non-executive directors and audit committee members have appropriate knowledge
and training to hold management to account in a meaningful way regarding cyber risks.
• Explore and determine the board’s tolerance to cyber security such as risk tolerance and risk
appetite.
• Improve the understanding between board members and IT specialists.
• Instil the ethos of reporting early breaches without penalty in staff and where security is seen as an
enabler of digitally based business rather than a compliance process.
File Note – the ethical implications for our firm tendering and, if successful, accepting the one-off
assurance assignment
The FRC Revised Ethical Standard (paras. 5.2–5.7) discusses the various types of work that a firm
might perform for an audit client – effectively this could be an audit engagement, audit-related
services, non-audit services or additional services. Only the first two types could be considered
compatible and therefore subject to similar levels of ethical scrutiny. However, due to being
considered separate activities from those carried out as part of an audit, both non-audit and
additional services require the engagement partner to consider the threats to objectivity and
independence before they can be accepted.
The finance director suggests that the fee for this work would be lower as we could use some of our
findings as part of the audit work. However, the nature of this additional work is not to gather
evidence to support the audit opinion and the nature and extent of this assignment will not be
determined by the auditor but by the terms of the engagement agreed with the client.
This assignment therefore appears to be a ‘non-audit service’ and the firm should identify any threats
to independence and objectivity. If a low fee for the work is agreed as suggested in the email, then
this could affect the quality of work undertaken if adequate resources cannot be provided within the
fee constraints. The firm should not undertake work for which it does not have expertise. There is a
basic requirement that ICAEW Chartered Accountants act in accordance with professional
competence and behaviour. Doing work which is beyond their knowledge would be a breach of the
ICAEW Code of Ethics.

Other considerations here are the nature of the proposed work and whether it creates a self-review
threat if the firm would be auditing its own work when assessing the cyber arrangements for audit
purposes. There is also a hint here that the firm is being pressurised by the client with the threat that
it might lose the audit and this in itself would be an intimidation threat which should be carefully
considered.
However, by far the most significant factor in this discussion relates to the guidance on providing
non-audit services for public interest entities: as UHN is effectively a public interest entity and the
non-audit services requested do not appear to fall within the permitted non-audit services (FRC
Revised Ethical Standard, para 5.40) the firm should politely decline the offer to perform this value
for money report.
31 Couvert (November 2014)

Scenario
In this scenario the candidate is in the role of a recently-qualified ICAEW Chartered Accountant
assigned to the audit of Couvert plc. Couvert has made two acquisitions during the year: a 55%
shareholding in Ectal, an overseas subsidiary; and a 100% shareholding in a UK subsidiary, Bexway,
acquired partway through the year. The skills required to answer this question successfully are:
financial statement analysis in conducting relevant analytical review procedures; application of
technical knowledge to identify appropriate actions; assimilation and structuring skills eg, in linking
poor corporate governance with the financial reporting question over control of Ectal; and
communication skills to different audiences.
The candidate is first asked to perform analytical procedures on Ectal’s financial information which
has been provided to Couvert only very recently and close to the reporting date. The candidate
should identify that the information is incomplete (SOCIE and cash flow is missing, no tax expense)
and perform financial statement analysis in preparing eg, profitability ratios. The candidate should
identify that Ectal has performed significantly worse than in 20X3 and against budget expectations,
which raises the possibility of earnings management prior to the acquisition to enhance the
acquisition price. Linking the finance costs in the statement of profit or loss with the SOFP suggests a
return of 10% on a loan from a director. The candidate should express scepticism over the amount of
interest and question whether it is reasonable in the context of the overseas jurisdiction. The
candidate should select relevant financial ratios and determine that the financial position has
declined in 20X4 and in particular inventory ratios indicate a slow-down in the inventory turnover.
The candidate is then asked to discuss the governance structure at Ectal and identify that control is
effectively retained by the vendor of the 55% shareholding. Linking this to the financial reporting
treatment of the investment is an embedded point requiring higher level skills.
The candidate is asked to explain the financial reporting treatment and again there is an embedded
point to be identified concerning the impairment of assets in the statement of profit or loss which has
implications for the value of goodwill at acquisition.
The candidate is then asked to recommend appropriate audit actions arising from the investment
and is required to apply technical knowledge therefore of ISA 600.
Finally the candidate is required to explain the appropriate financial statement adjustments in
respect of a pension issue and a put option which arise in the financial statements of Bexway, the
100% newly-acquired subsidiary.
Marking guide Marks
Financial performance 15
Corporate governance 9
The actions to be taken and the potential implications 8
40
Total 40

Report on analytical procedures of Ectal’s financial information for the year ended 31 August 20X4
Prepared by Anton Lee, Audit Senior
Introduction
It is clear that Ectal’s performance has declined significantly; the business produced a substantial loss
in 20X4, compared to budgeted and prior year profit. This loss in 20X4 arose primarily because of
the highly significant impairment of property, plant and equipment.
General comments
The financial statements, on which the analytical review is based, are incomplete. There is no
statement of cash flows, no explanatory notes, no statement of changes in equity and the
performance statement also appears to be incomplete. The movement in retained earnings for the
year is a reduction of C$70.2 million, but only C$50.2 million has been accounted for as loss in the
year. Therefore there is, presumably, a further C$20 million of loss/expense accounted for in other
comprehensive income. If this is accounted for by a dividend paid in the year it would be expected
that 55% of it will have been received by Couvert. But it could be something else and we need to find
out what this difference relates to.
Ectal’s performance
Ectal classifies expenses by nature, rather than by function. The budgetary information for the year
ended 31 August 20X4 provides a set of expectations against which actual performance can be
judged, and a comparison against the prior year results is also possible. Analysis of the principal
profit or loss items shows the following:
Actual 20X4 as a % Actual 20X4 as a %

of budget of 20X3
Revenue 85.2% 87.2%
Raw materials (RM) and consumables used, adjusted 87.3% 87.9%

for changes in inventories and WIP*
Employee expenses 101.9% 125.2%
Depreciation expense 86.2% 88.2%
Other expenses 141.4% 140.1%
*Consumption of raw materials and consumables adjusted for inventory change (C$m):
20X4 Actual 20X4 Budget 20X3 Actual

Inventory change 5.9 (8.3) (18.6)
RM and WIP used (192.8) (205.7) (194.1)
(186.9) (214.0) (212.7)
Revenue for 20X4 is very much lower than both prior year and budget figures, which may suggest a
downturn in trade. However, it is also possible that cut-off at the beginning of the year was incorrect,
and that revenue was recognised too early in order to manipulate profits immediately prior to
takeover and to improve the price paid for the acquisition. This factor could have affected many of
the figures in both the performance and position statements, and if so, the consequences for the
audit and for the client would be very significant. It would be helpful to undertake some trend
analysis of Ectal’s results, going back over three or four years, and also to look at the extent to which
their budgeting has deviated from actual results in the past. We should be able to obtain this
information from the due diligence files.
Employee expenses are higher than budget, and much higher than in the previous year. The increase
appears to have been expected in that the 20X4 budget figure is substantially increased compared
to 20X3 actual figures. It may indicate a significant planned pay increase for staff, but it is difficult to
tell without further information. Other expenses have increased even more, both against budget and
prior year. Again, more information would be required. It is possible that expenses have been
misallocated, and that the totals that we are currently examining are not accurate comparators.

Depreciation, on the other hand, is much lower than planned, and much lower than in the prior year.
However, the C$60 million impairment, which is material, has had a significant impact on the PPE
balance. More information would be required about the timing of this impairment. If it occurred and
was recognised at the year end, as seems likely, then it does not explain the drop in depreciation
which should have been recognised in full before the amount of the impairment was calculated. It is
impossible to reconcile the movement in property, plant and equipment without further information
on acquisitions and disposals. The carrying amount of PPE at 31 August 20X3 was C$603.7 million,
which reduced to C$551.3 million at 31 August 20X4. The difference between the two figures is
C$52.4 million, exactly the amount of the depreciation charge for the year ended 31 August 20X4. It
appears, therefore, that net acquisitions amounted to exactly C$60 million, balancing the amount of
the impairment. The note to the financial statements on PPE and the cash flow statement would help
in providing explanations.
Profitability
Because of the classification of expenses by nature, no figure for gross profit is disclosed. However,
gross profit can be estimated by deducting change in inventory, RM and WIP used, employee
expenses and depreciation expenses from revenue, as follows:
20X4 Actual: 305.4 + 5.9 – 192.8 – 26.3 – 52.4 = 39.8 (ie, excluding impairment)
20X4 Budget: 358.6 – 8.3 – 205.7 – 25.8 – 60.8 = 58.0
20X3 Actual: 350.4 – 18.6 – 194.1 – 21.0 – 59.4 = 57.3
Margins can then be calculated as follows:
Gross profit margin 13.0% 16.2% 16.4%
Operating profit margin (14.8%) 10.3% 10.3%

(operating profit = (loss)/profit before tax +
finance costs)
Net pre-tax margin (16.4%) 8.9% 8.9%
Note: All calculations exclude other income, which was not budgeted. There is no indication of what
this might be, but audit work will be required on this figure. Gross margin has suffered a significant
decline. This may possibly be the result of a change in sales mix, but the decline requires further
explanation.
Finance costs
Linking finance costs to the statement of financial position, the principal liability at the 20X4 and
20X3 year ends was the loan from director. It appears that the director is earning approximately 10%
pa from this loan. Whether or not this is a reasonable return depends to some extent upon interest
rates in Celonia, but the interest rate may be excessive.
Other issues
Return on capital employed (7.7%) 5.6% 5.6%
Return on capital employed is negative in 20X4. Budgeted and 20X3 actual ROCE are both relatively
modest figures. It could be helpful to compare these and other performance ratios with industry
averages, both within Celonia and globally.
There is no tax expense or credit for 20X4. We need to know more about tax relief available for
losses in Celonia, but on the face of it, a figure appears to have been omitted in this respect.
Depending upon loss relief available, the bottom line loss for 20X4 may be reduced.

Financial position
A selection of relevant accounting ratios is presented in the table below:
Non-current asset turnover 0.55 0.58 0.58
Inventory turnover (days)* 134.7 days 109.3 days 114.7 days
Receivables turnover (days) 60.6 days 56.0 days 59.4 days
Current ratio 1.48:1 1.51:1 1.46:1
Quick ratio 0.51:1 0.66:1 0.62:1
Payables turnover (days)** 148.3 days 134.4 days 142.3 days
* Calculated on the basis of year-end inventory/(change in inventories and WIP, raw materials and
consumables, employee expenses and depreciation expense).
** Calculated on the basis of year-end trade and other payables/(change in inventories and WIP, raw
materials and consumables, employee expenses and other expenses).
The statement of financial position shows a general decline between the two financial year ends.
Non-current asset turnover has declined, even though it is calculated on a year-end figure that has
been subject to impairment. Inventory turnover is significantly worse than budget and last year, and
may indicate inability to sell finished goods. Presumably quite a lot of finished goods are sold to
Couvert (we need to know the proportion of Ectal’s business that is accounted for in this way) and so
it may reflect a decline in demand in the UK for Celonian products. Current ratio looks quite
reasonable, but quick ratio confirms the initial impression given by a review of the statement of
financial position which is that the business is illiquid. Both payables turnover and inventory turnover
are at a very high level and there is only an insignificant quantity of cash in the business at 31 August
20X4.
We currently have no explanation of the C$16 million in provisions and we need to obtain further
information on this point without delay. There is no indication of where this amount has been
recognised in profit or loss. This information may help to explain some of the anomalies in the
comparison of the expense totals, mentioned earlier.
Analytical review summary
The analytical review raises a lot of questions, and also some suspicions about the opening position.
The significant decline in 20X4 could suggest that the financial statements for the year ended 31
August 20X3 were manipulated to show a better performance in the year then ended and a stronger
closing position. Due diligence should have revealed any accounting manipulation but clearly this
effect was not observed.
Concerns about the corporate governance of Ectal
Couvert plc is a listed company. Assuming that it is listed on the London Stock Exchange, the UK
Corporate Governance Code applies to it. Because Ectal is a subsidiary, and is incorporated in
Celonia, the Code does not formally apply to it. It would, however, be best practice to adopt the
Code in Couvert’s subsidiaries, including any foreign subsidiaries. Many provisions of the Code are
apparently missing in Ectal’s corporate governance arrangements. For example, the board of Ectal
appears to have no non-executive directors, and there is no separation of the roles of chairman and
chief executive. There appear to be no board committees, and the whole board does not, in practice,
meet regularly.
The corporate governance arrangements for Ectal effectively grant power over Ectal’s operations to
Ygor Vitanie. The arrangements are constitutionally unsatisfactory in that, unless all three Couvert
directors attend board meetings, Ygor has control of the Board. Even if only one Couvert director is
absent, the board is four in number, and Ygor has the casting vote in case of a tied vote. This
assumes that Ygor’s daughter, Ruth, always votes with her father; we may be able to test this
supposition with the cooperation of the Celonian auditors, by examining board minutes. An interview
with Couvert’s operations director, who has attended all of Ectal’s board meetings this year could
help to establish the pattern of voting that actually took place during the year.

The additional problem is that the Couvert directors have not, on the whole, taken much interest in
Ectal’s operations in the first year of ownership. Because Couvert’s marketing director has not yet
attended an Ectal board meeting, all meetings have therefore been dominated by Ygor (again,
assuming that his daughter votes with him). This is clearly unsatisfactory, and should be addressed by
Couvert, the majority shareholder, without delay.
Financial reporting implications for Couvert’s consolidated financial statements for the year ended
31 August 20X4
The implications of the analysis above are as follows:
(1) Ectal’s financial reports for the year ended 31 August 20X4 are incomplete, and appear to
require a lot of additional work. This may have the effect of delaying the consolidation and thus
placing the group’s preliminary reporting deadline at risk.
(2) Goodwill on consolidation in respect of the Ectal investment may be misstated, and any
misstatement could be highly material. The material impairment loss in respect of property, plant
and equipment could indicate that PPE was overstated at acquisition, and that goodwill was
therefore understated. However, if the financial statements for the year ended 31 August 20X3
(the opening position for this year) were manipulated to show an improved performance and
position, it is likely that Couvert paid too much for the investment, and goodwill may require
impairment. If the loss for the year ended 31 August 20X4 is, on the other hand, genuine (and
not affected by the misstatement of the opening position) goodwill may still require impairment.
(3) The extent to which Couvert actually controls Ectal requires careful examination from a financial
reporting perspective. Couvert has the majority shareholding which would normally indicate
control. However, IFRS 10, Consolidated Financial Statements states that an investor controls an
investee if and only if it has all of the following: power over the investee; exposure, or rights, to
variable returns from its involvement with the investee; and the ability to use its power over the
investee to affect the amount of the investor’s returns.
Couvert apparently has power over the investee as it owns 55% of the share capital. The fact that
the Couvert board members have not exercised control is not a determining factor in deciding
whether Couvert has control over Ectal. However further information would be required
regarding the rights of the shareholders to appoint board members. If Ygor has further rights to
appoint more members of his family it could be that Couvert does not have control over Ectal.
If Couvert does not control Ectal under IFRS 10, then the investment cannot be recognised in the
consolidated financial statements as a subsidiary and would be recognised instead as an
associate.
Actions to be taken by PG, and potential implications for the group auditor’s report arising from the
audit of Ectal by Stepalia
Reassessment of audit risk
We may need to reassess audit risk in respect of the investment in Ectal. Audit risk was originally
assessed as moderate. There appear to be some good reasons for reassessing the risk as high:
(1) There are now questions over the effectiveness of Ectal’s corporate governance and, especially,
over the extent of Couvert’s involvement in Ectal’s governance.
(2) There is now an apparent risk that Ectal’s opening figures were misstated and that due diligence
was compromised.
(3) There is a continuing lack of communication from Stepalia (see below).
If the due diligence engagement was not conducted thoroughly, PG’s relationship with Couvert may
be damaged, and engagement risk may increase.
Poor performance by Ectal’s auditors, Stepalia in respect of the audit for the year ended 31 August
20X4
As at today’s date, no returns or information have been received from Stepalia. ISA (UK) 600 (Revised
November 2019), Special Considerations – Audits of Group Financial Statements (Including the Work
of Component Auditors) requires that group auditors should evaluate the work of the component
auditor but currently it is not possible to do this.

We should take the following actions immediately:
• Seek a meeting with the Couvert finance director to explain that our group audit cannot be
concluded satisfactorily unless full information is received about the Ectal audit from Stepalia.
• Attempt further direct communication with the Stepalia audit team via phone or email.
• Plan attendance at key audit meetings between Stepalia and Ectal’s management. This is likely to
involve a visit to Celonia before our audit completion deadline.
If we do not receive full information from the component auditors before our reporting deadline, the
implication for our audit report is that modification may be necessary. This is likely to be on the basis
that we have not obtained sufficient appropriate audit evidence (a limitation on scope opinion),
which is material but not pervasive. The appropriate form of audit report would state a true and fair
opinion (assuming no other audit modification was necessary in respect of Couvert and other parts
of the group) except in respect of the audit of Ectal where insufficient information was received from
the component auditors. We would also need to consider any Key Audit Matters as Couvert is a listed
company.
Financial Reporting queries received by email from Couvert’s finance director
Issue 1 – Accounting for retirement benefits
The following working shows the movement in the six-month period in respect of pension plan
assets and obligations:
Assets Obligations
£’000 £’000
Fair value/present value at 1 March 20X4 8,062 8,667
Interest for six months to 31 August 20X4 (£8,062,000 ×
3%) (£8,667,000 × 3%) 242 260
Past service costs 500
Contributions paid into plan 842
Benefits paid (662) (662)
Gain on plan assets (balancing figure – OCI) 146
Gain on remeasurement (balancing figure – OCI) ––––– (312)
Fair value/present value at 31 August 20X4 8,630 9,057
The present value of obligations at 31 August 20X4 has been adjusted upwards to take account of
the additional £500,000 in plan liabilities in respect of the plan amendment. The increase in benefits
has been announced and is therefore properly recognised as a liability.
Journal entries to reflect these transactions are as follows:
Debit Credit
£’000 £’000
Staff costs (in respect of service costs) 1,104
Plan obligations 1,104
Finance costs 260
Plan obligations 260
Finance costs 242
Plan assets 242
Plan assets – contributions to the scheme 842
Staff costs 842

Debit Credit
£’000 £’000
Pension plan assets – gain on plan assets 146
Pension plan liabilities – gain on plan liabilities 312
OCI actuarial gain ––––– 458
2,906 2,906
The total gain on pension assets and liabilities is recognised in other comprehensive income. The six-
month discount rate of 3% is applied to opening plan assets and liabilities, and the amounts
calculated are added to plan assets and liabilities and credited/debited to finance costs in profit or
loss.
Issue 2 – Financial asset
The put option appears to fulfil the definition of a derivative: its value changes in response to the
changing price of an underlying security, its initial investment is small relative to the underlying value
of the security, and it is settled at a future date. This being the case, the correct IFRS 9 classification
for the option is as a derivative at fair value through profit or loss. The initial recognition of the
financial asset was therefore incorrect, and the following correcting journal is required:
£ £
DEBIT Financial assets at fair value through profit or loss 63,000
CREDIT Investment in equity instruments 63,000
The share price has fallen below the put option price of £6.00 and the option is therefore in-the-
money. A gain can be expected on the option, measured at the year-end date of 31 August 20X4 as
the increase in the fair value of the option of £32,000 (£95,000 – £63,000).
The required journal entry is:
£ £
DEBIT Financial assets at fair value through profit or loss 32,000
CREDIT Profit or loss 32,000
Examiner’s comments
Financial statement analysis
Most candidates made a reasonable attempt at the first part of the question which required analysis
and explanation of Ectal’s incomplete financial statements, plus queries for Ectal’s management and
its auditor. There were few really impressive answers, but most candidates managed to achieve at
least half marks for this section.
Few candidates identified the risk that the prior year figures may have been manipulated to improve
the price paid to acquire the subsidiary. The fact that the statement of profit or loss analysed
expenses by nature rather than function was rarely commented on therefore caused problems in the
calculation of standard ratios such as gross profit margin. Although some candidates commented on
the loan from a director, it was very rare to see the loan related to the level of interest and the
possibility that the interest being paid was excessive. Finally, disappointingly few candidates noted
that the information given was incomplete thus limiting the amount of analysis that could be done
and few identified the unexplained movement in retained earnings.
However nearly all candidates achieved all the available marks for identifying further enquiries to be
made.

Other points that were picked up and commented on by most candidates included:
• the significant and unexpected downturn in revenue;
• the appearance for the first time of other income;
• the high levels of employee expenses and the unexpectedly low level of depreciation;
• the current year impairment and creation of a provision (most also commenting that these were
potentially ‘one off’ expenses); and
• the decline in liquidity ratios and the low level of cash held at the year end.
Concerns about corporate governance and financial reporting implications
There were some very good answers to this part of the question which required identification and
explanation of concerns about Ectal’s corporate governance. However, relatively few candidates
considered the potential impact of the corporate governance failings on the group financial
statements. Very few candidates grasped the point that goodwill might be overstated and might
require impairment.
Actions to be taken by PG and group audit implications
The third part of the question required an explanation of the actions that the group auditors, PG,
should take in respect of the apparently inadequate performance by the component auditors, and an
explanation of the potential effect on the group audit report. This part of the question was generally
well-handled, although it was noticeable that a large minority of candidates failed to apply their
knowledge of ISA 600 to the specific circumstances in the question. So, for example, many
candidates wasted time on spelling out the actions that the group auditor should have taken at the
start of the audit, rather than examining the actions that the group auditor should take now in the
final stages. Most candidates managed to say something sensible about the implications for the
group audit report.
Financial reporting treatment of defined benefit pension scheme and financial asset
The fourth and final part of the question required the candidate to provide advice on accounting for
retirement benefits (a defined benefit scheme) and for a derivative financial asset. Accounting for
retirement benefits was generally well understood by candidates, although some seemed to spend a
lot of time and space on their description of the adjustments. The aspect of the question that most
got wrong was the past service cost with some candidates ignoring it altogether and others
including it in the year-end liability but not the expense or vice versa. Most did identify that debiting
current year contributions to staff costs was incorrect although some simply ignored what had been
done and simply wrote out the standard journals to account for the movements in the pensions
account.
Candidates generally fared less well with the financial asset. It was common to find that they did not
understand that the financial instrument was a derivative and must therefore be recognised as at fair
value through profit or loss. A significant minority of candidates became heavily bogged down in
discussions of hedging.
32 ERE (November 2014)

Scenario
The candidate in this scenario is asked to review the audit procedures performed by a junior
member of staff on payables and deferred tax. To answer this question the candidate needs to
identify weaknesses and missing procedures and to recommend further audit procedures to enable
a conclusion to be determined on the audit of ERE. There are also errors in financial reporting which
the candidate needs to assimilate in order to recommend adjustments. A summary of uncorrected
errors needs to be prepared from which the candidate should determine a reasonable course of
action to enable the firm to arrive at an audit opinion on the financial statements of ERE.
Finally the candidate must identify the ethical issues arising from the scenario which relate to the
potential weakness in the firm’s quality procedures and a potential fraud at the client.

Marking guide Marks
Key weaknesses in the audit procedures 10

Financial reporting issues and appropriate adjustments 12
Adjustments and further actions 6
Ethical issues 6
34
Total 34
General weaknesses
(1) The working paper prepared by Chris does not adequately document the work he has
performed.
(2) There are no references to how he has calculated his sample size and how he has used the
materiality level.
(3) There is no evidence that he has carried out analytical procedures.
(4) ISA (UK) 500 requires that audit evidence should be ‘sufficient’ and ‘appropriate’.
Appropriateness relates to the quality of evidence which should be relevant and reliable:
(a) In terms of relevance, there is no reference to relevant audit assertions for each class of
balance being tested. Nor has he identified which audit assertions are more relevant
dependent upon the nature of each balance.
(b) With respect to reliability, he has relied heavily on the client for oral evidence which is not an
independent source. In so far as he has examined supplier statements this provides third
party evidence but he has allowed the client to select the sample which reduces the quality
of such evidence.
Specific weaknesses in work performed by Chris
Trade payables
(1) It appears that the client chose the balances for the supplier statement reconciliation test on the
basis of the largest balances at the year end. The client should not have selected the sample.
Also it should have been selected based on throughput rather than year-end balance as the key
risks are both understatement and overstatement.
(2) Chris has also underestimated the amount of coverage of the sample selected since he has
based the percentage coverage on the supplier balance not on the ledger balance. His sample
represents 53% of the unadjusted purchase ledger balance.
(3) The work performed on the cash in transit is inadequate and needs to be followed up – there is
evidence here of window dressing and this point needs to be raised with the board. There is at
least £1.2 million which has reduced the payables and cash balances at the year end and I have
recorded £1.2 million on the schedule below. However, there may be more and the amount
should be quantified and raised at the audit completion meeting.
(4) The work on invoices in transit is not adequate. Chris should have determined when the goods
were received rather than just when invoice was posted. If the goods were received pre year
end, Chris should have agreed the amount to an accrual within goods received not invoiced and
ensured that the goods were either in inventory or sold at the year end. Further audit procedures
are required to provide assurance that payables are not understated by sampling goods
received notes immediately prior to the year end and ensuring they are recognised in payables,
particularly where they have not been invoiced at the year end.
(5) The large number of invoices in transit on two suppliers may suggest a cut-off error so further
emphasises that there is a need to do careful work here.
(6) The explanation of the invoices on ‘hold’ is inadequate and should be taken forward to be
discussed with those charged with governance. Potentially this is indicative of a fraud at a
supplier company and has ethical implications and reputational risks for the firm and for ERE as
there may be collusion with ERE staff – see below.

(7) The calculation of the KH exchange gain is incorrect – see below financial reporting issues. The
work performed by Chris is again inadequate. He should have enquired about other currency
denominated creditors and how these have been treated at the year end.
(8) Chris should also have asked whether there are any hedging arrangements in place for such
large forex balances as there may be unrecognised derivatives at the year end.
(9) The legal claim and Medex disputed invoices should be raised for discussion with the board and
further audit procedures are required in terms of direct confirmation with the legal advisers and
potentially an auditors’ expert.
(10) The adjustment to credit purchases is large – £850,000, and in excess of materiality, and there is
no evidence that Medex has accepted liability and intend to issue credit notes for this amount. I
have highlighted this on the schedule below.
(11) The work on debit balances is inadequate – Chris should have investigated how and why such
balances have arisen this year and whether they are recoverable.
Other payables
(12) The provision for restructuring and the lease have been calculated incorrectly – see below
under financial reporting issues. In terms of the audit procedures performed this is also limited.
The division has now closed and Chris should have confirmed the restructuring costs to
payments after the year end. There are also potentially further costs for impairments of non-
current assets and receivables and no audit procedures appear to have been carried out to
identify these.
(13) No work has been performed on other accruals which has increased from last year even after
taking account of legal costs, and exceeds the materiality level.
(14) Deferred tax work is clearly inadequate – I have therefore summarised the risks and audit
procedures in the following schedule:
Audit risks and procedures:
Audit risks Procedures
• Risk of both over and understatement of • Re-perform a sample of supplier statement

year end trade payables. reconciliations based on throughput, obtain
explanations for all reconciling items and
recommend appropriate adjustments.
• Perform cut off procedures on supplier
invoices, accruals – directional testing in
both directions, both pre and post year end.
• Obtain explanation for debit balances and
confirm they are recoverable.
• Obtain a list of credit notes after date and
determine whether further adjustments are
required.
• Obtain documentation in respect of
disputed Medex invoices and assess
appropriateness of the credit note accrual.
• Quantify the total cash-in-transit and
determine whether adjustment is required to
eliminate window dressing.
• Obtain permission from those charged with
governance to contact Mesmet. If
permission refused consider whether
alternative procedures are possible to
confirm the balance. Document for audit
completion meeting the ethical implications
of the invoices on ‘hold’ see below.

Foreign exchange
• There is a clear risk that there may be other • Review the list of trade payables for other
misstatements of Forex balances. currency balances and reperform
• Inventory may be overstated if the goods calculations of exchange gains and losses.
purchased in other currencies are still in • Confirm with other team members that
inventory at year end. adequate testing has been performed on
• There may also be missing balances in NRV for inventory.
respect of derivatives. • Enquire whether there have been any
forward contracts undertaken in the year.
Enquiries should be made of the finance
director as this is unlikely to be an area
which is the responsibility of the financial
controller.
Other payables
• Other payables may not be fairly stated. • Obtain a list of other payables, compare to
previous year and supporting
documentation. Verify to third party
evidence and re-performing calculations as
appropriate.
Provisions
• There is a risk that there may be other similar • Review accruals schedule for other accruals
balances that required discounting which which may need discounting and quantify
may cumulatively be material. the impact of such an adjustment.
• There is a risk that impairments of assets in • Confirm with other audit team members that
the factory have not been correctly assessed adequate testing has been performed on
therefore non-current assets will be impairments of receivables and non-current
overstated. assets.
• Receivables relating to the division may also • Review payments after date and ensure that
not be correctly stated. the provision is fairly stated. Agree to
• There could be additional liabilities which supporting third party documentation.
have arisen which were not originally in the
budget.
Legal claim
• The financial statements may not be fairly • Make appropriate enquiries of those
stated if the legal claim is not disclosed. charged with governance including
obtaining representations.
• Review board minutes and correspondence
with ERE’s legal advisers.
• Ask for permission from those charged with
governance to communicate directly with
ERE’s lawyer by means of a letter of enquiry
with the reply sent direct to HH.
• Consider all matters pertaining to the legal
case up to the date of signing the auditor’s
report.
Deferred tax
• There is a risk that the client lacks the • Review the current tax computation for any
appropriate financial reporting knowledge temporary differences not accounted for as a
to prepare accurate deferred tax deferred tax adjustment.

computations resulting in a misstatement • Obtain a reconciliation of profit per the

of the financial statements. financial statements to taxable profit and
ensure that deferred taxation has been
appropriately provided for temporary
differences only.
• Verify that the tax rate at which the liabilities
and asset unwind is in line with tax
legislation enacted.
• Agree the opening position of the deferred
tax liability to the prior year financial
statements.
• Consider whether it is appropriate for the
company to recognise deferred tax assets
and liabilities given future forecasts of
taxable profits.
Identify and explain the financial reporting issues. Recommend appropriate adjustments.
Issue 1 – Forex gain on KH balance
The purchase has been recorded correctly at the rate of exchange on 1 October 20X3.
£’000 £’000
DEBIT Purchases 3,478
CREDIT Trade payables 3,478
On 1 April 20X4 ERE paid €2,000,000 to settle half of the trade payable (£1,739,130). This cost
€2,000,000/€1.20:£1 = £1,666,667 and the company therefore made an exchange gain of £72,463,
which (assuming the credit has gone to profit or loss) has been correctly recorded as:
£’000 £’000
DEBIT Trade payables 72
CREDIT Exchange gains: profit or loss 72
However on 31 July 20X4, the year-end date, the liability should be recalculated using the year-end
balance: €2,000,000/€1.27:£1 = £1,574,803 which gives rise to a further gain of £1,739,130 –
£1,574,803 = £164,327.
Further adjustment required:
£’000 £’000
CREDIT Exchange gains: profit or loss 164
Issue 2 – Legal claim made by hospital

The issue here is whether the legal claim should give rise to a provision or a contingent liability
requiring disclosure and, if possible, quantification; or if remote no disclosure. It appears likely that
this issue represents a contingent liability and further audit procedures are required to determine
and quantify the level of disclosure. There may also be an offsetting claim against Medex and an
assessment must also be made of whether any disclosure can be made in respect of a contingent
asset. At the moment there is insufficient information to determine the adjustment for this claim.
The legal fees have been correctly accrued. Given the size of the balance, discounting is unlikely to
be material but should be quantified for the schedule of uncorrected misstatements below. I have
used an annual discount rate of 5% for two years (1/1.052) to calculate the following adjustment:
100,000 × 0.907 = £90,700

However the interest rate should be confirmed as appropriate to this type of liability and level of risk.
Issue 3 – Provision for restructuring
The provision for restructuring has been overstated and should not include the one-off payment nor
the removal costs of the plant and machinery. An adjustment is required as follows:
£’000 £’000
DEBIT Other payables 450
CREDIT Restructuring costs: profit or loss 450
Further adjustments will be required on completing of audit work in this area.

Issue 4 – Lease cost
ERE was not correct in creating a provision for £1.1 million. This is an onerous lease contract, which is
dealt with under IFRS 16, Leases, rather than IAS 37.
In accordance with IFRS 16, a lease liability and a right-of-use asset was correctly recognised in the
statement of financial position. The carrying amount of the right-of-use asset at 31 July 20X4 is
£1,853,280 × 6 years / 10 years = £1,111,968. The potential fall in rental income indicates that the
right-of-use asset is impaired, because it is underperforming. An impairment test must be carried out
and an impairment loss allowance recognised for the right-of-use asset.
The present value of the sublease arrangement is:
£60,000 × 5.076 = £304,560
This is lower than the carrying amount of the right-of-use asset of £1,111,968, and therefore the
right-of-use asset should be written down to the present value of the sublease arrangement, giving
an impairment loss of £1,111,968 – £304,560 = £807,408:
£’000 £’000
DEBIT Impairment loss: profit or loss 807
CREDIT Right-of-use asset 807
The provision of £1.1 million should be removed:
£’000 £’000
DEBIT Other payables 1,100
CREDIT Lease costs: profit or loss 1,100
Issue 5 – Deferred tax

The offsetting of deferred tax assets and liabilities is permitted by IAS 12 provided that the entity has
a legally enforceable right to offset current tax assets against current tax liabilities – this appears to be
the case but further audit procedures should be carried out to confirm this.
A temporary difference arises with the upward revaluation of the head office building. This should be
provided for in full and therefore the following adjustment is proposed:
£’000 £’000
DEBIT Other comprehensive income 200
CREDIT Deferred tax liability 200
Unused tax credits carried forward against taxable profits will give rise to a deferred tax asset to the
extent that profits will exist against which they can be utilised.
The existence of unused tax losses, however, is strong evidence that future taxable profits may not be
available. The deferred tax asset should be limited to the likely future profits – £1,250,000 × 20% =
£250,000

£’000 £’000
DEBIT Deferred tax: profit or loss 150
Therefore the total deferred tax liability at year end is £790,000.

Summarise any proposed adjustments you have identified on a schedule of uncorrected
misstatements and determine what further action we should take
Statement of profit Statement of

or loss financial position
Debit Credit Debit Credit
£’000 £’000 £’000 £’000
(1) Window dressing – cash in transit
DEBIT Cash 1,200
CREDIT Payables 1,200
(2) Medex disputed invoice
DEBIT Purchases 850
CREDIT Trade payables 850
(3) Exchange gain on KH balance
Exchange gains: profit
CREDIT or loss 164
(4) Discount on legal fees
DEBIT Accruals 10
CREDIT Legal costs 10
(5) Provision for restructuring
DEBIT Other payables 450
Restructuring costs:
CREDIT prof/loss 450
(6) Lease costs
Impairment loss: profit
DEBIT or loss 807
CREDIT Right-of-use asset 807
DEBIT Other payables 1,100
Lease costs: profit or
CREDIT loss 1,100
(7) Deferred tax on office building
Other comprehensive
DEBIT income 200
(8) Deferred tax asset
Deferred tax: profit or
DEBIT loss 150

Further action
Clearly some of these adjustments are material and will therefore be required so that the financial
statements are fairly stated. However, the audit work to date would appear to be inadequate
therefore I propose the following actions:
• Completion of audit work as proposed above.
• Review of the entire audit file and quantification of adjustments by an appropriately qualified
member of staff.
• The schedule of uncorrected misstatements should also include any brought forward errors which
impact on the current year’s results and SOFP.
• Arrange a meeting with those charged with governance to discuss the adjustments.
• Refusal to adjust or refusal to permit HH to obtain necessary explanations and confirmations may
result in limitation on scope of audit work and a modification of the audit opinion may be
required.
• In accordance with ISA (UK) 530, Audit Sampling (para. 14), for tests of details, HH is required to
project misstatements found in the sample onto the population. If the projected misstatement
(plus anomalous misstatement if any) exceeds the tolerable misstatement the sample does not
provide a reasonable basis for conclusions about the population. HH may then (1) request
management to investigate actual and potential misstatements, or (2) perform further audit
procedures (paras. A.22-23).
Identify and explain any ethical issues for HH, and recommend any actions you believe we should
take
• For HH there is a professional ethical concern in respect of the quality of the work being
performed. HH are not acting in accordance with the FRC and ICAEW ethical codes in respect of
professional competence and due care.
• A junior member of staff appears to have been inadequately supervised and performed
inadequate audit work to date. Although this has been identified on a timely basis on this
assignment there may be quality issues with other assignments.
• Although there is no breach of the ethical code in respect of Josi’s appointment at ERE (as she
had not completed her training contract she would have held a junior position within the audit
team), clearly relying on the work she is producing represents a threat to audit independence
which needs to be addressed in the planning of audit procedures.
• There is evidence of poor training, lack of professional competence and maybe also lack of
policies in HH for addressing problems when staff members leave for employment with a client.
• There is potentially a fraud being perpetrated at an ERE supplier company, Mesmet. HH needs to
determine whether there is collusion with ERE staff and whether there is a risk of material
misstatement in the ERE financial statements. This is an ethical issue for HH if the client has
unaddressed ethical issues as this increases engagement risk for HH.
• HH should adopt an attitude of professional scepticism and obtain relevant audit evidence of this
impact which should be documented including tests performed, discussions with audit team
members and detailed enquiries made at the appropriate level of management and their
responses.
• If fraud is suspected, HH should report to those responsible for governance at the appropriate
level – as potentially the finance director is involved then this should be given careful
consideration.
• There may also be responsibilities under the money laundering legislation and therefore we
should consult the firm’s money laundering compliance principal (MLCP).
Comment on candidates’ performance
A significant minority of candidates’ attempts at this question were perfunctory and partial. Some
candidates omitted answering this question which makes being successful at the exam very difficult.
However, there were some excellent answers demonstrating a very high level of analysis skills and
knowledge of auditing and financial reporting.

Key weaknesses, risks and procedures
The first requirement was an explanation of key weaknesses in the audit procedures carried out on
payables by a junior member of the audit staff. There were many relevant points that could be
identified in this respect and well-prepared candidates appeared to find little difficulty in scoring the
maximum marks for this part of the question. Even weaker candidates were often able to score
relatively highly on this, although their efforts were often marred by repetitious and sometimes
irrelevant answers.
Candidates produced comprehensive answers that clearly identified the weaknesses in the work
done as well as identifying risks and suggesting procedures. Most answers were in a logical format
with candidates working their way methodically through the information given. The most common
weakness was with regard to further procedures which were sometimes vague – ‘discuss with
management’ or inappropriate – suggesting contacting a supplier directly without first obtaining the
client’s permission.
Financial reporting treatments and appropriate adjustments
The second requirement was to identify and explain the financial reporting issues. This was generally
less well-handled. Despite lengthy calculations and explanations, many candidates were unable to
calculate an exchange gain. Weaker candidates were unsure about how, or if, to recognise a
contingent liability, and relatively few identified the point about the need to discount the liability for
legal fees. A significant number of candidates completely omitted any reference to the provision for
restructuring. Of those that did address the provision for restructuring, few candidates realised that
relocation and costs of removing plant and machinery should not be included. Well-prepared
candidates were able in most cases to produce a correct calculation for the present value of the
sublease arrangement, and the consequent correcting journal. Weaker candidates tended to omit
any reference to this issue. Most candidates who got this far were able to calculate the deferred tax
asset and deferred tax liability correctly, although some omitted to recommend adjustments.
Other common errors included:
• Mis-calculating the foreign currency gain at the year end by ignoring or dealing incorrectly with
the impact of the part payment made/occasionally treating it as a loss rather than a gain.
• Suggesting a provision should be set up even where the solicitors had advised that it was only
possible the claim would succeed.
• Failing to reverse out the adjustment for credit notes that had not been agreed with the supplier.
• Identifying that there was an onerous lease but making errors in calculating the discounted future
cash flows.
• Recognising the entire amount for the deferred tax asset re trading losses rather than calculating
the adjustment to the asset currently recognised.
Schedule of uncorrected misstatements
The third part of the question required candidates to summarise their adjustments on a schedule of
uncorrected misstatements. This requirement was often omitted. Missing out sections of questions is
not advisable. Those candidates who did attempt it tended to produce just a list of journals, without
any attempt to separate the profit or loss effects from the statement of financial position effects.
Those who did attempt to explain further action often achieved good marks for simple points such as
discussing the errors with the client and considering the potential impact on the audit report.
Ethical issues
Finally, candidates were required to identify and explain any ethical issues in the scenario. Most
candidates were able to gain a mark or two, at least, on this section and some did very well.
Most candidates made a reasonable attempt at identifying the ethical issues but the most common
weakness was to focus almost entirely on the issue of a previous member of the audit team joining
an audit client.
Other issues such as the quality of work performed by the junior member of the team, the potential
fraud at a supplier and the motive to manipulate caused by the potential AIM listing were then often
overlooked limiting the marks that could be awarded.

33 Congloma
Scenario
The candidate is an audit senior working on the audit planning for a group audit. They receive details
of a number of transactions and are required to determine the appropriate financial reporting
treatment of these transactions and also their implications for the group audit.
To answer this question, a good understanding of accounting for acquisitions and disposals
(including step acquisitions and part disposals) was essential. The scenario required the candidate to
link information concerning the group transactions from different sources and to assimilate the
information to determine the correct financial reporting treatment. The candidate was then required
to summarise adjustments against the consolidated profit before taxation. The audit element
required the candidate to set out the additional audit procedures not only procedures for the
individual transactions but also at group level to assess the impact on the group audit scoping.
Requirement Skills
Draft a response to Jazz’s email (Exhibit 2) and Identify the implications of control threshold not
its attachment (Exhibit 3). In your response you being crossed in respect of the acquisition of
should: Oldone shares.
• Set out and explain, for each of the Apply technical knowledge to determine the
transactions she identifies, the correct split of equity and liability in respect of the
financial reporting treatment in Congloma’s bond.
consolidated financial statements for the Apply IFRS 10 to determine whether control
year ending 31 August 20X4. Recommend exists in respect of the Neida investment.
and include appropriate adjustments and
calculations. Explain the implication of unidentified
intangible assets in Neida on consolidation.
• Calculate the consolidated profit before
taxation for the year ending 31 August 20X4, Describe the impact on the control threshold
taking into account the adjustments you arising from the sale of Tabtop and the
have identified. implications for the consolidation.
Determine the allocation of goodwill between
parent and NCI in respect of the Shinwork
disposal.
Identify potential omissions regarding fair
values and other costs and provisions in respect
of the Shinwork disposal.
Assimilate information on adjustments and
prepare a revised profit before taxation.
Set out in a working paper the additional audit Determine relevant audit procedures to the
procedures that we will need to perform as a transactions identified.
result of the transactions Jazz has identified. Identify the potential to manipulate profits
Include an explanation of the impact that the arising from the sale of the Oldone CEO’s
transactions will have on the scope of our audit shares – link relevant procedures to this risk.
procedures and the components that we
consider to be significant. Apply concept of materiality to determine that
Neida is potentially not material to the group
and therefore that subsidiary level procedures
may not be required.
Link the changes in group structure to the
assessment of work required on the
identification of significant components and
hence the level of audit procedures required at
associates and subsidiaries.

Marking guide Marks

Consolidated PBT 5
40
Total 40
(1) Financial reporting treatment of the matters raised in the finance director’s email
Oldone
As Oldone has been recognised as a subsidiary for some time, the acquisition of a further 20% does
not ‘cross an accounting boundary’ nor result in any change in control. As a result, no gain or loss will
be recorded. The proposed fair valuation exercise is therefore not required.
The accounting entries required in the consolidated financial statements will be as follows:
DEBIT Non-controlling interests £2.8m

DEBIT Shareholders equity (balancing figure) £1.2m
CREDIT Cash (or elimination of investment in holding company) £4.0m
Convertible bond issue

The bond issue should be accounted for as a compound financial instrument with a liability element
and an equity element.
The liability element of the gross proceeds is calculated as the net present value of the maximum
cash flows at the rate of interest for a similar bond without conversion rights, 8%:
Cash flow Discount factor PV

Year £‘000 8% £‘000
1 500 0.926 463
2 500 0.857 429
3 10,500 0.794 8,337
9,229
Hence of the £10 million gross proceeds, £9.229 million should be shown as a liability payable (on
issue). The split between the short and long term elements will need to be redetermined at the year
end of 31 August. The remaining balance of £771,000 should be shown as equity. The effect on profit
before taxation will be a charge of three months’ interest on the bond. This will be £9,229 @ 8% ×
3/12 = £185,000.
Neida
IFRS 10 para 12 states that “An investor with the current ability to direct the relevant activities has
power, even if its rights have yet to be exercised”. IFRS 10 para B47 also requires an investor to
consider potential voting rights in considering whether it has control and (para B22) whether they are
substantive ie, whether the holder has the practical ability to exercise the right.
Although Congloma does not have the majority of the voting rights in Neida and there are other
powerful investors, two factors in accordance with IFRS 10 suggest that Congloma may still have
control and should therefore account for Neida as a subsidiary rather than as an associate.
• It has the power to affect its returns from Neida through its control of Board decisions over
research and development, arguably the most important decisions in a research driven entity such
as Neida.
• It has the right to acquire further shares through its call option. The exercise of this option will give
it a majority holding of 65%. In this case the rights to acquire further shares appear to be

substantive as Congloma’s additional 20% holding will cost it £1.5 million compared to the £3.0
million it paid for its initial 45% shareholding. While this is a higher amount per share it is not
substantially higher and can reasonably be expected to be a competitive price for a stake which
takes it to a majority holding in the company.
The FD’s proposal to account for Neida as an associate is therefore incorrect.
Accounting for Neida as a subsidiary means that 100% of its results, assets and liabilities will be
consolidated within the group financial statements and the 55% share not owned by the group will
be accounted for as non-controlling interests.
The acquisition will have a significant impact on the group statement of cash flows with the
investment shown within investing activities.
Using the share of net assets method to determine goodwill on acquisition and the net asset
information provided will give a goodwill figure of £3 million + (55% of £200,000) – £200,000 =
£2.91 million which will be included as an intangible asset in the group financial statements and will
need to be subjected to a review for impairment.
However further consideration needs to be given to whether some/most of this value should be
attributed to intangible assets which are not shown at present on Neida’s statement of financial
position. In particular, there may well be value in the research and development project for Lastlo
which appears to have reached the commercial exploitation stage.
The Lastlo project should be valued as a separable intangible on acquisition (and subsequently
within the consolidated financial statements) if it could be sold separately from Neida and has a
stand-alone value. Treatment as a separable intangible will also affect group accounts in future years
as intangible assets other than goodwill are amortised through the statement of consolidated profit
or loss.
In addition to the Lastlo project there may be other separable intangible assets in the form of
intellectual property rights or contractual rights such as patents.
As Neida is accounted for as a subsidiary, its loss for the 3 months ending 31 August 20X4 will be
included in group profit before taxation (although 55% of it will then be attributed to the non-
controlling shareholders) – therefore adjustment required of £300,000 × 3/12 = £75,000.
Consideration also needs to be given to whether the option to acquire a further 20% of Neida has a
value which should be recorded within the financial statements.
Given Neida’s loss for the year, an impairment review should also be considered.
Sale of Tabtop
As a significant interest in Tabtop is expected to be retained, Tabtop will be an associate following
the part disposal. The loss of control triggers the need to re-measure goodwill and the retained
interest will therefore be valued not at net asset value but at fair value.
Therefore, the FD is correct in his recommendation of the accounting treatment in this instance
however the calculation of the gain on disposal is incorrect. There is in fact a small loss, calculated as
shown below:
£m
Proceeds received 6.0
Fair value of 25% interest retained 1.0
7.0
Less:
Net assets of Tabtop 5.6
Goodwill 1.5
(7.1)
Loss on disposal in group accounts (0.1)
This loss includes the downward revaluation to fair value of the remaining non-controlling interests,
thus explaining why it is different to the calculation performed by Jazz.

Jazz is correct in her proposal that from now on the remaining interest in Tabtop will be equity
accounted for. The full results of Tabtop will be included in the consolidated statement of profit or
loss up to 30 June 20X4. From that date onwards just the group’s share of Tabtop’s loss after tax will
be included and this will also be deducted from the carrying value of the investment in Tabtop in the
consolidated statement of financial position.
Tabtop will be included as an associate rather than a subsidiary for the last two months of the year.
This will mean that rather than a loss of £3m × 2/12 = £500,000, only a loss of 25% of that amount
(£125,000) will be included in profit before taxation. Therefore, an adjustment of £375,000.
As Tabtop has been making losses it is possible that it will not succeed under its new owners and the
remaining investment in the company will need to be reviewed for impairment.
Shinwork
An impairment adjustment will be required if the carrying amount is lower than the higher of the
value in use and the fair value less selling costs. The value in use is £9.2 million which is below the
carrying amount and therefore an impairment charge should be recorded. The following calculation
assumes that it is correct to use the value in use. If the fair value less costs to sell the remaining
business were higher then that figure should be substituted in the calculations above giving a lower
impairment charge.
The impairment in the overall value of Shinwork needs to be allocated between Congloma and the
non-controlling interests. As the non-controlling interests are determined using the proportion of net
assets method, there needs to be a notional grossing up of goodwill in order to compare the
carrying and recoverable amounts.
The parent company’s goodwill of £4 million needs to be notionally adjusted to include the NCI
notional goodwill of £1 million (20%/80% × £4m) giving a total goodwill figure of £5 million.
Hence the impairment can be calculated as:
£m
Net separable assets 8.0
Goodwill 5.0
13.0
Value in use (9.2)
Impairment loss allowance 3.8
Of the total impairment, 80% is allocated to Congloma giving a goodwill impairment of £3.04 million
to be recorded in the financial statements which is allocated first to goodwill.
Other financial reporting issues
Whether there are other costs which should be provided for? There are likely to be redundancy costs
and other costs of closure/disposal which should be provided for at the point at which a detailed
plan and announcement have been made (IAS 37). It is not clear from the information given whether
this is the case or will be by year end. However both the amount of the required provision and the
timing of its recognition need further consideration.

Effect on consolidated profit before tax for the year ending 31 August 20X4
£’000
Projected profit before adjustments 7,000
Oldone – no effect on profit before taxation but will affect the amount of profit
attributable to the non-controlling interests as this will be 20% to 31 May and nil
thereafter. 0
Bond issue – effect on profit before taxation will be charge of 3 months’ interest on the
bond. This will be £9,229 @ 8% × 3/12 (185)
Acquisition of Neida – as Neida is accounted for as a subsidiary, its loss for the 3
months ending 31 August will be included in group profit before taxation (although
55% of it will then be attributed to the non-controlling shareholders) £300,000 ×
3/12 = £75,000.
Goodwill is not amortised but there will be a further reduction in profit if there are other
intangible assets for which amortisation is charged. (75)
Tabtop – loss on disposal
In addition, Tabtop will be included as an associate rather than a subsidiary for the last
two months of the year. This will mean that rather than a loss of £3m × 2/12 =
£500,000, only a loss of 25% of that amount (£125,000) will be included in profit (100)
before taxation. Therefore, an adjustment of £375,000. 375
Shinwork: Impairment loss (3,040)
Adjusted projected profit before taxation 3,975
(2) Group audit procedures required on transactions identified

General points on scope of group audit work
The group auditor’s ability to obtain sufficient evidence will be affected by significant changes in the
group such as those for Congloma. Identification of significant components may change as entities
are added to the group or sold off or as the relative materiality of their operations changes. The
group auditor should be involved in the assessment of risk for all significant components which will
require a full audit using component materiality; and audit of specified balances related to significant
risks.
If work done at significant components does not provide sufficient audit evidence then some non-
significant components will be selected and additional procedures performed at those rather than
the analytical reviews performed in the past. Changes in the group may mean that such an approach
becomes necessary.
In this case, work at the components is performed by other teams from A&M LLP but the group audit
partner will still need to be involved in planning and directing the work of those teams to ensure that
sufficient assurance is given at group level.
Oldone
• As Oldone has been a subsidiary for some time, few additional audit procedures are likely to be
required.
• However, the sale by the Chief Executive of his shares does increase his incentive to overstate the
results of the company in the period to 31 May 20X4. There is therefore an enhanced risk of
management override of controls and fraud. The subsidiary audit team should be made aware of
this and asked to report to the group team on the results of focussed audit procedures on journal
entries and judgemental provisions.
• The results as at 31 May 20X4 will determine the entry made to reserves and therefore some
additional work may be required to look at whether an accurate cut off in revenue and costs was
achieved at that date. Any unusual trends in the last three months compared to the earlier part of
the year should also be thoroughly investigated.
• The sale and purchase agreement for the shares should be reviewed to identify key terms and
ascertain any performance conditions or additional liabilities.
• The entries made to record the new investment and the elimination of the non-controlling
interests balance should be reviewed to ensure that they are accurate.

Convertible bonds
• The terms of the convertible loan agreement should be reviewed and agreed to the loan
agreement document and ensure that the financial reporting treatment agrees to the terms.
• In particular the sources for the comparable interest rate should be checked as it is this which
drives the split of the compound instrument for accounting purposes. A higher or lower rate
could make a significant difference.
• The bond’s value is greater than planning materiality and is a complex transaction and requires
scrutiny given the lack of experience of the client’s staff.
Neida
• Review purchase agreement and loan agreement to identify key terms and form an independent
assessment as to whether Congloma has control over Neida and whether there are other key
terms which should be considered in forming that assessment or determining the amounts to be
included in the financial statements.
• Assess the date at which control passed and ensure that Neida’s results and cash flows have been
consolidated from that date. Given the immateriality of Neida’s results to the group, detailed audit
work at the subsidiary level is unlikely to be required, although consideration should be given to
the total level of costs incurred and whether any material amounts should have been capitalised
as R&D – this is unlikely in current year as total loss only expected to be £300,000 and this is likely
to equate to the costs as no significant revenue expected in start-up phase.
• Ensure that the investment balance held in the holding company has been eliminated on
consolidation and that the goodwill shown has been correctly calculated and disclosed. Check
that the investment is correctly included in the group cash flow statement as an investing cash
flow.
• Obtain details of the fair values attributed to assets and liabilities at the date of acquisition. For
each significant item (tangible assets and net current assets are unlikely to be significant based on
information provided), consider the basis for the fair value and assess the reliability of any
valuations provided by external experts. This is most likely to be relevant for separable intangible
assets such as R&D.
• Ensure that we have sufficient understanding of Neida’s operations and commitments to be able
to assess whether the assets and liabilities at the acquisition date are reasonable and complete as
it is possible that liabilities may have been missed or that the identification of separable intangible
assets is incomplete. Consider the monitoring controls which Congloma exercises over Neida and
discuss plans for the company with the Congloma nominated Neida directors.
• Review Neida’s business plans and consider whether there is any indication that the goodwill
and/or intangible assets are impaired. There will inevitably be significant judgement involved in
the valuation of a research company and the assessment performed at the time of the acquisition
and basis for the offer of £3 million should be relevant in making this assessment. While
significant change would not normally be expected in just a few months it is possible that a
research breakthrough or developments made by a competitor could have a significant effect on
the prospects of Lastlo and Neida and we need to make enquiries as to whether this is the case. A
change in key personnel, particularly those developing the project, would also be significant.
Tabtop
• Review sale agreement and ensure in particular that all costs have been recognised and that
consideration has been given to any liabilities or contingent liabilities arising from guarantees or
warranties given to the purchaser.
• Consider the terms of the agreement with the new majority shareholder and assess whether Jazz
is correct in saying that Congloma retains significant influence and should therefore account for
Tabtop as an associate.
• Review the accuracy of the accounting entries made to reflect the disposal.
• Consider the extent of procedures required at Tabtop to provide assurance on the results
consolidated for 10 months (which may still mean it is a significant component) and also whether
additional audit procedures are required at the disposal date at Tabtop to verify the accuracy of
the net asset balance used in the disposal calculation and the split of results between the period
when Tabtop was a wholly owned subsidiary and that when it is an associate. In considering the
level of work required we should take into account any due diligence procedures undertaken by

the acquirer (although we are unlikely to be given access to these) and whether a closing date
audit is planned on which we may be able to rely.
• Consider whether the inclusion of Tabtop as an associate changes our overall assessment of the
work required on the associate balances – Tabtop was considered significant when a subsidiary. It
may be that in the future it is audited by a different component auditor and that will give rise to
the need to assess that auditor and determine the level of assurance gained from their work.
Shinwork
• The key judgement in the impairment calculation is the amount of the value in use. Obtain
detailed projections supporting the value of £9.2 million and subject both cash flows and
discount rate to scrutiny comparing cash flows to past results, sales order levels etc, and
reviewing/performing sensitivity analysis for the key assumptions made.
• There may also be going concern indications and a going concern review should be considered.
• The amounts to be included in the consolidated statement of financial position for Shinwork will
be lower than in the prior year (as will its contribution to profit and revenue as business is
declining). Need to consider therefore whether Shinwork is still a significant subsidiary entity
(although it seems likely that this is the case given the size of its remaining value in use).
• Also need to consider whether, given Shinwork’s diminishing contribution and also the disposal of
Tabtop, work will be required at some of the subsidiaries previously considered insignificant in
order to obtain sufficient coverage of key balances across the group.
Oldone
Candidates correctly recognised that the acquisition of a further 20% of the shares did not cross the
control threshold or result in any change of control. However, the accounting entries required in the
consolidated financial statements were less well done.
Convertible bond issue
Candidates demonstrated a very good knowledge of the financial reporting treatment of convertible
bonds. They were able to explain how a compound instrument is split between debt and equity and
calculate the net present value of the cash flows, correctly allocating the residual value to equity. The
most common error was to discount the bond repayment for four years instead of three.
Neida
A significant number of candidates failed to consider the impact of IFRS 10 and therefore question
the issue of control. Although Congloma does not have the majority of voting rights there is strong
evidence of control via board decisions on R&D and the call option. Several candidates ignored
these factors and concluded that Neida was an associate or even a joint venture. Most candidates
were able to calculate the goodwill arising on acquisition but only a minority considered the need for
an impairment review. Only the very best candidates commented that there may well be other
separable intangible assets that require recognition.
Sale of Tabtop
Candidates generally displayed a good knowledge of the financial reporting treatment of a
reduction in interest from a subsidiary to an associate and were able to correctly calculate the loss on
disposal. Time apportioning profits correctly proved more challenging.
Shinwork
The impairment rules were explained well and most candidates were able to make a reasonable
attempt at the impairment calculation. The most common error was to not gross up the goodwill for
the NCI component. Other financial reporting issues were rarely identified.
Adjustments to profit before tax
This was generally well done, with candidates demonstrating the ability to assimilate information on
adjustments and prepare a revised profit before taxation. Most schedules were clear and cross
referenced and it was marked on an own figure principle. Weaker candidates ignored the statement
given in the question that the profit figure given was before accounting for any of the transactions.

Audit procedures
Those candidates who did well approached this section methodically addressing each transaction in
turn and suggesting procedures specifically relevant to that transaction and stating why the
procedure was required. Weaker candidates just produced an unstructured list of tests including
many ‘general’ procedures relating to intra company transactions and reliance on other auditors.
Many candidates just discussed ‘reviewing’ and ‘looking at’ without stating what they were looking
for or why they were reviewing.
Relatively few candidates focused on identifying significant components and instead often produced
lengthy answers discussing materiality.
For Oldone little consideration was given to the potential to manipulate profits arising from the sale
of Oldone’s shares held by the CEO. Few candidates thought that there may be an issue with buying
from the CEO and that there may be fraud. Time was wasted discussing fair values but these would
not have been relevant as control was not transferred as a result of the acquisition.
For Neida most procedures appropriately concentrated on the control aspect. Very little was
discussed about the fair value of the net assets and identifying the intangible assets. The losses may
have prompted the need for a goodwill impairment review but the most commonly mentioned
procedure was checking that the future losses were forecast correctly without saying why.
By the time Tabtop was discussed many were running out of fresh ideas and concentrated on
auditing the disposal – checking the calculations and the proceeds to the bank. It was disappointing
that few thought to check that the new holding gave significant influence and could have been
control or just an investment.
For Shinwork there were audit procedures of the VIU and little else. Some mentioned the need for a
going concern review but not many.
34 Heston
Scenario
Heston is a listed company which manufactures engines. It has four autonomous divisions operating
from separate factories. The candidate has recently joined Heston as deputy to the finance director.
Heston has had some difficult years recently but a new chief executive is beginning to turn the
company around. It has been decided to close the lawnmower division but at the accounting year
end under consideration it has not yet been sold. In order to boost sales volumes in the other three
divisions, selling prices were reduced by 10% at the beginning of the current financial year. Steel is a
significant raw material used in production. Fluctuations in steel prices are a major risk so the
company has entered into a cash flow hedge for a highly probable purchase of steel. Candidates are
required to:
• set out the financial reporting adjustments for the decision to dispose of the lawnmower division
and for the cash flow hedge;
• redraft the draft financial statements including comparatives; and
• analyse Heston’s performance and position for the current year using the redrafted financial
statements
Requirement Skills
Set out and explain the financial reporting Apply technical knowledge to determine the
adjustments required in respect of the issues in adjustments required for the discontinued
Exhibit 3. operation, including assets held for sale.
Set out the adjustment for cash flow hedge
determining the correct amount and the
presentation of the FV movement in OCI and
OCE.
Apply relevant adjustments required to
comparatives for SPL but identify that no HFS
adjustments required for comparative SoFP.

Requirement Skills
Explain relevant adjustments clearly identifying

the source of authority for treatment from the
relevant standard.
Prepare an adjusted statement of profit or loss Assimilate adjustments and prepare in

for the year ended 30 June 20X5 and an appropriate format.
adjusted statement of financial position at that Identify separate disclosure of continuing and
date in a form suitable for publication, including discontinued activities.
comparatives.
Analyse Heston’s performance and position for Identify causal factors for changes.
the year ended 30 June 20X5. Include Communicate in an appropriate style relevant
calculations and use the adjusted financial to the context of the FD’s section on the annual
statements. Outline any further information report and analysts’ questions.
needed, so I can ask somebody to investigate.
Identify separately the performance of
continuing and discontinued activities,
explaining the significance of each for
shareholders and other stakeholders.
Link price decrease to revenue increase and
provide reasoned explanation highlighting
changes in sales volumes.
Extrapolate results of analysis to infer reasons
for GP and profit changes.
Identify liquidity as an issue and explain main
factors affecting liquidity
Marking guide Marks
Financial reporting adjustments 14

Adjusted SPL 8
Financial analysis 8
30
Total 30
Set out and explain the financial reporting adjustments required in respect of the issues in Exhibit 3
Loss from discontinued operations
The Lawn Mower Division is a substantial and separate part of the Heston business as it is one of only
four divisions and it is a profit centre where revenues and costs are therefore separately identified. In
accordance with IFRS 5 para 31 it is therefore a component of the entity and should be treated as a
discontinued operation in accordance with IFRS 5 para 32. It is therefore required that Heston makes
appropriate presentation and disclosure of the effect of the division in the year ended 30 June 20X5
in accordance with IFRS 5 para 33 including comparatives for 20X4.
The costs identified are those that will no longer be incurred when the division is disposed of.
The post-tax loss for the Lawn Mower Division amounts to £12.274 million and is shown in Working 1
below.

Asset disposals – Held for sale
Plant and equipment appears to qualify as a held for sale asset in accordance with IFRS 5 from the
date they are marketed (ie, advertised for sale) and should be held at its fair value and in its current
condition (IFRS 5 paras 7 and 8). This is 1 April 20X5. Heston should charge depreciation up to the
time of classification and then no depreciation for the last three months. In Exhibit 3 a full year has
been charged which must be reversed and replaced by depreciation for nine months (see Workings
1 and 2 below).
It is not a disposal group as assets are to be sold to ‘a range of different buyers’.
At this date, according to IFRS 5 para 15, each asset of the Lawn Mower Division should be stated at
the lower of:
(1) their carrying amount, less depreciation up to the time it is classified as held for sale; and
(2) their fair value less costs to sell
If fair value is lower than carrying amount (as is the case above for plant and equipment but not for
the land and buildings) then an impairment charge should be made.
Thus the non-current assets held for sale should be recognised as a current asset and measured at
£17.27 million. An impairment charge of £1.235 million would be recognised. The details are shown
in Working 2 below.
The provision for redundancy appears to meet the conditions under IAS 37 but further information
should be obtained to confirm this.
The brand is not recognised (IAS 38) as it was not recognised previously in Heston’s financial
statements as it was internally generated.
Cash flow hedge
The arrangement qualifies for hedge accounting under IFRS 9, Financial Instruments, and meets the
objective-based test for hedge accounting, which focuses on the economic relationship between the
hedged item and the hedging instrument, and the effect of credit risk on that economic relationship.
It is a cash flow hedge.
Cash flow hedge accounting by Heston attempts to reflect the use of the forward contract to
purchase steel to hedge against future cash flow movements from inventory purchases arising from
steel commodity price movements. To do this, the movement in the fair value of the contract of
£42,000 (which is a loss), in the year ended 30 June 20X5, which would normally be recognised in
profit or loss, is recognised in other comprehensive income and in other components of equity and
as a financial liability.
This balance of £42,000 is recycled to profit or loss in the same period in which the hedged highly
probable forecast purchase of steel affects profit or loss. In this case, this is in the year ending 30
June 20X6 as the contract will be settled in September 20X5.
Note that under cash flow hedge accounting, the change in the fair value of the future cash flows (the
hedged item) is not recognised in the financial statements.
It is assumed that the contract is a fully effective hedge as it is based on the price of steel which
Heston acquires regularly.

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 comparatives
Statement of financial position as at 30 June 20X5
20X5 20X4
£’000 £’000
ASSETS
Non-current assets
Property, plant and equipment (113,660 – 18,260) 95,400 120,400
105,780 130,780
Current assets
Trade and other receivables 36,100 30,400
Cash and cash equivalents ––––––– 5,600
68,400 59,200
Non-current assets held for sale (W2) 17,270 –––––––
Total assets 191,450 189,980

Equity
Retained earnings (68,520 + 15,710) 84,230 68,520
Other components of equity (W3) (42) –––––––
121,188 105,520
Long-term borrowings 22,000 39,000
Current liabilities
Current tax payable 4,420 6,060
Financial liability 42 –
Overdraft 8,400 –
Provision for redundancy costs 3,800 –––––––
48,262 45,460
191,450 189,980

Statement of profit or loss and other comprehensive income for the year ended 30 June 20X5
20X5 20X4
£’000 £’000
Revenue (436,000 – 92,000)/(451,700 – 119,300) 344,000 332,400
Cost of sales (306,180 – 72,084)/(318,500 – 77,400) (234,096) (241,100)
Gross profit 109,904 91,300
Distribution costs and administrative expenses
(107,200 – 33,800)/(101,400 – 34,700) (73,400) (66,700)
Finance costs (1,500) (1,500)
Income tax expense (4,420 + 2,600)/(6,060 – 1,400) (7,020) (4,660)
Profit for the year from continuing operations 27,984 18,440
(Loss)/Profit from discontinued operations (W1) (12,274) 5,800
Cash flow hedge (W4) (42) –––––––
WORKINGS
(1) Loss from discontinued operations
£’000
Per draft accounts (Exhibit 3) (11,284)
Add back depreciation
for 3 months (980 – 90 – 645) 245
Impairment loss (W2) (1,235)

(12,274)

(2) Non-current assets held for sale
Plant and
Land Buildings equipment Total
£’000 £’000 £’000 £’000
Carrying amount at 1 July 20X4 5,600 5,040 8,600 19,240
Depreciation charge for 9
months
Buildings (6,000/50 × 9/12) (90) (90)
Plant (8,600 × 10% × 9/12) – – (645) (645)
Carrying amount at 30 April
20X5 5,600 4,950 7,955 18,505
Fair value less costs to sell
(13,000 & 7,000 × 96%) 12,480 6,720
Impairment loss allowance

(discontinued) Nil (1,235) (1,235)
Carrying amount 17,270
(3) Cash flow hedge
Value of contract: £’000

Price at 30 June 20X5 (6,000 × £158) 948
Price at 1 May 20X5 (6,000 × £165) (990)
Loss (42)

CREDIT Financial liability 42
Analysis of financial statements – for inclusion in finance director’s section of the commentary in the
annual report.
Revenue
The headline figure in the draft financial statements showed a decrease in revenue of 3.5% overall for
the company.
The adjusted financial statements strip out the Lawn Mower Division as a discontinued activity. The
revenue from Lawn Mowers fell significantly by 22.9% in the year but this, in part, was due to a major
new entrant in the industry over which Heston had no control. The response has been to decide to
sell off the Lawn Mower Division to prevent further losses.
The adjusted statement of profit or loss shows revenue of £344 million from continuing activities (ie,
from the three remaining divisions). This shows that revenue from these three divisions actually
increased compared to the previous year by 3.5%.
One of the underlying possible causes of this change could have been the reduction in all selling
prices of the three divisions of 10%, which may, as intended, have increased sales volumes.

If we adjust for this price change to show changes in sales at constant prices then this shows:
20X4: £332.4m
20X5: £382.2m (£344m/0.9)
This shows that sales volumes (crudely measured) have increased by about 15%. More information is
needed to explore the extent to which the price decrease was the primary causal factor for the
volume increase (for example, sales mix between products will also affect the year on year analysis)
but it is indicative that the policy has proved successful in expanding sales volumes.
Profit
The headline figures in the original draft financial statements show a significant fall of 31.1% in profit
for the year from £24.24 million to £16.7 million.
A key factor for analysts is the extrapolation of profits into the future by exploring trends. The
adjusted statement of profit or loss strips out the losses from the Lawn Mower Division and shows
profit from continuing activities which will form the basis of profit in future.
The adjusted figures reveal that the three divisions collectively showed an increase in profit for the
year on continuing activities of 52% from £18.44 million to £27.98 million.
This is a positive trend which can be emphasised to analysts, particularly if there is evidence that it
will continue in future.
Gross margin
The unadjusted gross profit margin has not changed significantly from 29.4% to 29.7%. However, the
gross margin from the discontinued operation has fallen from 35.1% to 21.6%.
The adjusted financial statements show that gross margin on continuing operations has increased
from 27.5% to 31.9%. At first sight this may seem surprising as selling prices have been reduced
which would normally indicate a reduction in gross margin. However, the increased sales volume has
taken advantage of the high level of fixed costs, and therefore operating gearing, in order to
enhance the gross margin and compensate for the selling price reduction.
Financial position and liquidity
The liquidity position of Heston has worsened significantly as measured by the decrease in cash of
£14 million from a positive balance of £5.6 million to an overdraft of £8.4 million.
On the other hand, £17 million of the long-term loan has been repaid in the year.
A concerning aspect of liquidity which may raise questions from analysts is the apparent worsening
of the working capital position. Both receivables and inventories have risen significantly, whilst
payables have decreased. All these have had a detrimental effect on cash and have been financed
from cash generated from operations. The reasons for the changes in working capital need to be
ascertained by further investigation.
There has been no cash spent on PPE in the year. It is not clear whether this is because there were no
viable opportunities to acquire new assets or because the cash was not available given it is being
consumed by increases in working capital.
A summary of the liquidity changes can be seen by drawing up a statement of cash flows for the year
ended 30 June 20X5 from the draft financial statements provided.
Note: Candidates are not expected to prepare a statement of cash flows, but may refer to individual
figures or groups of figures (investing, financing, or operating cash flows) within their narrative. The
statement of cash flows therefore provides a framework for such an approach.
£’000 £’000
Adjustments for:
Depreciation (120,400 – 113,660) 6,740
Provision 3,800
Increase in inventories (9,100)
Increase in receivables (5,700)

£’000 £’000
Decrease in payables (7,800)
Cash generated from operations 9,060
Income taxes paid (6,060)
Net cash from operating activities 3,000

Repayment of long-term borrowings (17,000)
Net decrease in cash and cash equivalents (14,000)
Cash and cash equivalents at 1 July 20X4 5,600
Cash and cash equivalents at 30 June 20X5 (8,400)
Other matters for further investigation

• An analysis of the fair value of assets. This would include the credentials of those who have
completed the valuation. This should evaluate the potential for borrowing using the assets as
security in order to enhance liquidity.
• Comparison of the ratios with those for other companies in the sector, to assess relative
performance.
• Additional segmental analysis for each of the three continuing divisions, to assess performance
and development opportunities for each segment independently. IFRS 8 segment disclosure may
be appropriate.
Financial Reporting adjustments
Candidates demonstrated a good knowledge of IFRS 5 and most answers focused on the accounting
treatment of assets held for sale. Some candidates wasted time by simply copying out every criteria
from the standard rather than focusing on the specific scenario given. The calculations of the
impairment of PP&E were generally well done although a minority incorrectly combined the land and
buildings and PP&E when carrying out their review. Although most candidates did recognise that
depreciation should stop when an asset is held for sale not all selected the right date and/or
calculated the adjustment correctly.
The consideration of discontinued operations was less well done with few candidates showing the
calculation of the collated loss from discontinued operations. A minority of candidates appeared
confused as to the difference between assets held for sale and discontinued operations.
Most questioned the need for the provision for redundancy and whether the brand could be
identified.
The cash flow hedge was not explained well. Many candidates copied the principles from the
learning materials but could not apply them to the scenario. The value of £42,000 was often
calculated correctly but then mistaken for a gain. Sometimes the calculations and the descriptions
were made and then concluded that the cash flow hedge did not apply because there was no
hedged item – demonstrating that some candidates did not understand the difference between the
fair value and cash flow hedges.
Adjusted financial statements
Answers to this part of the question were extremely disappointing with many not taking note of the
requirement which stated – ‘in a form suitable for publication’. Candidates often failed to
demonstrate even basic skills relating to the construction and presentation of financial statements eg,
allocating all assets categories into current or non-current assets, failing to adjust retained earnings
for profit adjustments.

In addition, candidates were unable to apply practically the disclosure rules from IFRS 5. Even though
most candidates identified that there was a discontinued operation in their earlier discussion many
just ignored this when re-stating the profit or loss statement. Even those who adjusted the current
year often failed to adjust the comparatives even though sufficient information was given to do this.
Assets held for sale were not shown as a separate line item of current assets. Some very weak
candidates incredibly wasted time copying out the question without adjustment.
Analysis of performance and position
Answers to this part of the question were extremely variable. Many candidates failed to consider the
context of the question and their content and communication style was either not appropriate or
irrelevant. Even if a candidate had not presented the financial statements appropriately showing
discontinued operations, the quality of the financial statement analysis would be significantly
improved had candidates considered that the division should be removed to identify the
performance of the continuing business. Weak candidates failed to interpret the scenario and to
identify separately the performance of the continuing and discontinued activities. Another common
weakness was to consider only performance and not position. At the other extreme there were some
exceptionally good answers which clearly and concisely communicated the key issues including
identifying high operating gearing and the relationship between price increase and sales volume.
Some candidates spent quite a lot of time calculating pages of ratios which were not then used in
their narrative. At Advanced Level ratios in isolation receive little or no credit.

35 Larousse
Scenario
The candidate is required to respond to various requests from a group’s managing director. The
Larousse Group has invested in 100% of the share capital of two subsidiaries. The candidate is
required to complete the draft consolidated financial statements, together with explanations of
adjustments made and further information required. Errors have been made in the initial drafting of
the consolidated financial statements and these required explanation and correction. Then the
candidate is required to prepare notes that analyse the performance and position of the two
subsidiaries. The Larousse Group board has been considering proposals to extend its social
responsibility reporting, and the candidate is required to explain the responsibility of the group’s
external auditors in respect of additional disclosures, and to evaluate the feasibility of commissioning
an additional assurance report. The candidate is required to describe the audit procedures required
for the additional assurance report. Finally, the candidate is asked to identify potential ethical issues
arising from an overheard conversation, and to describe actions that should be taken.
Requirement Skills
Prepare the consolidated financial statements Assimilate and demonstrate understanding of a

for Larousse for the year ended 30 September large amount of complex information.
20X5, correcting any errors. Provide Identify errors in the partially prepared
explanations and journal entries for any consolidation schedule, and related
adjustments you make. information.
Prepare notes for the board analysing the Identify appropriate accounting treatments for
performance and profitability of each of the two complex items such as goodwill, intangible
subsidiaries. assets, deferred consideration, intra-group
Respond to the proposals from the board about trading, share based payments.
social responsibility reporting by: Apply technical knowledge to identify
• explaining the responsibilities of our appropriate accounting adjustments in the form
external auditors in respect of the proposed of journal entries.
social responsibility reporting (Exhibit 3); Assimilate adjustments to prepare draft
and consolidated financial statements.
• evaluating the feasibility of an additional Analyse given information using appropriate
assurance report and describing the type of measurements such as gross profit margin.
work that might be involved in providing
verification of progress on the four key Demonstrate understanding of the importance
targets (Exhibit 3). of intra-group trading on the results.
Identify transfer pricing issue.
Apply knowledge of the scope of external
auditors’ responsibility in respect of voluntary
disclosures.
Identify issue of auditor firm competence to
produce additional assurance report.
Identify likely contents of additional report.
Assimilate knowledge, drawing upon question
content, to describe type of work required to
provide verification evidence.
Identify any potential ethical issues arising for Discuss appropriate responses and actions in
you and for Dennis Speed from the information respect of the apparent ethical dilemma.
in Exhibit 4, describing the actions that you Identify potential money-laundering issue.
should take.
Recommend caution in taking action.

Marking guide Marks
35.1 Consolidated financial statements 18

Social responsibility reporting 9
34
35.2 Ethics issues 6
6
Total 40
35.1 Completion of draft consolidated financial statements

Prepared by: Alex Chen
WORKINGS
(1) Acquisition of HXP
Marie’s treatment of the deferred consideration is incorrect. IFRS 3, Business Combinations
requires that consideration should be measured at fair value at the date of acquisition. Fair
value of the contingent consideration is the discounted present value of the consideration
payable on 30 September 20X7:
At 1 October 20X4: £6m × 1/(1.05)3 = £5.2m
Total consideration at 1 October 20X4 = (£12m + £5.2m) £17.2 million. After deducting
share capital and retained earnings at date of acquisition, goodwill is calculated as £5.8
million (£17.2m – £11.4m). The goodwill figure is high, relative to total consideration. It is
possible that at least part of it comprises unrecognised separable intangible assets, and
more information is required on this point.
Goodwill arising in a business combination should be tested annually for impairment.
More information is required on whether or not this test has been done, and on the results
of the impairment testing if it has been carried out.
Adjusting journal entries:
£m £m
DEBIT Goodwill (£5.8m – £2.6m) 3.2
CREDIT Deferred consideration (£5.2m – £2m) 3.2
HXP reports a profit before tax in the year ended 30 September 20X5 and therefore the
contingent condition is met for the first of the three years. The discount is unwound, and
debited to finance costs.
Fair value of deferred consideration at 30 September 20X5: £6m × 1/(1.05)2 = £5.4m. The
journal entry required to recognise the unwinding of the discount is as follows:
£m £m
DEBIT Finance cost (£5.4m – £5.2m) 0.2
CREDIT Deferred consideration 0.2

(2) Acquisition of Softex
The research asset can be recognised at acquisition as it is a separable identifiable asset
and the subject of a transaction at fair value. Goodwill is therefore reduced by £2 million;
the correcting journal entry is as follows
£m £m
DEBIT Intangible asset 2.0
CREDIT Goodwill 2.0
Intangible assets are subject to annual amortisation, but more information would be
required in order to determine an appropriate amortisation rate
(3) Adjustments for intra-group trading
Intra-group trading items must be eliminated upon consolidation.
Intra-group sales from HXP to Larousse: 50% × £12m = £6m
Sales outside the group therefore: £6 million
Intra-group sales from Softex to Larousse: 50% × £16m = £8m
Sales outside the group therefore: £8 million
The journal entry required to remove intra-group sales from group sales and cost of sales
is as follows:
£m £m
DEBIT Revenue (£6m + £8m) 14.0
CREDIT Cost of sales 14.0
In addition, a provision for unrealised profit is required in respect of any inventories

remaining in hand at the year end.
HXP: provision for unrealised profit = £6m × 20% × 40% (margin) = £480,000 (£500,000 to
nearest £0.1 million).
Softex: provision for unrealised profit = £8m × 25% × 20% = £400,000
Consolidated revenue: £56.5m + £6m + £8m = £70.5m
Consolidated cost of sales: £53.3m – £14m + £0.5m + £0.4m = £40.2m.
Journal entry required to recognise provision for unrealised profit:
£m £m
DEBIT Cost of sales (£500,000 + £400,000) 0.9
In addition, an adjustment is required to eliminate intra-group payables and receivables:
£m £m
DEBIT Trade payables (£1.2m + £1.4m) 2.6
CREDIT Trade receivables 2.6
(4) Share option scheme

The incentive scheme started by Larousse involves the exchange of services for equity
instruments in the entity. Therefore, this scheme falls within the scope of IFRS 2, Share-
based Payment, as an equity-settled share-based payment transaction. Marie is correct in
recognising this transaction in the financial statements, but the calculation is incorrect.
Where payments are received in the form of share options in exchange for services
rendered, IFRS 2 requires that the fair value of the transaction is recognised in profit or
loss, spread over the vesting period. The indirect method of measurement is appropriate
here: ie, measurement of the fair value of the equity instruments granted at the grant date.

The grant date in this case is 1 October 20X4, and the fair value to be used in the
transaction is at that date ie, £20 per share.
An adjustment is also required in respect of the non-market based vesting condition that
share options will vest on 30 September 20X8 only to those employees still in
employment with Larousse at that date. At 30 September 20X5, four of the 50 employees
have actually left, and a further six are expected to leave. Therefore, the calculation of the
expense to be recognised is based on 40 (50 – 4 – 6) employees. The expense must be
spread over the four-year vesting period, and the calculation is as follows:
(1,000 × 40 × £20.00)/4 = £200,000
The adjusting journal entry is as follows:
£m £m
DEBIT Equity: share options (£1m – £200,000) 0.8
CREDIT Administrative expenses 0.8
It is acceptable to recognise the adjustment to equity as a separate component of equity.

Larousse Group: draft consolidated financial statements for the year ended 30 September
20X5
Draft consolidated statement of profit or loss
Ref to
First draft Adjustment working Revised draft
£m £m £m
Revenue 84.5 (14.0) 3 70.5
Cost of sales (53.3) 14.0 3 (40.2)
(0.5)
(0.4)
Administrative expenses (12.3) 0.8 4 (11.5)
Selling and distribution costs (6.8) (6.8)
Finance cost (1.6) (0.2) 1 (1.8)
Profit before tax 10.5 (0.3) 10.2
Income tax expense (2.4) (2.4)
Profit for the year 8.1 (0.3) 7.8
Draft consolidated statement of financial position
Ref to
£m £m £m
ASSETS
Non-current assets
Intangible assets:
Research asset 2.0 2 2.0
Goodwill 5.6 3.2 1 6.8
(2.0) 2

Ref to
£m £m £m
Current assets
Inventories 12.8 (0.9) 3 11.9
Trade receivables 14.9 (2.6) 3 12.3
Cash and cash equivalents 2.6 ––––– 2.6
Total assets 100.7 (0.3) 100.4

Share options 1.0 (0.8) 0.2
Retained earnings at 1 October
20X4 35.8 35.8
Profit for the year 8.1 (0.3) 1, 3, 4 7.8
Non-current liabilities 30.4 3.2 1 33.8

0.2
Current liabilities
Trade and other payables 12.0 (2.6) 3 9.4
Current tax payable 2.4 2.4
Short-term borrowings 1.0 ––––– 1.0
Total equity and liabilities 100.7 (0.3) 100.4
Notes analysing and comparing the performance and profitability of each of the two
subsidiaries
Gross profitability
The performance of the group as a whole appears satisfactory, in that it is profitable: gross
profit percentage, based on the draft consolidated statement of profit or loss, is ([30.3/70.5] ×
100) 43.0%. Comparative figures, calculated using the same accounting conventions, would
help to indicate whether or not this is a good performance. Similarly, budget figures would
also help in assessing the extent to which performance falls short of, or outstrips, expectations.
Drilling down into the figures produces more refined information. Gross profitability across the
group can be analysed in more detail as follows:
Company/nature of sales Gross profit %
Larousse/all external ([23.2/56.5] × 100) 41.1%
HXP/internal to group 40%
HXP/external to group (W1) ([2.1/6.0] × 100) 35%
Softex/internal to group 20%
Softex/external to group (W2) ([1.9/8.0] × 100) 23.8%

W1: HXP split of sales and gross profit
HXP overall gross profit percentage £4.5m/£12.0 × 100 = 37.5%
Internal to group: £6.0m (ie, 50% of sales)
External to group: £6.0m (ie, 50% of sales)
Gross profit on all sales = (£12.0 – £7.5) £4.5m
Gross profit on internal sales = 40% (given) = £2.4m
Gross profit on external sales (£4.5m – £2.4m) = £2.1m
W2: Softex split of sales and gross profit
Softex overall gross profit percentage £3.5/£16.0 ×100 = 21.9%
Internal to group: £8.0m (ie, 50% of sales)
External to group: £8.0m (ie, 50% of sales)
Gross profit on all sales = (£16.0m – £12.5m) £3.5m
Gross profit on internal sales = 20% (given) = £1.6m
Gross profit on external sales (£3.5m – £1.6m) = £1.9m
The gross profit margins vary significantly between Larousse, HXP and Softex, although this
may be explained by differences in the nature of the products. The most striking element of
the analysis is that HXP’s sales to Larousse are at a gross margin of 40%, whereas its sales to
third parties outside the group yield only 35%. By contrast, Softex’s sales to third parties yield a
higher gross margin than sales within the group. These differences may well be explained by
sales mix factors, and more information would be required in order to refine the analysis. It is
possible, though, that the transfer prices used between the subsidiaries and the holding
company do not reflect commercial reality. The HXP transfer prices may be relatively too high,
and the Softex transfer prices relatively too low. This factor could help to explain Softex’s
relatively poor performance.
A further relevant factor in Softex’s performance is the impairment of inventories of £1.2 million
that was recognised in the year under review. Without this item, Softex’s gross profit would
have been £1.2 million higher at £4.7 million, and this presumably would have been
attributable to external sales, producing a total gross profit on external sales of £3.1 million, a
gross margin of 38.8%. This level of margin is much more akin to those of Larousse and HXP
and is significantly higher than the margin on intra-group sales. Again, sales mix could be a
perfectly reasonable explanation for the difference.
Other profit or loss items
Profit before tax margin for the group overall is 14.5% ([10.2/70.5] ×100).
The table below analyses profit margin and expenses in further detail.
Larousse HXP Softex Group
([Administrative expenses/sales] × 100) 14.7% 12.5% 9.4% 16.3%
([Selling & distribution/sales] × 100) 8.3% 5.8% 8.8% 9.6%
Profit before tax 15.2% 19.2% 3.8% 14.5%
Softex’s relatively poor performance in terms of gross profit margin follows through to profit
before tax margin. Its selling and distribution costs are relatively high, but administrative
expenses are relatively low. These differences may be explained by a different approach to
allocating costs between the headings. Management may wish to address this point, in order
to ensure that figures are broadly comparable across the group.
Again, it would be helpful to have comparative figures and budgetary information in order to
refine the analysis further.
A great deal more information is required in order to produce a sound analysis of profitability.
Information about the nature of sales, the sales mix, the group transfer pricing policy, budgets
and comparatives would all be of assistance in producing a more incisive analysis.

Response to the board on social responsibility reporting
External auditors’ responsibilities in respect of social responsibility reporting
Even though the proposed reporting is voluntary, there are implications for Larousse’s external
auditors. The auditors will be obliged to consider the potential impact of the new policies and
targets upon the financial statements. They will primarily be concerned to ensure that any
disclosures relating to social responsibility are not inconsistent with information seen by the
auditor in the course of the audit. In accordance with ISA (UK) 720 (Revised November 2019),
The Auditor’s Responsibilities Relating to Other Information the auditor’s report will need to
include an Other Information section. This will either include a statement that the auditor has
nothing to report or, if there is an uncorrected material misstatement of the other information,
a statement that describes the issue (ISA (UK) 720.22(e)).
The additional reporting by Larousse will therefore involve additional audit work. All four
targets can be expected to involve additional expenditure, and there may be implications such
as constructive obligations giving rise to the need for provisions. The auditors will also be
interested in the extent to which HXP and Softex are obliged, by local law and regulation, to
take responsibility for clean air and water. Such obligations could give rise to the recognition
of additional provisions. The auditors will be obliged to consider the existence of such factors
in undertaking their assessment of inherent risk. In extreme cases, non-compliance with
relevant laws and regulations or any of the new performance targets might affect a company’s
going concern status and the auditors would need to consider this as part of their own
assessment of Larousse’s going concern status.
Proposal for additional assurance report
The proposal that the auditors should be asked to produce an additional assurance report
goes beyond the normal external audit appointment. The auditors could be invited to provide
assurance in respect of the proposed social responsibility reporting, and this would form a new
engagement for services, separate from the statutory audit. This is a perfectly feasible
suggestion, although the audit firm would need to consider carefully its own competence to
provide such services, and it may decide that it does not wish to tender for such work. In such a
case, it would be necessary to appoint another external verifier.
Because there is no statutory or other regulatory requirement to produce a social responsibility
report, the terms of any assurance engagement can be determined by Larousse in discussion
with the appointee. However, it is likely to involve the use of the assurance standard AA1000
Accountability Principles issued in 2018 by AccountAbility, a non-profit network that works with
business and governments to promote sustainable development. The key part of this social
responsibility reporting is therefore content which outlines how we report our sustainability
credentials. AA1000 provides guidance on what this includes: in summary though, this kind of
reporting is expected to consider four main principles:
• Inclusivity – consideration of all stakeholders who affect, and are affected by, our work
• Materiality – consideration of any relevant or significant factors, not just financial
• Responsiveness – consideration of the actions taken by us in response to stakeholders’
issues
• Impact – consideration of the impact that we have on the economy, the environment,
society, stakeholders and even ourselves as an organisation
The additional assurance report might include the following:
• The objectives of the engagement and any limitations on its scope (to manage users’
expectations)
• Intended users of the report
• The responsibilities of both ourselves and the external verifier for this reporting
• Description of the scope of the report, including any limitations
• Description of the disclosures covered and the methodology used in verifying them,
including criteria used for evaluation
• Statement on level of assurance
• Findings and conclusions concerning the reliability of performance in line with the four
AA1000 principles (specified above)

• Observations and recommendations
• Notes on competencies and independence of the external verifier
• The name of the external verifier of the report, the date and place signed
Where there is objective, third-party, evidence about progress towards Larousse’s targets as
set out in Exhibit 3, their verification will be relatively straightforward. For example, in the case
of target 1, there should be regular monitoring reports about water quality, produced by
appropriately-qualified scientific observers. Provided that this can be assessed as high-quality,
third-party evidence, it should provide a good level of assurance for the verifier. Similarly, it
should be possible to assess, from employment records, the extent to which the employment
of child labour under target 3 is being successfully phased out. Where there are distinct,
quantifiable targets and records, verification is likely to be straightforward.
However, where targets are more qualitative in nature, it may be more difficult for the verifier to
draw conclusions. In this respect, targets 2 and 4 are more vague (what is an ‘effective’ health
and safety programme?) and it may be that the targets will require redrafting to be more
specific and quantifiable. It would be important to gain a precise understanding of the nature
of the proposed social responsibility reporting, as these would be the starting point for any
additional assurance report.
35.2 Ethical implications and actions arising from incident set out in Exhibit 4
Alex’s note of the overheard conversation is potentially highly significant. However, it contains
no actual evidence and the allegations are apparently informed by dislike of Dennis Speed.
This may be no more than malicious gossip, without any foundation in fact. The preliminary
calculation of goodwill on the acquisition of HXP (see earlier calculation) produces a relatively
high figure, but it may include as yet unrecognised intangible assets. HXP is profitable, and
there is no clear evidence that Larousse has overpaid for its investment in HXP.
Even if Alex considers that the allegation is malicious gossip, he is not entitled to ignore this
information. His first task should be to investigate the allegations, as discreetly as possible. If
the allegation that Dennis was involved in adjusting the price paid for the acquisition of HXP is
correct, then the issue is not just one of unethical behaviour; it may also have a criminal
dimension, as fraudulent manipulation of documents may have taken place. The transaction
could even be defined as money laundering. If this is the case, then Alex must take care that
his enquiries do not ‘tip off’ Dennis.
Once Alex is sure that he has all the relevant facts in the case, he may decide to escalate the
matter. He would be well-advised to contact the ICAEW for help in determining whether or not
the matter should be taken forward, what kind of evidence is required, and what action would
be most appropriate.
Both Alex and Dennis are ICAEW Chartered Accountants and are bound by the ICAEW Code
of Ethics. They must act with integrity in all circumstances and must display professional
behaviour. If the allegations are correct, then Dennis has been involved in fraudulent
manipulation for personal gain. This involvement, if more widely known, is likely to bring the
profession into disrepute.
It will be helpful to Alex if Larousse has established internal procedures for dealing with the
allegations. Larousse is unlisted and may not have appointed non-executive directors.
However, if there are non-executives, it may be appropriate for Alex to approach the chair of
the audit committee. However, before getting to this point, he must be certain of his facts, and
must be very careful about how he presents the allegations.
At all stages, Alex must keep a detailed record of his investigations, deliberations and
conclusions as this may be required as evidence in the event of criminal and/or professional
disciplinary action.
Aside from the ethical and legal issues that are potentially involved in this case, there are also
accounting implications in respect of the disclosure of related party transactions. A related
party is a person or entity that is related to the entity preparing its financial statements, in this
case Larousse. A person, or a close member of that person’s family is related to the reporting
entity if they are a member of the key management personnel of the reporting entity. Dennis
as finance director is, clearly, a member of Larousse’s key management personnel and his wife
is a close member of his family. Therefore, Lola Gonzalez is a related party to Larousse. HXP is a
related party to Larousse, as its subsidiary.

According to IAS 24, Related Party Disclosures, a related party transaction is a transfer of
resources, services or obligations between related parties. The transaction involving the sale of
Lola’s shares to Larousse is therefore very clearly a related party transaction that will require
disclosure in the group financial statements.
This was the best answered question on the exam, especially with regards to the financial
reporting treatment and adjustments to the consolidated financial statements. In general, the
quality of the journals throughout requirement 1 was better than in prior sittings, with many
candidates generating accurate correcting journals.
The weakest part of the question by far was the analysis of the subsidiaries, with many
candidates stopping at explaining that one subsidiary was better than the other due to having
higher margins. Weaker candidates who had been unable to adjust for intra group sales and
PURP therefore were also unable to produce meaningful financial statement analysis. The
questions at CR are designed to integrate financial reporting and financial statement analysis
(and when relevant assurance). Stronger candidates discussed the intra-group sales, the high
distribution costs and the lack of information.
Most students were able to answer the ethics discussion well, and a high number came up with
reasonable attempts at measuring the effectiveness of the KPIs in the social responsibility
aspect of the question. Credit would have also been given for suitable alternatives to AA1000,
such as adopting the Global Reporting Initiative (GRI) or a selection of the 17 United Nations
(UN) Sustainability Goals.
Detailed comments:
Preparation of consolidated statement of profit or loss and statement of financial position
including explanations of financial reporting treatment
Generally, this part of the question was well answered with many candidates achieving full
marks. Nearly all candidates recognised that the deferred consideration used to calculate
goodwill needed to be discounted to present value and that this would change the value of
goodwill (although a minority of candidates did discount for the wrong number of years).
The share options were also well dealt with, with most candidates identifying the errors made
by not using the fair value of the option at the grant date or adjusting for future leavers.
Answers to the issue relating to the recognition of an internally generated research asset were
more mixed. Many candidates wasted time discussing the general recognition criteria for
development costs missing the point that this was now a purchased intangible.
The most disappointing aspect to this question was the section relating to intra-group trading.
The adjustments required to revenue and cost of sales to eliminate intra-group trading, a
straightforward matter which is covered in FAR at professional level, proved baffling to many
candidates. Although most candidates realised that some adjustments had to be made it was
surprising that not all managed the simple contra out of intra-group trading or were able to
calculate the correct PURP. However most did manage to correctly discuss the elimination of
intra-group balances. Some candidates tried to use cumulative journals eg, to adjust for intra
group trading candidates tried to combine the revenue, profit and receivables in one journal
rather than splitting them down into one journal per adjustment. Invariably the journal did not
balance.
Pleasingly most candidates did prepare correcting journals and revised financial statements.
However, some wasted time on the latter by copying out the figures for all three group
companies then making adjustments rather than starting with the draft consolidated figures
given in the question. Some candidates also struggled with the credit side of the journal for
the deferred consideration often crediting retained earnings rather than a liability. Some also
lost easy marks by not discussing and showing the journal for the unwinding of the discount
for this consideration.
Notes for the board analysing and comparing the performance and profitability of the two
subsidiaries
Answers to the analysis and interpretation part of the exam were very mixed. Good candidates
identified the impact of the margins on the intra-group trading and the inventory impairment
in the year. It was expected that having asked the candidates to perform simple adjustments

for PURP in the first part of the question that they would then realise that this would impact on
the performance analysis.
Most candidates calculated gross profit and some sort of operating/net profit margin but the
weaker ones simply stated the obvious ie, one company’s margin was higher than the other.
Many candidates wasted time in anodyne and pointless description (eg, ‘Gross profit is low
because cost of sales are high’) which is not appropriate at this level.
The poorer quality answers tended to be lengthy and repetitive. Relatively few candidates
identified the key point that the margins on intra-group trading are subject to influence by
Larousse which controls them, and that this factor inevitably skews the analysis.
A number of candidates wasted time by calculating and commenting on ratios relevant to
position rather than performance.
Social responsibility reporting proposals
Answers to this requirement relating to social responsibility reporting were quite mixed and
candidates missed out on easy marks such as discussing the potential impact on the financial
statements. However, most candidates did identify the auditor’s responsibility to identify
inconsistencies between the financial statements and ‘other information’ and that if a separate
engagement was carried out it would result in a lower level of assurance than the audit report.
Nearly all candidates also discussed the type of work that could be carried out on the four key
targets and the difficulties involved in obtaining good quality evidence for the more qualitative
targets. However sometimes the suggested work was vague (‘ensure the health and safety
programme is effective’) or unrealistic (‘visit the factory and identify any underage workers’).
Ethics
The ethical issues were generally quite well addressed. Most candidates realised that the facts
should be determined rather than just relying on ‘gossip’, discussed the potential money
laundering issues and suggested contacting the ICAEW helpline for advice. However relatively
few commented on the accounting implications of the related party transaction. Very few
commented on the need to keep a detailed record of any investigations/discussions.
A few candidates had clearly not read or understood the question properly as they thought the
main protagonist in the question, Alex Chen, was the company’s auditor. In such cases the
recommendations to eg, contact the ethics partner were irrelevant and inappropriate.
36 Telo
Scenario
The candidate is required to respond to the instructions of an unlisted company’s operations
director. The candidate assumes the position of the recently-appointed financial accountant of Telo
plc. There is a range of issues which remain to be resolved in the preparation of Telo plc’s draft
financial statements. A trial balance is provided, with notes and descriptions of outstanding issues.
These include: a prior period error, translation of foreign currency sales invoices and related receipts,
accounting for a property which has become an investment property during the accounting period
under review and deferred tax adjustments. Having made appropriate adjustments, the candidate is
required to prepare a draft statement of comprehensive income and a statement of financial
position.
Requirements Skills assessed
Explain the appropriate financial reporting Assimilate complex information in order to

treatment of the outstanding issues, setting out produce appropriate accounting adjustments.
the necessary adjustments. Apply knowledge of prior period adjustments,
accounting for foreign currency transactions,
accounting for investment properties, deferred
tax to the information in the scenario.
Clearly set out and explain appropriate
accounting adjustments.

Prepare a draft statement of profit or loss and Assimilate and use adjustments identified in (1)
other comprehensive income for the year in drafting the two financial statements
ended 31 August 20X5, and a statement of requested.
financial position at that date, including your Use knowledge of financial statement
adjustments. presentation to present the financial statements
in appropriate format.
Marking guide Marks
Appropriate financial reporting treatment 22

Draft statement of profit or loss and other comprehensive income 8
30
Total 30
(1) Outstanding issues arising from draft trial balance
Prepared by: Sophie Blake
Calculation error in brought forward work-in-progress balance
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors requires that material prior
period errors should be corrected retrospectively. The error in calculation of opening work-in-
progress meant that work-in-progress was overestimated by £613,000, which is 16.3% of the correct
balance, almost 4% of sales revenue and which is likely to be material in relation to profit. Assuming
that the error is material, it will be necessary to restate the comparatives in the financial statements.
Profit for the year ended 31 August 20X4 was overstated by £613,000, as was work-in-progress, and
these comparative figures must be altered. In respect of the financial statements for the year ended
31 August 20X5, the correction of the error is to be reflected in the statement of changes in equity.
£‘000 £‘000
DEBIT Retained earnings 613
CREDIT Work-in-progress 613
Cost of sales for the year ended 31 August 20X5, before any other necessary adjustments to
operating costs, is calculated as follows:
£’000
Corrected opening WIP 3,742
Add operating costs 11,353
Less: closing WIP (4,437)
10,658
Accounting for foreign currency transactions

John correctly recorded the two invoices to Sourise during the year. However, his recording of the
receipt is in error as it failed to recognise any exchange gain or loss on settlement or at the year end
in respect of retranslation of monetary assets.

John’s treatment produced the following trade receivable amount due from Sourise at 31 August
20X5:
£’000
Invoices recorded (208 + 155) 363
Less: receipt ($250,000/1.12) 223
140
The first invoice, dated 31 December 20X4, for N$220,000 was settled in full out of the receipt of
N$250,000 on 31 August 20X5.
£‘000
Amount at which 31 December invoice recorded 208
Settlement: N$220,000 at rate of £1 = N$1.12 (196)
Loss on translation 12
The remainder of the amount received on 31 August 20X5 (N$250,000 – N$220,000 = N$30,000) is
set off against the second invoice dated 30 June 20X5. The balance that remains outstanding, as a
monetary asset, must be translated at the year-end date ie, 31 August 20X5.
As this is the same date as the receipt, the necessary adjustment can be calculated as follows:
£‘000
Amount at which 30 June invoice recorded 155
Settlement: N$30,000 at rate of £1 = N$1.12 (27)
Retranslation of closing monetary asset:
(N$180,000 – N$30,000) N$150,000 at £1 = N$1.12 (134)
Gain on translation 6
The required correcting journal is:
£‘000 £‘000
DEBIT Profit or loss (net loss on translation) 6
CREDIT Receivables 6
The directors have decided that an allowance of 50% of the debt should be made ie, £134,000 ×
50% = £67,000.
The required journal is:
£’000 £’000
DEBIT Profit or loss (operating costs) 67
CREDIT Receivables 67
This has been adjusted in profit or loss via operating costs, although it would also be valid to classify
it under another expense heading, such as administrative expenses.
Other transactions in foreign currencies should be checked, to ensure that similar errors have not
been made.
Investment property (53 Prospect Street)
As the letting of the property is to an unrelated third party, and the property is no longer occupied by
Telo, it is likely to be classified under IAS 40 as investment property. IAS 40 permits two alternative
accounting treatments: the cost model as under IAS 16, Property, Plant and Equipment, or the fair
value model. Under the latter model, any change in the value of the property is recognised in profit
or loss.

The property at 53 Prospect Street was subject to a change of use during the year. For the four-
month period from 1 September 20X4 to 1 January 20X5, it was recognised as property, plant and
equipment under the IAS 16 revaluation model. For the eight-month period from 1 January 20X5 to
the year end on 31 August 20X5 it was recognised as investment property under the IAS 40 fair value
model.
Where there is a change in use, IAS 40 requires that the property is revalued at the date of change
and any difference recognised as a revaluation gain or loss under IAS 16.
Calculation of revaluation gain or loss at change of use
Depreciation is charged on property, excluding land, held under IAS 16. No depreciation has been
charged for the four months to 1 January 20X5, and this must be adjusted.
Depreciation on building: (£3,180,000 – £600,000)/98 years × 4/12 = £8,775 (£9,000 to nearest
£’000)
Carrying amount of property at date of change of use:
£3,180,000 – £9,000 = £3,171,000
Property at revalued amount on 1 January 20X5: (£2,600,000 + £620,000) = £3,220,000
Revaluation gain to be recognised under IAS 16 at change of use: £3,220,000 – £3,171,000 =
£49,000
Journal entries to reflect adjustments for depreciation and revaluation:
£‘000 £‘000
DEBIT Operating costs (depreciation) 9
CREDIT Revaluation gain –– 49
49 49
Recognition of investment property

IAS 40 permits the inclusion of certain costs in an investment property. John has recognised
professional fees in respect of leasing 53 Prospect Street and this is acceptable. The subsequent
capitalisation of the cost in March 20X5 of installing the air conditioning system is also likely to be
acceptable. However, the inclusion of relocation costs of £30,000 to the 15 Selwyn Road property is
not permissible, and this item must be recognised as an expense in profit or loss:
£‘000 £‘000
DEBIT Operating costs 30
CREDIT Property 30
The carrying amount of investment property at 1 January 20X5 and 31 August 20X5 is therefore as
follows:
£‘000
Property at revalued amount on 1 January 20X5 3,220
Professional fees in respect of lease 25
Investment property at 1 January 20X5 3,245
Add: subsequent expenditure on air conditioning system 100
Investment property at 31 August 20X5 3,345
Revaluation of investment property

Investment property held under the IAS 40 fair value model is not subject to depreciation. Any
change in the value of the property, as noted earlier, is recognised in profit or loss.

The surveyor’s valuation at 31 August 20X5 of £3,500,000 (£650,000 for land and £2,850,000 for
buildings) exceeds the carrying amount above of £3,345,000 by £155,000. This amount is
recognised as a gain in profit or loss:
£’000 £’000
DEBIT Investment property 155
Deferred tax
The deferred tax balance at 1 September 20X4 arose in respect of the 53 Prospect Street property.
Because a revaluation under IAS 16 does not affect taxable profits, a deferred tax adjustment is
required, calculated as the difference between the tax base of the asset and the carrying amount.
The deferred tax treatment of an investment property depends upon the valuation model that is
adopted. Where investment property is held under the cost model, the accounting treatment is the
same as for IAS 16, where revaluation gains are recognised through other comprehensive income,
thus not affecting profit or loss. However, where investment property is held under the fair value
model, gains are recognised through profit or loss and the amount of the gain is taxable, or in the
case of a loss, allowable for tax.
Therefore, the revaluation gain arising under IAS 16 of £49,000 is subject to deferred tax, whereas
the gain arising in the last eight months of £155,000 under IAS 40 is not subject to deferred tax as it
is taxed as part of profits for the year.
Because deferred tax on IAS 16 revaluation gains is recognised through other comprehensive
income, the amount of the revaluation surplus reported at 31 August 20X4 was reduced by the
amount of the deferred tax balance. The ‘gross’ revaluation surplus was therefore: £971,000 +
£243,000 = £1,214,000. This amount has been increased by £49,000 in the year ended 31 August
20X5 to a total of £1,263,000.
Deferred tax on this amount: £1,263,000 × 20% = £253,000 (to nearest £’000), an increase of
(£253,000 – £243,000) £10,000. Therefore an adjustment is required as follows:
£’000 £’000
CREDIT Deferred tax 10
(2) Draft financial statements
Telo plc: Draft statement of profit or loss and other comprehensive income for the year ended 31
August 20X5
£’000
Revenue 15,680
Cost of sales ([W1] 10,658 + 6 [W2] + 67 [W2] + 9 [W3] + 30 [W3]) (10,770)
Gross profit 4,910
Selling costs (1,162)
Administrative expenses (2,340)
1,408
Other income 70
Gain on investment property [W3] 155
1,633
Current tax (350)

£’000
Revaluation surplus 49
Less deferred tax (10)
39
Telo plc: Draft statement of financial position as at 31 August 20X5
£’000
ASSETS
Non-current assets
Property, plant and equipment (242 – 110) 132
3,632
Current assets
Work-in-progress 4,437
Receivables (3,281 – 6 [W2] – 67 [W2]) 3,208
Cash 82
7,727
Total assets 11,359

Share capital 60
Retained earnings (5,051 – 613 [W1] + 1,283) 5,721
Revaluation surplus (1,263 – 253 [W4]) 1,010
6,791
Deferred tax 253
Current liabilities
Trade payables 3,965
Current tax payable 350
4,568
General comments
This question examined three Advanced Level topics IAS 21, IAS 40 and IAS 12 which are not
covered in full at Professional Level. It was therefore very disappointing that some candidates
appeared to have not studied these areas and performed very poorly.

Detailed comments
This question required candidates to explain the financial reporting treatment of four issues and
most candidates did approach the requirement in a structured way.
(1) Prior year adjustment
The first issue was a straightforward prior year adjustment arising from an error in the valuation
of opening inventory. Although most candidates did identify that this was an IAS 8 issue
requiring retrospective adjustment through retained earnings relatively few seemed able to
calculate the revised cost of sales figure. Some candidates appeared to miss the point
completely instead discussing general inventory valuation issues or even whether this was an
adjusting event. Some candidates ignored the adjustment completely and others thought that it
was up to the company’s auditors whether or not such an adjustment should be made. Common
errors were to adjust closing inventory and also to put the PYA against revenue. Relatively few
candidates were able to calculate cost of sales correctly, which is a surprising error at this level.
(2) Foreign currency
The second issue related to foreign currency sales with an outstanding foreign currency
receivable at the year end. Most candidates did realise that both the settled transaction and the
re-translation of the year-end balance would result in foreign currency gains or losses and
attempted to calculate these. Most then realised that such gains and losses should be taken to
the profit or loss account although a significant majority thought they should be recognised in
equity and other comprehensive income – a very basic technical error. The question also
involved the requirement to write the closing receivable down which nearly all candidates did
respond to. However, it was worrying to see how many candidates thought this would result in
an IAS 37 provision rather than a reduction in the receivable balance. Some candidates wasted
time in this part of the question by discussing general revenue recognition issues at great length.
(3) IAS 40 investment property
The third issue involved a revalued property being transferred from property, plant and
equipment to an investment property part way through the year. In addition, candidates needed
to identify whether some additional costs should have been capitalised. Answers were often
confusing and difficult to follow and many candidates wasted time discussing and calculating
figures for the revaluation of the property that had taken place at the end of the previous year.
Although candidates frequently stated that the property should have been depreciated up to the
time of the change in use it was relatively rare to see a completely correct calculation of this
figure. Most candidates did understand that the revaluation gain at the time of the change of use
should have gone to equity with subsequent gains going to profit and loss but it was not that
unusual to see this the other way round or be unable to follow which revaluation candidates
were referring to. With regard to the capitalised costs by far the most common error was to state
that professional fees should be expensed and not capitalised.
(4) Deferred tax
The final issue related to deferred tax on the revalued property. Some candidates wasted time by
not reading the information carefully and therefore discussed irrelevant deferred tax issues (such
as the write down of the receivable). Most candidates understood how the deferred tax balance
relating to the property had arisen but fewer understood the implication of the tax treatment of
gains on investment property matching the accounting treatment.
Financial statements
The requirement to produce financial statements from the trial balance plus relative adjustments was
generally well answered with many candidates achieving full marks.
37 Newpenny (amended)
Scenario
This question requires the candidate to show both financial reporting skills and the ability to assess
the adequacy of internal controls from an audit perspective. The financial reporting elements require
the ability to analyse a complex and specific contractual arrangement together with an issue in

product performance and relate those to the principles of provisioning and revenue recognition, as
well as identifying that there are also effects on inventory valuation.
The audit element requires a detailed assessment of controls over purchasing, looking in turn at each
relevant audit assertion and using the information given in the question. The candidate is also
required to use judgement in assessing the adequacy of the controls to meet relevant objectives.
The candidate must then set out further concerns regarding Newpenny’s internal control system for
purchase orders based on the data analytics dashboard provided.
Draft an email to Rosa Evans providing, with Assimilate complex information in order to
explanations, the financial reporting advice she produce appropriate accounting adjustments.
has requested in her email. Apply knowledge of provisions, contingent
liabilities, assets to the information in the
scenario.
Identify the need for further information and
appreciate that further liabilities may arise.
Prepare a memorandum which will help me to Apply technical knowledge to explain

consider Rosa’s suggestion that we should assertions relevant to the scenario.
place more reliance on internal controls in our Assimilate information to identify control
audit of Newpenny’s trade payables and activities relevant to audit assertions.
accruals for the year ending 31 December
20X5. Identify weaknesses in control and impact on
audit procedures.
Determine the additional information needed
to ensure audit assertion is met.
Set out further concerns regarding Newpenny’s Interpret information provided in various
internal control system for purchase orders formats.
based on data analytics dashboard. Evaluate the relevance of information provided.
Use a range of data types and sources to inform
analysis and decision making.
Make evidence-based recommendations which
can be justified by reference to supporting data
and other information.
Marking guide Marks
Financial reporting advice 8

Reliance on internal controls 22
Future concerns 10
40
Total 40
Email to Rosa Evans:

Financial reporting advice
JE agreement
The new agreement with JE introduces the possibility of a retrospective change in the price paid for
motors from 1 August 20X5 to 31 December 20X5. This is unlikely to be determined before August
20X6 as it depends on the quantity of motors purchased for the year to 31 July 20X6.

In considering whether a provision for any additional payment is required, Newpenny will need to
have regard to the requirements of IAS 37 which requires a provision where:
• there is a present obligation as a result of a past event – that is the case here so long as the order
threshold of 100,000 units has not already been exceeded by the year-end as the contractual
arrangement was made before the year end;
• a reliable estimate can be made – that is likely to be the case here as Newpenny should have a
budget showing predicted purchases and will know both the number of motors purchased pre
year end and the additional cost of £1 per motor if total purchases less than 100,000; and
• it is probable that there will be an outflow of resources. This will depend both on the number of
motors purchased to date and those which Newpenny expects to purchase in the 7 months
following the year end.
If actual purchases to date and projected purchases for the next 7 months show that the target of
100,000 motors will be exceeded then no provision is required, although this should be kept under
review in the period after the reporting date until such time as the financial statements are issued.
If the actual and projected purchases total less than 100,000 then a provision equivalent to £1 for
every motor purchased between 1 August 20X5 and 31 December 20X5 should be made. To the
extent that the motors have been used in vacuum cleaners that have been sold, this will increase the
cost of goods sold.
The number of motors purchased is in Newpenny’s control and it would be possible to achieve the
cheaper price by stockpiling motors. However, it would then be necessary to consider whether any
provision would be required against potentially excess inventory and there would also be
considerations regarding the level of purchases Newpenny could commit to in future years.
To the extent that motors are held in inventory at the year end this may affect the value at which
inventory is carried. However, this will need careful consideration as the standard cost established at
the start of the year is likely to be based on the then agreed price of £20 per motor and may or may
not have been changed when the agreed price changed.
Newpenny will need to look carefully at what standard cost has been used and what variances have
been included in inventory to ensure that the inventory of motors is carried at the actual expected
cost of £20 per motor assuming an additional payment is required.
The liability being considered here is not a contingent one as the future event (that is orders of
motors) which will determine the price per motor is within Newpenny’s control.
In order to recognise at year end any refund for motors purchased, Newpenny would need to have
already exceeded the target quantity of 110,000 motors. As the future purchases of motors are within
its control it can also recognise an asset if it is virtually certain that it will meet the threshold. If this is
the case, then the inventory carrying value will again require consideration as outlined above.
Warranty
The issue with the Model2000 cleaners appears to be a specific one and is unlikely to be covered
adequately by the general warranty provision which is based on the history of past claims. Newpenny
has an obligation to repair or replace faulty products which are under warranty and there is therefore
a present obligation in respect of a past sale. A specific provision should therefore be made.
If the issue is regarded as a warranty issue then the maximum population of cleaners which can be
returned will be those still in warranty at the year-end (and not already replaced). It seems likely that
not all of these will develop the fault so the provision should be based on the total number of
Model2000 cleaners which Newpenny expects to be returned under warranty and the cost of
repairing or replacing them (based on an engineer’s assessment of the work required and the cost of
the relevant parts/product).
However, as one customer has alleged that the fault has caused a fire, there is also the potential for
legal claims for consequential losses and the potential for these needs to be taken into consideration
when determining the total amount to be provided.
Newpenny should take legal advice as to whether it should recall all potentially faulty product as
further issues like this could be costly both financially and reputational and there may also be a safety
issue which Newpenny has an obligation to resolve. This might well increase the replacement
cleaners/parts which Newpenny has to provide but reduces the potential for damaging and
expensive legal cases.

The basis for the provision can therefore only be determined when Newpenny has legal advice as to
the steps it should take and the likelihood of significant claims against it if it does not take those
steps. The details of the product returned to date and the findings of the engineers will be important
in determining the appropriate course of action.
Memorandum to assist in planning audit – initial assessment of controls in place
General observations
In order to place reliance on the operating effectiveness of controls we will need to be confident that
the controls were in place throughout the period. That may not be the case as the procedures
documentation was prepared by the purchasing manager who only joined Newpenny in May 20X5.
He may have changed the procedures on his appointment.
While the purchasing manager will clearly have some insight into procedures and controls in this
area he may not be the best person to provide an overview of all relevant procedures and controls.
We also need to consider where additional relevant controls may be present but not visible to the
purchasing manager.
In addition, we need to understand the extent to which controls have changed or been strengthened
following the audit findings in the prior year.
Existence/rights and obligations – should the liability be recognised in the accounts at all?
The liabilities which are recorded have occurred and pertain to products or services which
Newpenny has purchased.
Control activities identified:
The liability for goods received is triggered by the goods received clerk posting details of the
physical receipt of goods which match to goods ordered by Newpenny. There is segregation here
between that clerk, the purchase clerk who inputs the orders and the finance clerk who inputs
invoices.
Invoices are either matched to purchase orders or goods received entries or are sent for
authorisation by the relevant department prior to posting. They are only posted to the purchase
ledger once that approval has been obtained.
Orders for materials are authorised by a manager in accordance with the authorisation limits set by
the finance department so transactions should only be initiated for materials which are required by
the business.
Purchase orders for services are also prepared and authorised by the relevant departments.
There is segregation between the preparation of purchase orders, the receiving of goods and the
processing of invoices.
Month end accruals for open purchase orders are reviewed by the financial controller who also tests
a random sample of items to back up to ensure that they are valid.
Initial assessment of the design of the controls:
The activities identified are designed reasonably effectively for ensuring that the liabilities recorded
for materials used in manufacturing reflect the goods which have been delivered. However, in the
prior year there were old items on the GRNI accruals listing which did not represent valid accruals.
We need to determine whether similar items are there this year and also whether a control process
such as a review of the listing has been introduced.
The control activities have more significant design weaknesses for other purchases either of goods
or services as, if there is no purchase order, it appears that the invoice may be posted without any
further check as to whether the goods or services have actually been received. It is therefore possible
that a liability may be recognised without a valid underlying transaction pertaining to Newpenny.
Completeness and allocation – are there any more liabilities which should be recognised?
Liabilities have been recorded for all goods and services delivered before the year end and not yet
paid. The cut-off procedures at the period end accurately differentiate between goods and services
which were delivered before the year end and those which were delivered after year end.
The recognition of a GRNI accrual is initiated by the matching of goods received on the system.
There is segregation of duties between those posting the receipt of goods and those who have
authorised and posted the orders.

Posting details of the physical receipt of goods generates a ‘received’ sticker. The store manager
checks for the presence of this sticker before moving the goods into the stores area thus ensuring
that all goods received have been booked into the system and an accrual has therefore been
recorded.
At the month end the purchase clerk reviews all open purchase orders to determine whether the
goods and services were received before the period end and an accrual should therefore be made.
Supplier statement reconciliations are performed if a supplier provides a monthly statement.
The control activities appear to be designed to give reasonable assurance that the liabilities
recorded in respect of manufacturing goods received are complete and recognised on a timely basis
thus ensuring a correct cut-off. They could be further enhanced if action is taken promptly when
goods are discovered without a ‘received’ sticker or there is a ‘back-up’ of unprocessed deliveries.
In addition, further information is needed about what happens when goods are received for which
there is no purchase order and how these are followed up.
The control activities to ensure the completeness of other liabilities are less convincing as they
appear to rely on a review of open purchase orders and it is clear from the procedures that purchase
orders are not raised for all purchases. We need to understand the proportion of purchases for which
no order exists so we can assess whether this is likely to be a material part of the overall population.
Supplier statements are reconciled which is an excellent control for completeness and accuracy but
this is only the case if the supplier routinely sends a statement and may only cover a small proportion
of the total population.
Where a purchase order has not been raised, the posting of invoices is delayed until the invoice has
been authorised. This means that there is a risk of cut off errors and missed accruals. Controls could
be improved if the invoices were logged as they were received so that they could be accrued for as
necessary at a period end and also to ensure that none go missing or are unduly delayed by this
authorisation process.
Further evidence that the control activities here may not be designed effectively is provided by the
audit adjustment for missed accruals in respect of agency staff in the prior year. We need to enquire
whether additional controls have been introduced as a result. These could sit within the HR function
and therefore not be visible to the purchasing manager.
A further complication is introduced by the presence of new purchase contracts such as that with JE –
these mean that the complete recording of accruals/invoices based on the ‘agreed price’ may not in
itself be adequate to ensure the overall completeness of payables and associated accruals. We need
to enquire into the processes to ensure that all such contracts are identified, fully understood and
their impact accounted for appropriately. This area is not addressed at all at present.
We should also enquire as to whether any arrangements exist whereby goods not physically
delivered to the warehouse nevertheless give rise to an obligation to pay for an asset which belongs
to Newpenny.
It is also important for completeness that cash payments made and processed to the ledger are paid
to the correct supplier and have not been fraudulently diverted to another account. Would expect
controls over the purchase ledger Masterfile data to address this risk. None are identified in the
information provided.
Accuracy and valuation – is the liability recorded at the correct amount?
Payables and associated accruals are recorded accurately at the actual amount which will be payable.
The purchase ledger is reconciled to the nominal ledger at each month end.
The bank account is reconciled to the bank statement at each month end.
Accruals for goods received are made automatically based on the standard costs within the system.
Month end accruals made by the finance clerk are reviewed by the financial controller who requests
back up on a sample basis.
Supplier statement reconciliations are performed when a supplier provides a statement.
Payment runs are authorised by the financial controller and one of the other BACS signatories which
means that there is a final review by those not involved in the authorisation or posting of purchases

before the amounts are paid. This also serves as a review of items posted to the payables balance
and the reasonableness of the amounts involved.
The controls identified provide some assurance but further details are required to assess whether
they are designed effectively.
Reconciliation activities are as expected but financial controller both authorises payments and is
responsible for the reconciliation. Need to see further detail about who reviews the reconciliation
and how any reconciling items are dealt with before assessing the effectiveness of that control.
The accruals for materials received are based on standard costs which is not unreasonable providing
that such costs are kept up to date and there are not large variances. Need to understand more
about the control processes in place here.
The review process for accruals seems good and supplier statement reconciliations will also help to
ensure accuracy – however, as discussed previously there are reservations over how much of the
population these cover.
Classification and presentation – is the liability properly disclosed and presented?
Payables and associated accruals are classified correctly in the nominal ledger and financial
statements.
Controls identified
The purchase ledger is reconciled to the general ledger at each month end.
Controls identified to date are clearly inadequate. They cover only one small part of the population
and no reconciliation of the GRNI accrual or other accruals balances is identified.
However, this is not likely to be a complex area and may be best covered by substantive procedures
on the financial statements as a whole.
Data analytics
Test 1
Dashboard data: Data Comment
Number of manufacturing 30 Only one of the 30 managers has been identified as an

managers outlier.
This provides some assurance about the processes and
controls for a large majority of manufacturing
managers.
Average value per £2,343 The average value per individual order is less than half
individual order (47%) the maximum of £5,000. This indicates that the
limit is well within manager’s normal operating limits
and does not constrain most managers making orders
without the need for authorisation.
There is the risk of split orders however to avoid the
need for authorisation. For example, managers may
split an £8,000 order into two orders for £4,000.
Average value of monthly £45,864 The average monthly value of orders is less than half
total orders per manager (46%) the maximum of £100,000. This indicates that the
limit is well within manager’s normal operating limits
and does not constrain most managers making orders
without the need for authorisation.
There is the risk of managers early ordering to avoid the
need for authorisation. For example: if July is a peak
month then they could order more at the end of June
than is needed, so there is enough inventory to avoid
£100,000 being exceeded in July orders. Patterns of
orders late in the month preceding a peak month could

be investigated.
Frequency of managers 16 There are no instances of managers exceeding

exceeding £90,000 in any £100,000 in a month (which would have required
one month authorisation) but a number of instances where
managers came close to this limit.
Frequency of managers zero Investigate where managers have been near limit and
exceeding £100,000 in investigate behaviour around limit, eg, delaying orders
any one month (requiring at the end of the month and making early orders at the
approval from senior end of the previous month.
manager) Understand role of managers. Some managers may be
responsible for higher value/volume orders.
Understand why a flat limit for all managers has been
applied if this is the case.
Outlier – John Fuller
Average value per £3,246 The average order is 39% higher than the average order
individual order for all managers and 65% of the maximum for a single
order.
This places John Fuller as a high risk item in ordering
more than other managers.
This may mean a build-up of inventory arising from
excessive orders or inefficient usage.
An alternative explanation is that John may work in a
high cost area. He may therefore need a higher limit
than other managers.
Average value of monthly £64,379 The average monthly total of orders is 40% higher than
total orders the average monthly order total for all managers and
64% of the maximum for a single month. Investigate the
price and volume causes of the high average value.
% of individual orders 35% A high proportion of John’s orders were near the
exceeding £4,000 £5,000 limit yet the next most frequent incidence is 0–
£1,000. This may be regarded as an unusual pattern.
Benford’s Law (First digit law) is that numerical data sets
frequently show that the leading digit is likely to be the
most common. (Ie, in this case there should be more
small orders than large orders.) This is true in other
sections of John’s distribution but not of the highest
grouping of £4,001– £5,000.
This may be a risk of excessive ordering or possibly
fraud.
% of individual orders in 27% A significant proportion of orders occurred in a short

last three days of the period of time at month ends. If this does not reflect the
month pattern of usage then it may be a behavioural response
by John to circumvent monthly maxima for ordering
without authorisation (see above).
Investigate the reasons why this pattern of ordering
should have occurred and whether there is any
commercial rationale.
Compare with other managers whose order patterns
have not been extracted by DAACA analytics as outliers.

Frequency of John 7 There were only 16 occurrences of orders exceeding

exceeding £90,000 in any £90,000 by 30 managers and John made 7 (almost half)
one month of these.
Despite this, on no occasion did his monthly order total
exceed £100,000, thereby requiring authorisation.
There may be a risk he is avoiding authorisation and any
scrutiny.
Test 2
Dashboard data:
Number of orders 13,546 The norm is that orders should be matched with GRNs.
matched with GRN This total figure should be reconciled with the total
number of orders and GRNs issued in the period.
Number of unmatched 1,175 This could be a timing difference between the order
orders being made and the goods arriving.
Analyse by each individual supplier and assess whether
the time delay is normal for each supplier’s delivery
terms.
Predict number of outstanding unmatched orders
based on totals of orders made and usual time delay for
each supplier.
Number of unmatched 22 Two months seems excessive for a delayed delivery.

orders over 2 months old This is a small number so all 22 could be investigated in
case they reveal a control weakness (eg, undelivered
orders not been followed up; inability of supplier to
deliver).
Number of unmatched 17 The goods received department staff are instructed that
GRNs if there is no matching purchase order on the system,
materials should not be accepted.
If this instruction had been fully applied, then this
number should be zero. This suggests a control
weakness in that goods may have been received and
delivery accepted for goods not ordered.
There may be a further risk that an invoice has been
received and paid which would be a more serious
control weakness.
Investigate all 17 items and establish the causes.
General comments
The discussion of the contract price and warranties was the lowest scoring section of the exam. Many
students failed to apply IAS 37 to the contract price and instead spent a lot of time discussing issues
which scored little or no marks. The warranty provision fared slightly better. A number of students
were able to attempt a discussion of IAS 37 and score marks on the issues surrounding the legal case
and the warranties.
The controls assessment produced a wide variety of answers. Strong candidates laid their answers
out according to the layout suggested by the question. These candidates were often then able to
discuss the assertions and then identify the relevant controls, with reasonable attempts to analyse the
strength of these.
Weaker candidates simply listed facts from the scenarios, picking up some marks for identifying
controls but without really analysing the strengths or weaknesses of them. A significant minority of

candidates listed controls that weren’t mentioned in the scenario, suggesting they were simply
copying out of all controls relevant to liabilities, rather than studying the controls given and their
suitability.
Detailed comments
JE contract
Answers to this issue were very disappointing. Many candidates completely missed the point which
was the potential need for a provision if orders of a key component fell below an agreed price. Very
few understood the implications of the fact that the number ordered was completely within the
company’s control and/or the potential impact on inventory valuation. There was a good deal of
discussion about what a provision is but not much application to this scenario. Very few candidates
analysed the three scenarios: 100,000, <100,000 and >100,000. Almost all candidates incorrectly
identified a contingent liability or a contingent asset. A few candidates thought that this was a
revenue recognition issue. Only the very good candidates identified the impact on the inventory
valuation demonstrating higher skills of integration and assimilation.
Warranty issue
Answers to the second issue relating to a warranty provision were slightly better with many
candidates recognising the potential for legal claims and the need for legal advice. Few candidates
understood that this was a new issue and the provision should be based on the likely future claims
plus the possible impact of having to recall all the units sold.
Internal controls evaluation
Many candidates achieved excellent marks on this part of the question producing lengthy and
comprehensive answers. However, answers were often poorly structured and repetitious and weaker
answers did not attempt to structure the answer using the relevant audit assertions. Most candidates
did identify key controls and attempt to evaluate gaps and whether the controls were sufficient.
However, a number of candidates were too critical and seemed unwilling to accept that any of the
controls were valid. Some candidates also described audit procedures on payables rather than
evaluating the system given.
Although most candidates did include a section headed up ‘general points’ this often just repeated
points made elsewhere in the answer. Disappointingly few candidates focused on the fact that the
system changes had only been made part way through the year and whether the purchasing
manager was the best person to do this. Very few queried the apparent attempt by the client to
dictate the audit approach to be taken.

38 Earthstor
Scenario
The candidate is asked to review the work of an audit senior who has summarised the minutes of
board meetings during the audit of Earthstor an AIM-listed company. The audit senior identified the
company’s financial reporting treatment of the transactions in the minutes in a separate exhibit. The
CEO of Earthstor dominates the board which presents both ethical and governance issues. The
finance director has resigned after raising concerns over transactions with a supplier TraynerCo and
has not been replaced. Potentially Earthstor is assisting TraynerCo to evade tax in a non-UK tax
jurisdiction. The candidate is required to review the work of the audit senior and identify appropriate
financial reporting treatments for the transactions noted in the minutes which include an interest-free
loan in a foreign currency to a supplier; an equity investment in a foreign company; IAS 40 issues in
respect of a foreign investment property; and website development costs.
Requirement Skills
Explain the financial reporting implications of Assimilate and demonstrate understanding of a

each of the transactions noted from the board large amount of complex information.
minutes by Greg (Exhibits 2 and 3). Identify appropriate accounting treatments for
Recommend appropriate accounting complex transactions including an interest-free
adjustments. Please ignore any tax implications loan in a foreign currency to a supplier; equity
of these adjustments. investment in a foreign company; IAS 40 issues
in respect of a foreign investment property; and
website development costs.
Apply technical knowledge to identify
inappropriate accounting adjustments.
Recommend appropriate accounting
adjustments.
Identify the key audit risks arising from each of Assimilate knowledge, drawing upon question
the transactions (Exhibits 2 and 3) and content to identify key audit risks.
recommend the audit procedures we will need Describe relevant audit procedures required to
to complete to address each risk. provide verification evidence for each risk.
Prepare a revised draft statement of financial Assimilate adjustments to prepare draft

position at 30 June 20X6 (Exhibit 1). This should statement of financial position.
include any adjustments identified in (1) above
Explain any corporate governance issues for Assimilate information to identify potential
Earthstor that you identify from Greg’s file note problems with the governance of Earthstor.
(Exhibit 2). Also explain any ethical issues for Identify potential ethical and money‑laundering
our audit firm and set out any actions that our issues.
firm should take.
Discuss appropriate responses and actions for
the firm in respect of the potential ethical
issues.

Marking guide Marks
Financial reporting implications 18

Key audit risks 10
Revised draft statement of financial position 5
Corporate governance issues 7
40
Total 40
Working paper for the attention of Tom Chang

Financial reporting treatment and key disclosure requirements of each of the transactions noted by
Greg
Loan to TraynerCo
The loan to TraynerCo represents a financial asset for Earthstor. IFRS 9 requires a financial asset to be
measured initially at fair value. A zero interest rate loan issued at par would not result in an arm’s
length transaction and IFRS 9 requires the fair value in such a case to be determined as the present
value of the cash receipts under the effective interest rate method. The discount rate should be that
on similar loans. The loan will meet the business model test and the contractual cash flows test
(payments of principal, being the initial fair value and interest, being interest accrued using the
effective interest rate method), and should be subsequently measured at amortised cost.
The initial fair value of the loan when issued on 1 July 20X5 is therefore:
MYR20m/(1.06)2 = MYR17.800m
In terms of £ sterling this would be translated at this date as:
MYR17.800m/5 = £3.560m
The difference of £0.44 million between the £4 million recognised by the company in trade and
other receivables and £3.56 million is recognised as an expense in profit or loss.
Each year the unwinding will be treated as finance income. It would be appropriate to use the
amortised cost method as the loan is a non-derivative financial asset; there is a determinable
repayment date and the intention appears to hold the investment to maturity. The loan at the
financial year end of 30 June 20X6 is:
MYR17.8m × 1.06 = MYR18.87m
This is a monetary asset and would be translated at the year-end rate of £1 = MYR6. In the financial
statements of Earthstor it would therefore be translated as:
MYR18.87m/6 = £3.15m
There are two elements to this transaction for financial reporting purposes:
• Finance income on the loan
• Exchange loss
Finance income
The finance income is recognised at the effective rate, even though there is no cash interest received.
As the interest accrues over the year, it is translated at the average exchange rate.
The finance income in MYR is therefore:
MYR17.8m × 6% = MYR1.07m
Translated using the average rate into £ this is:
MYR1.07m/5.5 = £0.20m

Exchange loss
The exchange loss has two elements:
• On the interest
• On the loan
The exchange loss on the interest is:
MYR1.07m/5.5 – MYR1.07m/6 = £0.02m
The exchange loss on the loan is:
MYR17.8m/5 – MYR17.8m/6 = £0.59m
£’000
Finance income 200
Exchange loss:
On interest (20)
On loan (590)
(410)
This reconciles with the opening balance divided by the opening exchange rate less the closing
balance divided by the closing exchange rate as above (£3.56m – £3.15m) = £0.41 million.
The loan is currently recognised at MYR20m/5 = £4 million and should be recognised at £3.15
million.
Exchange differences and interest should be reported as part of profit or loss. An adjustment is
required as follows:
£’000 £’000
DEBIT Financial asset (debt instrument) 3,150
CREDIT Trade receivables 4,000
DEBIT Exchange differences – retained earnings (0.02 + 0.59) 610
CREDIT Finance income – retained earnings 200
DEBIT Finance cost – (£4m – £3.56m) 440
TraynerCo Loan – Audit risks and procedures
Audit risk Audit procedures
The supplier may not be able to repay the loan Confirm procedures used to verify the
and it would then be impaired. This is a key risk creditworthiness of the supplier when the loan
as there are no cash interest payments to was originally extended.
observe that these can at least be serviced. Verify the terms of the loan and whether any
security has been pledged if the loan is not
repaid – eg, enquire whether there is a charge
over assets as security for the loan.
Examine correspondence (legal
correspondence, board minutes, as well as
letters/emails/memos with TraynerCo) for any
possibility of early repayment.
The market rate of interest of 6% may not be a Compare rates to corporate loans to similar
risk equivalent in which case the measurement companies where interest is paid in full.
of the loan and the interest payments would be
incorrect.

Classification of the loan as loans and Confirm terms by examining the loan
receivables may be inappropriate. agreement.
Examine correspondence for any possibility of
early repayment.
There is a control risk in authorising a large loan Review level of authorisation of loan (main
on favourable terms. board).
Review treasury procedures to attest
information on creditworthiness, legal advice
and means of drawing up loan agreements.
Consider whether there is a risk of a link Examine the contractual supply agreement with
between the provision of the loan and the cost TraynerCo for example deep discounting of
of goods from TraynerCo – the CEO has purchase cost of goods as part of loan
referred to a deal on the rent and this may also agreement.
apply to the loan. Prepare analytical procedures on history of cost
of goods from TraynerCo.
Risk of incorrect exchange rates. Verify exchange rates and estimate average
exchange rates.
Confirm the date on which loan was extended.
TraynerCo – equity investment

The investment in TraynerCo is an equity investment held for the long term and not intended for
immediate sale. An irrevocable election has been made to recognise the movement in fair value in
other comprehensive income, and this includes foreign currency exchange gains and losses (except
in the case of an impairment).
IFRS 9 para 5.1.1 states that (unless the financial asset is measured at fair value through profit or loss)
the transaction costs are added to the value of the asset, not written off to profit or loss. Therefore,
Earthstor’s treatment of the legal costs is correct.
IFRS 13 defines fair value as “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date”. Fair value is
a market-based measurement, not an entity-specific measurement. It focuses on assets and liabilities
and on exit (selling) prices. It also takes into account market conditions at the measurement date. In
other words, it looks at the amount for which the holder of an asset could sell it and the amount
which the holder of a liability would have to pay to transfer it. IFRS 13 states that valuation techniques
must be those which are appropriate and for which sufficient data are available. Entities should
maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
With regards to the investment in TraynerCo, there is no observable quoted price for the shares.
There is evidence that the price has fallen because Henry Min has sold a further 10% of the shares for
MYR36 million and therefore the fair value recognised at 1 October 20X5 has changed at 30 June
20X6.
The question is whether the subsequent sale of a further 10% of the shares in TraynerCo by Henry
Min represents a fall in the fair value of the shares at the year-end due to: (1) market conditions or (2)
because the company is performing poorly or (3) because the initial valuation was incorrect either
deliberately or unintentionally as suggested by the comments made by the finance director.
As the fall is due to market conditions, then the loss including the exchange difference is taken to
other comprehensive income.

The following adjustments are required:
Recognition and subsequent recognition £’000

Initial recognition of shares is MYR45m/5 including transaction costs 9,500
At year end MYR36m/6 6,000
Loss to be recognised in OCI 3,500
As the loss is recognised in other comprehensive income an adjustment is required as follows:
£’000 £’000
DEBIT Equity investment: TraynerCo 1,500
CREDIT Translation reserve 1,500
CREDIT Equity investment: TraynerCo 3,500
DEBIT OCI/OCE 3,500
Being reversal of translation of investment in equity instrument and movement in fair value
IFRS 7 requires disclosure of risks relating to financial instruments which include credit, currency,
interest rate, liquidity, loans payable and market risk. For each type of risk, disclosure is required of
the exposures to each risk and how they arise, the entity’s policies and processes for managing risk
and any changes from previous period.
TraynerCo Equity investment – Audit risks and procedures
There is a risk that management have not Consider the guidance provided in the design
understood the significance of fall in price for of audit procedures set out in IAPN 1000.
the shares in relation to this equity instrument Review and assess the valuations made by the
and the additional disclosure required under directors.
IFRS 7 resulting in incorrect measurement and
recognition. Ensure disclosure of risks is appropriate and in
compliance with IFRS 7.
Agree the cost of acquisition of the shares to
legal documents, share certificates and
payment.
A key risk is that supporting evidence may not Obtain third party evidence of the valuation at
be available in respect of the valuation as the 30 June 20X6.
shares are unquoted. Consider the nature of the fall in fair value in the
light of other information about TraynerCo – by
reference to financial statements, cash flow
projections.
Consider whether there is a risk of a link Examine the contract for the acquisition of the
between the provision of the equity finance and shares and ensure that this is not related to the
the cost of goods from TraynerCo – the CEO has supply agreement for goods.
referred to a deal on the rent and this may also Prepare analytical procedures on history of cost
apply to the equity finance. of goods from TraynerCo.
Risk of inaccurate exchange rates. Verify exchange rates.
Singapore investment property

The property should be recognised as an investment property. The company has adopted the fair
value method to account for investment properties and therefore the property should be revalued at
the year end to its fair value. Movement on the change in fair value of investment properties is
recognised in profit or loss.

The Singapore investment property should be recognised at cost on 1 February 20X6 and the
change in fair value measured as follows:
£’000
At 1 February 20X6 SG$10,000,000/2.1 4,762
At 30 June 20X6 SG$11,000,000/2.7 4,074
Change in fair value 688
The property should be separately recognised as investment property.
£’000 £’000
DEBIT Operating costs (retained earnings) 688
CREDIT PPE 4,762
DEBIT Investment property 4,074
Investment property
The valuation presents a significant risk as this Confirm that fair value has been measured in
may not be a market price in an active market accordance with IFRS 13:
• Obtain more recent evidence of the market
value and confirm the reasonableness of the
valuation.
• Agree valuation to evidence of other sale.
• Recalculate gain or loss on change in fair
value and agree to amount in statement of
profit or loss and other comprehensive
income.
• Consider the use of an auditor’s expert to
perform valuation.
There is a risk that management lack of Confirm compliance with IAS 40/IFRS 13, for
expertise will result in inadequate disclosure example:
• Disclosure of policy adopted.
• If fair value model adopted disclosure of a
reconciliation of carrying amounts of
investment property at the beginning and
end of the period.
Website development costs

The costs of acquiring and developing software that is not integral to the related hardware should be
capitalised separately as an intangible asset. This does not include internal website development and
maintenance costs which are expensed as incurred unless representing a technological advance
leading to future economic benefit.
Capitalised software costs include external direct costs of material and services and the payroll and
payroll related costs for employees who are directly associated with the project.
Capitalised software development costs provided they meet the criteria under SIC 32 and IAS 38 –
the fact that the costs integrate the website with other process systems of the business and are not
merely providing content and advertising would suggest that they do – should be stated at historic
cost less accumulated amortisation. Amortisation is calculated on a straight-line basis over the assets’
expected economic lives. Amortisation is included within administrative expenses in the statement of
profit or loss.
Therefore, Earthstor has probably incorrectly capitalised the planning costs, and also possibly the
fees paid to Tanay and the photography and graphic design costs (further information is required on

the nature of these expenses). These costs should be expensed during the year. An amortisation
charge of £22m/7 years × 2/12 = £524,000 is required to be charged from 1 May 20X6. This is below
the materiality level on its own but taken together with the incorrect capitalisation of costs, this
should be adjusted:
£’000 £’000
Operating expenses (£3,000,000 + £1,300,000 + £5,000,000 +
DEBIT £524,000) 9,824
CREDIT Intangible assets 9,824
Reporting to Audit committee

The adjustments will be required to be reported to the Audit committee as they are all above the
agreed £120,000 reportable limit.
Given the increased capital expenditure during Obtain details of internal software development
the year there is a risk that both external and costs and agree to:
internally generated expenditure relating to the • invoices from third parties; and
website have been incorrectly capitalised
instead of being written off to profit or loss. • where the costs relate to staff costs, agree to
time records
There is a risk that the useful life of seven years
may be excessive given the nature of the Ensure that costs capitalised are incremental
expenditure. costs relating to the project and not time spent
on management.
Consider the appropriateness of the useful life,
enquire of appropriate management and past
history of similar projects.
Related party transactions

TraynerCo
TraynerCo is a supplier and although there is significant interdependence between Earthstor and
TraynerCo, TraynerCo is not a related party of Earthstor.
Revised statement of financial position as at 30 June 20X6
£’000 £’000
Revised
ASSETS
Non-current assets
Intangible assets – website 31,300 – 9,824 21,476
Financial asset – TraynerCo 8,000 – 2,000 6,000
PPE 56,309 – 4,762 51,547
Loan to TraynerCo 3,150
Current assets
Trade and other receivables 22,420 – 4,000 18,420
Total assets 333,548 320,186

£’000 £’000
Revised

Equity
Ordinary share capital (£1 shares) 10,000 10,000
Other components of equity (1,500) + (2,000) (3,500)
Retained earnings 163,362 – 850 – 688 – 9,824 152,000
Non-current liabilities 12,175 12,175
Current liabilities 149,511 149,511
Total liabilities and equity 333,548 320,186
Ethical and corporate governance implications

Dominic appears to dominate the board which represents a governance issue – but not necessarily
an ethical issue. There seems to be no separation between the chair of the board’s role and the CEO.
The company is also operating without a finance director which would again present a governance
issue as the board would not be operating with the appropriate skills to manage the company
effectively. The board is therefore not acting effectively and there is a lack of transparency in
Dominic’s behaviour.
A deal appears to have been made to charge no rent to TraynerCo in exchange for lower cost of
goods sold. There may potentially be an ethical issue as the company may be entering into a
transaction which could be assisting a supplier company to evade tax in a non-UK tax jurisdiction.
However, more detail of the tax treatment of the rental deduction and the taxation of profits would
need to be obtained and consulting a tax expert in Singapore and Malaysia. Also need to ensure that
Earthstor’s tax position is correct and that the company is paying the correct UK taxes.
There may be an intimidation threat if Dominic attempts to intimidate the audit staff – the firm should
ensure that appropriately briefed and experienced staff are assigned to the audit.
As there is no finance director, the firm may face a management threat if it acts in the finance director
role.
Actions the firm should take:
The increase in audit risk should be addressed with additional audit procedures in respect of the
above transactions.
AIM listed companies are not required to make disclosures of compliance with the provisions of the
UK Corporate Governance Code. However, from September 2018 they have to comply with or
explain their non-compliance with a recognised code. Furthermore ISA 260 (UK) (Revised November
2019) requires matters of concern to be raised with those charged with governance; the audit
committee would be a point of contact to raise concerns. In addition, information published in the
financial statements should be reviewed for consistency and appropriate professional scepticism. In
respect of the potential tax evasion, further information should be obtained and the matter reported
to the firm’s money laundering compliance principal. The firm will need to engage expert tax advice
in Malaysia and Singapore.
General comments
This was the best answered question on the exam, especially with regards to the financial reporting
treatment and identification of risks and procedures. Very few candidates commented on the need to
report to the audit committee.
Detailed comments
(1) Financial reporting treatment
Many candidates identified (erroneously) a related party issue with this question and those who did
often produced lengthy explanations of the disclosures that would be required. Some better answers

identified that there was an issue with transactions not conducted at arm’s length, but that this did
not create a related party.
The financial asset aspects of the question were often not handled well. In relation to the interest-free
loan, weaker candidates simply accounted for the foreign currency movement and disregarded
discounting and interest altogether. Only a small number of candidates who managed to discount
the opening receivable could explain that discounting resulted in an initial expense in the profit or
loss. Some recognised that the transaction resulted in the recognition of a receivable but then
accounted for the unwinding of the receivable (interest income) as a cost to profit or loss. Some even
considered the asset was a liability. However, this was a relatively difficult topic and it was pleasing
that so many candidates did manage to make the necessary adjustments correctly.
In relation to the investment in 10% of Trayner’s shares, it was quite common to find candidates
accounting for this as an associate and therefore recommending the equity method. Sometimes this
was as a result of arguments that Earthstor and Trayner are very closely linked, and that the apparent
overpayment for the 10% investment could have involved a premium related to significant influence.
However, in many cases it appeared that candidates think that an investment of 10% automatically
results in significant influence. Most candidates (but not all of them) realised that the treatment of
transaction costs was correct. However, many thought that the creation of a translation reserve was
also correct. Occasionally there were some reasoned debates demonstrating higher skills about the
nature of and reason for the movement in the fair value and these were credited in the marking.
Most candidates gained marks on the website asset. Weaker candidates took the opportunity to
write out sections of the standards for the markers to read – unfortunately the marks at this level are
for the application of knowledge to the scenario – to gain marks the candidate has to explain why a
particular standard applies to the scenario.
However, in general candidates were able to articulate that costs for the website should only be
capitalised when future economic benefit had been demonstrated. Almost all then went on to
undertake a reasonable calculation of the amortisation for the period.
There were some surprising errors in relation to the mainstream topic of investment property. A
substantial minority of candidates put time and effort into isolating the foreign currency effect of the
investment property fair value movement and reporting it separately, which is not required. More
surprising at this level was the readiness to post the fair value movement to a revaluation reserve
rather than to profit or loss. Many candidates got tangled up in lengthy explanations about the
granting of rent-free accommodation to TraynerCo.
(2) Audit risks and procedures
In general, the audit risks and procedures were sufficiently well identified and discussed for
candidates to score highly with many scoring close to maximum marks for this section. Marks were
lost when the audit tests were not appropriately linked to the scenario or were repetitious. The best
answers highlighted the recoverability issues with the TraynerCo loan and suggested appropriate
procedures to address this risk. However, a significant number thought that an acceptable approach
to many risks would be to obtain management representations, despite the governance and ethical
issues discussed in relation to Dominic Roberts in the last section of the question.
Candidates should identify the main risk with each issue. Weaker candidates start by discussing the
exchange rates and the correct discount factors and then do not comment on the more obvious
issues like the recoverability of the loan. Candidates score better if they produce quality rather than
quantity.
For the investment many discussed disclosure as an equity investment at FVTOCI and the exchange
rate issues again but did not think that the fall in value would be significant (some had called it a non-
adjusting post period end event). This meant that the procedures were weak too.
The risks surrounding the website and the investment property were identified more clearly.
Procedures were not thought through well. Many mentioned looking at board minutes although it
was clear from the question that Dominic may not have discussed/minuted these and had cancelled
meetings.
There was a lot of discussion about related parties which was not relevant. Many thought the
incorrect/insufficient disclosures of related parties was the main risk for some issues.
There was also a lot of discussion about the reliance of Earthstor on Trayner for supplies and that
there was a going concern risk for Earthstor. The question said that if they could not buy supplies

from Trayner they may not be able to trade successfully in the footwear market but this was
sometimes interpreted as imminent corporate failure for Earthstor.
(3) Statement of financial position
Most candidates were able to use their own figures from part (a) to complete enough of the key
elements of this section. However, few presented the loan to Trayner separately from trade
receivables and many candidates failed to demonstrate that the balance sheet should balance.
(4) Corporate governance and ethics
The corporate governance element of this section was generally well completed with most
candidates identifying the dominance of Dominic Roberts, lack of segregation of CEO/chairman and
the cancelling of board meetings as indicative of poor corporate governance. Some very weak
candidates speculated on the nature of the ‘close friendship’ with Henry and said this was unethical.
However, many incorrectly noted that, as the company was AIM listed, it was required to comply with
the UK Corporate Governance Code, rather than it being best practice.
The ethics section was poorly completed by most. A large proportion of candidates interpreted the
requirement as relating to Dominic Roberts’s ethics rather than the audit firm’s and commented on
potential unethical business practices. Where candidates did interpret the question correctly, few
raised anything other than the intimidation threat as an ethical issue. Very few recognised the
potential for tax evasion. Consequently, the ‘actions’ were very limited.
39 EyeOP
Scenario
The candidate is working in the finance department of a listed company, HiDef plc, and is required to
respond to the instructions of the CEO. HiDef has an investment in EyeOP Ltd and is planning to
acquire a controlling interest. The candidate is required to explain the impact of financial reporting
issues including: the calculation of consolidated goodwill; the correction for the accounting
treatment of the company’s pension scheme obligations; the treatment of development costs and
revenue recognition. Having made appropriate adjustments, the candidate is required to prepare a
draft forecast statement of comprehensive income assuming HiDef makes the acquisition of EyeOP’s
shares. Finally, the candidate is required to analyse the impact of the acquisition on key performance
targets
Requirement Skills
Calculate the goodwill relating to the proposed Use technical knowledge to calculate the
purchase of 650,000 ordinary shares in EyeOP goodwill on consolidation.
on 1 August 20X6, which would be included in
HiDef’s consolidated statement of financial
position as at 30 November 20X6. For this
purpose, use the expected fair value of EyeOP’s
net assets at 1 August 20X6 of £63 million.
Explain the impact of each of the outstanding Assimilate complex information in order to
financial reporting issues (Exhibit 1) on EyeOP’s recommend appropriate accounting
forecast financial statements for the year ending adjustments.
31 December 20X6. Recommend appropriate Apply technical knowledge to the information
adjustments using journal entries. in the scenario to determine the appropriate
accounting for pension accounting,
development costs and revenue recognition.
accounting journals.
Prepare a revised forecast consolidated Assimilate and use adjustments identified in (b)
statement of comprehensive income for HiDef in drafting the statements requested.
for the year ending 30 November 20X6. Use knowledge of financial statement
Assume that HiDef acquires 650,000 shares in presentation to present the financial statements

Requirement Skills
EyeOP on 1 August 20X6 and incorporate any in appropriate format.

adjustments you recommend in respect of the Appreciate that control threshold passed and
outstanding financial reporting issues (Exhibit therefore a gain on re-measurement to fair
1). value arises which is recognised in OCI.
Analyse the impact of the acquisition of Analyse information to determine EyeOP’s

650,000 shares in EyeOP on HiDef’s key impact on the performance ratios.
performance targets (Exhibit 2) for the year Determine the predicted impact for 20X7.
ending 30 November 20X6 and, where
possible, for the year ending 30 November Conclude on the extent to which performance
20X7. targets are met subsequent to the acquisition.
Marking guide Marks
Goodwill calculation 4
Revised forecast SOCI 6
Impact of acquisition 8
30
Total 30
Part (1)
For this purpose, use the expected fair value of EyeOP’s net assets at 1 August 20X6 of £63 million.
Goodwill is calculated as:
£m
Fair value of consideration paid to acquire control 85.0
Non-controlling interests (valued using the proportion of net assets method) 30% ×
£63 million 18.9
Fair value of previously held equity interest at acquisition date 6.2
110.1
Fair value of net assets of EyeOP 63.0
Goodwill 47.1
This calculation assumes that there is no impact on the net assets figure at 1 August 20X6 arising
from the correction of the errors identified below in EyeOP’s financial statements for the year ending
31 December 20X6.
Part (2)
Pension schemes (Note 1)
Scheme B appears to be a defined contribution plan therefore the accounting treatment adopted by
the finance assistant is correct. This is a defined contribution plan because there is no obligation on
the part of EyeOP other than to pay its contribution of 7% to the pension fund.
Scheme A is a defined benefit plan because EyeOP has provided a guarantee over and above its
obligations to make contributions. Therefore, the contribution of £6.4 million in respect of Scheme A
should be credited from the statement of profit or loss and debited to the net benefit obligation. The
service cost of £5.9 million and finance cost of £1.9 million (see calculation below) should be
charged to the profit or loss.

In addition, a gain on re-measurement must be calculated and taken to OCI as follows:
Plan assets Plan obligations

£m £m
At 1 January 20X6 22.0 (60.0)
Interest cost on obligation (5% × £60m) (3.0)
Interest on plan assets (5% × £22m) 1.1
Current service cost (5.9)
Payments to pensioners (2.1) 2.1
Contribution paid 6.4
Curtailment –––– (4.2)
Sub total 27.4 (71.0)
Gain/(Loss) on re-measurement recognised in OCI 5.2 (3.5)
At 31 December 20X6 32.6 (74.5)
Note: Above table shown for marking purposes – a merged presentation also acceptable.
Recommended adjustments:
£m £m
DEBIT Finance costs (£3 million – £1.1 million = £1.9 million) 1.9
CREDIT Net benefit obligation 1.9
DEBIT Operating expenses (£5.9 million + £4.2 million) 10.1
CREDIT Net benefit obligation 10.1
DEBIT Net benefit obligation 6.4
CREDIT Operating expenses 6.4
CREDIT OCI 1.7
DEBIT Net benefit obligation 1.7
IAS 19 requires that the interest should be calculated on the net benefit obligation. This means that
the amount recognised in the profit or loss is the net of interest charge on the obligation and the
interest income on the assets. Therefore, the actual return on the plan assets is not relevant here.
EyeOP has taken on an additional liability in respect of the senior employees made redundant – this
cost is a curtailment cost which is charged to the statement of profit or loss.
Medsee camera – revenue recognition (Note 2)
This item does not represent a non-recurring item and it is incorrect to expense all the development
costs as it is possible that some of the costs should be capitalised.
In the period to 1 January 20X6 not all the criteria in IAS 38 appear to have been satisfied as the
technical breakthrough in relation to the project happened on 1 January 20X6, and so the costs of £4
million a month should be expensed in the statement of profit or loss. Therefore, the treatment was
correct for the financial statements for the year ended 31 December 20X5 as the probable future
economic benefits were uncertain before that date.
Once the technical breakthrough was made on 1 January 20X6, the development costs should have
been capitalised until the project was completed on 30 April 20X6. An intangible asset of £14 million
(4 × £3.5m) should therefore have been created.

The following adjustment is therefore required:
£m £m
DEBIT Intangible asset 14
Once production of the Medsee commenced in May 20X6, the development costs should be
amortised. This can be done on a unit of production basis (per IAS 38 para 98). I recommend that
£14 million is amortised over the number of Medsee cameras produced in the year ended 31
December 20X6. This gives an amortisation charge of £200,000 (£14 million × 50/3,500).
£m £m
DEBIT Operating expenses 0.2
CREDIT Intangible asset 0.2
EyeOP intends to recognise revenue in respect of the 600 cameras which customers will order by 31
December 20X6 because the orders are non-cancellable. However, following IFRS 15, Revenue from
Contracts with Customers, revenue should only be recognised when the performance obligations in
the contract have been satisfied. There is only one performance obligation: supply of the cameras.
This performance obligation is satisfied when control of the cameras has been transferred to the
buyer. This normally is upon delivery, and so revenue in respect of only 50 cameras should be
included in the statement of profit or loss 50 × £60,000 = £3 million. The cash received in relation to
orders not yet fulfilled should be treated as a contract liability.
The adjusting journal is therefore:
£m £m
DEBIT Revenue 33.00
CREDIT Receivables 24.75
CREDIT Contract liability 8.25
The accrual for cost of sales should therefore be removed in relation to the original journal for
revenue.
£m £m
DEBIT Inventories 12.1
CREDIT Cost of sales (550 × £22,000) 12.1
EyeOP draft statement of profit or loss
Ref to Revised
First draft Adjustment Working draft
£m £m £m
Revenue 178.9 (33) 2 145.9
Cost of sales (92.6) 12.1 2 (80.5)
Operating expenses (36.3) (10.1) 6.4 (0.2) 1, 2 (40.2)
Non recurring item (14.0) 14.0 2 0
Finance cost (12.2) (1.9) 1 (14.1)
Income tax expense (4.8) (4.8)
OCI (Gain) 1.7 1 1.7

Part (3)
Consolidation adjustments
• Disposal of previously held shareholding in EyeOP
When control is achieved:
• any previously held equity shareholding should be treated as if it had been disposed of and then
reacquired at fair value at the acquisition date; and
• any gain or loss on re-measurement to fair value should be recognised in other comprehensive
income in the period because the original investment was at FVTOCI.
As the shares in EyeOP were previously classified as being at fair value through other comprehensive
income, any gains in respect of it which were previously recognised in other comprehensive income
may not be reclassified from other comprehensive income to profit or loss, and any gain arising on
derecognition is also recorded in other comprehensive income.
Therefore, the following journal is required in HiDef’s statement of comprehensive income to dispose
of the shareholding in EyeOP before consolidation:
£m £m
DEBIT Investment in EyeOP: £6.2m – 2.5m 3.7
CREDIT Other comprehensive income and other components of equity 3.7
To recognise the gain on the deemed disposal of the existing holding prior to control being
obtained.
IFRS 10 states that where a subsidiary prepares accounts to a different reporting date from the
parent, that subsidiary may prepare additional statements to the reporting date of the rest of the
group, or if this is not possible, the subsidiary’s financial statements may be used for consolidation
provided that the gap is three months or less and that adjustments are made for the effects of
significant transactions.
EyeOP
20X6 Adjusted Consolidated
£m £m £m £m
Revenue 383.0 145.9 × 4/12 48.6 431.6
Cost of sales 264.2 80.5 × 4/12 26.8 291.0
Gross profit 118.8 65.4 21.8 140.6
Administrative expenses (102.0) (40.2) × 4/12 (13.4) (115.4)
Profit from operations 16.8 25.2 8.4 25.2
Finance costs (5.5) (14.1) × 4/12 (4.7) (10.2)
Profit before tax 11.3 11.1 3.7 15.0
Income tax (2.3) (4.8) × 4/12 (1.6) (3.9)
Profit for the year 9.0 6.3 2.1 11.1
for the year 3.7 1.7 × 4/12 0.6 4.3
Total comprehensive income for

the year 12.7 8.0 2.7 15.4

Owners of HiDef 10.5
Non-controlling interests (2.1 × 30%) 0.6

Consolidated statement of other comprehensive income
Other comprehensive income 4.3
Owners of HiDef 14.6
Non-controlling interests (2.7× 30%) 0.8
15.4
Part (4)
(1) Revenue increase by 7%
Consolidating the adjusted revenue of EyeOP results in the revenue target being met in the year
ending 30 November 20X6.
£400 million × 107% = £428 million compared to projected revenue including EyeOP for 4 months,
of £431.6 million.
Next year the target will also be met as predicted revenue will be £578.4 million (see below) which
represents a 34% increase on the revenue for 20X6. However, in subsequent years without further
initiatives or acquisitions, revenue will remain constant and therefore the growth will need to be
either organic or from other acquisitions.
(2) Gross profit percentage of 35%
This target is currently not predicted to be achieved either with (32.6%) or without (31%) the
acquisition of the 650,000 EyeOP shares. EyeOP achieves a gross profit percentage of 45%
compared to HiDef 31%. The acquisition will not have a significant impact in achieving this target in
the current financial year because only 4 months of EyeOP’s results will be consolidated with HiDef’s.
In addition, the impact of the Medsee contract on the consolidated gross profit for the current
financial year is relatively small because only the sale of 50 cameras should be recognised in
revenue.
The margin predicted on the Medsee contract in 20X7 and subsequently is 63%:
£m
Revenue (3,500/4 = 875 cameras × £60,000) 52.50
Cost of sales (875 × £22,000) 19.25
Gross profit 33.25
EyeOP’s gross margin in 20X6 excluding the revenue from the 50 new imaging cameras contract is as
follows:
£m £m £m
Revenue 145.9 (3.0) 142.9
Cost of sales 80.5 (1.1) 79.4
44.8% 44.4%
The directors should be sceptical about EyeOP’s assertions regarding the margin achievable on the
Medsee contract as currently it is significantly greater than the margin achieved on its other
contracts. There may also be additional fixed costs.
In 20X7, 100% of EyeOP’s results for the entire year will be included in the consolidated statement of
profit or loss which will increase the overall gross profit percentage. Given the assumption that other
revenues and costs will remain constant, the contract for the sale of imaging cameras therefore
represents further additional revenue for the group.

EyeOP’s gross profit for the year ended 31 December 20X7 would include an additional £33.25
million from the Medsee contract which would be consolidated together with its results for the entire
year (assuming these remain constant) in the group financial statements for the year ending 30
November 20X7 (see working below).
WORKING
Predicted group revenue and gross profit for the year ending 30 November 20X7
Revenue Cost of sales

£m £m
EyeOP
20X6 excluding Medsee 142.9 79.4
Add: new contract additional revenue 875 cameras 52.5 19.3
Projected for year ending 31.12.20X7 195.4 98.7
Add HiDef 383.0 264.2

Group revenue 578.4 362.9
Group cost of sales (362.9)
Gross profit 215.5
GP % 37.3%
The group gross profit percentage for the year ending 30 November 20X7 is likely to be 37% which
would mean that the target of 35% would be met next year.
Tutorial Note
The amortisation of the development costs could also be included in cost of sales.
(3) EBITDAR/Interest more than 12 times

The finance cost is a significant figure on EyeOP’s profit or loss indicating that EyeOP is highly
geared. In addition, EyeOP has a significant pension obligation which affects this cost.
£m
EBITDAR before consolidation of EyeOP
Add:
Depreciation 28.1
Lease rentals 35.5
80.4
Interest 5.5
EBITDAR/Interest 14.6 times
Before consolidation, this key ratio target has been met comfortably. On consolidation of EyeOP, the
ratio decreases to 9.0 times and therefore the target of 12 times will not be met.

£m
EBITDAR after consolidation of EyeOP
Group profit from operations 25.2
Add:
Depreciation (£4.1m × 4/12) + £28.1m 29.5
Lease rentals (£5.5m × 4/12) + £35.5m 37.3
Amortisation of development costs £0.2m × 4/12 = £0.07m 0.1
92.1
Interest 10.2
EBITDAR/Interest 9.0 times
General comments
This question was generally well answered by most candidates although some found the sections
relating to the production of a P or L and subsequent analysis quite challenging.
Detailed comments
Part (1)
Goodwill calculation
This was extremely well completed by candidates with many scoring full marks.
Part (2)
FR issues
Candidates attempted this element well. Most identified the difference between the two pension
schemes and were able to calculate correctly and account for the movements in the defined benefit
scheme. In addition, the issues in relation to the capitalisation of the Medsee expenses were well
discussed. Many then went on to correctly identify that there should also be an adjustment to
revenue and cost of sales, although often missing the contract liability element.
Some candidates became confused between the two pension schemes, but follow through marks
were given where information was correctly applied. Marks were lost however when candidates were
not explicit regarding which statement the various movements should be posted to.
A worrying aspect of some candidates’ answers was the lack of understanding regarding the
recognition of revenue with many failing to apply the recognition criteria as the point of delivery.
Part (3)
Financial statements
Whilst most candidates were able to complete the basic requirements of this question, many did not
correctly identify the time period over which the results of EyeOP should be apportioned and/or did
not time apportion the profit adjustments in addition to the original P or L amounts.
Some of the more common errors were:
• adjusting EyeOP but then failing to add it to HiDef;
• inability to work out the number of months between 1 August 20X6 to 30 November 20X6 (it is 4
months not 5 or 11);
• adjusting HiDef rather than EyeOP; and
• taking 70% of EyeOP’s revenue and expenses.
Part (4)
KPIs
There were few candidates who made a satisfactory attempt at this question – calculating the ratios
and then linking the data back to the scenario for both the current and future periods. Of the

remaining candidates, the majority just calculated some ratios and then concluded whether or not
the KPI was met; a significant minority did not attempt this element of the question.
40 Topclass Teach
Scenario
This question requires the candidate to provide accounting advice on an arrangement which may
include a lease and then to identify the risks associated with the audit of PPE, together with an
outline audit approach. The question required the application of knowledge of lease accounting and
the ability to differentiate between inherent, control and detection risks. The candidate was also
required to prepare an outline audit plan using appropriate approaches and timing for the given
situation.
Requirement Skills
Draft a response to Karel’s request for advice on Assimilate complex information in order to
the financial reporting implications of the produce appropriate accounting adjustments.
proposed agreement with Beddezy on the TT Apply knowledge of relevant accounting
financial statements for the year ending 31 standards to the information in the scenario to
August 20X6 (Exhibit 3). You can ignore any tax appreciate that the rights of use of the two
or deferred tax consequences. assets result in different accounting response.
Determine that the management training centre
arrangement results in a lease under IFRS 16.
Identify and explain the inherent, control and Apply technical knowledge to explain risks
detection audit risks associated with our audit relevant to the scenario.
of the PPE balance in TT’s financial statements Assimilate information to identify control
for the year ending 31 August 20X6. activities relevant to audit assertions.
Identify weaknesses in control and impact on
audit procedures.
Determine the additional information needed
to ensure audit assertion is met.
Prepare an outline audit approach for TT’s PPE Appreciate that evidence of good controls over
balance at 31 August 20X6 which explains additions last year should again be tested for
those aspects of our audit of PPE where: effectiveness and informal nature of recording
• we are able to test and place reliance on the system indicate controls would not be effective.
operating effectiveness of controls; Identify the need for an auditor’s expert in
• we will need expert input; terms of valuations.
• audit software can be used to achieve a Identify specific areas for audit software for
more efficient audit; depreciation arithmetic, samples for control
testing, to identify unusual journal entries.
• substantive analytical procedures will
provide us with adequate audit assurance; Appreciate that substantive analytical
and procedures over depreciation calculations will
be effective.
• tests of details can be performed during our
interim audit visit. Determine areas where tests of control would
be required – eg, additions, classification and
existence.

Marking guide Marks
Financial reporting implications 6

Control and detection: audit risks 12
Audit approach 12
30
Total 30
Part (1)
Draft response to Karel’s request for advice
Draft financial reporting advice
The proposed arrangement with Beddezy involves both the sale of a piece of land and ongoing
arrangements in respect of two buildings which will be built on it.
To determine how both the initial land sale and the ongoing arrangements should be accounted for,
it is necessary to consider whether the arrangements in respect of the buildings constitute lease
arrangements. This is addressed by IFRS 16, Leases.
Key factors to consider are as follows.
• Is there an identifiable asset?
• Does the customer have the right to obtain substantially all the economic benefits from use of the
asset throughout the period of use?
• Who has the right to direct how and for what purpose the asset is used?
• Does the customer have the right to operate the asset throughout the period of use without the
supplier having the right to change those operating instructions?
In the case of the hotel, the IFRS 16 criteria are not met as TT will not have the ability to operate the
hotel and there is more than a remote possibility that more than an insignificant amount of its
capacity will be taken by parties other than TT. Indeed, TT has no commitment to take any rooms. TT
does not have the right to obtain substantially all the economic benefits from use of the asset, the
right to direct how and for what purpose the asset is used, or the right to operate the asset without
Beddezy being able to change the operating instructions.
In the case of the management training centre, the IFRS 16 criteria are met as the centre will be
operated by TT and its manager will supervise those controlling access to the building. It will also
have exclusive use of the centre. The arrangement does therefore include a lease for the
management centre and this should be accounted for under IFRS 16.
Having established that the arrangement contains a lease, it is necessary to return to the sale of the
land and consider how that should be accounted for. Half of the land which has been sold will be
used for the hotel and TT has no right to re-acquire that land and no lease over it during the term of
that arrangement. That element of the sale should therefore be accounted for as a disposal, resulting
in the disposal of an asset with a carrying amount of £1.5 million (assuming the entire plot is priced
at the same price per acre) and the recognition of a profit of £1 million in the period in which the
arrangement is signed. Further information is needed to assess whether the price for the land is a fair
market price given that the sale is part of a much more complex arrangement.
This entry will give rise to an increase in net assets as the profit is recognised.
The sale and leaseback of the land provided for the management training centre and for the centre
itself must be accounted for in accordance with IFRS 16.
The present value of the future lease payments cannot be calculated without first determining what
element of the payments relates to the cleaning, maintenance, security and reception services to be
provided as this would need to be excluded from the calculation. The cost of the building to
Beddezy will be £4 million. Excluding the element (of £100,000 per annum) which relates to staff
costs and services, the future lease payments (undiscounted) will be £3 million (15 × £200,000).
However, this covers the lease of the land as well as the building. Apportioning between them in the
ratio of the cost to Beddezy would mean that (£3 million × 4.0/6.5) = £1.85 million would relate to
the building before discounting.

Financial reporting adjustments
The element of the lease payments which relates to the services to be provided should be taken to
profit or loss as a charge in the period in which those services are provided.
The land sale for the management training centre will be treated as a sale and leaseback under IFRS
16, with a gain recognised on the rights transferred and a right-of-use asset in respect of the rights
retained, calculated as:
Carrying amount × (PVFLP ÷ FV)
As regards the training centre, this is effectively a new lease as the building did not exist at the time
of the sale. A right-of-use asset would be set up consisting of the discounted present value of the
future lease payments relating to the building.
Part (2)
Identification and explanation of audit risks associated with PPE
Inherent risks
Management incentive to misstate the balance
We need further information to assess the extent to which management may be under pressure to
overstate assets and it is possible that there is an incentive to do so. This risk is considered further
below in connection with the judgements involved in the proposed revaluation.
Overall business environment
Training needs and revenues will fluctuate with changing regulations and so facilities and courses
offered may need to change over time as the engineering courses have in the current period. This
means that asset lives could be shorter than anticipated. The fact that the disposals recorded in the
nine months to 31 May 20X6 had a carrying value which represented 40% of their cost is also
indicative that the useful lives used for depreciation may be too long and need to be reassessed in
the light of actual experience and the changing business environment.
Carrying value and level of transactions in the period
The PPE balance is very significant and is many multiples of materiality in size. This increases the risk
of material misstatement as individual transactions may well be material if accounted for incorrectly.
There are a number of ongoing capital projects with a high value and this increases the risk of mis-
statement due to the large number of transactions which need to be processed.
Complexity of transactions
The proposed transaction with Beddezy is complex and the client is seeking assistance in
determining the financial reporting treatment. Complex transactions increase the risk that
inappropriate accounting policies may be adopted or the nature of a transaction misunderstood by
the accounts department.
In addition to the Beddezy transaction, major renovation projects such as those on the science
laboratories are likely to have elements which are capital and other elements which are revenue in
nature as they represent more routine repairs. Separating the different elements can be difficult in
practice especially if projects evolve or change as they progress. In addition, the capital elements of
the projects will result in the construction of components which have differing lives – some relating
potentially to the fabric of the building and others to shorter lived assets such as air conditioning or
lift systems or moveable partitions. In addition, there may be elements which should be classified as
furniture, fittings and equipment rather than freehold land and buildings and it is surprising that, on
the transfer of the new business school into depreciable assets, the whole of the £13.5 million was
categorised as freehold land and buildings. This suggests that appropriate componentisation and
classification may not have taken place.
Work on the renovation of Laboratory 2 includes some rework costs which should not be capitalised
as they will not contribute any value to the finished building. We will need to ensure that, to the
extent that the costs incurred by year end have not added value, they are charged to profit or loss
rather than being capitalised and should also consider whether there are other similar costs included
in the total cost of other projects.
The IT project is likely to include elements which are PPE – ie, physical equipment – but also elements
which should be classified as intangible assets such as software. There may also be other elements
such as training which should not be capitalised at all.

Expert input
TT is proposing to revalue its assets in the current year and has included in its plan an upward
revaluation of £40 million, representing nearly 30% of the carrying value of land and buildings prior
to that revaluation. This is not totally unreasonable when compared to the observed movement in
market prices since the estate was last revalued (25%) or the anticipated profit on the sale of the land
to Beddezy (67%) although that may or may not be at fair value and may not reflect existing use.
However, the uplift of the valuation is very significant in the context of an organisation which may be
trying to maximise its net asset value (see above).
The revaluation of an extensive campus is a complex and judgemental exercise especially when the
campus includes specialised assets such as the laboratories. It is unlikely that such properties will
have moved with market indices and, indeed, an alternative valuation model such as depreciated
replacement cost may in fact be appropriate. In addition, there is evidence as summarised above that
land values may have moved more than building values so separate consideration of each element
needs to be made.
TT had a professional valuation three years ago and is not required to have another one for three to
five years. It may therefore be entitled to use its internal experts for the valuation at 31 August 20X6
providing that they have the requisite skills and experience. However, use of internal experts
increases the risk of management manipulation of results and the influence of senior management
such as the finance director. It is also questionable when the expected revaluation change is so
significant.
Judgements
Assessment of useful lives for depreciation purposes is inherently judgemental and, as outlined
above, there are some indications that past judgements may have been incorrect. This increases the
risk of mis-statement. The average useful life for fixtures, fittings and equipment appears to be
around 8 years (Depreciation charge for the year = £3.8 million; average cost = (£32.1m + £0.5m +
£29.5m)/2 = £31.05m; £31.05m/£3.8m = 8.17 years) which is quite long for some types of
equipment. However, this may well be offset by assets which do have a longer useful life.
Another factor which will make a difference to the depreciation charge is the timing of the transfer of
completed assets from assets in the course of construction which are not depreciated into categories
of asset which are depreciated. If this entry is not made on a timely basis, then depreciation will be
understated. Karel’s email says that Laboratory 1 has been completed but the forecast figures for the
final quarter in the management accounts do not show any transfer to Freehold land and buildings
(other than the Business School which has already been transferred).
Susceptibility to theft
Certain of the PPE assets are susceptible to theft – in particular IT equipment such as laptops and
expensive but portable equipment in other areas.
Unrecorded disposals
Major renovation projects such as those on the science laboratories potentially result in the
replacement of components created by previous renovation work or indeed the initial construction
of the building. The level of disposals recorded in the management accounts is very low and there is
therefore a risk that the recording of disposals may be incomplete.
Quality of accounting systems
The systems for accounting for property, plant and equipment are not part of the main accounting
system and were developed by the finance department. There is therefore a risk that they have not
been maintained correctly or that mis-programming has occurred. However, the fact that there have
been no audit adjustments in prior years suggests that the systems have in fact worked well.
Control risks
Staff
The long term sickness of Harry George and the fact that another individual has had to take over the
accounting for PPE increases the risk that errors are made. As the individual who has taken over is not
within the accounts department there is also a risk that they might have less knowledge of the
financial reporting treatment of more complex transactions. This means that it will be difficult to place
reliance on their assessment in the more judgemental and complex areas such as major projects.

Segregation of duties
The person who has taken over responsibility for the PPE accounting sits within the estates
department rather than the finance department. They may have other responsibilities within that
department and will, in any event, report to a manager who does. There is therefore a risk that
segregation between approval, initiating and recording transactions may be compromised although
additional information is required to assess the extent to which this might be the case.
Use of spreadsheets and PC
The use of spreadsheets to calculate key accounting entries and record extensive data increases the
risk that the IT systems are not robust, reliable and subject to appropriate security and integrity
checks.
A PC is also likely to have poor built in controls and security.
Detection risk
There are no specific factors (such as first year audit or incomplete records) which affect the
detection risk associated with this balance. Prior year audits have highlighted no major issues or
limitations of scope and the fact that the balance is largely comprised of relatively few high value
assets helps to reduce the detection risk.
Note: Credit should also be awarded for answers that discuss the impact of ISA (UK) 540 (Revised)
estimation uncertainty, as well as management bias and the controls in place at this client leading to
a separate assessment of audit risk for these categories of balances.
Part (3)
Outline audit plan
(1) Areas where we may be able to test and rely on the operating effectiveness of controls:
• Completeness and accuracy of additions to fixtures, fittings and equipment posted during the
year. Controls in this area were operating effectively last year and, although there have been
changes in staff, the basic processing and classification of invoices may not have been affected
adversely. While further judgement and analysis may well be required for major projects,
accounting for additions to fixtures, fittings and equipment is more straight forward and controls
reliance may still be possible.
• The physical verification exercise proposed is a good control over unrecorded disposals and
should be relied on to the extent that we can.
While there may also be some good controls in other areas, the informal nature of the accounting
system and the change in personnel make it less likely that they are operating effectively.
(2) Areas where we will need expert input:
• The key area for expert input will be in the revaluation of freehold land and buildings. We will
need our expert to look at the methodology, assumptions and conclusions in the valuation report
and to ensure that they are reasonable and do not show signs of bias.
• Expert input may also be required when considering the componentisation of major projects or
indeed the revalued assets.
(3) Areas where audit software can be used:
• To re-perform depreciation calculations for individual assets looking both at the charge for the
year and the remaining carrying amount
• To check the arithmetic accuracy of the PPE register and also the integrity of formulae used to
create reports etc
• To select samples for controls testing or tests of detail
• To identify any journal entries or other unusual transactions which require further investigation
(4) Areas where substantive analytical procedures will give adequate assurance:
• If the depreciation charge is not tested in its entirety using audit software, then it can be tested
using substantive analytical procedures to establish an expectation of the depreciation charge for
the year by category based on the cost/valuation of assets; additions and disposals in the year;
assets already fully depreciated; the average useful life of assets in that category. This can then be
compared to the actual charge for the year.

(5) Tests of detail which can be completed during the interim audit visit:
• Review of major projects completed in the year (Business School and Laboratory 1 of the Science
refurbishment) to test the appropriateness of the amounts capitalised, the timing of the transfer
from assets in the course of construction, the classification and componentisation of assets, the
complete recording of any associated disposals
• Testing of additions to property, plant and equipment for the first 9 or 10 months of the year
• Testing of disposals recorded in the first 9 or 10 months of the year
• Review of the agreements with Beddezy and further consideration of the financial reporting
treatment
• Testing of the data provided to be used by the estates department as part of the revaluation of
freehold land and buildings
• Consideration of the useful lives used in the depreciation calculation, taking into account the risk
factors identified above
• Our own testing on the existence of assets on the register, including sample testing of freehold
land and buildings to evidence of ownership such as the land registry
General comments
It was evident that quite a number of candidates did not allow sufficient time for this question as their
answers were clearly rushed and disorganised. The question was capable of being done well, as
some very good candidates demonstrated.
Detailed comments
Part (1)
Financial reporting – Sale of land
In general, this element was reasonably well completed by most candidates. Whilst, only around half
the candidates identified that the two transactions should have been dealt with separately, most then
demonstrated sufficient relevant technical knowledge to obtain follow through marks. Many
candidates spotted that there was a possible sale and leaseback in the scenario. Explanations were
quite often lengthy, disorganised and incoherent. But some did this section well and scored full
marks.
Part (2)
Identification of inherent, control and detection audit risks associated with the audit of PPE
Overall strong candidates identified a good selection of inherent and control risks, relating them to
the scenario. In particular, most identified the absence of Harry George, complexity of accounting,
materiality of assets, segregation of duties and the use of spreadsheets as risks. There was some
confusion between what was an inherent risk compared to a control risk, but marks were awarded as
long as the risks were linked to the scenario. Limited marks were given for generic risks not linked to
the scenario of Topclass Teach plc.
Hardly any candidate identified that there were no specific factors that impacted detection risk,
instead discussing team structure and lowering materiality as risks/actions. A handful identified that
the absence of Harry George might give rise to difficulty in accessing supporting evidence and
potential limitation in scope.
A common error was to set out a generic set of risks, largely or wholly unrelated to the information in
the scenario.
Part (3)
Outline audit approach for TT’s PPE balance at 31 August 20X6
The majority of candidates provided a well-structured answer to this part of the question, dealing
with each of the aspects requested and relating the areas for testing to the facts of Topclass Teach
plc. Weaker candidates lost marks where the answer was not structured as requested or where the
audit approach was merely a list of audit procedures often generic rather than a reasoned approach
to each aspect. These candidates were not demonstrating higher skills required at this level. The
question requirement was very helpful in organising the answer but many weaker candidates simply
ignored this.

In addition:
• candidates could not identify the areas where controls could be relied upon;
• ‘substantive analytical procedures’ was often read as ‘substantive procedures’ and so detailed
tests were listed and not analytical procedures;
• vague descriptions of tests of detail lost marks eg, ‘look at additions and disposals’; and
• also some candidates provided tests that would have been more relevant at the year end and not
for an interim audit – for example cut off procedures.
These were the main weaknesses.

41 Zego
Scenario
The candidate is in the role of audit senior assigned to the audit of Zego, a 100% owned subsidiary
of Lomax plc. Zego’s revenue has declined in the financial year and a competitor brought out a
superior product to its Ph244 which has had a significant impact on the recoverable amounts for
capitalised development costs and PPE related to the product. Also, important to the scenario is that
Lomax has previously provided loans but evidence is presented in the question to show that this
support will not be continued for new projects and that Zego must now look for alternative sources
of finance.
The candidate is required to prepare analytical procedures on financial information provided after
adjusting for the impact of impairment of the development costs and inventory write down. The bank
has requested a meeting with Zego. The bank monitors performance by reference to interest cover
and gearing as key ratios. Zego has achieved positive cash flows from operating activities but there
are indications that some of its other products may be coming to the end of their lifecycle too.
The financial reporting implications include impairment adjustments for development assets and a
specially constructed production facility. This question requires information to be collected from
different exhibits and sources and a specific requirement for additional information means increases
the skills difficulty in this question. The candidate must also identify key risks and implications for
audit of Zego and implications of these risks for the financial statements of Zego, Lomax and the
Lomax group.
Requirement Skills
Notes explaining and, where possible, Assimilate and demonstrate understanding of a

calculating adjustments that are required to large amount of complex information.
Zego’s draft financial statements for the year Identify appropriate accounting treatments for
ended 31 October 20X6 (Exhibit 3). complex items including PPE/Intangible
Do not prepare revised financial statements, but impairments and deferred taxation.
you should clearly identify areas where more Apply technical knowledge to identify
information is required to make appropriate inappropriate accounting adjustments.
adjustments.
A working paper setting out preliminary Assimilate knowledge, drawing upon question
analytical procedures. Include relevant content, to describe type of work required to
calculations and explanations. Your calculations provide verification evidence.
should take into account any adjustments that Prepare analytical procedures having made
you have proposed to the financial statements. assimilated adjustments and restated relevant
account balances.
Identify areas for further investigation and areas
of audit risk.
A memorandum explaining the key audit risks Link analytical procedures to relevant audit
for Zego. Set out the implications of these risks risks.
for the financial statements for the year ended Use the information in the scenario from
31 October 20X6 of: different sources to identify audit risks.
• Zego Apply scepticism to the information provided
• Lomax plc by inexperienced financial controller.
• The Lomax Group Apply the risks to the financial statements
seeing the risks from different company
perspectives.

Marking guide Marks
Adjustments to financial statements 18

Analytical procedures 12
Key audit risks 10
40
Total 40
Part (1)
Information is available (Exhibit 2) that allows for an estimation of impairment adjustments in respect
of Zego’s non-current assets.
The property, plant and equipment and intangible development assets relating to non-Ph244
production do not appear to be impaired but more information would be required on this point.
Impairment of Ph244 PPE and intangible development asset
Specially-constructed production building
Recoverable amount is the higher of fair value less costs to sell and value in use. In the case of the
specially-constructed production building, the asset can apparently be sold only if it is adapted for
more general use. Fair value less costs to sell therefore appears to be £6.5 million (£8m – £1.5m). The
value in use of the asset is uncertain as it is dependent upon funding being made available for future
R&D projects.
The carrying amount of this building is £6.2 million. This is less than the estimated recoverable
amount of £6.5 million and so no impairment loss appears to arise in respect of this building.
The renegotiation of the bank loan and the apparent unavailability of future funding from the Lomax
Group suggests that the asset may not have a value in use.
More information is required on this point, and such information may not become available until the
conclusion of renegotiations over funding. However, at the moment, as the recoverable amount is
higher than the carrying amount, the value in use calculation would not be required.
R&D: Intangible development asset
The balance on the Ph244 development asset at 31 October 20X6 of £6 million and the balance of
PPE £0.9 million (£7.1m – £6.2m) can be examined together for recoverability, especially as an offer
exists that covers both elements. If recoverable amount is lower than £6.9 million, an impairment loss
allowance should be recognised.
The fair value less costs to sell of the Ph244 assets is estimated at £2.4m – £0.2m = £2.2 million,
based on the offer from the non-UK competitor.
The value in use of the Ph244 assets can be estimated by discounting projected net cash inflows
from the project, as follows:
Year ending Net cash inflows Discount factor Discounted net cash inflows
£m £m
31.10.X7 1.4 1/1.08 1.3
31.10.X8 1.0 1/ (1.08)2 0.9
31.10.X9 0.5 1/ (1.08)3 0.4
Total 2.6
Applying the IAS 36, Impairment of Assets criteria, recoverable amount appears to be around £2.6
million, as value in use is higher than fair value less costs to sell.
If this value is realistic, the impairment loss allowance that should be recognised is £6.9 million
(carrying amount) – £2.6 million (recoverable amount) = £4.3 million.

However, there is a great deal of uncertainty surrounding the above calculation of impairment loss
allowance. Questions arise as follows:
• Are the projected net cash flows dependent upon the availability of the Ph244 production
building? If so, the value in use depends upon Zego continuing to own the production building.
• Is the discount rate of 8% pa supplied by Zego’s Finance Director in September 20X6 realistic?
The discount rate used should be a pre-tax rate that reflects current market assessments of the
time value of money and the risks specific to the asset for which future cash flow estimates have
not been adjusted. We would require more information to be satisfied that 8% pa is appropriate.
• The fair value less costs to sell figure of £2.2 million comprises one offer from a non-UK
competitor and a rough estimate of costs to sell. Neither may be representative of potential
outcomes. More information would be required about the potential market for the technology.
Inventories
Inventories fall outside the scope of IAS 36, Impairment of Assets. Inventories should be measured at
the lower of cost and net realisable value, according to IAS 2, Inventories.
£3.6 million of the inventories balance relates to Ph244 products. Cost = 60% × sales value, so this
inventories balance represents (£3.6m × 100/60) £6 million in potential sales and (£6m – £3.6m) £2.4
million in potential gross profit.
The total forecast future sales of Ph244 can be estimated from the sum of forecast net cash inflows as
follows:
(£1.4m + £1.0m + £0.5m) = £2.9m. Forecast cost of sales = (£2.9m × 60%) = £1.7m.
Therefore, if the forecast of future net cash inflows proves to be reliable, the maximum amount of
inventories that can be sold at cost = £1.7 million.
The impairment loss allowance on inventories that should be recognised now is therefore estimated
at (£3.6 – £1.7) = £1.9 million.
Clearly, a great deal more work would be needed to confirm that the estimates of future cash inflows
are realistic.
Taxation
The draft financial statements include no estimates in respect of tax, possibly because Julia Brookes
is not technically qualified to perform tax calculations. Adjustments are likely to be necessary. The
impairment losses estimated so far total £6.2 million (£4.3 million in respect of Ph244 assets and £1.9
million in respect of Ph244 inventories), and there may be adjustments to the tax expense or
deferred tax balance in respect of these losses.
However, insufficient information is currently available to estimate the tax impact.
Part (2)
Working Paper
Zego Ltd: Analytical review
Prepared by: Andy Parker
November 20X6
I have estimated impairment losses totalling £6.2 million. These estimates are likely to require
revision, and there will probably be further accounting adjustments required, especially in respect of
taxation.
However, assuming additional losses of £6.2 million, the profit figures in profit or loss are all affected.
Gross profit (assuming impairment losses are recognised in cost of sales) falls to (£9.6m – £6.2m)
£3.4 million.
Operating profit becomes a loss of (£2.4m – £6.2m) £3.8 million.
Profit before tax and profit for the year become losses of (£0.6m – £6.2m) £5.6 million.
On the statement of financial position:
Non-current assets fall from £32.6 million to (£32.6m – £4.3m) £28.3 million.
Inventories fall to (£12.0 – £1.9m) £10.1 million.
Retained earnings are reduced to (£17.0m – £6.2m) £10.8 million.

Key accounting ratios for Zego are those specified by the bank covenants ie, interest cover and
gearing.
Interest cover
Interest cover per the draft financial statements: (2.4/1.8) = 1.33
Interest cover for 20X5: (3.8/1.4) = 2.71
Interest cover per the draft financial statements is therefore just within the parameter set by the bank
of 1.2
Clearly, once impairment losses are considered, the interest cover covenant is breached as there is
an operating loss of £3.8 million.
Gearing = net debt/equity
Gearing per the draft financial statements: (20.6 + 3.2)/21.0 = 1.13 × 100 = 113%
Gearing for 20X5: (22.4 – 3.6)/20.4 = 0.92 × 100 = 92%
Gearing at the 20X6-year end, per the draft financial statements, like interest cover, is within the
parameter set by the bank of 1.3.
Once impairment losses are considered, equity falls to (£10.8m + £4.0m) £14.8m and the gearing
calculation is as follows:
(20.6 + 3.2)/14.8 = 1.61 × 100 = 161% and the bank covenant is breached.
The calculation of additional ratios is in the Appendix.
Performance
There has been a significant drop in revenue between 20X5 and 20X6 (over 21%). An explanation for
this is the disappointing performance of the Ph244 products. However, this factor may be masking an
overall downturn in sales performance. Zego was able, in the 20X5 financial year, to generate £31.4
million in sales without the Ph244 product, and it has not matched this performance in 20X6.
It may be that some of the other Zego products are nearing the end of their lifecycle and that they
will have to be replaced by new products. It would be helpful to see a budget for the 20X6 financial
year to see how far actual sales of other products have deviated from budget.
Given the change in sales mix, some variation in gross profit margin is to be expected. It has, in fact,
fallen. Cost of sales may already include the recognition of losses relating to the Ph244 product or
other write downs. After recognising impairment losses, gross profit margin is much reduced.
Operating expenses have been reduced by £1.6 million (over 18%) between the two accounting
years. This is surprising as such expenses would normally be expected to be fixed in nature rather
than variable. A possible explanation for the reduction is a cost-saving programme. Zego is short of
cash, having moved from a comfortable cash position at the end of 20X5 to a sizeable overdraft at
the end of the 20X6 financial year. Cost-saving measures would be recommended in the
circumstances, and may have been successful. However, it is also possible that eg, accruals may have
been understated, deliberately or accidentally, and cut-off in respect of operating expenses may
require additional audit work.
Finance costs have risen over the year, as might be expected because of the additional overdraft
borrowings. Taking year-end figures, the approximate interest rate on borrowings has increased only
slightly, which may be due to a more expensive rate on short-term overdraft finance. More
information will be required on the terms attached to borrowings.
Profit for the year before tax is much reduced from the previous year, before considering the effect of
impairment losses. Return on capital employed is low at 5.4% even before considering impairment
losses.
Cash flow
Even though Zego has obviously had a very difficult year, there is nevertheless a small cash inflow
from operating activities, an indicator which could bode well for the future. Profit before tax adjusted
for depreciation, amortisation and finance costs is very little changed in 20X6 compared to 20X5.
Cash interest cover has fallen substantially.
Investing activities have declined in 20X6 compared to 20X5, possibly because Zego has lacked the
finance for investment in new projects (only £5.6 million of investment compared to £17.0 million in
the previous year).

This is a concern if, as surmised above, some of the company’s products are nearing the end of their
lifecycle. This industrial sector appears to require large investments in R&D and any falling off could
have a significant effect on the company’s ability to generate future cash flows.
However, the ratio of capital expenditure to depreciation and amortisation, although much reduced
from the previous year, shows a positive figure, and the company is continuing to invest at a slightly
faster rate than depreciation and amortisation.
Zego benefitted from £13.0 million in financing inflows in the 20X5 financial year, much of which
appears to have been invested in the Ph244 development. By contrast, in 20X6, the only financing
cash flow has been a repayment of £1.8 million. The meeting notes (Exhibit 5) show that £1 million
was repaid to the bank on 1 June 20X6, but no mention is made of an additional £0.8 million
repayment. This may have been a repayment made to Lomax, but further investigation would be
required.
Efficiency
Inventory turnover in the Zego business appears to be very slow indeed. This may be a feature of the
industry, but better control would improve working capital usage. The ratio has worsened
significantly in the 20X6 financial year because of the effects of failing to sell Ph244 products.
Trade receivables days have remained constant between 20X6 and 20X5. Without knowing the terms
of Zego’s trade it is not possible to say if 67–68 days represents a good performance.
Liquidity
The ratio of current assets to current liabilities is high in both years under review. However, once
inventories are removed from the equation Zego looks somewhat exposed at the 20X6 year end in
this respect, as current liabilities exceed trade receivables balances.
Appendix: Zego – accounting ratios
20X6 20X5
Gross profit margin (Gross (9.6/24.8) × 100 = 38.7% (12.6/31.4) × 100 = 40.1%
profit/revenue) × 100
Gross profit margin after impairment (3.4/24.8) × 100 = 13.7% N/A

adjustment
Operating profit margin (Operating (2.4/24.8) × 100 = 9.7% (3.8/31.4) × 100 = 12.1%
profit/revenue) × 100
Operating loss margin after ((3.8)/24.8) × 100 = (15.3%) N/A

impairment adjustment
Operating expenses as a % of revenue (7.2/24.8) × 100 = 29.0% (8.8/31.4) × 100 = 28.0%

(Operating expenses/revenue) × 100
Interest rate on year-end borrowings (1.8/(20.6 + 3.2)) × 100 = 7.6% (1.4/(22.4 – 3.6)) × 100 = 7.4%
(Finance costs/Year end net debt) ×
100
Return on capital employed (Profit (2.4/(21.0 + 20.6 + 3.2)) × 100 = 5.4% (3.8/(20.4 + 22.4 – 3.6)) × 100 = 9.7%
before interest and tax/(Equity + net
debt)) × 100
Return on capital employed after ((3.8)/(14.8 + 20.6 + 3.2)) × 100 = N/A

impairment losses (9.8%)
Cash from operations compared to (3.0/2.4) × 100 = 125% (7.3/3.8) × 100 = 192.1%
profit from operations
(Cash generated from
operations/profit from operations) ×
100
Cash interest cover 3.0/1.8 = 1.67 7.3/1.4 = 5.21

Cash return/interest paid
Non-current asset turnover (before 24.8/32.6 = 0.76 31.4/31.2 = 1.0

impairment)
Revenue/non-current assets

20X6 20X5
Capital expenditure to depreciation 5.6/4.2 = 1.3 17.0/2.9 = 5.9

and amortisation
Capital expenditure
(additions)/depreciation
Inventory turnover (before impairment) (12.0/15.2) × 365 = 288 days (7.8/18.8) × 365 = 151 days
Inventory/cost of sales × 365
Trade receivables turnover (4.6/24.8) × 365 = 67.7 days (5.8/31.4) × 365 = 67.4 days
Trade receivables/revenue × 365
Current ratio (before impairment) 16.6/7 = 2.4: 1 17.2/5 = 3.4:1

Current assets: current liabilities
Quick ratio (16.6 – 12.0)/7.0 = 0.66 (17.2 – 7.8)/5.0 = 1.88

(Current assets – inventories) : current
liabilities
Part (3)
Memorandum – Audit risks for Zego
Prepared by: Andy Parker
November 20X6
Breaching gearing ratio and financing
There is a significant element of financial risk related to the continuing financing of the company.
Zego is already highly geared, even before the effects of impairment losses are considered. Once
impairment losses are recognised the business has breached its loan covenants. The fact that the
bank has called a meeting to take place next week suggests that the bank is aware of the company’s
current difficulties. The worst-case scenario is that the bank will exert its fixed and floating charge
over the assets of the business. Although the value of assets has fallen significantly because of
impairment losses, it is likely that there will be sufficient assets to recover the entire value of its
outstanding loan with the bank. Also, a payment of £1 million to the bank is due on 1 December
20X6 (Exhibit 5) and the company has no cash to pay it.
However, this would mean that the company would face liquidation unless group support (eg, a
commitment by Lomax Group to repay the bank borrowings) could be obtained. The notes of the
meeting with Grahame Boyle, Group Finance Director, suggest that Lomax’s main board directors are
reluctant to provide further support to Zego, in which case the level of financial risk is heightened.
The bank may be prepared to renegotiate its lending to Zego, and the liquidation of the company
could be averted. A significant factor that is likely to be considered by the bank is that the business is
fundamentally profitable; it has produced positive operating cash flows in 20X6. However, there are
indications that some of the Zego products could be reaching the end of their life cycle, and further
investment would be required to fund new R&D to develop a pipeline of new products.
The financial risk is augmented because of timing. Zego is material in group terms, and the Lomax
Group has made a commitment to a preliminary announcement of results on 5 January 20X7.
Negotiations with the bank may not have been concluded by that date, which adds to the overall
financial risk.
From an audit viewpoint, compliance with ISA 570 (UK) (Revised September 2019), Going Concern,
would be required, and this is likely to be a significant element of the audit work. Auditors are
required to evaluate management’s assessment of the business’s ability to continue as a going
concern, including the possible existence of any material uncertainties regarding going concern. This
would involve examining the process involved in the assessment, the assumptions upon which the
assessment is based and management’s plans for future action.
The extent of the financial risk facing Zego is currently uncertain and developments during the
period of the audit must be monitored closely.
Operating performance
During 20X3 and 20X4 Zego’s management made a significant investment in a new product. The
investment has now largely failed, resulting in major impairment losses. The failure may call into

question the R&D capability of the company, making it less likely that further finance will be
committed to future related projects.
There is some evidence arising from the preliminary analytical procedures on the draft financial
statements that investment in other projects may have tailed off, and a suggestion that other
products are nearing the end of their life cycles. More information is needed on Zego’s product
range to confirm or refute these possibilities.
The Ph244 product was superseded by a better product from a competitor. If the competitor
maintains its technological superiority, Zego’s longer-term prospects could be prejudiced.
Lomax’s group directors appear to be sceptical about the capabilities of Zego’s management team.
This may be no more than a reaction to the failure of Ph244, but the lack of confidence is likely to
feed into future decisions by group of the level of support they are prepared to provide Zego.
Absence of a finance director and inexperienced financial controller
Compliance risk is, currently, less of a concern than financial and operating risks for Zego. However,
the absence of a finance director is a significant concern and a suitably qualified replacement has not
been appointed.
There is currently no qualified Chartered Accountant, as far as we know, working in Zego. The part-
qualified financial controller has prepared draft financial statements, but has not recognised any
adjustments in respect of impairment or taxation, which may cast doubt upon her technical abilities.
She may not be sufficiently technically competent to recognise compliance needs and the company
could therefore find itself in breach of regulations.
The audit team needs to be vigilant to ensure that compliance risk is recognised by Zego’s
management, and that sufficient steps are taken to ensure compliance with relevant regulation.
Implications for financial statements
Zego
If renegotiation fails for additional finance and the Lomax Group is unable/unwilling to provide
support, Zego may no longer be a going concern and its financial statements would probably have
to be prepared under the break-up basis of accounting. Additional disclosures would be required
under IAS 1, Presentation of Financial Statements.
If doubt continues over the business’s ability to continue as a going concern, the financial statements
must disclose clearly that there is a material uncertainty. If the auditors consider that adequate
disclosures have been made, the audit opinion is unmodified but a Material Uncertainty Related to
Going Concern section is added. If adequate disclosures are not made, the auditors must express a
qualified or adverse audit opinion.
Lomax plc
The main implication for the financial statements of Lomax plc, the parent company, is the
measurement of the assets of investment in Zego Ltd and the long-term receivable. Either or both
may be impaired, and additional audit work will be required in respect of measurement and
recoverability.
Group
The main implication for the group financial statements (given that intra-group balances cancel out)
is in respect of the measurement of goodwill on acquisition of Zego, which may be impaired.
General comments
The corporate reporting issues examined in this question were mostly straightforward, but the
question required advanced level skills in the understanding, collating and ordering of pieces of
information embedded in various parts of the question. Better-prepared candidates could
demonstrate their skills in this respect.

There were some very good answers to this question, producing clear, rational and concise figures,
discussions and conclusions.
Points candidates covered well were:
• descriptions of impairment were explained well;
• calculations of the value in use of the intangible development asset (although this was sometimes
attributed to the building);
• identifying that the building’s fair value was higher than the CV so there was no impairment; and
• identifying that the intangible needed impairing and taking the higher of VIU and FV less costs to
sell and comparing to the CV. The journals were clearly stated and correct.
However, some candidates evidently struggled.
Some basic errors included the following:
• The assumption that where recoverable amount exceeds carrying value IAS 16 requires the
increase in valuation to be recognised. Also, some candidates pondered at length the question of
whether the company had an accounting policy of revaluation, although it should have been clear
from the absence of any revaluation surplus in equity that it did not have this policy.
• Musings, often extended, about impairment but without calculating any impairment losses. This
was particularly noticeable in respect of inventories. Better candidates produced an estimate of
inventory write-down, while noting that more information would be required to confirm it.
• Failure to carry through impairment losses from the first to subsequent parts of the question.
Better candidates realised that impairment losses would produce an operating loss for the year
and that interest cover and gearing would therefore be affected and that this was a big deal for
the company. Weaker candidates ignored their own impairment calculations and analysed
unadjusted financial statements.
• Having calculated impairment losses in the first part of the question, a lot of candidates then
speculated upon the need for impairment losses in the second and third parts, disregarding the
fact that they had already calculated them.
• Layout of candidates’ answers was often messy and discussions were incoherent.
• Some candidates majored on speculations about, for example, assets held for sale while ignoring
the key points about impairment.
• Some candidates, evidently spotting the key words ‘development expenditure’ gave lengthy
descriptions of the IAS 38 criteria for capitalising development costs. Although the question
clearly stated that the criteria for recognition had been fulfilled, weaker candidates spent time on
reproducing the IAS 38 criteria, while ignoring the key issue of impairment.
Analytical procedures
The answers for the analytical procedures were very mixed. Good candidates focused on the two key
ratios which were ‘flagged up’ in the question ie, interest cover and gearing and did make
adjustment to the numbers given for the issues identified in part (a). These candidates also tended to
focus on the obvious cash flow problems, the high level of inventories and the quick ratio. Weak
candidates calculated numerous ratios and then simply repeated facts such as ‘revenue has fallen’
without making any attempt to relate this to other information in the question ie, the launch of a rival
product and the fact that underlying revenue had also fallen.
Candidates also wasted time discussing audit issues not arising from the analytical review which were
more relevant to part (c) of the question.
Improvements to marks could have arisen from simple presentation of a working paper as requested
and using adjusted figures from the financial reporting treatment in part (a).
The calculation of gearing was often inept. The question clearly stated that gearing in this case was to
be calculated as net debt/equity, but many candidates used D/D+E and/or ignored the ‘net’ element
of net debt (some even missed out the share capital from equity).
Key audit risks
Weak candidates failed to focus on key risks such as going concern and instead spent time
discussing relatively low risk areas such as having to contra out intra-group balances. Where
candidates identified the key audit risk as going concern and focussed on the analysis on the

breaching of the gearing and interest cover, the operating performance and its anticipated further
decline were often neglected.
However nearly all candidates did refer to the implications in the three sets of financial statements
and correctly discussed the use of the break-up basis and impairments to the investment, loan and
goodwill. Worryingly it was clear that some candidates believed that goodwill was recognised in the
individual financial statements of the parent rather than in the consolidated financial statements.
42 Trinkup
Scenario
The candidate is in the role of a financial accountant working for Trinkup plc. Trinkup has acquired an
overseas company called ZCC, which operates under a different GAAP.
The candidate must advise on the appropriate financial reporting treatment of several adjustments
including those relating to intragroup trading, pension and deferred tax. Key to answering this
section is to appreciate which adjustments impact on the parent and the subsidiary financial
statements.
The candidate is then required to prepare a consolidated statement of comprehensive income and
the consolidated goodwill and foreign exchange reserve.
Requirement Skills
Set out and explain the appropriate Apply technical knowledge to the information
adjustments for the outstanding financial in the scenario to determine the appropriate
reporting issues (Exhibit) for the year ended 30 accounting for intragroup trading, pension
September 20X6 for: accounting, deferred tax and the loan.
• the individual company financial statements Appreciate that the accounting for the loan
of Trinkup and ZCC; and represents a net investment in a foreign
• the consolidated financial statements. operation and recommend appropriate
accounting treatment.
You should assume that the current tax Demonstrate high level technical knowledge by
expenses are correct, but you should include explaining how the adjustments impact on the
any deferred tax adjustments. financial statements for the group, parent and
subsidiary.
Prepare Trinkup’s consolidated statement of Assimilate complex information to produce

comprehensive income for the year ended 30 financial statements.
September 20X6. Please use the adjusted
individual company financial statements.
Calculate Trinkup’s consolidated goodwill and Clearly set out and explain appropriate
consolidated foreign exchange reserve at 30 workings for the translation and the
September 20X6. Show your workings. consolidation of the overseas subsidiary.
Marking guide Marks

Consolidated SOCI 8
Consolidated goodwill and FX 6
32
Total 32

Part (1)
There are adjustments to be made for Trinkup and ZCC and on consolidation:
Issue 1 Inventory – PURP adjustment – on consolidation
An adjustment is required for the profit on coffee in Trinkup’s inventory. This is because in the
consolidated income statement this profit is not realised and therefore should not be reflected in the
combined results of the two entities. Once the inventories are sold to a third party this adjustment
will no longer be required.
This is an adjustment to the consolidated financial statements and not the individual company
accounts (although it is required to calculate the NCI).
£18m × 30%/130% = £4.2 million
The temporary difference results in a deferred tax asset as in the group accounts there is a tax
expense (or in ZCC’s case the tax losses may be understated) for a non-existent asset which needs to
be removed.
Although no adjustment is required to the individual financial statements, a deferred tax asset would
be included in the consolidated financial statements as follows:
Carrying amount of inventory in the consolidated financial statements

£m
£18m – £4.2m 13.8
Tax base 18.0
Difference 4.2
Deferred tax asset at 20% 0.8
Journal required on consolidation:
£m £m
CREDIT Inventory 4.2
CREDIT Tax expense 0.8
This is a consolidation adjustment and will impact the consolidated reserves (Cost of sales) and
inventory.
Intragroup trading must be eliminated on consolidation. Therefore, the revenue and costs of sales
must be adjusted for the intragroup sales and purchases.
£m £m
DEBIT Revenue K294m @ average rate £1 = K4.8 61.3
Issue 2 – Management charge

Also, the intragroup management charge must be eliminated:
£m £m
DEBIT Operating income – K75m @ £1 = K4.8 15.7
CREDIT Operating expenses 15.7
As the transactions are settled transactions, there are no adjustments required for exchange
differences.

These are consolidation adjustments and will cancel each other out on the consolidated statement of
profit or loss. They will not impact on the individual financial statements.
Issue 3 – Deferred tax on tax losses – adjust ZCC before consolidation
Potentially an adjustment is required for deferred tax in respect of the tax losses of ZCC. The future
profits may allow ZCC to recognise a deferred tax asset. However, there is a risk that not all the losses
will be recoverable ie, to the extent that the tax loss arises from an intragroup charge.
A deferred tax asset could therefore be recognised of K100m – K75.3m = K24.7m × 20% = K5m
Km Km
DEBIT Deferred tax asset 5
CREDIT Tax expense 5
This is an adjustment to ZCC before consolidation to align Zland GAAP to IFRS.

Issue 4 – pension contribution adjustment to ZCC before consolidation
ZCC’s financial statements must be adjusted to comply with IFRS before consolidation.
The contribution to the pension should be shown in expenses in the statement of profit or loss
because this is a payment to a defined contribution scheme. Under IAS 19 this is shown under
expenses and not as a reserve movement.
A deferred tax adjustment arises on this because the tax base is zero. A tax deduction will be
available in the future of K56.6m × 20% = K11.3 million.
These are adjustments to ZCC before consolidation.
Km Km
CREDIT Tax expense – Profit or loss – deferred tax on pension cost 11.3
DEBIT Profit or loss – transfer of pension cost to expenses 56.6
CREDIT OCI 56.6
Issue 5 – Loan from Trinkup to ZCC

• Interest
The interest should be accrued in both companies - In Trinkup this will be:
5.25% × K160m × 6/12 = K4.2m/4.8 = £1 million (rounded) – this will affect the statement of profit or
loss and receivables and payables but these will all cancel on consolidation.
Note: Year end rate also accepted.
It is assumed that the interest has been correctly treated for current tax purposes.
• Loan to ZCC – net investment in foreign operation
The loan to ZCC is a monetary item and as it is denominated in the functional currency of the
subsidiary the exchange difference is recognised in the parent company’s profit or loss.
Therefore, an adjustment is required in Trinkup’s own financial statements to record the exchange
gain as follows:
£m
K160 million @ 4.4 (1 April 20X6) 36.4
K160 million @ 4.2 (30 September 20X6) 38.1
Exchange gain 1.7
DEBIT Amount owed by ZCC £1.7m

CREDIT Profit and loss £1.7m

On consolidation, however, the loan is treated as a net investment in a foreign operation and the
exchange difference is removed from profit or loss and it will be recognised as other comprehensive
income and recorded in equity in the consolidated statement of financial position.
On consolidation, the exchange gain should be transferred to OCI and shown as part of total
exchange differences on consolidation.
This is because the loan is similar to an equity investment in ZCC as the loan is not required to be
settled in the near future. Therefore, accounting for the exchange difference in equity ensures that
the monetary item is effectively treated in the same way as an equity investment.
The intra group loan cancels on consolidation.
DEBIT Long term liabilities £38.1m

CREDIT Amount owed by ZCC £38.1m
Issue 6 – Fair value adjustment for land – consolidation adjustment

Adjustments to the fair values of assets and liabilities of a foreign operation under IFRS 3 are
recognised in its functional currency; the adjusted carrying amounts are then translated at the closing
rate.
The land should be revalued for consolidation purposes by K76 million and this will form part of the
goodwill calculation.
Parts (2) & (3)
Consolidated statement of comprehensive income
ZCC Before consol.

Trinkup (W1) adjust. Adjs. Adjs.
£m £m £m
intragroup sales
Revenue (Note 1) 189.2 103.0 292.2 (61.3) 230.9
unrealised profit
Cost of sales (Note 1) (124.0) (73.8) (197.8) 61.3 (4.2) (140.7)
Gross profit 65.2 29.2 90.2
Management
charge
Operating income 15.7 15.7 (15.7)
Operating expenses and exchange gain

finance costs on loan to OCI
(£35m – £1.7m exchange (1) 1 interest
gain – £1.0m interest) (32.3) (52.0) (84.3) 15.7 1.7 (70.3)
Profit/loss before tax 48.6 (22.8) 19.9
defer’d tax on
unrealised profit
Taxation (9.0) 3.4 (5.6) 0.8 (4.8)
Profit/(loss) for the year 39.6 (19.4) 15.1

Owners of the parent company 19.7
Non-controlling interests
(£19.4m × 20% = £3.9m + share of PURP – deferred tax
adjustment = £3.4m × 20% = £0.7m) (4.6)
21.3 foreign
Other comprehensive income exchange gain 21.3
Owners of parent company 19.7 + 18.0 37.7
(£4.6m share of loss – £3.3m share of gains) (1.3)
*Alternative presentation of PURP adjusting the subsidiary results also accepted.
WORKINGS
(1) ZCC – process journal adjustments and translate the profit or loss at average rate and SOFP at
HR/closing rate
Pension and Average

deferred tax Interest rate
Km Km £m
Revenue 494.6 494.6 4.8 103.0
Cost of sales (354.2) (354.2) 4.8 (73.8)
Gross profit 140.4 140.4 4.8 29.2
Operating expenses and
finance costs (188.8) (56.6) (4.2) (249.6) 4.8 (52.0)
Profit/loss before tax (48.4) (109.2) 4.8 (22.8)

Tax 0.0 16.3 16.3 4.8 3.4
Profit/(loss) for the year (48.4) (92.9) 4.8 (19.4)
Other comp. loss (56.6) 56.6 ––––––
Total comp. income for
the year (105.0) (92.9) (19.4)
(2) Goodwill
Calculate goodwill – the percentage of net assets has been used.
Calculating goodwill involves:
Comparing the consideration plus NCI with the fair value of net assets – this is done in the
functional currency of the subsidiary – before translation.
Net assets at acquisition Km

Share capital 50.0
Pre-acquisition profits 240.5
Fair value adjustment on land (Issue 6) 76
Fair value of net assets acquired 366.5

Goodwill Km £m
Consideration transferred 350.0
366.5 × 20% 73.3
423.3
Fair value of net assets acquired 366.5
Goodwill 56.8 at HR 5.4 10.5
Exchange gain – balancing figure 3.0
Carrying amount goodwill at 30 September 20X6 56.8 at CR 4.2 13.5
(3) Foreign exchange reserve
£m
Exchange gain on goodwill (W2) 3.0
Exchange gain on net investment in foreign operation (Issue 5) 1.7
Exchange gain on retranslation of subsidiary (W4) 16.6
Total gains to OCI 21.3
NCI share of gains (3.3)
Consolidated exchange reserve at 30.9.20X6 18.0
(4) Exchange differences on retranslation of subsidiary
Km £m
Opening net assets 366.5 5.4 (HR) 67.9
4.2 (CR) 87.3
gain 19.4
Retained loss for year (92.9) 4.8 (AR) 19.3
4.2 (CR) 22.1
loss (2.8)
Overall gain 16.6
NCI share in exchanges gain (20%) 3.3
General comments
Generally, this was well answered with most candidates methodically working through the
information given and explaining the required adjustments. The deferred tax aspects of the question
were answered well and many candidates recognised the deferred tax implications of the PURP and
the pension contributions. The answers to the third part, requiring consolidated goodwill and
consolidated foreign exchange reserve, were often excellent. It is incredible however, that some
candidates consolidated 80% of the subsidiary’s results on a line by line basis.

Detailed comments
The main issue with this part of the question was that students failed to ‘explain’. In some cases, all
that was given were journals, even though the numbers were correct. There were also some very
basic errors and weaknesses which included:
• calculating the PURP incorrectly and/or adjusting for it through revenue rather than cost of sales
or deducting, rather than adding it, to cost of sales;
• failing to link the challenge from the tax authorities to the management charges recoverability
with the deferred tax asset on the losses;
• failing to recognise that under IFRS pension contributions should be an expense rather than taken
to reserves;
• basic adjustments for cancellation of intra-group sales and cost of sales were often presented as
unbalanced journals – with a different figure cancelling cost of sales from revenue – sometimes
even in different currencies;
• some candidates clearly have difficulty distinguishing between a deferred tax liability and a
deferred tax asset as the pension adjustment was often presented as a liability;
• the forex gain was labelled as ‘difference’ which was not clear and very few identified the net
investment to the OCI; and
• the fair value of the land was a fair value adjustment for goodwill although some candidates
explained incorrectly that there needed to be a revaluation reserve created with movements
through OCI. Most also went on to produce journals to show the effect of the deferred tax even
though this was not required.
Trinkup’s consolidated statement of comprehensive income for the year ended 30 September 20X6
The quality of workings was sometimes poor and it took significant forensic effort to identify relevant
figures in the financial statements. Also, if the requirement is to prepare the statement of
comprehensive income, as in this case, there is nothing to be gained by preparing the SFP as well
which some candidates did.
Most candidates translated the subsidiary profit or loss at the average rate. Very often the
adjustments were not shown in the correct place demonstrating a lack of understanding of which
adjustments impact on the subsidiary and which are consolidation adjustments. Many showed a
separate working for the subsidiary profit or loss and included all the adjustments for the
consolidation (eg, eliminating inter-company revenue). Generally, adjustments were added randomly
in brackets with no identification. NCI share of profit is the share of profit in the subsidiary only, not
the whole group’s profit (this was a very common error).
Consolidated goodwill and consolidated foreign exchange reserve
These calculations were completed accurately and most candidates showed workings and achieved
maximum marks on this section. A few candidates had difficulty with finding the net assets at
acquisition deciding to use ‘Net Current Assets’ instead but otherwise this section was done well.
43 Key4Link
Scenario
This question is an audit scenario requiring the candidate to identify and respond to several
accounting and auditing issues. The scenario for this question is the final stages of the audit. The
audit manager has had a cycling accident and the candidate is in the role of audit manager and
needs to determine whether matters identified by the partner and manager have been adequately
resolved by the audit senior. The successful candidate is required to explain the financial reporting
implications of related party disclosures, accruals, provision for restructuring, share options and
building revaluation. Audit procedures are also required for each of these. The ethics requirement
asks the candidate to consider the tender for tax work for the audit client given the context of the
client being reluctant to correct the company’s tax return.

Requirement Skills
For each of the matters identified in Carey’s file Apply knowledge of relevant accounting
note (Exhibit 2) taking into account the standards to the information in the scenario to
procedures already undertaken by Kevin appreciate financial reporting adjustments
(Exhibit 3) and Max’s email (Exhibit 4) identify arising from errors, omissions and incorrect
and explain: application of financial reporting standards.
• any additional financial reporting Assimilate complex information to produce
adjustments, including journals; and appropriate accounting adjustments.
• any auditing issues and the additional audit Apply scepticism to identify potential for fraud.
procedures required in order to complete Identify the need for further information
our audit and reach a reasoned conclusion needed to conclude on whether the related
on the unresolved matters. Identify any parties are appropriately disclosed.
further information required from Key4Link.
Link information on related parties to additional
You do not need to consider any tax or deferred audit procedures on creditors (Farnell creditor).
tax adjustments.
Apply technical knowledge to explain auditing
issues relevant to the scenario.
Explain any ethical issues for HJM arising from Identify threats to the firm using appropriate
Max’s request for HJM to bid for Key4Link’s tax analysis of the ethical code.
advisory work (Exhibit 4). Set out any actions Apply judgement in terms of the level of errors
that HJM should take. and misstatements in the scenario to consider
whether the firm should continue with the
assignment.
Recommend appropriate actions.
Marking guide Marks
Financial reporting adjustments and audit issues 21

Ethical issues 7
28
Total 28
Part (1)
Supplier statements
On Barnes, there appears to be a clear error. Although immaterial on its own, it adds to the
unrecorded misstatement of £50,000 already identified and is above £5,000 (the level at which
adjustments should be accumulated for further consideration). Hence, I propose an adjustment to
record the missed liability:
DEBIT Cost of goods sold £57,230

CREDIT Accruals £57,230
Auditing issues and additional auditing procedures

Kevin has completed the remaining audit procedures but his work has identified some errors. We will
therefore need to look again at whether there could be further material errors in the untested
balance and may need to extend our testing.
On Farnell, Kevin has already taken the right action by raising an audit adjustment (although we may
want to consider if cost of goods sold is the right classification for engineering services). The related

party nature of this transaction is considered below along with other procedures to ensure that it
related to pre-year end transactions at a fair price.
In addition, we should undertake further audit procedures to determine whether there are other
examples of goods delivered direct to customers as was the case with the Barnes accrual and
therefore not captured by the normal accruals process. This should be discussed with the operations
manager.
Overall, the understated accruals identified by our work now amount to £267,230 (£160,000 +
£57,230 + £50,000) which is a material amount and we should ask Max to make this adjustment.
We should also enquire further about the reasons for the errors and consider any possible motivation
for under-stating costs. One such motivation might be the share option scheme target of £2.6 million
for profit before taxation (depending on the precise definition in the share option agreement)
although at present this is still met when this adjustment, and the addition to the reorganisation
provision proposed by Max are made – see below.
With enhanced fraud risk, it is likely that we will need to do more work in this area. However, this is
not straightforward as it is Max who is himself proposing the additional provision (albeit for an
amount which ensures that the target is still met before any other adjustments are made).
Building revaluation
Financial reporting adjustment
Assuming the £200,000 uplift is correct and that the previous revaluation uplift has been recorded
correctly, the adjustment to be made in the financial statements will be:
DEBIT Carrying value of freehold property £200,000

CREDIT Revaluation reserve £200,000

Carey identified only the signed final valuation report as outstanding. This has still not been received
but Max has indicated that he will bring it with him tomorrow.
Max also indicates that the new report will show a higher valuation than the one on which we
performed our audit procedures. Such a last-minute change is unexpected and requires further
investigation.
In addition, Max’s email implies that the valuation may have been influenced by a discussion
between Jan and the valuer, who clearly know each other socially.
In the light of this knowledge and the last-minute change, we will need to perform additional audit
procedures on the revised valuation and should reconsider whether we involve our own expert for an
independent view on the assumptions and methodology used now that the independence of the
company’s valuer has been called into question.
Specific procedures to be performed are as follows:
• Obtain a copy of the updated valuation report.
• Discuss with the valuer the reviewed assumptions/methodology used and the reasons for the last-
minute change in his assessment of the value.
• Conclude as to whether the revised valuation is on an appropriate basis and within a reasonable
range.
• Consider whether management might have any motivation for increasing the asset value such as
future borrowing requirements secured on the asset or the net asset value in any potential sale of
shares/the business.
• Assess the valuation used in the light of our assessment of other estimates within the financial
statements and our overall consideration of bias.
Restructuring cost provision
Whether the provision should be made as suggested by Max depends on the outcome of additional
audit procedures.

The auditing issue here is that the financial statements may be misstated if Max makes the £175,000
provision as proposed.
Kevin has performed some detailed work on the provision proposed by Max. His work on the
accuracy of the redundancy costs and the carrying value of the trucks is sufficient. However, his work
does not address adequately the following points:
• Is it appropriate for the provision to be made as at 30 September 20X6? IAS 37 states that for a
constructive obligation to exist for restructuring costs there must be a detailed plan and an
announcement made to those who will be affected by the restructuring (in this case the lorry
drivers). Kevin has not ascertained whether this is the case.
• Whether it is correct to assume that there will be no proceeds at all from the sale of the trucks.
This appears to be what is being assumed and it seems an unlikely outcome.
• Whether the trucks should be reclassified as assets held for sale and how any anticipated
reduction in their value should be treated within the financial statements.
• Are there any other legal or other costs which should also be provided for within the provision?
Further procedures and information required is as follows:
• Enquire as to when the decision was made to outsource the delivery function and seek evidence
such as board minutes to corroborate this. If the decision was not made until after the year end,
then the provision should be reversed as there is no present obligation as at 30 September 20X6.
• If the decision was made before 30 September 20X6, seek further evidence that detailed plans
had been made at that date identifying the number of employees affected and setting out costs
and timetables. Much of that clearly exists now but the question is whether it did at the year end.
• Request evidence that an announcement had been made to the employees affected by 30
September 20X6 and corroborate this through discussion with HR personnel and, if deemed
appropriate, those affected (such as the manager of the delivery function).
• Enquire what plans there are for the trucks and whether they were held for sale at 30 September
20X6 or were still in use at that date. To be reclassified as ‘held for sale’ assets and valued at the
anticipated net proceeds, they would need to be both held for sale and actively marketed.
• Ascertain why Max has assumed no sales proceeds on disposal of the trucks given that they have
a carrying value and therefore would appear to have remaining useful life (unless the depreciation
rate is inappropriate).
• Seek external evidence of the prices for similar second-hand trucks and determine whether an
audit adjustment is required to reduce the amount of the provision made.
• Consider further how any ‘impairment’ to the carrying value of the trucks should be reflected
within the financial statements – it would seem more appropriate to show this as
impairment/additional depreciation thus reducing the carrying value of the asset rather than
including it within provisions.
• Enquiry as to whether there will be legal or other costs incurred which should also be included
within the provision.
One additional point for consideration is the need to reconsider our materiality figure given the
reduction in profit from this adjustment and the creditor adjustments identified above and the share
option scheme considered further below.
Share option scheme
Financial reporting adjustment
Max’s response about the share option scheme raises a new issue as entries should have been made
to record the cost of the share option scheme over the vesting period.
Considering the adjustments identified above, the company’s profit before taxation (before any
charge for the share option scheme) is:
£3.2 million – £175,000 (maximum) for the reorganisation provision – £267,230 for missed accruals =
£2,757,770 – which is above the target profit of £2.6 million. Thus, a share option expense should
have been recorded as follows:

2,500 options × fair value of £45 = £112,500, which should have been recognised equally over the
four years to 30 November 20X6 falling into financial years as follows:
Year ending
30 September 20X3 (10 months) £23,438
30 September 20X4 £28,125
30 September 20X7 (2 months) £4,687
Prior period errors have clearly occurred here and IAS 8 requires these to be corrected
retrospectively where material, thus presenting the financial statements as if the error had never
occurred. In this case the error in each year and cumulatively to 30 September 20X5 is not material
(£79,688) and therefore the error should be corrected in the financial year ended 30 September
20X6, resulting in an additional charge to profit or loss of £107,813. The correcting journal entry is as
follows:
DEBIT Share option cost – operating expenses £107,813

CREDIT Equity £107,813

The fact that Max has not told HJM about the share option scheme previously raises some questions
about his openness with the auditor (especially as he might have been expected to know how to
account for it) but it may also be, as he suggests, an honest mistake and he has been open about it in
response to Carey’s question. It also seems surprising that the scheme was not identified from a
review of the minutes of Board and shareholder meetings so steps should be taken to ensure that it
was approved appropriately. We should also consider carefully whether any changes should be
made to the audit approach to ensure that other similar items are not missed, albeit that this one was
not material to any of the years signed off.
Max’s apparent failure to understand how to account for the share option scheme does also raise
questions about his competence and we should consider carefully whether there are other matters
he may have got wrong.
Our audit procedures to corroborate this charge are as follows:
• Obtain a copy of the rules for the share option scheme and ensure that all relevant factors have
been considered in the calculation of the accounting entries.
• Evaluate the basis on which the fair value of £45 was calculated, the expertise of Max who
calculated it and the need for expert input in assessing it.
• Ensure that appropriate disclosures are made in the financial statements. Required disclosures
include:
– a description of the scheme;
– the number of options outstanding at the beginning and end of the year (2,500), along with the
exercise price (£5);
– details of how the fair value was determined;
– for key management (such as Max and possibly others), the share options should be disclosed
as related party transactions; and
– the total expense in the period.
When the shares are issued £2,500 should be credited to share capital and £10,000 to share
premium as the exercise price is higher than the nominal value of a share.
Completeness of related party disclosures
There are several related parties and transactions which may require disclosure in the financial
statements. Further audit procedures need to be undertaken to identify these before
recommendations can be made.

There is still outstanding audit work in this area as the matter raised by Carey has not been
addressed by Kevin or in the response from Max.
Kevin’s work has however identified one potential related party with whom there have been
transactions during the year, Farnell.
IAS 24 sets out details of what constitutes a related party and what needs to be disclosed.
Farnell is owned by Jan and his brother but it is not clear from Kevin’s work whether Jan, Carol and/or
their close family members control or have significant influence over the company. This is information
that should be sought from Jan or from independent sources. If they do control it then Farnell will be
a related party (as Jan and Carol are key members of management of Key4Link) and the nature of the
relationship, along with details of transactions and balances must be disclosed. Audit procedures will
need to be performed to agree the balances disclosed to accounting records and to review those
records for evidence of any further transactions with Farnell.
Also, we need to apply additional scepticism in respect of the Farnell liability and to perform further
testing to ensure that the liability does indeed relate to pre-year end services and that the amount
charged represents a fair price.
In addition, audit work is required to conclude as to whether there are also other related party
transactions to disclose. The procedures to be performed will include:
• enquiry as to the procedures Key4Link have in place to identify director/shareholder interests –
this will include the register of interests maintained by the board;
• review of publicly available records to ascertain whether the directors/shareholders have interests
in other companies which might be controlling interests. Might also be helpful to identify any
companies in which they hold directorships although this will not of itself necessarily make the
other company a related party;
• review of minutes for any disclosed conflicts of interest;
• enquiry of the directors as to the other interests they have; and
• scrutiny of the company’s ledgers and minutes to identify transactions with any parties identified
as related parties from the procedures performed.
The share option scheme is also a related party transaction – the accounting and disclosure of this
are considered above.
Part (2)
Max’s request and comments about his current tax advisors raise several potential issues for HJM.
One of the fundamental principles in the ICAEW Code is integrity and this states that a professional
accountant should not be associated with a return where they believe that the information includes a
false or misleading statement. The current tax advisor, Blethinsock Priory, is therefore acting
appropriately by requesting an open and honest approach in respect of the error noted in the tax
return. Max himself may also be a Chartered Accountant and therefore bound by the same code.
Having become aware of the underpayment of tax, HJM may have a duty to report this under the
money laundering regulations if Key4Link chooses not to make good the tax owed. That is because
the definition of criminal property under those regulations includes tax evasion. The partner will
therefore need to report this to HJM’s money laundering compliance principal (MLCP) who will
decide whether a report to NCA is required.
If appointed as tax advisor, HJM could not put itself in the position of making a knowingly false tax
return or, indeed, omitting to mention the error in a subsequent return. This would have to be made
clear to Max in any response to the tender and he should also be reminded of his own personal
position. However, care will also need to be taken to avoid tipping off and the advice of the MLCP
should be sought before there is direct communication with Max on this matter.
As auditor, HJM also needs to consider compliance with the FRC Revised Ethical Standard for
auditors which requires it to consider carefully whether any non-audit services performed are
consistent with its role as independent auditor.

The proposed tax advisory services give rise to several potential threats in this respect:
• Self-interest threat – this arises where there is undue reliance on the total fees from one audit
client such that the objectivity of the audit partner might be impaired. The total fees from both the
audit and the proposed tax services need to be compared to HJM’s total revenues to assess
whether this threat has materialised. The tone of Max’s email suggests that this would be a
significant client for HJM but whether the level of reliance would be inappropriate cannot be
assessed without further information.
• Self-review threat – this could be an issue if, as auditor, HJM were auditing tax calculations it had
prepared or uncertain tax positions on which it had advised. Safeguards would be required to
separate tax and audit teams and to involve experts separate from the tax advisory team where
appropriate.
• Management threat – as auditor HJM cannot act in the role of management. It can advise but not
make decisions and it would be important for the HJM Board to make key tax planning decisions
and approve returns. What is not clear here is whether there are informed management with the
ability to do this as some of the questions Max asks suggest that he has limited technical
knowledge and that may be the case with tax as well.
HJM also needs to consider whether it wishes to take appointment as Key4Link’s tax advisor given
Max’s attitude to errors and underpayment of tax and this may be a relevant factor too (along with
the failure to disclose the share option scheme and further assessment of the missed accruals and
the revaluation gain) in considering whether it wishes to retain the audit or to resign as auditor given
the client’s attitude to the underpayment.
Part (1)
The corporate reporting issues examined in this question were mostly straightforward.
Most candidates adopted a methodical approach and worked through the file note considering both
the financial reporting issues and the audit procedures. Many candidates identified the potential
related party transaction, calculated the correct figures for the share options and understood the
issues arising from the provision and the changes to the valuation report. Journals were clearly
presented.
Weaker candidates struggled to ‘explain’ the additional financial reporting treatment and simply
stated a financial reporting rule. For example, the identification of Farnell as a related party was
identified without questioning whether the parties have control or have significant influence over the
company. Many candidates assumed the related party relationship existed without explanation of
why or questioning the control aspect and went straight on to discuss the audit issues. There were
some very basic errors. The credit entry on a revaluation of a non-current asset was often presented
as recognised in profit or loss.
Audit procedures were frequently too vague to gain credit eg, “ensure the correct fair value has been
used for the options.”
Part (2)
There were some excellent answers here with many candidates correctly identifying the problems
arising from the client’s reluctance to resubmit the prior year tax return and the threats, such as self-
interest and self-review, relating to bidding for the tax work. Weaker candidates tended to focus on
just one of these issues and failed to cover a range of points or wasted time by talking about
perceived ethical issues that did not relate to the tax work.

44 Konext
Scenario
The candidate is asked to assist in the preparation of an assurance report on the interim financial
statements for Konext plc a company listed on the AIM. The financial controller Menzie Mees has
identified some transactions which he believes may have been treated incorrectly for financial
reporting purposes by the finance director, Jacky Jones. These transactions involve potential financial
reporting issues around revenue recognition, deferred advertising costs, pension schemes and the
impairment of a CGU. To prepare a good answer to this question the candidate needs to appreciate
the requirements of IAS 34. Also, that the audit procedures required may be different when reporting
on the interim financial statements and the year-end financial statements.
The candidate was also asked to comment on the adequacy of management’s comments in the
interim financial statements regarding a suspected cyber attack. Also, to explain any ethical issues for
Noland, the auditor, and set out the actions Noland should take.
Explain the appropriate financial reporting Assimilate and demonstrate understanding of a

treatment of the issues in the summary large amount of complex information.
provided by Menzie (Exhibit 3). Recommend Identify appropriate accounting treatments for
appropriate adjustments to the draft complex transactions including revenue
consolidated interim financial statements for recognition, the impairment of a CGU, deferred
the six months ended 30 June 20X4. advertising costs and pension schemes.
Apply technical knowledge to distinguish
accounting treatments at the interim and year
end.
adjustments.
Prepare a revised consolidated statement of Assimilate adjustments to prepare draft

profit or loss for the six months ended 30 June statement of profit or loss.
20X4. Set out the relevant analytical procedures Use financial statement analysis to prepare
on the revenue and gross profit in the revised relevant analytical procedures.
statement of profit or loss. Identify potential
risks of material misstatement. Assimilate knowledge, drawing upon question
content and own procedures to identify key
risks of misstatement.
Set out briefly the key audit procedures Describe relevant audit procedures required to
required to address any risks of misstatement of provide verification evidence for each risk.
revenue you have identified. For these risks, set Apply technical knowledge to determine the
out separately the audit procedures for: procedures relevant to the interim financial
• the interim financial statements; and statements and the financial statements for the
• the financial statements for the year ending year ending 31 December 20X4.
31 December 20X4. Present information in accordance with
instructions.
In respect of the details you receive from Jacky Assimilate information to identify adequacy of
about the information security issue (Exhibit 4): the disclosure.
• evaluate the adequacy of the management Identify potential ethical and reputational issues
commentary disclosure in relation to the for Noland.
information security issue (Exhibit 2); and Discuss appropriate responses and actions for
• explain any ethical issues for Noland and set the firm in respect of the potential ethical
out the actions Noland should take. issues.

Appreciate the public interest and role of

corporate social responsibility.
Demonstrate understanding of the importance
of contributing to the culture of the profession.
Marking guide Marks

Revised consolidated P/L and analytical procedures 12
Audit procedures 5
Security issue 8
40
Total 40
Part (1)
Financial reporting treatment and adjustments
Revenue recognition
Konext has recognised £15 million revenue in respect of the Denwa+ device. However, following
IFRS 15, Revenue from Contracts with Customers, revenue should only be recognised when the
performance obligations in the contract have been satisfied. There are two performance obligations:
supply of the mobile devices and provision of the software services. In the case of the mobile devices
this is a performance obligation satisfied at a point in time. It is satisfied when control of the devices
has been transferred to the buyers, that is upon delivery. This takes place on 1 August 20X4, so no
revenue for this will be recognised in the financial statements for the six months to 30 June 20X4.
In the case of the software services, this is a performance obligation satisfied over time. This is
because the customer simultaneously receives and consumes the benefits provided by Konext’s
performance as it performs. Time elapsed (an input method) is an appropriate way to measure
progress towards satisfaction of the performance obligation, and therefore the software services
should be recognised separately over the two-year period.
Therefore, none of the £15 million will be recognised in the interim financial statements and only
some of it will be recognised in the year ending 31 December 20X4.
The cash received in relation to orders not yet fulfilled should be treated as a contract liability.
The deposits should be recognised in cash and included as a contract liability. Although they are
non-refundable it does not create an obligation to complete the contract.
IAS 34 requires the same recognition and measurement principles to apply in the preparation of the
interim financial statements as at the year end. Therefore, although ultimately the sales will be
recognised in the year to 31 December 20X4, no revenue should be recognised in the six months to
30 June 20X4 in respect of the Denwa+ devices as delivery will take place in August 20X4.
Guarantee of replacement device
This is a multi-element sale and it needs to be determined whether there is a market price for the
guarantee element – which would require separate recognition.
As no revenue is recognised at 30 June 20X4 the adjustment for guarantees, if any, would be made
at the year end.

At 30 June 20X4, I would need to determine where the original entries had been booked and to
reverse them – therefore I recommend the following adjustments:
Debit Credit
£’000 £’000
Revenue – sales of devices 10,000
Revenue – software services 5,000
Contract liability 2,000
Receivables 13,000
Accrued costs 6,000
Cost of sales 6,000
Being removal of revenue and related cost of sales

This will leave the deposits as a balance of £2 million as a payable on the statement of financial
position at 30 June 20X4.
Impairment of Refone
Refone is a cash generating unit. The net assets of the Refone business should be carried at no more
than the recoverable amount which is defined as the higher of the fair value less costs to sell and the
value in use.
Indicators of impairment
The launch of the new product with a guaranteed replacement of the device rather than repair, is one
factor which could indicate impairment. The amount of third party business is not known but if a
significant part of its business comes from Konext customers then a decline in the number of devices
needing repairs will be an indicator of impairment.
However, the trend of results would indicate too that there is impairment of the Refone CGU.
The Refone business has generated £2.1 million in revenue in the first six months. The results from
the previous year suggest that the business is in decline. The business generated £5.2 million in the
six months to 30 June 20X3 and only £2.6 million in the second half of the year.
Calculation of the impairment loss
The recoverable amount is the higher of the value in use and the fair value less costs to sell. A recent
offer to buy Refone suggests that the fair value is £8 million.
The value in use should be calculated using management-approved forecasts. Jacky estimates £1.2
million as a reasonable forecast of the cashflows from the division for five years.
Basing the value in use on the pre-tax cash flow of £1.2 million over five years then the PV of a five-
year annuity is:
£1.2m × 4.329 = £5.2 million.
The fair value less costs to sell is £8 million (which is greater than the value in use and therefore
represents the recoverable amount).
This would suggest an impairment loss of £12.450 million – £8 million = £4.45 million. However,
there are several risks arising from this calculation:
• The discount rate – no information is given as to how this has been calculated and therefore
management should be asked to justify this rate.
• The cash flows would appear to be optimistic considering the division’s declining performance.
• The recoverable amount is based on one offer and there is no indication of when this offer was
received and how firm the offer was.
IAS 36.76 states that the carrying amount of the CGU should not include the carrying amount of
liabilities unless the recoverable amount cannot be determined without considering the liabilities –
the net assets have been used in this calculation as it is assumed that the business would be sold
with the liabilities.
If the liabilities were not going to be assumed by the buyer, then the comparison to determine the
recoverable amount would have taken into consideration the gross assets only.

The impairment loss is recognised first against goodwill and then the remaining amounts allocated
to the other non-monetary assets – this precludes it from being allocated against inventory because
inventory valuation is dealt with under IAS 2.
£’000 £’000
Brand name 4,175 881
Goodwill 1,975 1,975
4,450
£4.45 million – £1.975 million = £2.475 million to allocate

£2.475 × £7,550/£7,550 + £4,175 (£11,725) = £1,594,000 to PPE
£2.475 × £4,175/£11,725 = £881,000 to Brand name
Timing of the impairment
There is uncertainty about when this impairment should be recognised. IAS 34 states that the same
recognition and measurement principles should be used in the interim financial statements as in the
annual financial statements. Therefore, if the conditions for impairment were met at 30 June 20X4 the
impairment should be recognised.
Further enquiries should be made of the directors to determine the future of this business after the
launch of the new mobile device. Particularly regarding the recent offer for the net assets.
The adjustment required is:
£’000 £’000
CREDIT Property, plant and equipment 1,594
CREDIT Brand name 881
CREDIT Goodwill 1,975
The above assumes that none of the PPE had been revalued.
Deferred advertising costs
The cost of the advertising services should be recognised when the service has been delivered.
There does not appear to be any grounds for deferring the costs. IAS 34 states that a guiding
principle is that an entity should use the same recognition and measurement principles in its interim
statements as it does in its annual financial statements.
As the costs would not be regarded as an asset at the year-end it would not be appropriate to
recognise the deferral of the costs as a prepayment since they have already been incurred before 30
June 20X4.
Share issue to Nika
The issue of shares to Nika falls within the scope of IFRS 2, Share-based Payment. It is an equity
settled share-based payment because essentially Konext has received a service in exchange for an
issue of shares. This type of transaction with a third party is normally measured at the fair value of the
services received. The value of the shares at the settlement date will therefore be irrelevant. The cost
should be shown in profit or loss when the service has been delivered – therefore the cost has been
incorrectly prepaid.

The adjustment required is:
£’000 £’000
CREDIT Prepayments 1,000
To remove the prepayment and charge the cost to profit or loss

A further issue is the £1m credit balance being shown as a payable to Nika. Because it is going to be
settled by an issue of shares, we should no longer show a liability but instead recognise shares to be
issued as part of equity. The adjustment required is:
£’000 £’000
DEBIT Payable 1,000
CREDIT Equity 1,000
To remove the liability to Nika and to recognise the shares to be issued

Pension schemes
The treatment with respect to the defined contribution payment is correct.
IAS 19, Employee Benefits encourages the use of a professionally qualified actuary in the
measurement of the plan’s defined benefit obligations. For interim reporting purposes, IAS 34 states
that reliable estimates may be obtained by extrapolation of the latest actuarial valuations.
The treatment of the contribution paid in respect of the defined benefit payment is incorrect and
estimates should be made by extrapolation as follows:
£’000
Fair value of assets 12,200
Present value of obligations (14,500)
Net benefit obligation at 31 December 20X3 (2,300)
Interest cost 3.25% × 2,300,000 (75)
Service cost £2,800,000 × 6/12 (1,400)
Contributions paid into the scheme 900
Estimated net benefit obligation at 30 June 20X4 (2,875)
Therefore, the following adjustment is required:
£’000
DEBIT Profit or loss – administrative expenses service cost 1,400
CREDIT Profit or loss – administrative expenses – contribution paid 900
CREDIT Net pension benefit obligation 575

Part (2)
Revised consolidated SPL and analytical procedures
A revised consolidated statement of profit or loss for six months ended 30 June 20X4
20X4
£’000
External Revenue (Note 1)
Mobile device business
Customised mobile devices (30,300 – 10,000) 20,300
Software services sales (18,010 – 5,000) 13,010
Other mobile devices 15,700
Refone – mobile device repairs 2,100
Total 51,110
Gross profit (39,541 – 9,000) 30,541
Distribution costs (3,823)
Administrative expenses (6,563 + 1,400 – 900 + 1,000 + 4,450) (12,513)
Finance costs (1,280 + 75) (1,355)
Taxation (2,000)
Profit for the period 10,850
Analytical procedures to identify risks of misstatement

The purpose of the following analytical procedures is to identify relationships and unusual items that
may indicate a risk of misstatement.
Revenue
6 months to
30.6.20X4 6 months to Projected revenue to Year ended
Restated 30.6.20X3 31.12.20X4 31.12.20X3
£’000 £’000 £’000 £’000
Hardware 20,300 20,700 (2%) 50,750 51,700
Software 13,010 10,800 20% 32,525 25,900
Repair 2,100 5,200 (60%) 5,250 7,800
Other mobile
services 15,700 6,100 157% 39,250 20,500
Total 51,110 42,800 127,775 105,900
× 120% 127,080
The projected revenue to 31.12.20X4 has been calculated by considering the seasonality of the
business by multiplying the results to 30 June 20X4 by 100/40.
If the business remains seasonal and 60% of revenue is generated in the second half of the year and
after adjusting for the error in recording the revenue for the new Denwa+ deposits, the directors’
prediction of an increase in revenue of 20% by 31 December 20X4 is achievable overall based on
the performance to 30 June 20X4.
Sales of other mobile devices have increased by 157% – although this increase is in line with the
figures estimated for the number of devices to be delivered in 20X4 as per the management

commentary, the increase could be indicative of a revenue recognition risk of misstatement – see
later conclusion.
The above analysis reveals some unusual trends which could be linked to a risk of material
misstatements as follows:
The revenue from sale of customised mobile devices is not predicted to increase in absolute terms.
The above analysis indicates that revenue will fall by 2%.
Using the above analysis and adjusted revenue figures, the estimated selling price of Konext devices
appears to have fallen whereas the sales price of third party devices appears to be remaining
constant.
Also, the software service element has increased from £41 to £50.
Konext devices and software
Number Selling price device only Software
650,000 × 40% = 260,000 260,000 20,300,000/260,000 = £78.08 13,010,000/260,000 = £50
12 months to 31 December 20X3 636,000 51,700,000/636,000 = £81.3 25,900,000/636,000 = £41
Other mobile devices
Number Selling price

392,000 × 40% = 156,800 156,800 15,700,000/156,800 = £100
12 months to 31 December 20X3 205,000 20,500,000/205,000 = £100
Gross profit
An analysis of the gross profit margins also reveals some unusual relationships:
6 months to
30.6.20X4
6 months to Year ended

Gross profit analysis As originally stated Revised 30.6.20X3 31.12.20X3
£’000 £’000 £’000 £’000
Customised mobile devices Balancing

and software figure 34,986 25,986 18,540 46,560
Other mobile devices 25% 3,925 3,925 1,525 5,125
Repair 30% 630 630 1,560 2,340
39,541 30,541 21,625 54,025
Gross profit % on
customised devices and 34,986/48,310 × 25,986/33,310 ×
software 100 100
72% 78% 59% 60%
The gross profit on customised devices and software can be calculated by taking the gross profit for
repairs and third-party sales from the total GP figure. The gross profit margin has increased from
20X3. Although the management commentary does refer to an increase this is not quantified. An
increase from 60% to 78% would require explanation as it suggests that there is potentially further
risk of misstatement possibly in the recognition of software revenue which shows a 20% increase in
the same period for 20X3 revenue recognition.
There may also be risk of cut off errors which would lead to an understatement of the cost of sales.
Conclusion
Risk of misstatements
(1) The number of proposed adjustments indicates that there may be risk of other errors which may
be a deliberate attempt to present the results favourably. Professional scepticism should be

applied to any information produced by Konext. The queries have been raised with us by the
finance director’s assistant and we have only his word. It would be appropriate to discuss the
proposed adjustments with Jacky first before concluding on whether there has been deliberate
attempt to manipulate the results.
(2) Revenue recognition – the results indicate that there is a potential issue with the application of
appropriate revenue recognition policies based on control transferred to the customer.
(3) The amount recognised for the software services has increased and may indicate a change in
policy or the incorrect application of accounting policy.
(4) The management commentary states that 40% of devices are delivered in the first six months of
20X4.
However, in 20X3 the results indicate that only 29.76% of ‘other mobile devices’ were delivered
in the first 6 months of the year. (£6.1 million/£20.5 million × 100 = 29.76% or 205,000 × 40% ×
£100 = £8,200,000 compared to £6,100,000 reported in the SPL). This indicates that there may
be an attempt to inflate the 6-month figures to produce a more favourable position at the half
year.
Part (3)
Key audit procedures for misstatement of revenue
Revenue recognition
There is a risk that revenue is recognised in advance in respect of deals involving deposits and
payment schedules. Also, the increase in software revenue suggests that revenue may have been
recognised as it is invoiced instead of when the performance obligations are satisfied.
Audit procedures
• Interim financial statements
Further enquiries should be made of management regarding the revenue recognition policies
and whether there have been any changes in the recognition methods used for software services
and devices. The recognition of the revenue based on deposits received is in contravention of
IFRS 15 and if unadjusted would result in a modified report on the basis that the recognition of
this revenue represents a departure from the IFRS framework. Not recognising software services
based on the service delivered would be similarly a breach of IFRS.
• Year-end audit
Further revenue recognition errors could be made at the year-end. Key audit procedures would
include:
– examination of major contracts with customers to identify potential revenue recognition errors
concerning deposits and scheduled payments;
– agreement of sales invoices to delivery documentation to ensure that goods are delivered in
the same period as the revenue is recognised;
– agreement of service contracts to ensure the cost is spread over the life of the contract to the
profit or loss and the correct amount shown as a contract liability;
– review of amounts held in contract assets and contract liabilities and agreement to contracts to
ensure the amounts are recognised in accordance with IFRS 15; and
– circularisation of receivables at the year-end to confirm the existence of year-end balances.
Detailed cut off work on cost of sales will be required at the year-end including, for example:
• testing client controls over recording of sales are sufficient to ensure that purchases are recorded
in the appropriate period.
• re-performing payables reconciliations to ensure costs are appropriately accrued.

Part (4)
Adequacy of management commentary
The commentary is factual and not inconsistent with the information provided in Exhibit 4; it is
however extremely brief.
What is concerning is that the specific clients do not seem to have been informed about the breach
in information security and there seems to be a deliberate attempt to hold back information from the
company’s clients. Konext may be in breach of legal requirements regarding the protection of client
data.
Ethical issues for Noland
Noland should have concerns about professional competence and due care exercised by the FD, a
fellow ICAEW member. Also, her integrity and objectivity appear to be questionable.
The FD has demonstrated a lack of transparency in her willingness to cover up the security breach
which highlights a weak attitude towards corporate governance. In addition, other incidences have
arisen during the audit:
• The management commentary states that the gross profit for customised devices has increased
from 60% – but does not state by how much – the gross profit appears to be around 78% which is
a significantly large increase which has not been explained.
• The FD appears to be trying to present a favourable view of the results at the interim by
prepaying costs and bringing forward income.
There is a self-interest threat for Noland as they may not wish to jeopardise their relationship with
Konext.
Actions
The engagement partner for Noland should discuss the information security issue with the Konext
directors to establish the facts. The ethics partner should be consulted to consider whether there is a
case for reporting a fellow member in breach of the ethical code to the ICAEW. Noland could suffer
reputational damage and should seek legal advice.
General comments
question required Advanced Level skills in the understanding, collating and ordering of pieces of
There were some very good answers to this question, producing clear, rational and concise figures,
discussions and conclusions.
This question asked for journal adjustments. Where a question does this, marks are specifically
awarded for the journals. Candidates should not ignore the requirement.
Some common errors occur in respect of journal adjustments:
• Failing to provide them at all
• One-legged adjustments
• Journals that do not balance
• Adjusting journals that have an impact on cash
It was quite clear that some candidates are still having trouble with debits and credits.
Part (1)
This was well answered with nearly all candidates identifying and addressing the four issues and
identifying the key points. The great majority of candidates recognised that revenue had been
incorrectly recognised although few commented that the normal recognition and measurement
principles should be applied in the interim accounts. The impairment was answered well too and
most candidates identified the relevant numbers and calculated the impairment correctly. Most also
realised that the impairment should first be allocated to goodwill and then allocated to other non-
monetary assets (although some described this but didn’t go on to do the actual allocation
calculation). For the share-based payment most realised that the treatment as a prepayment was
incorrect and had to be reversed out although many then went on to make unnecessary adjustments

to equity. Most candidates clearly understood the different treatments of the two pension schemes
although disappointingly few managed to get the calculations for the defined benefit scheme
completely correct.
Some basic errors included:
• inappropriate double entry for the adjustment to cost of sales – often by debiting inventories
rather than accrued costs;
• allocating some of the impairment loss to inventory and receivables;
• crediting equity for the future share based payment; and
• mixing up the contributions paid on the two pension schemes and/or failing to time apportion the
service cost for six months and/or incorrectly time apportioning the finance cost when the rate
given was for six months.
Part (2)
Most candidates managed to produce an adjusted income statement showing the adjustments and
then adding across to complete the statement of profit or loss.
The analytical review section was done surprisingly well by many candidates. Overall, they took the
task seriously and produced a review that was consistent with their earlier answers. A few candidates
did not read the question with enough care. The question asked for ‘analytical procedures on the
revenue and gross profit…’. Some candidates made other comments on for example the net profit
and the effect of the adjustments for impairment and pension scheme that were not relevant. A few
simply described what would be involved in an analytical review, but did not actually perform any
analysis using the revised figures. The candidates who produced additional calculations on
percentage change in the year, or prices per product, were generally able to produce a much higher
standard of analysis and commentary.
Nearly all candidates realised that cut off to revenue was a key risk but far fewer focused on the high
level of errors and potential ‘window dressing’ of the interim accounts.
Part (3)
This section was generally well done. A few candidates overlooked the fact that the requirement
related to revenue procedures only, and wasted time by setting out audit procedures relating to
other areas of the financial statements.
Part (4)
This section was not done well, and many candidates wasted time on long-winded explanations of
how any related provisions and other potential adjustments should be identified and/or audited.
Some candidates told the client how to set up a squad responsible for cyber security reporting
directly to the board or discussed at length the potential impact such a breach could have on
everyone (from customers through to the general public at large), or instructed the board to perform
an overhaul of the IT systems. All of which would make interesting answers but to a different
question.
Candidates demonstrated some significant errors in understanding. A few were under the
impression that the client was preparing management accounts rather than interims. Some
candidates felt that the auditors should be responsible for communicating directly with Konext’s own
customers.
Some candidates completely ignored the second part of the requirement and failed to mention
Noland at all. Some thought that Noland was the client rather than the auditor.
Not many identified that Jacky was an ICAEW member and should abide by the ethical code – they
simply stated that the directors need to show integrity and be honest. The actions were often for the
client and not for Noland.
When actions for Noland were discussed, many candidates favoured the simple option to resign, an
attitude which is going to make them popular with their firms when they reach more senior positions.
Few wished to get further information or to talk to the ethics partner but most would call the ICAEW
ethics hotline.

45 Elac
Scenario
The candidate is the financial controller for Elac plc, a construction company listed on the LSE. The
candidate returns from holiday to find an unqualified assistant has prepared a first draft of the
financial statements using briefing papers prepared by the finance director. The assistant has made
several errors in interpreting the information and the candidate is required to correct the financial
reporting entries and explain the adjustments required for complex transactions which include; the
midway consolidation of an associate company; foreign exchange and intra group trading
transactions; incorrect treatment of an onerous contract as a contingent liability and recognition of a
provision for commission. The candidate needs to assimilate information from different exhibits to
determine the appropriate financial reporting treatment and to prepare a revised consolidated
statement of profit or loss and financial position.
Explain the financial reporting adjustments Assimilate complex information to recommend

required in respect of the matters described in appropriate accounting adjustments.
the briefing papers prepared by Elac’s finance Apply technical knowledge to the information
director (Exhibits 1 and 2). Include relevant in the scenario to determine the appropriate
journal entries. Identify any further information accounting for the acquisition of shares in
required. Ignore the effects of accounting Fenner.
adjustments on taxation.
Identify further information required to
recommend appropriate financial reporting
treatment.
Prepare Elac’s revised consolidated statement Assimilate and use adjustments identified in (1)
of profit or loss for the year ended 31 May 20X7 in drafting the statements requested.
and consolidated statement of financial position Use knowledge of financial statement
at that date. These should include any presentation to present the financial statements
adjustments identified in (1) above. in appropriate format.
Marking guide Marks

Revised consolidated SPL 10
30
Total 30
Working paper
(1) Elac’s investment in Fenner Ltd
Until 1 February 20X7, the investment in Fenner was recognised in the consolidated financial
statements of Elac at cost in non-current asset investments. Any dividends received from Fenner were
credited to finance income. On 1 October 20X6 Elac received a dividend from Fenner of 20p per
share: £100,000 (20p × £10m × 5%). This was correctly recognised in finance income.
However, a change of status of the investment took place on 1 February 20X7 with the purchase of
an additional 20% of Fenner’s ordinary share capital. Elac’s holding of 25% appears to confer
significant influence over the operations of Fenner and therefore Fenner is an associate of Elac from
1 February 20X7. Normally, a holding of over 20% of the ordinary share capital of another entity
suggests significant influence, and this is further reinforced by the power to appoint a director. It is
clear that no one party exerts control over Fenner and this factor also makes it more likely that Elac
can exert significant influence.

As Fenner is an associate, Elac must recognise the investment using the equity method of
accounting. This means that in the consolidated statement of financial position, the investment in
Fenner is shown at cost plus the group’s share of post-acquisition retained profits or less the group’s
share of post-acquisition losses (less any dividend received). In the statement of profit or loss Elac
takes credit for its share of the associate’s profit after tax, or deducts its share of the associate’s loss
after tax.
Fenner was an associate for four months of the financial year (1 February to 31 May 20X7). Elac
recognises its share of the loss for that period: £46.5m × 4/12 = £15.5m × 25% = £3.9 million in
consolidated profit or loss.
Elac’s share of the dividend of 40p per share paid by Fenner on 30 April 20X7 is: £10m × 25% × 40p
= £1 million. This reduces the carrying amount of the investment in the associate.
Therefore, the carrying amount of the investment in Fenner in Elac’s consolidated statement of
financial position at 31 May 20X7 is calculated as follows:
£m
Original 5% investment at cost 50.0
20% investment at cost 350.0
Less share of post-acquisition losses (3.9)
Less dividend received (1.0)
395.1
The journal entries (1) required are as follows:
Debit Credit
£m £m
Investment in associate 350.0
Suspense account 350.0
Investments 50.0
Profit or loss 3.9
Finance income 1.0
Being the recording of the investment in, and income from, the associate.
Trading with Fenner
Equity accounting requires elimination of any unrealised profit in inventory, to the extent of the
group’s share. Where the associate sells to the parent, as in this case, the unrealised profit is in group
inventories, from which it must be eliminated. The group share of unrealised profit at 31 May 20X7 is
calculated as follows:
20/120 × £35m = £5.8m × 25% = £1.5m (to nearest £100,000)
This is recognised by debiting the share of profit/loss of Elac and crediting group inventories. The
journal entry (2) required is as follows:
£m £m
DEBIT Share of profit/loss of associate 1.5
Accounting for the group share of unrealised profit arising from trading with associate.

Sales to Otherland
Daniel has made several errors in respect of the transactions with Otherland customers.
Provision for onerous contract
IAS 37, Provisions, Contingent Liabilities and Contingent Assets, requires that a provision should be
made for onerous contracts at the time a contract becomes onerous. This is the point at which future
benefits under a contract are expected to be less than the unavoidable costs under it. The contract
with Otherland is described by the finance director as “expected to make a much larger margin than
UK sales”.
The consolidated profit or loss statement includes the results of Elac itself plus its other subsidiaries,
therefore Elac’s normal gross profit margin on UK sales cannot be calculated. However, the group
gross profit margin is 20%. If this is indicative of Elac’s own gross profit margin, the margin on the
Otherland contract is likely to be higher than this. Assuming a gross margin of 30% on the Otherland
contract, gross margin for the remaining seven months of the year could be calculated at 30% × (7
months × 1,600 × O$5,000) = O$16.8 million.
The Otherland dollar is clearly weakening over the 20X7 calendar year, with a loss in value of over
20% expected. However, the anticipated exchange losses are very likely to be outweighed by the
profits to be earned under the contract. Therefore, it is unlikely that the contract with the Otherland
customers is onerous, although more precise information about profitability would be required to
confirm this.
The provision made by Daniel must be reversed: The journal entry (3) is as follows:
£m £m
DEBIT Provision 5.5
Trade receivables
Trade receivables denominated in foreign currencies are monetary items. As required by IAS 21, The
Effects of Changes in Foreign Exchange Rates monetary items in foreign currency outstanding at the
reporting date should be translated at the closing rate.
Using the closing rate at 31 May 20X7, the balances due from Otherland customers translate at:
O$10.1m/2.4 = £4.2 million (to nearest £100,000).
Therefore, an exchange loss has arisen of (£4.8m – £4.2m) £0.6 million. The journal entry required (4)
is as follows:
£m £m
DEBIT Exchange loss (profit or loss) 0.6
CREDIT Trade receivables 0.6
Gains and losses arising from the retranslation of monetary items are recognised in profit or loss for
the year. Such gains and losses could be reported under various headings in the statement of profit
or loss. The adjustment in this case will be recognised in operating expenses.
Agent’s commission
It is incorrect to classify the agent’s commission as a contingent liability. At the reporting date, 31 May
20X7, an obligation exists to pay the agent commission for sales over the five-month period from 1
January 20X7. It is a present obligation arising from past transactions (the sales) and it can be
measured with a reasonable degree of certainty.
The finance director has stated that average monthly sales for the first five months of 20X7 are 1,600
windows. If this level of sales continues to be achieved for the rest of 20X7, total sales for the year will
be 19,200 windows, which comfortably exceeds the 16,000 windows at which the agent is paid 5%
commission. Because commission depends upon total sales for the year it is not possible at 31 May
20X7 to calculate the commission figure with complete accuracy because a fall in sales for the rest of
the year could result in total sales falling below 16,000 units.
However, in the absence of any information to the contrary, it is reasonable to assume that the
commission accrual should be calculated at 5%, as follows: (1,600 × 5 months × O$5,000) × 5% =
O$2 million.

This is a monetary liability and so should be translated at the closing rate on 31 May 20X7: O$2m/2.4
= £0.8 million (to nearest £100,000).
The journal entry (5) required is as follows:
£m £m
CREDIT Provisions 0.8
Further information
More precise information regarding profitability of the Otherland contract. Confirmation of expected
level of sales of windows to confirm commission.
(2) Revised draft of the Elac group’s financial statements for the year ended 31 May 20X7
Revised consolidated statement of profit or loss
Jnl ref Adjustment Adjusted

£m £m
Revenue 1,855.4 1,855.4
Cost of sales (1,482.9) 3 5.5 (1,478.2)
reverse provision
5
––––––– (0.8) –––––––
agent comm
Gross profit 372.5 4.7 377.2
Operating expenses (270.8) 4 (0.6) (271.4)
ex loss receivables
Finance income 3.6 1 (1.0) 2.6
dividend
Loss from investment in
associate 1 (3.9) (3.9)
2 (1.5) (1.5)
inventory
Finance costs (9.4) – (9.4)

Profit/(loss) before tax 95.9 (2.3) 93.6
Income tax (19.1) – (19.1)
Profit/(loss) for the year 76.8 (2.3) 74.5

Draft consolidated statement of financial position
Jnl ref Adjustment Adjusted

£m £m £m
ASSETS
Non-current assets
Tangible assets 1,799.7 1,799.7
Investments 456.0 1 (50.0) 406.0
Investment in associate 1 350.0 395.1
1 50.0
1 (3.9)
1 (1.0)
Suspense account 350.0 1 (350.0) –
Current assets
Inventories 243.8 2 (1.5) 242.3
Trade receivables 238.9 4 (0.6) 238.3
Cash 16.4 –––––– 16.4
Total assets 3,104.8 (7.0) 3,097.8
Equity
Ordinary share capital (£1
shares) 150.0 150.0
Reserves 2,255.4 4 (0.6) 2,253.1
5 (0.8)
1 (1.0)
3 5.5
1 (3.9)
2 (1.5)
Long-term liabilities 388.3 388.3
Current liabilities
Trade payables and accruals 305.6 305.6
Provision 5.5 3 (5.5)
––––––– 5 0.8 0.8
Total equity and liabilities 3,104.8 (7.0) 3,097.8
Part (1)
Investment in Fenner Ltd
The reasons for treating the increased holding as an associate were set out well with many
candidates showing good technical and assimilation skills. Many thought that it was a joint venture.
This is a possibility, but there is no mention of a contractual agreement in the question, therefore
associate would be the more likely classification.

A minority seemed to not understand the difference between significant influence and control and
suggested that Fenner should be consolidated as a subsidiary. This assertion was usually based on
Elac’s entitlement to appoint a director, but ignored the fact that the other three shareholders could
do the same, which results in no investor having control. This treatment led them into various
difficulties, mostly because they had to spend time on consolidation. A small number of candidates
could not make their minds up, and in a few cases, they produced workings as if Fenner was an
associate, then crossed them out in favour of accounting for a subsidiary, or vice versa. The amount
of time wasted on this pointless exercise often left insufficient time for other questions.
Common mistakes were:
• not distinguishing between the pre- and post-acquisition dividends and/or eliminating them all
and then forgetting about them – or suggesting a correction by crediting cash (?);
• incorrectly calculating the loss of the associate. Many took 5/12 × £46.5m × 25% or just 25% ×
£46.5m;
• not knowing how to calculate the investment in associate – many simply took £400 million cost;
and
• not taking 25% of the PURP adjustment.
Journals were often confusing with quite a few trying to post one half of the PURP journal to Fenner’s
books and the other to Elac’s.
Sales to Otherland and Onerous Contract
Most recognised that this provision was not required however the explanations for this were quite
poor with many spending some time on exploring hedging contracts. Many recognised that the
contract would be profitable although this could then morph into a discussion of commission rates
and exchange differences and generally get very muddled. Most focused on detailed explanations of
exchange rates and provisions as to why the contract provision should not be recognised.
Agent commission
The commission was often noted as needing a provision based on the number of windows sold at
the year end. However, there were some poor descriptions as to why and basic mathematical errors
in the calculation of the amount of provision required.
Common errors seen were:
• using the annual sales to calculate the commission;
• translating at the average or forward rate;
• deciding that the 5% rate would be appropriate and then using 3%;
• not translating the figure calculated; and
• netting this provision off against the onerous contract provision.
Part (2)
This was well answered with many candidates achieving full marks by including their own figure
adjustments and adding across to produce the consolidated financial statements.
46 Recruit1
Scenario
The candidate is an audit manager working for Hind LLP, a firm of ICAEW Chartered Accountants
with offices in several countries. The candidate has 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 recruitment and training. 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. The candidate is asked initially to review an
audit memorandum which has been prepared by a Hind audit team in Arca who are responsible for
the audit procedures for Recruit1’s subsidiary R1-Arca Inc. The candidate should identify initially that
movement in exchange rates impacts on the materiality level and that this should be considered
when determining the need for further work. Issues the candidate should identify and explain why

include inadequate performance of procedures on revenue, payroll and taxation and a potential
prior period adjustment. Key to answering this well is to explain why the procedure performed was
inadequate and then to determine the procedures to be performed at group and subsidiary level.
The candidate is then required to explain the financial reporting implications of a property
transaction in another of Recruit1’s subsidiaries R1-Elysia Ltd. This transaction has implications for
classification and measurement of a loan and property and for deferred taxation.
Review the reporting memorandum from the Identify weaknesses in the audit procedures
Hind Arcan audit team (Exhibit 2) and for each performed at subsidiary level.
account identified: Critically review the work of the junior and
• describe any weaknesses in the audit prioritise key issues.
procedures; Distinguish and explain the additional
• explain any potential financial reporting and procedures required at group and subsidiary
audit issues; and level.
• set out further audit procedures that either Appreciate and apply the concept of materiality
the UK group audit team or the Hind Arca in relation to group and subsidiary.
team should perform, together with any Appreciate and demonstrate technical
additional information for these procedures. understanding of the role of component
auditors.
Relate different parts of the question to identify
critical factors.
In respect of R1–Elysia’s property transaction Assimilate complex information to produce

and loan, review the additional information appropriate accounting adjustments.
provided (Exhibit 3) and: Apply knowledge of relevant accounting
• explain the financial reporting implications standards to the information in the scenario.
for the consolidated financial statements of Identify the need for further information.
Recruit1 for the year ended 30 April 20X7.
Recommend appropriate accounting Clearly set out and explain appropriate
adjustments including journals; and accounting adjustments.
• set out any additional audit procedures that Appreciate when expert help may be required
should be performed. in determining deferred tax adjustments.
Marking guide Marks
Weaknesses in audit procedures and further audit procedures 18

Property transaction 12
30
Total 30
(1) Review of Arcan reporting memorandum
The exchange rate has changed from when materiality was set in A$. If £300,000 is still the correct
component performance materiality, that would now be equivalent to A$540,000 meaning that the
other receivables and prepayments should have been tested. However, changes in exchange rates
across the group and differences in results from those anticipated when materiality was set may have
changed the overall materiality of component materiality for Arca. Group team should therefore look
at this before asking Arcan team to do more work on other receivables and prepayments.

Revenue
Weaknesses in audit procedures
The work performed on revenue seems very limited and is unlikely to be adequate – specific
weaknesses are:
• agreement to an invoice and the receivables ledger does not prove that the service to which the
invoice relates was delivered pre-year end and that it is appropriate to recognise the revenue. It
also gives no assurance as to the completeness of revenue; and
• payment from the customer may give some more assurance that the service has been delivered
but, in a business such as recruitment, there may well be stage payments and invoices or an
element invoiced in advance.
Financial reporting and auditing issues
Hence payment may be in advance of appropriate revenue recognition. The need for such testing is
emphasised by the error identified in relation to prior year revenue which should have been
deferred. It seems unlikely that there should not be a similar deferral in the current year but there is
no significant balance within creditors.
Further audit procedures and information required
As revenue is likely to be a key risk area (as required by auditing standards), the Group audit team
will need more detail on R1-Arca’s different revenue streams:
• Enquire of management about the key revenue streams, determine the critical invoicing dates
and appropriate point at which revenue is recognised for each revenue stream.
• Determine whether the recognition point is both appropriate and in line with the group policy.
• For each stream confirm by reference to customer contracts and invoices recorded that the
revenue recognised is in line with the policy and that revenue is both accurate and complete.
Payroll
The work performed on payroll appears to be limited to agreement to schedules prepared by a
third-party service company. There is no indication that the Arcan team has considered whether it is
appropriate to place reliance on this entity and its expertise and such an assessment should have
formed part of the audit work. In addition, it is unlikely that a payroll service company will operate
without reliance on data supplied by R1-Arca and this should be tested.
The financial reporting issue here is that there may be an over or understatement of liabilities at the
year end in respect of payroll balances. Also without an appreciation of the controls around the
payroll function and their service company, there is a possibility of fraud and inappropriate payment
for services not performed.
Further audit procedures and information required:
• Perform substantive analytical review procedures to assess whether the balance could be
materially mis-stated.
• Enquire of the Arcan audit team to determine whether they have assessed the expertise of the
service company and assessed internal controls.
Taxation
There is insufficient work done on taxation. No assessment has been made of whether their tax
advisers are suitably competent.
The taxation charge comprises current tax only and there is no mention of a deferred tax balance
even though it is clear that there are some temporary differences from the explanation of work done
on the current tax charge. Where such differences exist, a deferred tax asset or liability will exist and
should be recognised (unless in the case of an asset it is not considered recoverable).

More information is required as to what temporary differences exist and whether any deferred tax
has been or should be recognised. It is possible that any balance will be totally immaterial for group
purposes but that cannot be assessed without further information.
Reserves
The audit procedures comprise no more than identifying why the reserve balance is different and are
completely inadequate.
The commentary on the brought forward reserves figure appears to identify a material item which
relates to the prior year and was erroneously recorded within group revenue in the year ended 30
April 20X6. A$2,250,000 equates to £1,250,000 at the year-end exchange rate which is above group
materiality.
A material error should be treated as a prior period adjustment and the comparatives restated.
However, as the amount is only just above materiality, it should be considered along with any other
smaller and similar adjustments noted in other group entities which might offset (or indeed add to) it.
In addition, it is important to determine whether there are related direct costs which should also be
deferred thus reducing the effect on reported profit.
However the error is treated, it should not be shown in the way it has been, simply as a reserves
movement. If a prior period restatement is required, then it should be shown as a reduction in the
prior year revenue. If not, then the reduction in revenue will be reflected in the current year profit or
loss account. There is also likely to be an adjustment to the tax charge (unless this has already been
taken into account).
The discovery of the error raises some potential issues with the accuracy of the prior year financial
statements in other areas and potentially with the competence of the finance team and the way in
which they keep the parent company informed. The group team should therefore consider whether it
affects the determination of component materiality or the level of work required in Arca.
Non-current assets
The overall balance is above component materiality and we would therefore have expected some
work on existence, ownership and potential impairment.
There is no audit evidence to confirm the existence, ownership and valuation of a material balance in
the financial statements. The potential is that the balance is therefore not fairly stated.
The team in Arca should be asked to perform these procedures as the scope set for them was to test
all balances over £300,000 and not all movements.
Trade receivables
A significant amount of the sample has not been followed up for further enquiry.
The receivables balance and revenue cut off are key audit areas and there is a potential for
misstatement of both balances.
The Arcan team should be asked to perform additional procedures to update their work on post year
end cash receipts and to perform alternative procedures to confirm the accuracy and validity of the
receivables balance if payment has not been received.
Procedures need to be performed to address the completeness of any receivable provisions by
reference to ageing, balances not paid within normal credit terms etc. These do not appear to have
been performed at present.

Cash and short-term investments
Although agreements to confirmations are key procedures, this is a very significant balance and no
detail is given of what is included.
The key issue here is presentation – there could be investments which need to be disclosed
separately within the financial statements or for which the valuation needs further consideration. It is
also possible that some items should not be treated as cash and cash equivalents within the cash
flow statement.
The Arcan audit team should obtain a breakdown of the balance and determine the appropriate
presentation of the balances.
Trade payables and accruals
The balance appears not to be material and therefore the Arcan team have not performed any
procedures.
However, it seems likely from the error discovered in prior year revenue that the balance is
understated, at least as far as deferred revenue is concerned. Even excluding this consideration, the
total balance of A$503,000 (excluding tax) seems very low compared to staff and other costs and is
potentially understated.
In addition, the tax payable balance will need to be classified separately within the group financial
statements and the group audit team will need to ensure that this has happened.
Audit procedures should be performed to check completeness by looking at post year end cash
payments and invoices and ensuring that the costs have been accrued in the correct period.
Other points
The memo does not set out any details of the team in Arca, their qualifications, their independence
etc. These confirmations will be required by the group audit team.
There may also be other general procedures that the Arcan team should perform such as review of
minutes, consideration of local laws and regulations etc. To the extent that these are required, the
results should be reported.
There is not clear identification in the memo of the audit risks identified and the focused procedures
performed in response to them. Would expect head office and Arcan teams to have input into the
identification of the risks.
Overall need to be satisfied that the UK team has had sufficient involvement in the planning,
execution and results of the work in Arca as required by auditing standards.
(2) R1-Elysia’s property transaction, review the further information provided
Bank loan
As there is no discount or premium on redemption, it is correct to recognise the loan at E$6,000,000
and accrue interest at 6%. The bank loan will be measured at amortised cost and the interest accrued
over the term of the loan. The interest ‘charge’ of E$210,000 appears correct being 7/12 of E$6
million at 6%. However, the total balance owing on the loan of E$6.210 million at 30 April 20X7
should be split between current and non-current elements and converted at the year-end exchange
rate of E$3.6: £1.00 resulting in the following balances within the group accounts:
Non-current liabilities £1,667,000
Current liabilities £58,000

Audit procedures: loan agreement should be requested and reviewed to ensure that all relevant
terms have been summarised and considered in determining the financial reporting treatment.
Classification of property
The property has been treated as an investment property in Elysia but is unlikely to qualify as such
under the provisions of IAS 40. This is because R1-Elysia uses the building for its own training courses
and provides services to the lessees of the property in the form of administrative support and
catering. Such services are unlikely to be insignificant to the rental arrangement.
As a result, the building should be included within PPE in the Recruit1 consolidated financial
statements and stated not at fair value but at depreciated cost in line with Recruit1’s accounting
policies. The revaluation gain of E$500,000 should therefore be reversed.
Audit procedures: further information should be requested on the extent to which R1-Elysia intends
to use the property to ensure that this cannot be regarded as insignificant and examine further the
total rental package and terms for external tenants to ensure that the services provided by R1-Elysia
could not be regarded as incidental.
Accounting for finance cost
At present, none of the finance cost has been included within the capitalised cost of the building.
However, assuming six months is considered ‘a substantial period of time’ (which seems reasonable
given the substantial conversion costs incurred) then capitalisation would be required under IAS 23
as the purchase cost has been ‘funded’ for that period before the asset can be brought into use. As a
result, interest of E$180,000 should be capitalised. No further borrowings were needed to fund the
building costs of conversion so there is no additional finance cost to consider.
Audit procedures: Confirm interest rate to loan agreement and dates to schedule of works or board
meeting minutes.
Measurement of property cost
Costs capitalised should be only the directly attributable costs of bringing the asset into working
condition for its intended use (IAS 16). As a result, it is incorrect for R1-Elysia to have capitalised the
following:
• E$900,000 relating to marketing costs
• E$750,000 relating to security, insurance and other running costs
The E$850,000 capitalised for allocated salary costs should only be capitalised if directly attributable
to the project and not if the members of staff would have been employed in any event.
Depreciation
No depreciation has been charged but the property was brought into use one month before the year
end. There should therefore be a charge for one month’s depreciation although this is not material at
E$10.38 million/25 years × 1/12 = E$34,600 (£9,600).
Assuming it was not correct to capitalise the allocated salary costs, the revised carrying value of the
property is:
E$ million
Cost 6.000
External contractor costs 4.200
Capitalised interest 0.180
10.380
Less depreciation (0.035)
10.345
E$10.345 million is translated at the year-end rate of E$3.6: £1 = £2.874 million as this is translation
arising on the consolidation of a subsidiary which maintains its accounting records in a currency
other than the group functional currency.
Audit procedures: As the amounts capitalised are material to the group results, the group team will
require supporting documentation for a sample of the costs incurred and will also want to see land

registry or equivalent documentation to establish ownership. In addition, physical verification work
may be required either by the team or a representative in Elysia.
Deferred tax
• There are temporary differences arising because of the treatment of interest and capital
expenditure which will give rise to deferred tax balances.
• In respect of the building, the tax base is stated as E$12.7 million less the 50% capital allowance =
E$6.35 million.
• The tax base of the accrued interest is nil as it will all be tax deductible in the future.
• The carrying value of the property in the financial statements (including the capitalised interest) is
E$10.38 million less depreciation of E$35,000 = E$10.345 million.
• The carrying value of the accrued interest is a liability of E$210,000.
• Any deferred tax on the revaluation is irrelevant in the group accounts as the revaluation is not
recognised in the group accounts.
A deferred tax liability arises in respect of a timing difference between the tax written down value of
the building (E$6.350 million) and its carrying amount. A deferred tax asset arises on the accrued
finance cost as tax relief is only available when the interest is paid on 30 September 20X7.
Audit procedures: As the Elysian tax regime is unlikely to be familiar to the group team, expert
advice should be sought to ensure that the information provided regarding the tax treatment of the
property investment and income is correct. The team should question whether the additional costs
capitalised for the contractor, salary and marketing really qualify for capital expenses. The tax
computation should also be requested so that the treatment within the current tax charge can be
confirmed.
There may also be other deferred tax implications from other items within the financial statements
but these are unlikely to be material.
Carrying Temporary
amount Tax base difference DT at 35%
E$m E$m E$m E$m
Property (excluding
capitalised interest) 10.165 6.350 3.815 1.335
Accrued interest 0.210 0 0.210 (0.074)
1.261
Alternative workings are acceptable.

Other points
The fact that the group finance director seemed unaware of such a large transaction in a wholly
owned subsidiary suggests that there may be a weakness in governance and internal controls and a
risk that other significant transactions may have been missed at group level as there are several
subsidiaries where detailed audit procedures have not been carried out. While the desk top review
will have identified significant balances, for example it may not have identified business relationships,
investments, contingent liabilities. The team should ascertain the extent to which senior management
was aware of the investment and then consider additional procedures such as review of subsidiary
board minutes, discussion with local financial controllers to ensure that no other significant
transactions have been missed.
Part (1)
Part (1) was often done very well, especially by those candidates who had planned their time carefully
and were able to give the question their full attention. Weaker candidates, who had not planned their
time well, usually demonstrated this by providing very brief answers.
A common error in approach was failing to focus on the specific weakness in the audit procedures
eg, completeness of revenue or the fact that a third-party service company was being relied on
without any assessment of their work. Instead, weaker candidates launched into generic tests which

were often unrelated to the scenario. For example – checking delivery notes without saying why or
indeed why delivery notes would be relevant to a company engaged in recruitment and training. Or
suggesting a need for a cash after date procedure when one had already been performed albeit
unsatisfactorily.
Very few picked up on the issues relating to cash and cash equivalents – items not meeting the
definition being included and investments potentially misclassified.
Other disappointing points were: not spotting that the PPE balance was material and concentrating
on depreciation; not appreciating that a bank statement was insufficient evidence; not spotting that
the procedures on operating expenses were fine and setting out additional procedures which were
already covered in the memorandum.
Technically, most candidates made some sound points, although a surprisingly large proportion
failed to identify the absence of any deferred tax adjustment, or to consider the prior period
adjustment. Although there were some excellent answers which identified and explained the
possibility that this error could have been replicated in the current period and linked the issue to the
weak procedures performed on revenue.
There seemed to be the principle of ‘more procedures = more marks’ being applied when the
approach of ‘quality rather than quantity’ would be more appropriate.
Part (2)
Answers to this were quite varied and often very brief. Most candidates did consider whether the
property met the definition of an investment property but not all reached the right conclusion. Again
most candidates considered which costs should be capitalised but many did not suggest including
the capitalisation of interest on the loan. Few identified that the company used the cost model for
property, plant and equipment so wasted time talking about the revaluation. Pleasingly a majority of
candidates did realise the deferred tax implications of the interest and capital allowances. Very few
realised the loan needed to be recognised as part of current and non-current liabilities and/or
commented that apart from that the treatment was actually correct.
Many candidates ignored the audit aspects or produced irrelevant generic procedures.

47 EF
Scenario
The candidate is an audit senior working on the audit of EF Ltd. The initial audit planning was
performed earlier in the year. After the audit plan had been completed, EF Ltd was acquired by a
large multinational company, MegaB. The management of EF are under pressure to process financial
reporting adjustments in respect of four matters relating to a brand, goodwill, PPE and a receivable
allowance which are set out in the attachment to an email from the EF CFO.
The candidate must also assimilate information to identify changes in key elements of audit approach
which includes, for example, the impact of the acquisition on the control environment and
materiality, management incentives to manipulate the financial statements, and complex financial
reporting issues. Also following the acquisition responsibility for routine accounting work was moved
to a shared MegaB service centre which the candidate was required to consider as part of the
changes to the audit approach.
The candidate’s firm is facing a potential conflict of interest regarding its ability to obtain further
consultancy work from MegaB and the fact that the EF audit will be performed next year by MegaB’s
auditors puts additional pressure on the candidate’s firm. The candidate is required to identify the
ethical matters in the scenario for the audit firm and to explain the appropriate actions.
Explain, for each of the adjustments required by Assimilate and demonstrate understanding of a
MegaB (Exhibit 2), the appropriate financial large amount of complex information.
reporting treatment in the financial statements Identify appropriate accounting treatments for
of EF for the year ending 31 December 20X7. complex transactions including recognition of
Identify any additional information you need to intangible assets, the difference between
finalise the accounting entries required. Ignore recognition of intangible assets on
any adjustments for current and deferred consolidation and in the subsidiary financial
taxation. statements, investment properties and IAS 40,
and allowances for bad debt.
adjustments.
Identify and explain the changes that we need Appreciate and demonstrate technical
to make to each element of the planned audit understanding of the role of component
approach summarised in the file note (Exhibit auditors.
1). You should also consider any additional key Relate different parts of the question to identify
areas of audit focus and risk using all the critical factors.
information available.
Be able to respond to changes in the audit plan
due to changes in the business environment.
Identify key judgement areas from a complex
scenario and different sources in a changing
time frame.
Identify gaps and where more information is
required to develop a revised plan.
Appreciate the impact on materiality level due
to changes in the business operations.
Understand the difference between component
and planning materiality.
Identify the risk of management override of
controls and the potential for manipulation of
judgement areas.

Explain any ethical matters which MKM now Demonstrate understanding of the importance
needs to consider in respect of the 20X7 EF of contributing to the culture of the profession.
audit and any actions that MKM should take. Discuss appropriate responses and actions for
the firm in respect of the potential ethical
issues.
Appreciate the public interest and role of an
ICAEW Chartered Accountant.
Demonstrate the principle of objectivity and the
threat derived from external time and fee
pressure imposed by other audit firms and
management.
Identify and recommend actions for a self-
interest and intimidation threats.
Marking guide Marks

Changes in audit approach 14
Ethical matters 8
40
Total 40
(1) Financial reporting matters relating to the acquisition of EF by MegaB
(a) Valuation of EF brand at £20 million
The brand is an intangible asset and the relevant accounting guidance is set out in IAS 38.
For it to be recognised within the separate financial statements of EF, it would need to be
identifiable, that is capable of being sold separately from the business or arising from
contractual or other legal rights. It is debatable whether this is the case and clear that EF has
not historically recognised the asset as an intangible within its financial statements.
In addition, to recognise an intangible, EF would need to be able to measure its cost
reliably. It could subsequently choose to adopt a revaluation model for intangible assets but
only if the requirements for initial recognition were met and an active market can be
demonstrated. The ‘cost’ to MegaB has been determined as part of the overall acquisition
cost but this is not the cost to EF and the CFO’s email makes it clear that he is unsure what
costs were incurred. Indeed, it seems likely that the value of the brand has built up over time
through reputation rather than because of direct expenditure.
Unless it can clearly be demonstrated that there has been an error and the brand could and
should have been recognised in the past, it would not be correct to do so now just because
a valuation has been obtained. Additional information is required. Clear evidence of an
error seems unlikely as the costs will have been considered at the time.
Hence the brand should not be reflected in the separate financial statements of EF as it does
not meet the requirements for recognition within those financial statements. No entry
should be made. The brand will be recognised on consolidation only as part of the
acquisition accounting entries.
(b) Goodwill of £1.2 million
This is goodwill generated internally by EF and it is clear from IAS 38 that internally
generated goodwill should not be reflected within an entity’s financial statements.
No entry should be made. The goodwill will be recognised on consolidation only as part of
the acquisition accounting entries in the consolidated financial statements.

(c) Revaluation of PPE
PPE, including the head office building, has historically been recognised within the EF
financial statements at depreciated cost – and the company can choose to change its
accounting policy and move to a revaluation model, providing the fair value of the asset can
be measured reliably (which does appear to be the case). It does however have to apply this
model consistently to a class of assets. In this case, MegaB has specified that the revaluation
model is to be used both for investment properties and all other land and buildings.
The only asset with an uplift if the revaluation model is used will be the Head Office Building.
In the fair value exercise conducted by MegaB this has been treated as an investment
property and we therefore need to consider whether this is the correct classification. The
relevant accounting guidance is set out in IAS 40.
For the whole property to qualify as an investment property, only an insignificant portion
should be owner-occupied. That is clearly not the case for the head office property as EF still
occupies two floors out of three. However, it is still possible that the portion which is rented
out could be regarded as an investment property if it were capable of being sold separately
or leased separately under a finance lease. Further information is needed to determine
whether this is the case.
If the rented-out floor is regarded as an investment property, then the carrying value will
need to be apportioned between the two portions and the valuation of the rented floor
determined separately from the value of the remaining owner-occupied portion. It is clear
from the information that historically the whole property was owner–occupied and therefore
we need to follow the guidance on ‘change in use’ within IAS 40. The change in use date
could be 1 September 20X7 when the rental agreement commenced. A valuation should be
obtained at that date and the uplift over carrying value (for the rented floor) recognised
under IAS 16 as a credit to revaluation reserve (within other comprehensive income). The
valuation of the investment property element is then re-measured at fair value at each
period end with subsequent gains and losses going to the profit or loss account.
The remaining two floors of the property which are still owner occupied will also need to be
valued as the fair value model is to be adopted. Any uplift will be taken to reserves through
other comprehensive income and to revaluation surplus and will need to be apportioned
between land and buildings so that depreciation can be based on the fair value.
Depreciation will need to be charged on the owner-occupied building element based on
the revalued amount and this will reduce operating profit.
The revaluation would increase reserves by £2.4 million. However, this depends on whether
the valuation method used is appropriate. For both elements of the valuation, accounting
guidance on the determination of fair value within IFRS 13 needs to be followed and the
income-based approach used by MegaB is not necessarily correct. It should be a market
value considering the ability of a market participant to generate value by using the asset in
its highest and best use. Further input from an expert will be necessary to ensure that both
elements of the valuation are on the correct basis before accounting entries are made.
There is also a lease to the new tenant to account for. Rental income of £13,333 should
therefore be accrued in the statement of profit or loss for the 4 months to 31 December
20X7.
(d) Trade receivable allowance
IFRS 9, Financial Instruments uses an expected credit loss model for impairment of financial
assets in which credit losses are recognised in three stages:
Stage 1: Initial recognition (and subsequently if no significant deterioration in credit risk): 12
months’ expected credit losses recognised and interest calculated on the gross carrying
amount.
Stage 2: Credit risk increases significantly (rebuttable presumption if > 30 days past due):
lifetime expected credit losses recognised with interest calculated on the gross carrying
amount.
Stage 3: Objective evidence of impairment exists at the reporting date: lifetime expected
credit losses recognised with interest calculated on the net carrying amount net of
allowance for credit losses after date evidence exists.

A simplified approach is required for trade receivables, contract assets and lease
receivables. For trade receivables or contract assets that do not have an IFRS 15 financing
element, the loss allowance is measured at the lifetime expected credit losses, from initial
recognition. Since the receivables in question do not have a significant financing
component, it is therefore not permissible to change to the three-stage process.
(2) Changes to overall audit plan and areas of audit focus because of information received
Audit timing
The timing of the audit will need to change as final audit work was planned for March and Lewis-
Morson require sign off by the middle of February. Whether EF can be ready by this date is
debatable as its October results will not be ready until early December implying that it takes it
more than a month for it to close its books. A difficult year end is likely to take even longer,
leaving little if any time for audit.
This issue needs to be discussed with the client as soon as possible to determine when it is
possible for audit work to start, what work can be done before the year end and rolled forward
and what can be left until after the group reporting date on the basis that it will not be material
given the higher level of component materiality. Leaving work until later may however not work
as more staff are due to leave at the end of February and it may be difficult to get answers to
enquiries about 20X7 after that date.
A realistic timetable needs to be agreed with the client and Lewis-Morson, especially as the new
issues and approach mean that the audit is likely to take more time than in the past.
Controls reliance
In the past, the audit approach has relied on testing the operating effectiveness of controls over
revenue and trade receivables. The controls were operating effectively until June 20X7. Since
that date there have been significant redundancies among finance and other staff and day to
day accounting has moved to a shared service centre. It is therefore highly likely that both the
controls and those responsible for carrying them out have changed. We know that the CFO is
now responsible for both reviewing the financial statements and posting journal entries for the
more complex and judgemental items which may be indicative of a lack of review and
segregation of duties.
In addition, there is a new and very significant revenue stream relating to sales to overseas
distributors which will not have been covered by the controls work done to date.
More information is needed on when processes changed, what the new processes are and what
assurance, if any, can be given by Lewis-Morson on the controls operating at the shared service
centre. Additional audit work will be required to assess the design and implementation of
controls in the post-acquisition period and to determine whether operating effectiveness should
be tested and relied on. It seems likely that in at least some areas, design and implementation
testing will identify weaknesses in control (due to staff or other changes) and that additional
substantive work will be required either on the whole balance or, for income statement balances,
for transactions processed under the new and potentially weaker control environment. Where
the old controls are relied on for 10 months of the year, we will still need to update the interim
testing to cover the two months from 1 November 20X7.
Urgent work on the control environment is needed to re-assess the audit approach and
determine what additional substantive procedures are required. This should include discussion
with Lewis-Morson.
Materiality
The forecast result for the year has changed significantly because of the additional revenue
following the acquisition. Planning materiality of £800,000 was based on a profit after tax of £16
million whereas the expected profit is now £26 million which might imply a rise in materiality to
£1.3 million on the same basis.
However, there are other factors to consider:
Lewis-Morson have asked us to use component materiality of £3 million both for reporting to
them and for the statutory audit. We cannot simply accept this but need to form our own view on
what materiality should be.
That view should be based, not only on the financial results, but on factors such as the ownership
structure (which has clearly changed) and the focus of the users of the accounts. Given that EF is

now a wholly owned subsidiary of MegaB rather than a standalone entity reliant on external
financing, it might be appropriate to increase materiality.
We also need to consider the key focus for users of the financial statements. For management,
the key focus will clearly be operating profit as they each earn a significant bonus based on
achieving the forecast profit of £34 million. If actual results are close to this level, then a small
change could make the difference between achieving and not achieving profit. That will need to
be considered in determination of the materiality level we use.
The EF board have said that they intended to retain the same level of fees. This puts MKM under
pressure to cut audit time and costs to retain margin and we need to make sure that this is not
unduly influencing the work proposed or the materiality level adopted.
Management incentive to mis-state the results
There is clearly an enhanced risk of management override of controls following the acquisition.
The remaining management will want to please the new owners and to deliver the anticipated
results as there is clearly significant emphasis on this in judging their performance and
potentially their future with the company/group.
In addition, they have significant personal bonuses contingent on achieving the forecast
operating profit.
We therefore need to think carefully about areas where they could manipulate results and to
focus our audit on all areas of judgement. This will include areas already identified as key areas
of audit interest but also some of the new areas identified below. Attention will need to be paid
to balances where analytical review procedures reveal changes in the post-acquisition period
and we should ensure that we look at this as soon as possible to identify any additional risk
areas.
The forecast gross profit looks challenging compared to prior year as there is an overall increase
of £12 million. However, the forecast operating profit assumes that there will be small decline in
operating costs from £42.8 million to £42.2 million. There would be additional depreciation on
the property, the additional irrecoverable debt expense and reorganisation costs, none of which
appear to have been considered. Further details on the forecast figures are required to assess
what level of risk there is to achieve the forecast and therefore the degree of pressure there will
be on management.
Last year of audit/group reporting
The last year in which an audit firm audits an entity increases the audit risk as the work will be
subject to the scrutiny of a new auditor. This is perhaps mitigated here as the new auditor is most
likely to be auditing the entity only as part of a much larger entity.
However, the MegaB group is a new stakeholder and may raise additional questions and issues
and reporting to the group auditor brings additional responsibility and therefore inherent risk.
Changes/additions to areas of audit focus
– Revenue recognition risk is increased by the new overseas sales channels. These are
intercompany sales and so will eliminate in the MegaB consolidation. They are therefore of
limited interest for group reporting. However, in the stand-alone financial statements of EF they
represent a new and material revenue stream and the contractual terms will need to be
understood fully.
– The new sales also appear to be EF’s first overseas transactions so there is a risk that foreign
currency transactions have not been accounted for correctly.
– Selling to other group companies at a lower margin than to external distributors may raise
transfer pricing questions in respect of tax and potentially increase the risk of an incorrect tax
expense.
– The pension obligation risk remains a key judgement but has been enhanced both by the
changes in assumptions applied by a new valuer and by the fact that the valuation to be used
will be that performed at an interim date rolled forward, thus increasing the risk that it does not
represent the best estimate of the position at the year end.
– In addition, the extensive redundancies are likely to give rise to a past service cost / benefit
which will need to be considered with appropriate actuarial input, so a simple roll-forward is
unlikely to be appropriate.

– While the work done by the group auditors will be a useful starting point, it may not have been
based on an appropriate level of materiality so additional work may well be necessary.
– The valuation of the head office building is inherently judgemental. The complexity of
accounting for the head office property also gives rise to additional risk both in terms of the
classification and disclosure of the property and accounting correctly for depreciation and
lease income. As for the pension fund, this will require assessment of a new valuer.
– There appears to be an increased risk of unpaid trade receivables. An allowance calculated on
the same basis as prior year is much higher at 31 August 20X7 than at 31 December 20X6 and
this was before any increase in revenue arising from the new sales channel. This implies that the
ageing has deteriorated and that there may be underlying issues either with the customers’
ability to pay or with revenue recognition arising too early. Although the additional provision
will cover some of this risk, the amounts involved are material and the judgements in this area
both in respect of potential under and over provisioning give rise to an area on which the audit
should focus.
– The measurement, classification and timing of recognition of the reorganisation and bonus
payments gives rise to an additional area of audit focus as these are one off transactions where
the finance team may be unfamiliar with accounting guidance. The CFO has already
demonstrated that he does not understand the need to accrue for estimated bonus payments
relating to the period.
– Going concern basis of preparation – If there is a definite plan to wind up the company and
transfer its trade to the parent in place by year end then it may be inappropriate to continue to
prepare the financial statements on a going concern basis – this should be reviewed at the year
end.
(3) Ethical considerations for MKM
There are pressures associated with the audit of EF this year around materiality, fees and timing.
We need to be mindful of the responsibility of all ICAEW Chartered Accountants to act in the
public interest and the collective interest of the community of those we serve. This community
does include clients and investors such as MegaB but also other users of the financial statements
such as Government, employees, creditors and lenders.
One of the fundamental principles of the ICAEW ethics code is objectivity and a requirement not
to be influenced by others to override professional judgement. This is relevant when considering
our response to the pressure to increase materiality and so cut work. While it may well be
entirely reasonable for MegaB and indeed EF to determine that they need assurance only to a
higher level of materiality, that may not be the case for other users of the financial statements
and we need to ensure that the firm makes its own independent judgement as to the materiality
to be used based on what the collective users might consider to be a material mis-statement.
The code identifies several threats to acting in accordance with the basic principles and the most
relevant of these to the EF audit are as follows:
Self-interest as it is clear the firm will only retain the audit work for this year (and potentially the
opportunity for significant non-audit work in future) if we act in the way that the client wants and
fit in with their unrealistic proposals on timing and fees. Their desire to retain the same level of
fees puts the firm under pressure to cut audit time and costs to retain margin and we need to
make sure that this is not unduly influencing the work proposed or the materiality level adopted.
Intimidation – there is implied intimidation both in the CFO’s comments about fees and the
manager’s view that MegaB may not give the firm non-audit work if it does not meet their
expectations on the audit work. This does give rise to the threat that the firm may be deterred
from acting objectively and we need to be very sure that appropriate safeguards are put in
place.
In addition, we need more information about the proposed non-audit services to MegaB and
whether these affect either our independence in respect of the EF audit or our ability to provide
an independent audit opinion to Lewis-Morson in respect of their audit of MegaB. Different rules
may well apply for MegaB as a listed entity and we need to discuss the proposed work not only
within MKM but also with Lewis-Morson.
We also need to understand the proposed consultancy contract in much more detail both in
terms of its timing and the nature and extent of the work, the likely level of fees and the fee
basis.

It may be that MKM decides it will perform the more extensive audit procedures for the quoted
fee in which case there will need to be more focus to ensure that this ‘low-balling’ does not lead
to any short-cuts on the audit work and that the staffing is appropriate, and all necessary
procedures undertaken.
It also seems that the CFO is being instructed what entries to make and may be tempted to
make these without question and without bringing his own professional judgement to bear. If he
is an ICAEW member, then we would have a duty to report any deliberate manipulation /
fraudulent reporting although there is no real indication that has happened here, and he has
asked for advice.
Further actions
We would need to discuss the above issues with MKM’s ethics partner at an early stage and
arrange for additional partner file review. Advice from ICAEW ethics helpline should be
obtained. Full documentation of any audit based decisions on level of work, contentious
audit/ethical issues, need to be fully documented. Consideration should be given to make
changes to ensure appropriate level and resilience of audit team.
General comments
question required advanced level skills in the understanding, collating and ordering of pieces of
There were some very good answers to this question, producing clear, rational discussions and
conclusions.
Part (1)
This part of the question was not generally well answered. A small minority of candidates misread the
requirement and provided accounting treatment of items in Exhibit 2, in addition to the attachment
to Exhibit 2.
EF brand – Most candidates correctly stated that the brand could not be recognised in EF’s financial
statements but could be recognised on consolidation. They were less skilled at explaining the
reasons why. Few identified the possibility that the brand may have been purchased by EF and
therefore could potentially have been recognised in its financial statements.
Goodwill – As with the brand, candidates could state that goodwill is not recognised in individual
financial statements but will be recognised on consolidation. However, the explanation of why
goodwill could not be recognised in EF’s accounts was often lacking or inaccurate.
Revaluation of PPE – Answers to this part of the question were very mixed and generally lacked
structure. Many candidates correctly recognised that the rented-out portion could be classified as an
investment property, but then lost marks by not explaining the correct accounting treatment for an IP
adopting a fair value model.
A common error was to state that the change in classification should be dealt with under IAS 8 when
the correct treatment under IAS 40 is to apply IAS 16 with a change of use requiring revaluation gains
to be taken to Reserves.
The owner-occupied portion was in most cases correctly identified as being treated as PPE. Only the
best candidates questioned the validity of the income based approach to the valuation obtained by
MegaB.
In respect of the proposed receivables allowance – many candidates applied inappropriate
standards eg, IAS 8, 37 and 36. IAS 37 was a particularly popular choice – an allowance for
irrecoverable debts is not an IAS 37 provision. Few candidates accurately identified that the
movement was a change in estimate, rather than a correction of an error or change in policy, and
therefore should be accounted for through profit or loss.

Part (2)
Part 2 focussed on the impacts of several factors within the scenario upon the proposed audit plan
for the EF audit. This requirement was well answered, with a significant number of candidates scoring
maximum marks. This scenario was set from the perspective of a subsidiary auditor under pressure
from group audit requirements. Pleasingly, a lot of candidates considered the higher-level issues
such as the implication of the need to change proposed subsidiary audit timings to meet group
reporting requirements and subsidiary materiality requirements being separate from group
materiality. Even without these higher-level points students could still (and did) score well due to the
number of different contributing factors presented within the scenario.
A common weakness in unsuccessful candidates was the repetition of points eg, looking at the
change in controls, applying this to revenue and then to pensions, redundancy, bonus, then looking
at incentives to manipulate applying this to revenues and then to pensions, redundancy, bonus.
These answers were laboured and sometimes led to candidates losing the focus of the question. The
better answers were produced by candidates who spent time planning and organising focussed
answers rather than rushing headlong into an unstructured answer.
Part (3)
Answers to this part of the question were disappointing. Almost all candidates identified a self-
interest threat from the consultancy work. A smaller number of candidates identified the intimidation
threat. Fewer candidates than usual put their answer into an audit context, such as reporting to the
ethics partner or suggesting an additional partner review.
The structure of answers was mixed with some candidates failing to break down their answers into
the different areas of ethics. Issues identified were generally not backed up with appropriate actions
to address the ethical challenges.
A significant minority failed to look at ethical issues from the auditor’s perspective, instead focusing
on client-focused ethical problems.
48 Wayte
Scenario
The candidate is working in industry for a manufacturing company called Wayte Ltd. Returning from
sick leave, the candidate is required to redraft information schedules to support an application for a
£10 million loan from the bank. The schedules have been prepared by an unqualified accountant
and require adjustment for: an investment in equity instruments which has increased in value but
because of the impact of exchange rate, has suffered a loss which is taken to OCI; a FVTPL
investment where the increase, a profit, goes to P or L; revenue incorrectly recognised which requires
an understanding of IFRS 15 and the current or deferred taxation implications of the adjustments.
The skills tested in this question require the candidate to identify errors in the financial reporting
treatment.
The question requires candidates to demonstrate understanding by revising extracts and specified
ratios of a schedule of information prepared by the client to support a bank loan application.
Because the adjustments involve movements to the statements of profit or loss and financial position,
the statement of cash flow is only minimally impacted.
The candidate is required to analyse and interpret the financial position and performance of the
company using the revised schedule of information and the statement of cash flows and provide a
reasoned conclusion of whether the bank will extend the loan. In this scenario, there are plenty of
positive points to identify. For example, there is a very positive cash from operations/profit from
operations ratio. However, the candidate should also question why £4 million has left the company in
dividends and bank loan repayment when the company is applying for a £10 million loan.
Explain the financial reporting adjustments Assimilate complex information to recommend

required in respect of the issues identified in appropriate accounting adjustments.
Jenny’s handover notes (Exhibit 3). Include Apply technical knowledge to the information
journal entries. in the scenario to determine the appropriate

accounting for the equity investments and

revenue.
Understand the accounting treatment required
by IFRS 15.
Identify the different treatment in deferred tax
adjustments arising from the classification of the
investment in equity instruments and the
accounting treatment of revenue.
Identify further information required to
recommend appropriate financial reporting
treatment.
Prepare a revised information schedule for the Assimilate and use adjustments identified in
bank (Exhibit 1) including all relevant drafting the schedules requested.
adjustments.
Prepare a report for the board in which you Use financial statement analysis to prepare
analyse and interpret the financial position and relevant analysis.
performance of Wayte using the revised Apply scepticism to the payment of a dividend
information schedule and other available of £4 million when the directors are seeking
information. Provide a reasoned conclusion on further bank finance.
whether the bank is likely to advance the £10
million loan. Assimilate knowledge, drawing upon question
content and own procedures to provide a
reasoned conclusion on the loan.
Marking guide Marks

Revised information schedule 8
30
Total 30
(1) Adjustments to information prepared by Jenny
Foreign exchange
• The investment in PSN, held at fair value through other comprehensive income, has increased its
fair value, and the increase should be recognised through OCI. The asset is measured at 30
September 20X7 at:
2,000 shares × AS$310 per share = AS$620,000
Translated at spot rate on 30 September 20X7
AS$620,000/1.6 = £387,500.
Although the value of the shares has increased, the exchange rate movement results in an overall
loss: £430,000 – £387,500 = £43,000 (rounded up).

The journal entry required is:
£’000 £’000
CREDIT FVTOCI financial asset 43
• The investment in LXP is classified as at fair value through profit or loss (FVTPL) and so any change
in fair value is recognised in profit or loss.
50,000 shares at AS$7 = AS$350,000
Translated at spot rate on 30 September 20X7:
AS$350,000/1.6 = £218,750
The increase in fair value is therefore: £219,000 (rounding up) – £192,000 = £27,000. The journal
entry required is:
£’000 £’000
DEBIT FVTPL financial asset 27
This transaction affects profit before tax, and therefore the opening item in the reconciliation of profit
before tax to cash generated from operations.
Service contract
IFRS 15, Revenue from Contracts with Customers sets out the steps that must be taken in recognising
and measuring revenue, one of which is to identify separate performance obligations. In this case,
the sale of goods is separate from the performance obligation to provide services in future.
It seems clear that there are separate components, and that the components are capable of being
measured by reference to the price of the goods. The service component should therefore be
treated as a contract liability (deferred revenue), to be recognised in the future in the period(s) in
which the service is carried out and therefore the performance obligation is satisfied. The value of the
service element to be deferred is £750,000.
The journal entry required is:
£’000 £’000
DEBIT Revenue 750
CREDIT Contract liability 750
This transaction affects profit before tax, and therefore the opening item in the reconciliation of profit
before tax to cash generated from operations. Because no costs have been incurred in respect of the
service revenue, no adjustment is required to cost of sales.
Deferred tax
Adjustments are required as follows in respect of deferred tax.
• Land and buildings
When the land and buildings are eventually disposed of, tax will arise on the gain calculated as the
difference between sale proceeds and original cost. At 30 September 20X7, therefore, the deferred
tax balance in this respect is: (£19,200,000 – £11,400,000) × 20% = £7,800,000 × 20% = £1,560,000.
The balance brought forward was £1,200,000, and so the deferred tax balance is increased by
(£1,560,000 – £1,200,000) £360,000. The deferred tax expense is recognised as an increase in the
deferred tax liability, and a decrease in the amount recognised through other comprehensive
income and reserves in respect of the revaluation.
• Temporary differences arising in respect of gains/losses on financial assets
Wayte has sustained a fair value loss in respect of the investment in PSN, held at fair value through
other comprehensive income. This is recognised in other comprehensive income in the year ended
30 September 20X7. The tax base of the asset is £430,000, but the carrying amount is £387,000. The
deductible temporary difference is therefore £43,000. At an income tax rate of 20% this creates a

deferred tax asset of (£43,000 × 20%) £8,600, rounded to £9,000. This amount is recognised as a
deferred tax asset and is credited to other comprehensive income. The related deferred tax effect is
also recognised in OCI so has no impact on profit or loss.
The treatment of the increase in fair value of the investment in LXP is different however. This is
recognised in profit or loss in the year ended 30 September 20X7, and a current tax expense is
increased in respect of the gain. This is because, in this jurisdiction, tax treatment follows accounting
treatment in respect of recognition of gains and losses through profit or loss. At an income tax rate of
20% this increases the current tax expense by (£27,000 × 20%) £5,400.
• Temporary differences arising in respect of the contract liability
The service income has been received. But, because it is now being treated as a contract liability it is
not subject to immediate taxation (because tax treatment follows accounting treatment in respect of
income recognition). The current tax expense and current tax liability are therefore reduced by an
amount of £750,000 × 20% = £150,000.
Journal entries required are as follows:
£’000 £’000
DEBIT Revaluation reserve (i) (Head office revaluation) 360
CREDIT Other components of equity 9
DEBIT Current tax expense (ii) (LXP) 5
CREDIT Current tax liability (ii) (LXP) 5
CREDIT Current tax expense (iii) (deferred revenue) 150
DEBIT Current tax liability (iii) 150
CREDIT Deferred tax (i) (360 – 9) ––– 351
515 515
Note: The deferred tax asset and liability have been offset. This is recommended presentation where
the entity has a legally enforceable right to set off current tax assets against current liabilities and
where the income taxes are levied by the same taxation authority. Both conditions are assumed and
are likely to be the case here.
(2) Revised information schedule for the bank (Exhibit 1)
Amendments shown in bold
Performance information for the year ended 30 September 20X7
20X7 20X6
£’000 £’000
Revenue (£35,400 – £750) 34,650 34,500
Gross profit (£10,020 – £750) 9,270 9,660
Extracts from statement of financial position at 30 September 20X7
20X7 20X6
£‘000 £‘000
Total assets (£35,670 + £27 – £43) 35,654 33,560
Total liabilities (£8,490 + £750 + £351 – £145) 9,446 8,730
Equity 26,208 24,830
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 387
Financial assets: fair value through profit or loss 219
28,484
Key ratios
20X7
£’000
Gearing (Net debt/equity) × 100
20X7 (450/26,208) × 100 1.7%
Gross profit margin (9,270/34,650) × 100 26.8%

Return on capital employed (operating profit/net debt + equity) × 100
20X7 (3,660/ [450 + 26,208]) × 100 13.7%
(Operating profit: 4,440 – 30 – 750)
WORKING
Summary of amendments required in journal entries above:
As stated JNL 1 JNL 2 JNL 3 Total

£’000 £’000 £’000 £’000 £’000
Revenue 35,400 (750) 34,650
Gross profit 10,020 (750) 9,270
Operating profit 4,410 (750) 3,660
Profit before tax 4,440 27 (750) 3,717
Total assets 35,670 (43) 35,654
27
Total liabilities 8,490 750 5 9,455
351
(150)
The adjusted figure for equity is (£35,654 – £9,446): £26,208

(3) Report to the board of Wayte
Prepared by: Damian Field, Financial Controller
Analysis of the schedule of information prepared as part of the application for a long-term loan of
£10 million.
The revised statement of cash flows is very little different from the draft – because the accounting
adjustments that are required do not involve cash flows.

Cash generated from operations is at a very healthy level in the 20X7 financial year compared to the
previous year. The key differences are in the non-cash items of depreciation and in the working
capital movements. Depreciation has increased by £410,000. This is partly attributable to the
purchase of new items of plant and machinery. The movements in working capital between the 20X6
and 20X7 year ends all show either decreases in current assets or increases in current liabilities.
While the direction of these movements can signal prudent management of working capital, it can
also be interpreted as a likely effect of cash shortages. A shortage of cash, as indicated by the
existence of an overdraft at the 20X7 year end compared with a positive cash balance a year earlier,
tends to put management under pressure to keep inventories to a minimum, to accelerate receipts
from debtors and to extend credit taken from creditors. These can indicate sound management but
there are risks in taking this type of working capital management too far. Wayte may experience
stock-outs and could lose credibility and goodwill with debtors and creditors.
Gearing is extremely low and interest-bearing debt is limited to the bank overdraft. Therefore, Wayte
is in a very good position to make a credible case to a lender for substantial borrowings. However,
the borrowings proposed are £10 million for investment in non-current assets. The implication is that
the scale of operations of the business will be significantly larger in future. It is important that cash
flow forecasts take full account of the consequent increased requirement for working capital, which
does not appear to be envisaged in the plans.
Turning to performance issues, Wayte is profitable, although the figures do show declining
profitability. After deferring service income, revenue has increased only slightly and gross profit has
reduced. The gross profit margin has deteriorated from 28.0% to 26.7% which is quite a significant
fall. Return on capital employed has also fallen between the two years, once the adjustments are
considered.
The issues that are likely to emerge in discussion with the bank are as follows:
• The level of dividend payment. No dividend was paid in the 20X6 financial year, but a very
significant amount of £3,000,000 was paid in the 20X7 financial year. The bank may well wish to
question why the directors chose to return so much cash to themselves. Had they not done so, or
had the dividend been at a low level, Wayte would have had a substantial balance at bank at the
30 September 20X7.
• A similar question is likely to arise over the repayment of loans to directors of £1,000,000. In total
£4 million has left the company in the year. The bank may wonder if the directors/shareholders
lack confidence in the expansion plans for the business. If they were confident, then it would
surely make sense to leave the £4 million in the business on the basis that it can generate higher
returns than is likely to be the case elsewhere.
The bank’s schedule does not require the presentation of cash flow ratios. Cash interest cover is not
an issue because there is so little interest-bearing debt in the business. However, cash return can be
expressed as a percentage of capital employed, as follows:
20X7
£’000
Cash return (cash generated from operations + dividends received)/ capital
employed) × 100
20X7: ([6,320 + 30])/26,208) × 100 24.2%
Capital employed = £26,208 + £450 = £26,649 – but left as equity above to enable comparative
This accounting ratio clearly shows the company in a good light. Another cash flow ratio, cash from
operations/profit from operations is also impressive:
20X7
£’000
(Cash from operations/profit from operations) × 100
20X7: (6,320/3,660) × 100 172.7%

Conclusion
The value of assets available as security is significantly higher than the borrowings sought. The bank
is likely to be reassured by the recent valuation of land and buildings. While the bank may have
specific questions about certain aspects of the historical information shown in the schedule, Wayte’s
performance on both a profitability and cash-generating level is impressive, and the board could be
cautiously optimistic that finance will be obtainable.
Part (1)
The financial reporting implications of the various adjustments were generally well answered and
most candidates identified the key elements of the treatment of the PSN and LXP instruments and
the adjustment required in respect of the service element of the contract, together with some basic
principles in relation to the tax accounting.
Regarding the revenue recognition issue, most candidates recognised that the revenue for the
service component needed to be separated out and deferred. However, a significant minority of
candidates thought that some revenue needed to be recognised in the current year even though the
question clearly stated that no service visits were due until the following year.
In relation to the tax accounting, most were able to calculate the appropriate tax expense or credit.
Many candidates recognised that the revaluation of land and buildings resulted in a deferred tax
liability that was to be adjusted.
A recurring mistake was to not recognise the movement of £360,000 and not to take this movement
to reserves.
Weaker students often failed to appreciate the current tax implications caused by the FVTPL financial
asset.
A reasonable number of candidates discussed the impact on current tax of the adjustment to
revenue.
Part (2)
Most candidates prepared well-presented draft financial statements and ratios, incorporating the
effects of their proposed adjustments. Many candidates achieved maximum marks for this
requirement. Credit was given for own figures.
Common errors were:
• Lack of workings, particularly for the ratios
• Adjusting cash from operations
• Incorrect calculation of ROCE based on cash from operations.
Part (3)
This was mostly done very well. Weaker candidates could not unpack the cash flow issues to
reconcile the positive operating cash flows with the end of year overdraft.
Better candidates were able to analyse the statement of cash flows, highlighting the core strength of
the business and commenting on the high dividend payment and the repayment of the directors’
loans. Many candidates were able to take a step back and comment on the low gearing and high
asset values as security for the loan although few attempted to calculate additional ratios to support
their arguments.
Weaker candidates simply focused on a decrease in revenue and the presence of an overdraft,
showing poorer analytical skills as they concentrated on two figures rather than understanding the
context of the situation.
Some candidates failed to draw any conclusion on the likelihood of bank finance and thus missed
easy marks.

49 SettleBlue
Scenario
The candidate is in the role of an audit senior who is required to evaluate whether an equity
investment of the client, SB plc should be accounted for as an associate or a subsidiary. The
shareholding acquired does not meet the 50% control threshold, however the call option, the
involvement of SB in the operation of the company and the share options in SB for the two remaining
shareholders provide strong indications that SB has control and the investment should be accounted
for as a step acquisition.
The candidate is also required to review the work of an audit associate who has gone on leave. The
audit associate had identified weaknesses in control procedures and requested data analytics of the
client’s purchases and payables. The candidate should identify that the audit assertions of valuation
and accuracy have not been substantiated. The audit associate’s testing of just 10 GRN is insufficient
and she has not performed any appropriate post year procedures nor obtained third party evidence.
The data analytics indicate that although the number of unmatched GRN’s would indicate an under
recording of purchases and payables, the client has made two adjustments; a large GRNI accrual and
an adjustment for a debit balance on its largest supplier’s account. Comparing the analytics with this
information indicates that purchases and payables are overstated rather than understated.
Explain, for each of the two matters identified in Assimilate complex information to produce
Geri’s email (Exhibit 1), the appropriate financial appropriate accounting adjustments.
reporting treatment in SB’s consolidated Apply knowledge of relevant accounting
financial statements for the year ended 30 standards to the information in the scenario.
September 20X7. Set out appropriate
adjustments. Ignore any potential adjustments Identify the need for further information.
for current and deferred taxation. Clearly set out and explain appropriate
Review the file note prepared by Ann (Exhibit 2) Identify weaknesses in the audit procedures
and the dashboard (Exhibit 3) and: performed.
• identify any weaknesses in the audit Critically review the work of the junior and
procedures completed by the audit team on prioritise key issues.
the two issues identified; Distinguish and explain the additional
• analyse the information provided in the procedures required.
dashboard to identify the audit risks; and Appreciate and apply the concept of
• set out any additional audit procedures that materiality.
we will need to perform. Relate different parts of the question to identify
critical factors.
Marking guide Marks

Audit procedures 18
30
Total 30
Part (1)
Investment in CG
The issue here is whether the purchase of 40% of John’s shares by SB on 1 January 20X7 and the call
option on 1 January 20X8 establishes control by SB over CG and whether the investment is treated
as an associate or a subsidiary in the consolidated financial statements.

Associate?
SB holds 10% + (40% × 60%) 24% = 34% of the shares of CG at 30 September 20X7. This would
indicate that SB has significant influence as this is presumed if an investor holds 20% or more of the
voting power. Further evidence of significant influence is that CG has a representative on the board
of directors and is effectively two of the four board members. There are other indicators too – for
example:
• CG is a key supplier of SB so there are material transactions between the investor and the
investee; and
• Ken and Sharon have roles as directors with SB so there is an interchange of management
personnel between CG and SB.
Significant influence would require SB to account for CG as an associate and to equity account for
the investment under IAS 28.
Is CG a subsidiary?
SB has signed a call option which means that they will own 70% of the shares in CG on 1 January
20X8. IFRS 10 requires an investor to consider potential voting rights in considering whether it has
control and whether it has the practical ability to exercise the voting rights.
Although SB does not have the majority of the voting rights, it seems likely that it may still have
control at 30 September 20X7 as SB has two out of four members of the board.
Recommended financial reporting treatment
It would therefore seem likely that control is established. SB should be accounted as a subsidiary
which means that 100% of the net assets and liabilities will be consolidated within the group financial
statements. The profit or loss account is consolidated from the date of control.
The acquisition represents a step acquisition which crosses the control boundary as a previously held
investment is increased to a controlling holding.
A profit on the deemed disposal of the previously held shareholding should be recognised in other
comprehensive income. This is calculated by comparing the fair value of the previously held equity
with its carrying amount at the date of disposal. Gains previously taken to other comprehensive
income cannot be recycled to profit or loss.
Goodwill is calculated by comparing the net assets at the date control is established (1 January
20X7) with the consideration plus non-controlling interests, and the fair value of the previously held
equity.
Share-based payment
IFRS 2 requires an entity to recognise share-based payments in its financial statements. Therefore, the
fact that no cash is involved is not a reason for not recognising an expense.
This transaction involves a choice of settlement and results in a compound financial instrument.
The fair value of the cash route is:
28,000 × £22 = 616,000
The fair value of the share route is:
32,000 × £20 = 640,000
The fair value of the equity component is therefore:
£24,000 (£640,000 – £616,000)
The share-based payment is recognised as follows:
Year ended 30 September 20X7 Liability Equity Expense

£ £ £
9/24 × 28,000 × £24 252,000 252,000
9/24 × £24,000 9,000 9,000

Disclosure implications of share-based payments:
SB will need to disclose the nature and extent of the share-based payments in the period to help
users of the financial statements to understand how the fair value is measured and the impact on the
earnings per share.
Share-based payments are also disclosed in accordance with IAS 24, Related Party Disclosures.
Share-based payments will also impact on the earnings per share (EPS).
Part (2)
The weaknesses in audit procedures performed by Ann have resulted in the audit assertions of
accuracy and valuation not being appropriately tested.
GRNI accrual
The audit team has identified a control weakness which revealed that the incorrect goods had been
matched to the purchase invoice – no tests of detail have been performed by Ann in respect of this
weakness.
Sample sizes should have been increased in response to the control weakness being identified.
It is not clear whether Ann has agreed the GRNI list to GRN or linked this to work on supplier
statement reconciliations. Therefore, she has not tested accuracy of the GRNI accrual.
Ann has selected just 10 GRNI from the list to make sure they are pre-year end, but she has not linked
this to purchase invoices and the payables ledger to ensure appropriate valuation and cut off. Audit
procedures (tests of detail) are required to match invoices to GRNs pre- and post-year end and vice
versa to ensure completeness and accuracy.
There is no justification for the sample size of 10.
Ann has only agreed to bank payments and confirmed that no invoices have been received – she has
not tested accuracy and authorisation by agreeing to GRN.
No work has been completed on supplier statement reconciliations to obtain third party evidence of
completeness, valuation and accuracy.
Examining key supplier statements may identify that a significant proportion of the accrual can either
be substantiated or confirmed as not required.
Audit procedures have not been focused on older and material items in the list of unmatched GRNs.
£290,000 for debit balance on MAK
The audit procedures on the £290,000 allowance for the debit balance are inadequate and lead to
inaccurate recording of cost of sales.
There has been no cross check to the accuracy of the accrual and to identify whether the adjustment
for the debit balance is double counted with the GRNI accrual – the results of the data analytics
would suggest that this is the case (see below).
No testing has been carried out on the timing of these payments to ensure that they are not paying
against earlier invoices.
Analysis of information in the dashboard to identify audit risks:
Dashboard data: Data Analysis of data
Number of purchase orders 7,246 6,884/7,246 × 100 = 95%

Number of GRNs raised and 6,884 95% of purchase orders raised are matched to GRN.
matched to purchase orders The difference could be a timing difference. However,
as liabilities are not recognised based on a purchase
order but are recognised when control is transferred
to SB, no accounting adjustment is required.
This percentage does however provide some comfort
that goods received are authorised by a purchase
order and reduces the audit risk of misstatement due
to authorisation.

Dashboard data: Data Analysis of data
Average time from GRN to 10 days The audit team reported that controls in the agreeing
receipt of purchase invoice of GRN to purchase invoices are ineffective.
The data analytics graph suggests that the problem is
related mainly to one outlier supplier MAK Ltd.
The average time to match the GRN to an invoice is 10
days and only MAK is exceeding the average time and
by 11 days at 21 days.
Number of GRNs not 311 This number represents the GRNs which have been
invoiced matched to purchase orders evidencing that goods
received are authorised, but the liability has not been
recorded in the financial statements as the suppliers’
invoices have not been received and hence are not
yet recorded on the system.
311/6,884 × 100 = 4.5%
This means that 4.5% of total GRNs matched to
purchase orders are not matched to a suppliers’
invoice and should be accrued as a liability and a cost.
(SB has established an accrual for GRNI based on the
GRNI list at 30.9.20X7 (see below).)
Of the 311 unmatched GRN 142 relate to MAK. Of the
156 unmatched GRNs over 2 months, 122 relate to
MAK.
Number of GRN unmatched 156 156/6,884 × 100 = 2.3%

to invoice over 2 months 2.3% of GRN unmatched are over 2 months old.
Average order £1,900
Test for MAK Ltd Data
Number of purchase orders 771 732/771 × 100 = 95%

Number of purchase orders 732 95% of MAK purchases orders are matched to GRN.
matched with GRN This is equal to the general population. This provides
some assurance that purchases are authorised. MAK is
SB’s large supplier.
Average time from GRN to 21 days The analytics supports the information received
receipt of purchase invoice elsewhere on controls testing that a specific problem
regarding invoicing at MAK is one of the reasons for
the large GRNI accrual.
Number of GRNs not 142 142/732 × 100 = 19%

invoiced at 30 September This represents 19% of total GRNs matched to
20X7 purchase orders compared to 4.5% for the total
population.
Number of GRNs 122 122/732 × 100 = 16.6%

unmatched to invoice over 2 16.6% of MAK GRNI are over 2 months old –
months old
142/307 × 100 = 46%
46% of all GRNI relate to MAK GRNs.

Audit risks
Delay in invoicing – accuracy and completeness
As there is a delay of 10 days between GRN and recording of invoices, there is an audit risk that
delays in invoicing could lead to inaccurate recording of inventory valuations and purchases. This is
increased for MAK where the delay is up to 21 days.
Unmatched GRN over 2 months – overstatement
GRN unmatched over 2 months increase the risk that purchases and payables are overstated and not
accurately recognised. The analytics supports the information received elsewhere on controls testing
that a specific problem regarding invoicing at MAK is one of the reasons for the large GRNI accrual.
Procedures performed by Ann are inadequate and do not confirm the accuracy and completeness of
the GRNI accrual and the adjustment for the debit balance on MAK.
There is a risk that the purchases and payables (accruals) have been overstated by £290,000 because
the accrual for the debit balance and the GRNI accrual both include the costs of goods supplied by
MAK Ltd.
Using the above analysis, the expected GRNI accrual can be calculated approximately as follows:
£
MAK GRNI 142 × £2,040 289,680
Other unmatched GRNI 311 – 142 = 169 × £1,900 321,100
610,780
GRNI accrual 610,000
Control weakness – measurement and accuracy

Control testing identified weakness in controls by staff matching the GRN to the correct purchase
invoice. The risk therefore exists that invoices have been recorded for goods not received or more
likely that the GRNI accrual is overstated.
SB has recorded an adjustment for payments made to MAK without invoices of £290,000 which
would represent 142 MAK orders based on the average order value of £2,040. There is a total of 732
MAK purchase orders matched to GRN.
An expected number of unmatched GRN based on the whole population would be 732 × 10
days/365 days = 20. As the total of unmatched GRN for MAK is 142, it suggests that the adjustment
for unmatched payments has been double counted in the GRNI accrual and the accrual for the debit
balance should be reversed.
• Further controls testing should be undertaken on the matching of GRN to invoice to confirm
whether the control weakness applied to other suppliers.
• MAK GRNs included in the GRNI should be tested 100% to ensure that they are appropriately
accrued. In addition, audit procedures should be focused on older and material items from other
suppliers in the list of GRNI. Any unmatched GRN’s should be removed from the GRNI accrual and
an audit adjustment calculated.
• Obtain the MAK supplier statement and agree invoices received post year end to the GRNI
accrual.
• Other key supplier statements should be agreed to invoices and GRN pre- and post-year end.
• Agree a sample of purchases invoices to purchases orders to ensure accuracy and valuation.
• Review supplier terms for each large supplier and assess whether the time delay is normal for
each suppliers’ invoice terms.
• Ensure appropriate valuation procedures are performed on inventory to record the correct cost of
inventory.
• Perform invoice cut off procedures by agreeing invoices pre- and post-year end to inventory
records and payables accounts to ensure correct recognition of payable and accruals and
inventory.

Part (1)
The explanation of the two financial reporting issues was handled well by most candidates. They
were able to identify the implications of control arising from the call option and the board
representation. There were many good discussions around the principle of control and step
acquisitions. However weaker candidates failed to expand on control and how it was achieved and
concluded that CG was an associate (although marks were awarded for appropriate accounting
treatments).
The choice of settlement for the share-based payment was also answered well – common
weaknesses were to fail to notice the choice of settlement and incorrect or lack of time apportioning.
Overall, this section was attempted well.
Part (2)
• Identify any weaknesses in the audit procedures completed by the audit team on the two issues
identified
Whilst many candidates were able to correctly identify where the procedures performed by Ann
could be improved, many expressed these improvements as additional audit procedures rather than
the specific deficiencies in the procedures performed.
A significant majority of candidates focussed only on completeness issues and failed to detect the
potential overstatement caused by the adjustment for the debit balance on MAK’s account.
Some candidates discussed at length the shortcomings and weaknesses of the system and/or what
the auditor should do about it rather than discussing the weaknesses of Ann’s procedures.
• Analyse the information provided in the dashboard to identify the audit risks
In general, many candidates performed a good level of analysis, identifying the fact that the terms of
business with MAK are significantly different to other customers. Good answers produced analysis
from the dashboard to identify risks
Weaker answers simply involved repeating facts from the question rather than developing them and
linking them to specific audit risks.
• Set out any additional audit procedures that we will need to perform
Most were able to identify additional procedures to be performed on the payables and purchases
balances. Weaker candidates would often resort to a ‘knowledge dump’ approach simply listing
generic risks and procedures surrounding payables.

50 EC
Scenario
For each of the three audit issues: Assimilate and demonstrate understanding of a
Explain and set out the correct financial large amount of complex information.
reporting treatment in the EC group financial Identify inappropriate accounting treatments for
statements and EC Ltd financial statements. the disposal of Luka shares.
Ignore any adjustments for taxation. Explain complex transactions including the
recognition of sale of shares crossing the
control boundary from subsidiary to associate.
Identify inappropriate treatment of a
discontinued operation.
Evaluate the treatment of the legal claim as a
contingent liability note.
Identify that no provision should be made for
future operating losses.
Explain the appropriate treatment for PPE
under IFRS 5.
adjustments.
Set out clearly the key audit risks and the audit Identify relevant key risks.
procedures we should perform. Describe appropriate audit procedures
required to provide verification evidence for
each risk.
Prepare a revised summary consolidated Assimilate adjustments to prepare draft

statement of profit or loss, including your statement of profit or loss.
adjustments, where appropriate, for the three
audit issues.
Explain briefly how your adjustments will impact Distinguish between impacts on current tax and
on the income tax expense. deferred tax timing differences.
Marking guide Marks

Audit risks and procedures 10
Impact on tax 4
40
Total 40
Disposal of shares in Luka

The directors have made a judgement that EC Ltd no longer has control or significant influence over
Luka and have recognised its shareholding in Luka as a simple investment.
The key judgement area here is whether EC retains a significant influence over Luka.

Significant influence is defined as the ‘power to participate’ but not to control.
Significant influence is presumed to exist if an investor holds 20% or more of the voting power of the
investee unless it can be shown that this is clearly not the case.
EC now owns just 15% and there are only two other shareholders – Walter Brown, the CEO clearly
holds the majority of the voting shares. However, there are other facts which may establish significant
influence for EC.
Together with the Japanese minority shareholder, EC could control the board of directors with
majority decisions as two of its board members are also on the Luka board.
There are material transactions between the two companies – the filters for Luka’s product are
specific to Luka’s product and are provided by a 100% owned subsidiary of EC Ltd. Also, EC
continues to provide support services to Luka.
The above would suggest that Luka is an associate of EC and IAS 28 requires the use of the equity
method to accounting for investments in associates. The results of the subsidiary are included until
disposal.
The loss on disposal calculated in profit or loss as part of discontinued operations of £500,000 has
been calculated incorrectly and is the amount which should be recognised in the parent company
financial statements not the group profit or loss - it is incorrect regardless of whether the investment
is treated as an associate or an investment.
Because the shareholding crosses the control boundary, the retained interest is measured at the fair
value at disposal, and the gain is measured by reference to the net assets at the date of disposal.
Net assets at date of disposal, 1 December 20X7
£’000
At 31 May 20X8 9,250
Loss for period 1 December 20X7 – 31 May 20X8 £1.5 million × 6/12 750
Net assets at 1 December 20X7 10,000
This results in a group profit as follows:
£’000 £’000
Proceeds received 7,900
Add: Fair value of 15% retained 1,000 ––––
8,900
Less: amounts recognised immediately before disposal
Net assets of Luka at 1 December 20X7 10,000

Goodwill (fully impaired) –
Less: NCI share was 25% at disposal (2,500) ––––
7,500
Profit on disposal 1,400

Alternative presentation £’000
Proceeds 7,900
Less: 60% × £10,000,000 of net assets have been sold 6,000
1,900
Retained interest at fair value 1,000
Retained interest at carrying amount 15% × 10,000 1,500
500
Total group profit 1,400
Treatment as discontinued?
To be presented as discontinued the sale of EC’s shares in Luka need to be part of a single
coordinated plan to withdraw from a major business line – the level of commercial links between EC
and Luka would indicate that this is not a discontinued operation and its results should be presented
in continuing operations to the date of sale which is 1 December 20X7.
6-months results for Luka are included on a line by line basis in the statement of profit or loss until
the date of sale – 1 December 20X7.
As Luka is to be presented on the SOFP as an associate using equity accounting, the group’s share of
the associate’s loss should be presented also as continuing operations.
£1.5 million × 6/12 × 15% = £112,500
As an associate, Luka would be a related party of EC and disclosure would be required of
transactions and services between the two parties.
Intercompany trading may give rise to adjustments for unrealised profit.
Audit risks
The key audit risk is that the group financial statements will be presented incorrectly, omitting the
results of the subsidiary from continuing operations and calculating the loss on disposal incorrectly
and the presentation of the remaining shareholding as an investment instead of equity accounted as
an associate.
Audit procedures required:
• Obtain and test the key assumptions made by management regarding the level of significant
influence.
• Agree costs to the sales agreement and ensure that they have been recognised correctly and that
the consideration has been fairly stated in accordance with the agreement.
• Agree the accuracy of the accounting entries and confirm the profit on disposal is correctly stated
and reperform the calculations for revenue and expenses to ensure that they have been correctly
time apportioned.
• Agree the calculations of fair value of the remaining interest and confirm that they are calculated
in accordance with IFRS 13. Test the assumptions of the cash flow projections and the
appropriateness of the discount rate used.
• Verify consideration to contract and agree to bank.
Contingent liability
IAS 37 states that a provision should be recognised if an entity has a present obligation as a result of
a past event which will result in a transfer of economic benefit which will be probable and a reliable
estimate can be made of the amount of the obligation.
The issue here is whether the company should be providing for potential costs in the first instance
and then to determine if the uncertainty means that the current treatment as a contingent liability is
correct and whether the disclosure is sufficient.
The contingent liability disclosure sets out the nature of the liability and states that its financial effect
cannot be estimated reliably. Audit procedures set out below should confirm whether the disclosure
is adequate.

Legal advice suggests that the outcome may not be probable at 52% – which means that it is a 48%
probability that fines would be payable – this is a very narrow margin and audit procedures would
need to challenge the assumptions made by the internal legal team (the management’s expert).
Should a provision be required it would be established at the most likely outcome.
With respect to the provision for future operating losses of £433,000, the directors appear to have
incorrectly included a provision for future operating losses as the costs relate to continuing business
and there is no obligating event either legal nor constructive at the reporting date. We should
recommend that this amount be adjusted by debiting provision and crediting profit or loss.
Audit risks
The key audit risk is that liabilities are incorrectly stated, disclosure in respect of the contingent
liability is not appropriate or in proportion to the risk as described by the directors within other
sections of the financial statements – eg, directors’ review of risks.
• Evaluate and test the Group’s policies, procedures and controls over the selection and renewal of
intermediaries and responses to suspected breaches of policy.
• Identify and test payments made to intermediaries during the year and ensure that payments are
only made in compliance with the Group’s policies.
• Enquire of management, the Audit Committee and the Board as to whether the Group is in
compliance with laws and regulations relating to bribery and corruption in the countries in which
EC operates.
• Discuss the areas of potential or suspected breaches of law, including the ongoing investigations,
with the Audit Committee and the Board as well as the Group’s legal advisers and assess related
documentation.
• Communicate with relevant component auditors to ensure that vigilance and scepticism is
maintained to identify possible indications of significant non-compliance with laws and
regulations relating to bribery and corruption whilst carrying out our other audit procedures.
• Evaluate whether the disclosure in the contingent liability note to the financial statements is
adequate for the users to understand the Group’s exposure to the financial effects of potential or
suspected breaches of law or regulation.
• Conclude on whether it is the case that the investigations remain at too early a stage to assess the
consequences and whether a provision should be included in the financial statements. Challenge
management’s estimations of the probability of the outcome of the investigation.
Sale of manufacturing operation
The directors’ treatment of the non-current assets of the manufacturing operation is incorrect.
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations requires non-current assets to
be held for sale if the carrying amount is recovered principally through a sale transaction rather than
through continuing use.
In respect of the factory building and the plant and equipment, the criteria appear to have been
satisfied. The factory has been advertised for sale and an offer has been received for the equipment.
These assets should be classified as held for sale at fair value and should not be depreciated after
the decision to sell the assets on 1 March 20X8. The assets should be measured in current assets at
the lower of the carrying amount and the fair value – the fair value is in the case of IFRS 5 defined as
the fair value less costs to sell – there is no requirement to follow the definition in IAS 36, Impairment
of Assets to determine the recoverable amount.

Depreciation for the last three months should be reversed as follows:
£’000 £’000
DEBIT Accumulated depreciation
Plant and machinery 72
Factory building 34
CREDIT Operating profit 106
Subject to the valuation being appropriate, the factory does not appear to be impaired.
£’000
Cost at 1 June 20X7 4,385
Less: Depreciation £685,000 + for 9 months/12 months × 137 = £103,000 (788)
3,597
Fair value
€5,040,000/1.20 4,200
Therefore, the factory should be held at the carrying amount of £3,597,000.

The plant and equipment however may be impaired if the offer received on 30 June 20X8 is
indicative of its fair value at the year end.
£’000
Less: Depreciation £1,986,000 + 9 months/12 months × £286,000 = £215,000 (2,201)
2,649
Fair value
€2,519,000/1.12 2,249
Impairment loss to P or L 400
The office should not be recognised as held for sale – Instead the office should be accounted for as
an Investment property as per IAS 40.
The property should be revalued at the date the change of use occurred to fair value and a
revaluation gain recognised in accordance with IAS 16.
The depreciation charge for the final three months should be written back to profit or loss as follows:
£’000 £’000
DEBIT Office building accumulated depreciation 40
CREDIT Operating profit 40
A gain on reclassification is calculated as follows:
£’000
Less: Depreciation £800,000 + 9 months/12 months × £160,000 = £120,000 (920)
3,720
Fair value at date of reclassification
€5,570,000/1.20 4,642
Gain recognised in OCI 922

Audit risks
There is an increased risk associated with the assets being purchased in a different currency and
located in different jurisdictions. There is specific risk over the valuations and the valuation methods
used which would lead to the assets not being correctly recognised in the financial statements.
No mention has been made of how the lease has been recognised and the financial reporting
treatment of this may also be incorrect.
• Evaluate the design and implementation of controls around property valuations by considering
the involvement of the EC board of directors and the expertise of the board members.
• Obtain the valuation report prepared by the Spanish surveyor and test its integrity by:
– Comparing the valuation for the factory with the surveyor’s evidence of the recent sale of the
similar property in the area.
– Agreeing the price per square metre to other properties for sale in the area.
– Appoint an auditors’ expert to agree the valuations.
• For the office building valuation, obtain the surveyor’s calculation and test the inputs to the
valuation by:
– confirming the rental price per square metre with properties advertised for let in the area; and
– agreeing the accuracy of the calculation and the reasonableness of the occupancy rates.
• Arrange a meeting with the valuer and assess the independence of the scope of the work they
have performed for EC. Agree the surveyor’s qualifications and ensure appropriate level of
expertise to carry out the valuations.
• Agree the valuation of the plant and machinery to evidence of the offer made by the Spanish
company.
• Obtain a copy of the lease agreement to ensure that the classification of the office is correct as an
investment property.
• Enquire of management how the lease agreement has been accounted for in the financial
statements.
EC Group – draft summary consolidated statement of profit or loss for the year ended 31 May 20X8
Issue 1
Profit on
Issue 1 disposal and Issue 3
Luka’s results associate’s Issue 2 Depn. and
Continuing operations for 6 months profit Provision impairment
£’000 £’000 £’000 £’000 £’000 £’000
Revenue 31,170 7,500 –––– ––––––––– 38,670
Profit before tax 1,896 (890) 1,400 433 146 – 400 2,585
Income tax (380) 140 –––– ––– ––––––––– (240)
Profit from continuing

operations 1,516 (750) 2,345
Post-tax loss of associate ––––– –––– (113) ––– ––––––––– (113)
Profit for the year ––––– –––– –––– ––– ––––––––– 2,232
Profit on disposal of shares

The profit on disposal of the shares is not taxable and therefore will not change the current tax nor
the deferred tax.
Write back of provision for operating losses
Because tax and accounting rules are the same – an adjustment made to the accounting profit will be
reflected in the income tax expense by increasing the current tax expense – therefore the write back
of the provision for future operating loss will result in an increase in the accounting profit and
therefore an increase in the current tax expense.

Depreciation for buildings
The decrease in the depreciation expense for the factory and the office building are disallowable
expenses and will not be compensated for by a deferred tax timing difference. Any cost for
depreciation of a building recognised in the income statement is added back to profit to calculate
current tax and no timing difference is required for deferred tax purposes.
Plant and equipment – write back of depreciation and impairment
The depreciation and impairment in respect of the plant and equipment will give rise to a temporary
timing difference – therefore the reduction in the cost for depreciation will cause the accounting
profit to increase but the impairment loss will cause the profit to fall – however both costs are added
back to calculate current tax. Deferred tax is calculated based on the timing difference arising
between the accounting base and the tax base. The carrying amount of the plant and equipment at
the year end is compared to the tax written down value and a deferred tax adjustment calculated.
Therefore, an adjustment to the deferred tax liability will need to be calculated. Further information
concerning the rate of tax depreciation is required.
Office building revaluation
The revaluation is taken to OCI and reserves. As the accounting base is different from the tax base a
deferred tax adjustment is required – the increase in the deferred tax liability is debited to OCI and
credited to the deferred tax liability included in non-current liabilities.
Associate profit
Each company is assessed to tax on its own profits – therefore this adjustment already includes the
group’s share of the associate’s tax expense and has no impact on the current tax expense.
General comments
Some candidates do not always make it clear which part of the question they are answering. For
example, many candidates combined questions 1 (a) and (b), dealing with both FR and audit aspects
of one issue before moving on to the next. There is nothing wrong with this approach, provided that
the line between financial reporting treatment and audit is clearly demarcated. Weaker candidates
merged the two sections in one long paragraph often without punctuation.
(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.
Candidates generally made a reasonable attempt at this part of the question scoring most of
the easier marks to gain a solid pass.
Disposal of shares
The majority of candidates correctly stated that following the disposal of shares, the
company retained significant influence. This conclusion was supported by appropriate
evidence. Even for those who decided the holding constituted control, or should be
recognised as a financial asset, there were plenty of marks available for assimilation and
structuring of the issue.
Contingent liabilities and provisions
Candidates could state the recognition criteria for provisions but were less skilled at
applying them to the scenario. Better candidates recognised that the probabilities were very
close to cut-off point for recognition and judgement would be required and the
assumptions should be challenged.
The majority of candidates stated that provisions for operating losses could not be made. To
score maximum marks, they needed to go on to explain why they are not allowed under IAS
37 and also give the correcting adjustment.
Full definitions per IAS 37 were given but there was too much acceptance that the losses
and the fine were treated correctly, and not enough challenging of the judgement about
how close 52% and 48% are to be judged probable. Many calculated a weighted average
probable outcome which means they did not understand the concept of most likely
outcome.

Assets held for sale
Nearly all candidates recognised that the issue was ‘assets held for sale’. However, answers
to this part of the question were very mixed and generally lacked structure. Better answers
tackled the three assets/asset groups separately. Several students found the foreign
exchange element of the question challenging.
The majority of candidates correctly recognised that the factory could be treated as held for
sale, giving a clear rationale for this accounting treatment. Candidates sometimes ignored
the adjustment for depreciation although they frequently stated the rule.
There were plenty of candidates who, despite typing out the measurement criteria from IFRS
5, did not understand that when an asset is reclassified as held for sale and the sales value is
greater than the carrying value, that the asset is held at carrying value and not revalued.
The office building was correctly identified as an investment property, but then candidates
lost marks by not explaining the correct accounting treatment at change of use for an IP
adopting a fair value model.
A common error was to state that gains would go to the profit or loss account on change of
use when the correct treatment under IAS 40 is to apply IAS 16 with a change of use
requiring revaluation gains to be taken to OCI.
Some candidates challenged whether the plant and machinery was part of the IFRS 5
treatment and treated it as a non adjusting post balance sheet event.
(b) Set out the key audit risks and the relevant audit procedures that we should perform.
There were some very high marks on this part of the question and some excellent answers,
with good use of information provided in the question. Most answers covered a wide
breadth of issues and several obtained maximum marks on this section. Candidates who
used active verbs such as evaluate – challenge – inspect – observe – calculate – using
appropriate evidence achieved high marks. Weaker candidates who used repeatedly review
– consider – discuss (without saying what or why or how?) and set out procedures which
were not relevant and reliable scored less well.
Some candidates had not familiarised themselves sufficiently with the software and in particular the
ability to use tables – good advice is to learn how to use the software as this will save time –
particularly the ability to set out information in column forms in parts 2 and 3 and to use the
arithmetical functions.
51 Raven plc
Scenario
Explain the appropriate financial reporting Assimilate and demonstrate understanding of a

treatment for each of the items in Simon’s notes large amount of complex information.
(Exhibit 2) and set out the adjusting journal Identify appropriate accounting treatments for
entries required. complex transactions including a cash flow
hedge, a share-based payment, impairment of a
previously revalued asset, a sale and leaseback
and a defined benefit pension scheme.
Apply technical knowledge to identify
inappropriate accounting adjustments.
adjustments in the form of journal entries.
Prepare revised financial statement extracts Assimilate information and use own accounting
adjustments to prepare revised extracts from
the financial statements.

Marking guide Marks
51.1 Financial reporting treatment 23

23
51.2 Revised financial statement extracts 7
7
Total 30
51.1 Cash flow hedge

Correctly reported at 30 April 20X7.
At 30 April 20X7, provided that the cash flow hedge was effective, it was correct to recognise a
financial asset and a matching credit in other comprehensive income. The amount of £705,930
was calculated as follows:
£
Value of contract at 30 April 20X7 (R$50,000,000/6.7) 7,462,687
Value of contract at inception on 1 March 20X7 (R$50,000,000/7.4) 6,756,757
Gain on contract 705,930
The change in the fair value of future expected cash flows on the hedged item is calculated as
follows:
£
Value of hedged item at 30 April 20X7 (R$50,000,000/6.5) 7,692,308
Value of hedged item on 1 March 20X7 (R$50,000,000/7.3) 6,849,315
842,993
As this change in the fair value is greater than the gain on the forward contract, the hedge is
deemed to be fully effective and the whole of the gain on the forward contract is recognised
through OCI.
The IFRS 9 criteria to use hedge accounting have been met, so it was valid to use hedge
accounting.
Remeasurement of financial asset at 31.7.20X7
At 31 July 20X7, the settlement date, the further gain and change in value of future expected
cash flows on the hedged item are recalculated:
£
Value of contract at 31 July 20X7 (R$50,000,000/5.7) 8,771,930
Value of contract at 30 April 20X7(R$50,000,000/6.7) 7,462,687
Gain on contract 1,309,243
£
Value of hedged item at 31 July 20X7 (R$50,000,000/5.7) 8,771,930
Value of hedged item on 30 April 20X7 (R$50,000,000/6.5) 7,692,308
1,079,622
As this change in the fair value of the hedged item is less than the gain on the forward
contract, part of the gain on the forward contract is said to be ineffective and this part of the
gain on the forward is recognised in profit or loss.

The effective part of the hedge is calculated on a cumulative basis by comparing the
cumulative gain on the forward contract at inception of the hedge with the cumulative gain in
fair value of the hedged item from the inception.
The cumulative gain on the forward contract is (£705,930 + £1,309,243) £2,015,173.
The cumulative change in value on the hedged item is (£842,993 + £1,079,622) £1,922,615.
The ineffective portion of the hedge is £2,015,173 – £1,922,615 = £92,558, and this is
recognised in profit or loss. The remainder, the effective portion, is recognised in other
comprehensive income: £1,309,243 – £92,558 = £1,216,685.
Journal entries are as follows:
£ £
DEBIT Financial asset 1,309,243
CREDIT Other comprehensive income 1,216,685
Subsequent treatment of cumulative gain

A cumulative gain of £1,922,615 (ie, £705,930 recognised in year ended 30.4.20X7 +
£1,309,243 the additional gain in the three months to settlement less £92,558 recognised in
profit or loss as the ineffective portion) has been recognised in other comprehensive income
and is held in equity.
This is a cash flow hedge of a new machine, which is a non-financial asset. Therefore, IFRS 9
requires that the amount accumulated in the cash flow hedge reserve is transferred to be
included in the initial cost or carrying amount of the non-financial item. This is not a
reclassification adjustment and does not affect the other comprehensive income of the period.
Recognition of asset and depreciation
At the date of purchase, 31 July 20X7, the machine asset is recognised at its fair value. The
effects of the cash transactions at 31 July 20X7 in respect of the purchase of the machine and
the settlement of the forward contract have been recognised in a suspense account. This
suspense account is now eliminated by the following entries.
£ £
DEBIT PPE (R$50,000,000/5.7) 8,771,930
CREDIT Suspense account 8,771,930
DEBIT Suspense account 2,015,173
CREDIT Financial asset 2,015,173
The net credit to the suspense account is (£8,771,930 – £2,015,173) £6,756,757, and so the
suspense account is eliminated.
IFRS 9 requires that the amount of the cash flow hedge reserve be deducted from the amount
of the capitalised value of the machine (£8,771,930).
This is recorded by the following journal entry:
£ £
DEBIT Cash flow hedge reserve 1,922,615
CREDIT Property, plant and equipment 1,922,615
In the financial year ended 30 April 20X8, nine months’ worth of depreciation is charged:
£(8,771,930 – 1,922,615) ÷ 5 years × 9/12 = £1,027,397

This is recorded by the following journal entry:
£ £
DEBIT Profit or loss 1,027,397
CREDIT Depreciation 1,027,397
Issue of ordinary shares

The issue of shares to Ester Ltd constitutes an equity-settled share-based payment transaction.
Because the shares are being issued to a third party, the transaction is recognised at the fair
value of goods provided, which in this case is £12,000, with a debit of that amount to cost of
sales, and a credit to equity. Therefore, the accounting entry already made is partly correct, but
the credit should be to equity rather than to trade payables. The credit is normally to either a
separate component of equity or to retained earnings. If the credit is to a separate component
of equity, the correcting journal entry is as follows:
£ £
DEBIT Trade payables 12,000
Non-current assets: fixed production line

Fixed production line
This asset was revalued on 30 April 20X5, three years after purchase, when its carrying amount
was (£8,000,000 × 7/10) £5,600,000. The amount of the revaluation was therefore (£6,300,000
– £5,600,000) £700,000. Because Raven does not have a policy of making annual transfers
from revaluation reserve to retained earnings, the revaluation amount of £700,000 relating to
the production line still forms part of Raven’s revaluation reserve at 30 April 20X8.
The carrying amount of the asset at 30 April 20X8, before impairment, was:
£6,300,000 × 4/7 = £3,600,000
The recoverable amount of the asset at that date was the higher of fair value less costs to sell
(£2,600,000) and value in use of £2,800,000. The amount of impairment to be recognised at
30 April 20X8 was therefore (£3,600,000 – £2,800,000) £800,000. This is offset first against the
amount of £700,000 relating to this asset in revaluation reserve, and then the balance is
recognised as an expense in profit or loss. The journal entry is as follows:
£ £
DEBIT Revaluation reserve 700,000
CREDIT PPE 800,000
Leased asset
This transaction must be accounted for in accordance with the sale and leaseback rules of IFRS
16, whereby a right-of-use asset is recognised for the rights retained and a gain on disposal is
recognised for the rights transferred. The present value of the future lease payments using the
5% interest rate implicit in the lease is £540,000 × 7.722 = £4,169,880.
A three-stage process is applied
Stage 1: Measure the right-of-use asset arising from the leaseback as a proportion of the
previous carrying amount of the asset that relates to the right of use retained by the
seller/lessee:
Carrying amount × PV of future lease payments at transfer date / fair value of asset at transfer
date
= £7,000,000 × £4,169,880 ÷ £10,000,000 = £2,918,916
The remaining carrying amount of £4,081,084 (7,000,000 – 2,918,916) represents the
transferred asset.

Stage 2: Recognise the amount of any gain on the sale that relates to the rights retained by the
seller:
Total gain on sale = £10,000,000 – £7,000,000 = £3,000,000
Gain relating to rights retained: £3,000,000 × £4,169,880 ÷ £10,000,000 = £1,250,964.
Stage 3: Recognise the amount of any gain on the sale that relates to the rights transferred to
the buyer:
The gain relating to the rights transferred is the balancing figure. Therefore, gain relating to
rights transferred is £3,000,000 – £1,250,964 = £1,749,036.
At 1 May 20X7, the following entries are required:
£ £
DEBIT Right-of-use asset 2,918,916
DEBIT Bank 10,000,000
CREDIT PPE 7,000,000
CREDIT Gain on disposal 1,749,036
CREDIT Lease liability 4,169,880
The right-of-use asset will be depreciated over the lease term of 10 years: £2,918,916/10 =
£291,892. (This is shorter than the remaining useful life of the building, which is 50 years.)
£ £
DEBIT Depreciation expense 291,892
CREDIT Right-of-use asset 291,892
The lease liability is amortised, going one year further to determine current versus non-current:
£
1 May 20X7 4,169,880
30 April 20X8 3,838,374
3,490,293
Amortisation for the year ended 30 April 20X8 is recognised by:
£ £
DEBIT Finance charge 208,494
DEBIT Lease liability 331,506
CREDIT Bank 540,000
Of the total lease liability at 30 April 20X8, 540,000 – 191,919 = £348,081 (capital repayment)
is current and £3,490,293 is non-current.

Journal entries are required as follows to record the disposal and to clear the suspense
account:
£ £
DEBIT Suspense account 10,000,000
DEBIT Right-of-use asset 2,918,916
CREDIT Gain on disposal 1,749,036
To record the disposal and leaseback on 1 May 20X7
£ £
DEBIT Depreciation expense 291,892
CREDIT Right-of-use asset 291,892
To record depreciation of right-of-use asset in the year ended 30 April 20X8

The lease payment of £540,000 made on 30 April 20X8 should not have been recorded in
profit or loss, so an adjustment is required:
£ £
DEBIT Finance costs 208,494
CREDIT Profit or loss (operating costs) 540,000
To record correction of incorrect charge of lease rental to profit or loss.

Pension scheme
Adjustments are required as shown in the table below:
Assets Obligations Notes

£ £
Fair value/Present value at 1 May 20X7 2,830,000 2,966,000
Interest cost on obligation:
£2,966,000 × 5% 148,300 DR Interest cost P or L
Interest on plan assets:
£2,830,000 × 5% 141,500 CR Interest cost P or L
Current service cost 390,000 DR P or L
Past service cost 120,000 DR P or L
Adjust for misposting
Contributions 575,000 to P or L
Benefits paid (330,000) (330,000)
Remeasurement gain/loss Gain/loss to OCI
(balancing figure) 31,500 163,300 (net loss of £131,800)
Fair value/Present value at 30 April
20X8 3,248,000 3,457,600
Explanation
The posting of the contribution to staff costs does not reflect the correct financial reporting
treatment under IAS 19. The opening obligation should be adjusted to reflect the service cost

which is the increase in the present value of the defined benefit obligation resulting from
employee services during the year; and the finance cost which represents the ‘unwinding’ of
the present value of the obligation.
The net defined benefit obligation needs to be remeasured to calculate the actuarial gains and
losses and actual return on plan assets which are taken to reserves through OCI.
The journal entries required are as follows:
£ £
DEBIT Finance cost 148,300
DEBIT Profit or loss (salaries) 390,000
DEBIT Profit or loss (salaries) 120,000
DEBIT Reserves 131,800
CREDIT Interest cost 141,500
CREDIT Net pension obligation –––––– 648,600
790,100 790,100
Correction of misposting of contributions to profit or loss (salaries)
£ £
DEBIT Net pension obligation 575,000
CREDIT Profit or loss (salaries) 575,000
51.2 Revised financial statement extracts

Statement of comprehensive income for the year ended 30 April 20X8
£’000
Profit before tax (working 1) 3,111
Other comprehensive income (working 2) 385
Statement of financial position at 30 April 20X8
As stated JNL (1) JNL (2) JNL (3) JNL (4) JNL (5) Revised
£’000 £’000 £’000 £’000 £’000 £’000 £’000
Non-current assets
Property, plant and

equipment 53,860 8,772 (800) (7,000) 51,881
(1,923)
(1,028)
Right-of-use asset (2,919

– 292) 2,627 2,627
Suspense account 6,757 (6,757) –
Financial asset 706 1,309 –
––––– (2,015) –––––

61,323 54,508
Current assets 20,859 20,859

As stated JNL (1) JNL (2) JNL (3) JNL (4) JNL (5) Revised
£’000 £’000 £’000 £’000 £’000 £’000 £’000
Equity
Share capital
(£1 ordinary shares) 200 200
Separate component of
equity 12 12
Working 1 total
adjustments 811
Revaluation reserve 6,200 (700) 5,500
Cash flow hedge reserve 706 1,217 –
(1,923)
Other reserves 600 (132) 468
33,626 32,991
Long-term liabilities
Loans 18,650 18,650
Lease liability 3,490 3,490
Pension scheme net 136 649 210
obligation (575)
Suspense account 10,000 (10,000) –––––

28,786 22,350
Current liabilities 19,770 (12) *348 20,106
Total equity and

liabilities 82,182 75,367
*Current lease liability
WORKINGS
(1) Revised profit before tax
JNL reference £’000 £’000

As originally stated 2,300
Gain on financial asset 1 92
Depreciation (1,028 + 292) 1, 4 (1,320)
Correction of rental charge to P/L 4 540
Impairment loss 3 (100)
Gain on disposal of sale and leaseback asset 4 1,749
Interest on lease liability 4 (208)
Finance cost pension scheme 5 (148)
Current service cost pension scheme 5 (390)
Past service cost pension scheme 5 (120)
Interest on pension scheme assets 5 141

JNL reference £’000 £’000
Correction of misposting 5 575
Net total of adjustments 811
Revised profit before tax 3,111
(2) Other comprehensive income
JNL
reference £’000
As originally stated 0
Recognition of financial asset (1,923 – 706) 1 1,217
Impairment (Production line) 3 (700)
Net actuarial loss on pension scheme 5 (132)
Revised other comprehensive income 385
Some candidates had not familiarised themselves sufficiently with the software and in
particular the ability to use tables – good advice is to learn how to use the software as this will
save time particularly the ability to set out information in column forms and use the
arithmetical functionality of the software.
Part (1)
Candidates made a reasonable attempt at this part of the question with most addressing all
five issues and including a good mixture of calculations and narrative explanations. Some
candidates lost marks by not providing journal entries, or by providing journal entries
demonstrating failure to understand double entry bookkeeping. However, it was quite
common for good candidates to score maximum, or close to maximum, marks for this element
of the exam.
Cash flow hedge
This part of the question was the least well answered. Whilst a minority of candidates
understood the basic mechanics of a cash flow hedge only the better candidates were able to
correctly deal with the ineffective part of the hedge and the release of the cumulative gain
either over the useful life of the asset or against the asset cost. There was a lack of basic
accounting skills demonstrated by weaker candidates who were unable to provide journal
adjustments to reverse the suspense account.
Share-based payment
Answers were reasonably robust, with many candidates scoring maximum marks.
Revaluation and impairment
This part of the question was well answered. The most common error was to not identify the
revaluation reserve at 30 April 20X5. Follow through marks were as usual available.
Sale and leaseback
Nearly all candidates correctly identified this as a sale and leaseback.
Defined benefit pension
This part of the question was well done, demonstrating a good knowledge of the accounting
treatment of Defined Benefit schemes.
Part (2)
Being able to reflect the impact of financial reporting treatments on the financial statements of
an entity is a key skill. Therefore, it was very concerning that a significant minority of candidates
appeared to lack basic understanding of double entry. Candidates who missed out this section
or were not capable of producing a reasonable attempt lost very straightforward marks.
There were, however, some very good attempts which received maximum marks available.

52 MRL
Scenario
Identify and explain the key audit risks for our Relate different parts of the question to identify
audit of MRL for the year ending 31 August critical factors.
20X8. Where appropriate, set out and explain Assimilate complex information to produce
any related financial reporting issues, including appropriate accounting adjustments.
relevant calculations;
Apply knowledge of relevant accounting
standards to the information in the scenario.
Identify the need for further information.
Apply professional scepticism to identify
potential for creative accounting to achieve
management bonuses.
Identify potential weakness in controls and the
ability of management to override controls.
For each of the operating expenses (Exhibit 1) Appreciate and apply the concept of
explain whether substantive analytical materiality.
procedures and/or test of details would be the Use technical knowledge and judgement to
more appropriate audit approach. Identify the determine appropriate audit approach of
key substantive audit procedures we should substantive analytical procedures or tests of
perform to test each operating expense; and detail.
Explain the additional procedures required.
Explain any potential ethical issues in respect of Appreciate the implications for Cromer Bell of
Gil Moore’s behaviour and summarise the former audit manager working for client.
actions that Cromer Bell should take to address Identify the need for a review of Gil’s work and
them. changes that may be necessary to the current
audit team.
Evaluate whether the errors are due to
incompetence or the incentive to manipulate
the results.
Question the reason for journal entries put
through by Gil.
Identify actions – consult with ethics partner and
potential need to report ICAEW member for
breach of ethical code.
Marking guide Marks
Key audit risks 13

Analytical procedures or tests 10
Ethical issues 7
30
Total 30

Financial reporting issues and audit risks
The expense relating to the allowance for receivables is lower than in the prior year, although there is
still a net charge for the year to date of £80,000. The level of this allowance is an area of judgement
and the movement booked by Gil in February 20X8 highlights that it is also open to potential
manipulation by management.
Gil has provided an explanation for his decision to reduce the allowance in February but this needs
further follow up. The IFRS 9 model for calculating the impairment of receivables is based on
expected losses, rather than incurred losses. Historic levels of debt written off are one relevant factor
in determining the allowance but it is also important to look at the ageing and at whether
irrecoverable debt is just remaining on the receivables ledger rather than being written off.
In addition, it is clear from the meeting with Gil that there has been a change in MRL’s customer base.
As a result, the historic level of write offs may not be a good basis to determining the current
required level of allowance.
As this is a judgemental area which is open to manipulation where change has occurred both in what
has been booked and the underlying business, an audit risk has been identified.
Sale and leaseback of branch office
The treatment of the sale and leaseback is incorrect. Under IFRS 16, only the gain on the rights
transferred may be recognised. First we calculate the gain on the rights retained:
Total gain × PV of future lease payments at transfer date / fair value of asset at transfer date
Total gain on sale = £300,000 (per question).
Present value of future lease payments = £120,000 × 7.020 = £842,400
Fair value (per question) = £1,000,000
Gain relating to rights retained: £300,000 × £842,400 ÷ £1,000,000 = £252,720
The gain relating to the rights transferred is the balancing figure. Therefore, gain relating to rights
transferred is £300,000 – £252,720 = £47,280.
The credit to profit or loss should be reduced by £252,720 to £47,280.
The transaction took place on the last day of the 10-month period, but for the final 2 months, and in
subsequent years, depreciation will be calculated on the right-of-use asset and the lease liability
amortised. The right-of-use asset is also apportioned and only the rights retained by the seller are
recognised in the statement of financial position:
Carrying amount × PV of future lease payments at transfer date/fair value of asset at transfer date
£700,000 × £842,400 ÷ £1,000,000 = £589,680
Legal and professional fees
The significant legal and professional fees in December 20X7 are not explained by the notes of the
meeting and need to be followed up. They could be indicative of a legal claim or of a significant
planned transaction which could give rise to enhanced audit risk or a financial reporting matter.
Start-up costs
The start-up costs relate to the new company set up with Peerless and appear to relate to an amount
subscribed as initial capital. It therefore appears incorrect that this should have been treated as an
operating cost.
The relevant accounting guidance to consider is that concerning joint arrangements. MP is a
separate entity and will have Articles setting out the contractual arrangements between the parties.
As 50:50 shareholders, neither Peerless nor MRL will have control. MP will have its own assets and
liabilities and the arrangement is therefore a joint venture rather than a joint operation. It should
therefore be accounted for using the equity method in the consolidated accounts for the Milcomba
Group.
The initial capital represents an investment in the JV and should have been shown in the statement of
financial position as an investment and not accounted for as an operating cost. In MRL’s separate
financial statements, the investment will in accordance with IAS 27, be held at cost less any
impairment in value or in accordance with IFRS 9. An impairment seems unlikely as MP is profit
making.

For the Milcomba consolidated accounts, the investment value will increase by MRL’s share of the
profit made by MP (50% of £50,000 = £25,000 (less any tax)). This, together with any associated tax
expense, will be reflected in the group statement of profit or loss.
MRL will also have transactions with MP to pay its share of the ongoing trading costs and we will
need to ensure that these are properly accrued and accounted for – and this represents a clear audit
risk. It should eliminate from its costs any unrealised profits – this could arise where costs in respect of
an ongoing recruitment job are incurred in MP and carried on the SOFP of MRL. Only half of the
profit is eliminated as the other half accrues to the other investor, Peerless.
Provision for legal claims
While the net movement on this provision is not material, there have been movements in the year
and the completeness of the provision is an audit risk.
Revenue recognition and WIP
Recruitment fees are invoiced when the position is filled which is the point at which MRL becomes
entitled to a fee. However, the costs will have been incurred over a period of time before that date.
IFRS 15, Revenue from Contracts with Customers requires revenue to be recognised when a
performance obligation is satisfied. The performance obligation in this case is the service to the
customer, which is filling the position so an initial recognition point at the date on which an offer is
accepted seems reasonable, providing the amount of the revenue can be reliably determined at that
date. Direct costs incurred prior to that point must be expensed as incurred under IFRS 15, and may
not be carried in work in progress.
Refunds are payable if the employees recruited leave their positions within three months. There may
be established expectations for refunds from the financial services industry but MRL’s knowledge of
refund levels for the new sectors it has moved into will be less extensive and it may be difficult to
estimate refund levels.
The inherent uncertainty of refund levels is a key audit risk and financial reporting issue, as is cut-off
and ensuring that costs and revenue are recorded in the right periods.
Risk of management override of controls
There was an incentive at the half year to meet targets so that management bonuses were paid.
Although Gil will not get a bonus himself, he may have been under pressure from the rest of his team
to ensure that their bonuses were earned. Incentives to achieve certain results will lead to increased
audit risk and there is also evidence of pressure from the Group finance department. It is important
that all incentive schemes are understood as part of the audit and that pressures on management are
considered in shaping the audit response to the risk of management override of controls which is a
presumed audit risk.
The fact that the finance director can post journals also increases the risk in this area and we need to
plan a focused audit response which includes all journals and not just those affecting operating
expenses.
Audit approach to operating expenses
Substantive analytical procedures are likely to be a good audit procedure to test populations where
there is a large volume of transactions which is predictable over time. Whether they are a good test
also depends on other factors such as whether a reliable estimate can be developed from reliable
data in order to make a prediction as a benchmark expectation against which to judge actual results.
In addition, we need to consider whether substantive analytical procedures alone will provide
sufficient evidence or whether they are or need to be supported by other audit evidence. In most
cases, the work on the expenses will be supported by work on liabilities or provisions.
It is also necessary to consider whether they are likely to be the most efficient audit test.
Wages and salaries for administrative staff
• These meet the criteria for substantive analytical procedures as there is a large volume of
transactions and the costs are generally predictable based on data such as the prior year costs
(already audited), changes in staff numbers (which can be tested) and the wage rise (which can
generally be agreed to support unless very variable across the population).
• Substantive analytical procedures are therefore a good way to test most of this balance,
supported by detailed tests on the data used to develop that substantive analytical procedure
and a reconciliation of the overall costs to the detailed payroll records.

• Certain elements of the balance such as bonus payments and any termination payments are not
so predictable and should be tested in detail. The work will include review of any formal
agreements to ensure that the costs recorded are complete, in line with authorised amounts and
recognised in the correct period.
Other staff expenses
Other administrative expenses
These are typically not predictable balances. It may be possible to scope them out having gained an
understanding of the balance. However there has been at least one item identified as being of audit
interest – the tablet computers – and this suggests some detailed sample testing may be appropriate.
Depreciation
Substantive analytical procedures would normally be effective to test this balance based on
movements in the non-current assets and the expected useful lives. The amount will increase in
future years, due to the additional depreciation on the right-of-use asset relating to the branch office
sold and leased back.
Utilities
This is made up of several different charges each of which should be reasonably predictable.
Substantive analytical procedures on each element of the balance basing an expectation on the prior
year charge and external data about price rises should be a good way to test that balance assuming
that there has been no significant change in operations.
Receivables allowance
Substantive analytical procedures could be used here for modelling deterioration of credit risk since
the inception of the loan.
The charge here results from movements in the allowance which will be tested as part of our
procedures on receivables. Those procedures will need to include the following:
• Obtain an understanding of the basis for the allowance and whether that has been applied
consistently.
• Agree the ageing of receivables to source documentation and confirm that ageing is
appropriately calculated.
• Agree cash collected after the year end to year-end balance and ensure correct allocation to the
customer ageing.
• Review historical data for write-offs and whether that can be applied to a changing population of
customers.
• Document and understand client’s procedures for identifying any new risks arising for new
customers.
Profit on sale of branch office
The revised profit on sale and leaseback should be tested in detail as part of the testing of non-
current assets at the year-end.
Legal and professional fees
This is not a predictable balance and will tend to be made up of one off costs. Detailed testing of a
sample of costs is therefore likely to be the best way to understand and test the balance agreeing
individual costs to invoices or other external evidence.
Provision for claims and other legal matters
The expense is equal to the net addition to a judgemental provision which will need to be tested in
detail. Procedures will include:
• Understanding the nature of the claims which are being provided for and obtaining legal or other
input to support the amount of the provision
• Considering whether all claims have been provided for by reviewing board minutes, legal letters
etc
• Discussing with management outside the finance department whether there are matters for which
provisions should be made

Start-up costs
These should be reversed and will not be tested as part of operating expenses. Substantive analytical
procedures are not appropriate for this balance.
Potential ethical issues relating to Gil Moore
Gil Moore was an audit manager with Cromer Bell and is almost certainly a Chartered Accountant. He
is therefore required to follow the principles and spirit of the ICAEW Code of Ethics and to act at all
times with integrity, objectivity and professional competence and due care.
Several questions have arisen concerning Gil’s conduct both while at Cromer Bell and in his role at
MRL:
• Review notes raised as part of the cold review appear to have been critical of Gil’s work. While he
will not have taken ultimate responsibility for the audit documentation (that is the role of the
partner), the role of senior manager is a key one on the team and the comments do raise some
potential questions about his diligence and focus on detail. He may have been contemplating or
even discussing his move to MRL while working on the audit and his judgement may have been
influenced by his desire to please a future potential employer.
• Gil took over as MRL finance director on 1 March 20X8, only two to three months after the audit
was completed. It is possible that he was talking to MRL about the role while still operating as the
audit manager. If this were the case then there would be questions about the objectivity he
brought to his audit role. I would expect questions to have arisen on this point when Gil
announced his resignation and it may be that there were conversations with the partner at the
time he started to pursue the opportunity at MRL. More information is needed on this to assess
whether he acted with an appropriate level of integrity and openness. This might also raise
questions about Gil’s work on the audit but some comfort can be taken from the fact that an
external cold review has been conducted and that any issues with the audit will presumably have
surfaced through that. Nevertheless, Cromer Bell should consider the scope of the review and the
need to look again at any areas of the file which were not reviewed.
• The audit planning work has revealed some areas where the returns used by the group for
reporting half year results appear to contain errors – notably in accounting for joint ventures and
failure to accrue the half year bonus. The entries concerned were made before Gil took up his role
as finance director but they are large and distorting and one might have expected Gil to question
them when submitting the half year results. It would be an issue under the Code if Gil were shown
to have furnished information recklessly or without due professional competence or care. Further
enquiry is needed to ascertain when Gil became aware of the entries and the extent to which he
took responsibility for the half year reporting. Given that the entries which are clearly incorrect
understate profit, he would have had no incentive for ignoring them so it seems likely that he was
not aware of them at the time the interim results were submitted.
• Gil’s treatment of the gain on the sale and leaseback was also clearly incorrect which does
suggest either incompetence and a lack of care, or deliberate manipulation of the results.
• The analysis of operating expenses shows clearly that there appear to have been many adjusting
entries in February and that these have resulted from the release of judgemental allowance for
uncollectible receivables and provision for legal claims, the latter entry being reversed the
following month when an increased provision was established. While there may have been valid
reasons for this, it is also possible that the half year results were manipulated to ensure that the
management bonus recorded through the journal entry was earned. The entries made are
material and any deliberate misstatement of the half year results would be an ethical issue. The
findings here should be discussed with the group team.
• Gil is clearly under pressure from the group team and this can incentivise unethical behaviour.
• It is unusual for the finance director to make journal entries. The entry for the bonus is perhaps
understandable as that might be a confidential item. The entry for the purchase of computers
looks very odd and, although immaterial, needs further investigation as a journal entry for a cash
transaction seems odd. Cromer Bell needs to enquire into this further, to ascertain why normal
purchasing and recording processes were not used and to ensure that the computers are being
used in the business, as such items could be for personal use. Other staff expenses have
increased compared to the prior year.
• Gil appears to have quite detailed knowledge of the results of the cold review for which a report
was received after he left the firm. This is an indication that someone within Cromer Bell may have

been indiscrete and shared with a former colleague confidential information. However, that needs
further discussion as it is not necessarily unusual to share some of the results of the review.
Actions
• Judgement is involved in all the matters above and it is likely that the engagement team will want
to consult with the ethics partner and possibly other senior partners in Cromer Bell. Discussion
with the group audit team in Elysia is also required, particularly in relation to errors or potential
errors in the half year results.
• As Gil was not the audit partner on MRL, Cromer Bell can continue as auditor. However, as he was
a member of the MRL engagement team and has joined MRL as a key member of the executive
team and a director within two years of being involved with the audit, Cromer Bell needs to look
at the composition of the audit team and to ensure that it is, for example, appropriately
independent of Gil and not made up of individuals who are close to him or accustomed to
working under his instruction. It may therefore be necessary to change the composition of the
audit team.
• If having undertaken all enquiries, there is evidence that Gil has acted unethically or even
fraudulently, then Cromer Bell will need to report the breaches of the Code to the ICAEW and
consider the need to talk to the other directors of MRL.
Candidates did not always make it clear which part of the question they are answering. This was a
problem with sections (a) and (b). Some answers were a jumble of FR and audit points and failed to
answer the question as set. Candidates answered the question they wanted to see rather than the
one they were asked – for example part (a) asked for risks and financial reporting implications – not
procedures – the exam is designed to be completed within the time therefore candidates make time
pressure for themselves by attempting to give answers to questions not asked by the examiner.
Part (1)
This was generally well done with the majority of candidates correctly identifying key audit risks.
Candidates identified the risks arising from the accounting treatment but often calculations of the
impact, when given, were not accurate.
Weaker candidates focused on foreign exchange risks and group issues to the exclusion of other
more relevant risks and also included audit procedures in this section which was not asked for in the
question.
Part (2)
Answers to this part of the question were generally poor with candidates often failing to answer the
question set. The requirement was to explain whether substantive analytical procedures or tests of
detail would be more appropriate for each line item under operating expenses. Many candidates
simply failed to do this. Others seemed confused about the difference between substantive
analytical procedures and tests of detail. Weak candidates were unable to distinguish between
substantive analytical procedures and tests of detail and were not able to discuss why each could be
used. Some candidates just referred to ‘substantive tests’ rather than distinguishing between the two
types of tests. However, where it was answered well, candidates could score highly and gain
maximum marks.
The question was restricted to operating expenses – some candidates wasted time giving
procedures for revenue and PPE.
This question required candidates to consider the overall approach to the audit of operating
expenses for MRL given the risks already identified and the results of the data analytics. Weak
candidates often just provided a list of procedures rather than an approach.
Candidates who remained focused on the question scored very well on this section and could score
maximum marks answering the question as set, demonstrating that they understood the difference
between a substantive analytical procedure and a test of detail and justifying their choice of
approach.
Part (3)
The ethics requirement was often dealt with well and most candidates were able to identify the issues
and to suggest appropriate actions.

There were some very high marks on this part and some excellent answers. Most candidates put their
answer into an audit context, such as reporting to the ethics partner or reviewing work. Most
candidates made a good attempt at listing the steps Cromer Bell should take to address the issues
identified.
A minority of candidates accused Gil of fraud/false accounting and wanted to notify the MLRO/the
Police – there was little in the scenario to warrant such a harsh assumption to be drawn about Gil’s
integrity and honesty. Gil was until very recently a former colleague.

53 Zmant plc
Scenario
The candidate is an audit manager working for Dealy and Brant (DB), a firm of ICAEW Chartered
Accountants. DB has audited Zmant plc and its subsidiaries for some years.
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
acquired an investment in a company called KJL which operates in Otherland. KJL is audited by a
local firm called Welzun.
DB is not the auditor for KJL and has identified KJL as a significant component. The audit plan
included an assessment of Welzun’s professional qualifications and independence and no issues
were noted.
Following a review of KJL’s financial statements, DB asked for further information regarding certain
transactions and balances which may impact on the group audit opinion. The report received from
Welzun casts doubt on the integrity of the management and the quality of the financial reporting at
KJL. It also raises concerns that DB’s original assessment of Welzun may be incorrect and further
audit procedures will be required to ensure that a misstatement does not arise in the group financial
statements because of the consolidation of KJL with the Zmant group. The matters giving rise to
concern are the recognition of development expenditure in the statement of profit or loss which is
required to be capitalised under IAS 38 and the incorrect presentation of entertainment costs as
research costs. The result of the recording of these transactions in this way enables KJL to take
advantage of a tax relief to claim a significant refund of tax which it has recorded as a current tax
receivable.
The assurance element of the question requires the candidate to identify that Welzun has not applied
the concept of materiality appropriately to these transactions and hence to identify that insufficient
audit procedures have been carried out. Those procedures which have been completed do not
cover all auditing assertions – particularly accuracy and presentation. From a higher perspective, the
candidate should recognise that these issues require a reassessment of the original audit plan and
DB may be required to complete a full audit of KJL using component materiality.
Further technical issues are raised by Zmant’s newly appointed finance director who asks for
assistance with consolidation adjustments for KJL. These include the financial reporting treatment of
a foreign currency loan which represents a net investment in a foreign operation; the revaluation
surplus and deferred tax adjustment in KJL’s financial statements; and intercompany trading
adjustments for inventory.
A newspaper article is supplied which highlights that some of the research and development costs
are at best entertaining costs and hence incorrectly form part of the claim for a tax refund and at
worst potentially bribes. The ethical requirement links therefore the audit and financial reporting
aspects of the question.
For each matter in Exhibit 1: Demonstrate understanding of the business

• set out and explain the appropriate financial context by relating nature of project
reporting treatment and recommend expenditure to the business context.
adjustments to KJL’s financial statements for Identify risks within a scenario by linking
the year ended 30 September 20X7; incorrect financial reporting treatment with the
• identify and explain any weaknesses in the potential fraudulent claim for R&D tax refund.
audit procedures completed by Welzun; and Identify elements of uncertainty within a
• set out any additional audit procedures that scenario by appreciating that more information
should be performed by DB and by Welzun and procedures required to ensure appropriate
to provide assurance for the group audit financial reporting treatment.
opinion. Appreciate that Welzun has not applied
technical knowledge of materiality correctly.

Appreciate that reassessment of Welzun in

original audit plan is required by seeing an
overview of the whole scenario and identify a
range of outcomes.
Make appropriate recommendations for
financial reporting and additional audit
procedures.
Set out and explain the appropriate Identify the client’s requirements by clearly
adjustments for the financial reporting queries setting out which adjustments impact the group
raised by Janet (Exhibit 2) for the year ended 30 or individual financial statements.
September 20X7 for: Identify the relevance of the information
• the individual financial statements of Zmant presented to the financial reporting treatment.
and KJL Set out the adjustments and explanations in a
• the consolidated financial statements of format suitable for presentation to the finance
Zmant director.
Calculate goodwill to be recognised for KJL in Assimilate and apply technical knowledge by
Zmant’s consolidated financial statements for linking information from the introduction and
the year ended 30 September 20X7. Assume the exhibits to calculate goodwill.
Zmant uses the proportion of net assets method
to value the non-controlling interests in KJL.
Explain the ethical issues for DB arising from the Link information from Exhibits 1, 2 and 3 to
newspaper article (Exhibit 3) and any related identify and structure the ethical issues for
matters. Set out and explain how DB should different parties involved.
respond. Advise Janet on any actions she Appreciate that tax evasion is a public interest
should take. matter and has legal implications and risks for
the different parties.
Marking guide Marks

Adjustments 10
Goodwill 4
Ethical issue 8
42
Total 42
(1) Appropriate financial reporting treatment

Research and development (R&D) expenditure O$10,700,000
Project: Sound
Financial reporting implications
The project appears to meet the definition of development expenditure and the costs that meet the
criteria for capitalisation under para 57 should be capitalised under IAS 38 as an intangible asset.
The project involves adapting existing technology for the car industry. Provided that the technology
satisfies the general recognition criteria that there are expected future economic benefits attributable
to the technology and that the costs can be reliably measured, an intangible asset shall be
recognised (IAS 38 para 21).

There is judgement involved in this initial assessment but there is clear external evidence in the
initiation from an external customer for the product and significant orders have been received from
the same customer.
The judgement involved here is not just about whether this expenditure is deemed to be research or
whether it is development expenditure. The project does involve the design and preproduction of a
prototype which is a specific example of development expenditure given in the standard. The
judgement also involves deciding when the criteria are met.
IAS 38 para 65 makes clear that development costs can only be capitalised from the date when the
criteria are first met. Because the customer placed a large order on 1 April this would seem to be the
appropriate date – however the auditors have not carried out audit procedures to confirm this – see
below. Thus, assuming 1 April is the appropriate date, any of the costs incurred between 1 January
and 1 April (other than capital/PPE costs) should not be capitalised.
Points to indicate capitalisation from 1 April 20X7
Recognition criteria per IAS 38 Points to indicate cost should be capitalised
Technical feasibility? Question says – adapting an existing speaker
Intention to complete and sell? Specific request from an existing customer
Ability to use or sell intangible asset? Company using the development cost to make a
Generate probable future markets? product to sell for which they have a firm order
from a customer
Adequate technical – financial resources?
Measure reliably? Nothing in question to say the company can’t

measure reliably – further information is required
IAS 38 states that the development costs comprise all directly attributable costs. These include
materials for the prototype O$1,725,000, the salary costs of the development staff O$1,270,000 and
the fees to secure the legal right to the design O$910,000. If the costs meet the recognition criteria
for development expenditure the standard says the costs must be capitalised.
We should be sceptical about the motivation for expensing which has significant tax benefits for the
company.
Amortisation of these costs should commence once the product is ready for sale. To advise on an
adjustment, more information will be needed on amortisation rates.
The allocated general overhead potentially should be written off unless these are specific to the
development of the technology. It is however questionable whether this expenditure would meet the
criteria of research expenditure.
Further information should be obtained to determine how this cost has been calculated and whether
they are specific to the development asset.
With respect to the computer equipment and the car, both these assets meet the definition of an
asset and should be capitalised. Management comment is unacceptable regarding the hiding of the
cost of the car from the tax authorities to prevent personal tax liability for CEO.
The computer costs of O$1,700,000 should be capitalised as part of PPE and depreciated over two
years. Assuming that this was purchased on 1 January 20X7 depreciation of 9/24 × O$1,700,000 =
O$637,500 should be recognised in the statement of profit or loss – it is possible to include
depreciation within the research and development costs and more information should be obtained.
The car too should be capitalised and the cost less residual value depreciated over its useful
economic life. Further information is required.

Summary of costs to be capitalised:
O$’000 Recommended FR treatment
Materials for prototype model 1,725 Capitalise as development

expenditure
New computer equipment – bought on 1 1,700 Capitalise and depreciate

January 20X7
Salary costs of development staff
Incurred after 1 April 20X7 1,270 Capitalise as development

expenditure
Incurred before 1 April 20X7 790 Expense to profit or loss
Registration fees for design 910 Capitalise as development

expenditure
Car used for speaker testing – bought on 1 555 Capitalise as asset

January 20X7
Allocated general overheads 950 Expense to profit or loss
7,900
As all the costs have been expensed an adjustment is required to capitalise the items identified
above.
Project: Entertain
Financial reporting implications
The recognition of this cost in the profit or loss account is correct because it appears to represent
selling and marketing costs from which the entity will not derive a future economic benefit. The
report will also not satisfy the general recognition criteria of being capable of future economic
benefits and being separable/identifiable. The newspaper article in Exhibit 3 further suggests that
the costs are no more than entertainment costs and are largely for the benefit of KJL’s directors and
there is limited invitation to customers.
These costs do not meet the criteria for research costs and have therefore been presented incorrectly
in the statement of profit or loss.
Including these costs as research costs has resulted in the company benefiting from additional tax
relief and potentially fraudulently obtaining a tax refund.
Income tax receivable balance O$8,025,000
The calculation of this balance assumes that all costs recorded as research costs in the statement of
profit or loss qualify under Otherland tax rules for the tax refund. Clearly if these costs have been
misstated then this balance too is misstated, and further audit procedures are required to
substantiate the accuracy of this balance and whether the amounts are recoverable from the
Otherland tax authorities.
Weakness in audit procedures
Materiality
The materiality level used is the component materiality which has been determined by DB, the group
auditor. For group reporting purposes this is acceptable. However, Welzun’s explanation shows a lack
of understanding of materiality.
ISA (UK) 320 (Revised June 2016), Materiality in Planning and Performing an Audit states that the
auditor’s frame of reference for materiality should be based on the relevant reporting framework (ISA
(UK) 320.3). KJL reports under IFRS and IAS 1 gives the following definition of materiality: Omissions
or misstatements are material if they could individually or collectively influence the decisions that the
users make based on the financial statements.

Welzun should have made their own assessment of materiality based on nature, value and impact
and set a performance materiality to reduce the possibility that an aggregate of uncorrected
misstatements exceeds materiality for the financial statements.
Given the profit for the year recorded in retained earnings (See Exhibit 2) is $15 million a cost of
$10.7 million is material by value and, as it includes the cost of a car used by the CEO, also material
by nature.
Furthermore, grouping the costs together results in a balance which exceeds component materiality
level regardless of whether performance level materiality has been set by Welzun.
R&D
Project Sound
The clear weakness here is that Welzun has not carried out any audit procedures to determine the
risk of material misstatement at the assertion level as per ISA (UK) 315 (Revised July 2020).
Project Entertain
The auditors have not carried out audit procedures to determine the nature of these costs as
research costs. Incorrect classification of the costs could result in tax evasion since the impact is a
larger claim for tax to be refunded. The assertion of classification therefore has not been
substantiated.
It also seems extremely questionable that the report has not been received and yet KJL has accepted
the obligations to pay for this service.
Confirmation to invoice and bank statement confirms the audit assertion of occurrence but does not
confirm completeness. Are there any further costs to be recorded?
As the report has not been received, there is no confirmation that the cut off assertion has been
satisfied.
The auditors have accepted management statements without challenge and corroboration.
Income tax receivable
Accepting the work of Welzun’s own tax department for the income receivable balance is also not
sufficient. This does not challenge management assumptions about the nature of the costs included
in the claim.
The tax department may not have oversight of the nature and classification of these costs.
Additional procedures
Group auditor responsibilities
The group auditor cannot discharge their responsibility to report on the group financial statements
by unquestioning acceptance of the component’s financial statements (ISA (UK) 600 (Revised) para.
11).
The initial assessment of Welzun performed at the audit planning stage should be reviewed to
ensure that DB believes that sufficient audit evidence on which to base a group audit opinion can be
obtained from the work performed on KJL by Welzun. We should question whether DB’s involvement
at the planning stage was appropriate.
If the group auditor does not consider that sufficient appropriate audit evidence has been obtained
then the group auditor or the component auditor should perform one or more of the following:
• a full audit using component materiality
• an audit of one or more account balances, classes of transactions or disclosures
• specified procedures (ISA (UK) 600 (Revised) para. 27)
DB should consider the evidence and determine whether a revision of the audit plan is needed and
whether it has correctly assessed Welzun’s ability to complete audit procedures of sufficient standard
to enable an opinion on the group financial statements to be made. Depending on this assessment,
additional procedures should be identified. These could be completed by the group auditor or by
the component auditor (ISA (UK) 600 (Revised) para. 31).

Project Sound
Specific procedures would be:
• Confirm existence of computer equipment and car by physical inspection and agree the cost to
purchase invoice to confirm occurrence.
• Evaluate depreciation and amortisation policies to ensure appropriate to the asset and consistent
with accounting policies.
• Agree costs recorded for other expenditure to supporting documentation such as invoices,
payroll records to confirm accuracy and cut off.
• Obtain schedule of allocated general overheads and re-perform the calculations, applying
professional scepticism to ensure the reasonableness of underlying assumptions.
Project Entertain
Whilst it is possible that the report has been delayed, completeness of the costs can be ascertained
by agreeing to a contract between KJL and GetGo – this will also enable confirmation of the
appropriate classification of the costs.
Obtain direct confirmation of costs with GetGo to ensure appropriate cut off.
Income tax receivable
Although it is reasonable to consult Welzun’s tax department, the audit team should also make their
own assessment of the claim, agreeing to relevant tax legislation and re-performing the calculations
to ensure accuracy.
Welzun should challenge the assumptions management have made regarding the classification of
the costs as research costs considering their knowledge gained on the audit.
Consider the appointment of an auditor’s expert to review the research and development claim.
There are potentially deferred tax adjustments if the tax and accounting treatment of these
adjustments require further information.
(2) Loan to KJL
The loan to KJL is a monetary item and because it is denominated in the functional currency of the
subsidiary an exchange difference should be recognised in Zmant’s profit or loss account.
Therefore, an adjustment is required in Zmant’s own financial statements to record the exchange gain
as follows:
£’000
O$21 million @ 6.0 (1 January 20X7) 3,500
O$21 million @ 4.8 (30 September 20X7) 4,375
Exchange gain 875
Deferred tax and current tax implications

Because for income tax purposes, tax is not payable on exchange differences, there are no current
tax liability implications. However, because tax liabilities will be higher in the future when the gain is
taxed, a temporary taxable difference will arise.
In the financial statements for Zmant the deferred tax adjustment for the temporary taxable
difference would be taken to the tax expense. This is because IAS 12 requires current tax and
deferred tax adjustments to be recognised in profit or loss except if they arise from a transaction
which is recognised outside of profit or loss.
Temporary taxable difference
£875,000 × 20% = £175,000

Journals
Zmant’s financial statements:
£’000 £’000
DEBIT Loan to KJL 875
DEBIT Income tax - P or L 175
On consolidation, the exchange difference will be removed from the consolidated profit or loss and
it will be recognised as other comprehensive income and recorded in equity in the combined
statement of financial position.
Consolidation adjustments:
£’000 £’000
DEBIT Retained earnings £875,000 – £175,000 700
CREDIT Foreign exchange reserve 700
The loan should be presented as a receivable in Zmant’s financial statements and it will cancel on
consolidation. As the loans will cancel on consolidation, the following consolidation adjustment will
be required:
£’000 £’000
DEBIT Non-current liabilities 4,375
CREDIT Loan to KJL 4,375
Janet’s query was in relation to the receivable balance of £3,500,000 – she also needs to investigate
the treatment of the interest. The loan has an annual interest rate of 6%. She needs to ensure that 9
months of interest have been accrued or charged in KJL and credited in Zmant’s individual financial
statements. If the interest is outstanding at the year end there would be implications for the forex
gain and, depending on the tax treatment, a deferred tax implication.
On consolidation the interest would require translation at the average rate.
There will also be a consolidation adjustment to cancel the finance cost and income.
Note: Answers which made reasonable assumptions regarding the interest were accepted.
Inventory adjustment – PURP adjustment and deferred tax adjustment on consolidation only
The accountant’s calculation is incorrect – for example the accountant has adjusted for profit on
goods bought from KJL not on the goods held in inventory.
An adjustment is required for the profit on goods in Zmant’s inventory. This is because in the
consolidated income statement this profit is not realised and therefore should not be reflected in the
combined results of the two entities. Once the inventories are sold to a third party, this adjustment
will no longer be required.
This is an adjustment to the consolidated financial statements and not the individual company
accounts.
£2,500,000 × 35%/135% = £648,148
The temporary difference results in a deferred tax asset as in the group accounts there is a tax
expense for a non-existent asset which needs to be removed.

Although no adjustment is required to the individual financial statements, a deferred tax asset would
be included in the consolidated financial statements as follows:
£’000
Carrying amount of inventory in the consolidated financial statements
£2,500,000 – £648,148 1,852
Tax base 2,500
Difference 648
Deferred tax asset at 20% 130
Journal required on consolidation:
£’000 £’000
DEBIT Cost of sales 648
CREDIT Inventory 648
This is a consolidation adjustment and will impact the consolidated reserves; NCI and inventory.
Assuming goods are purchased evenly over the year, an adjustment will also be required to remove
intra group trading.
DEBIT Revenue £5,500,000 × 9/12 = £4,125,000

CREDIT COS £5,500,000 × 9/12 = £4,125,000
(3) Goodwill on consolidation of KJL assuming Zmant uses the net assets method to value non-
controlling interests in KJL
To calculate goodwill on acquisition, need to first establish the net assets at 1 January 20X7.
The fair value of the net assets acquired at 1 January 20X7 was:
O$’000
Share capital 25,000
Retained earnings at 1 October 20X6 45,000
3 months profit 1 January 20X7 3,750
Net assets at acquisition 73,750
Goodwill
O$’000 £’000
73,750,000 × 40% 29,500
82,300
Fair value of net assets acquired 73,750
Goodwill 8,550 at HR 6.0 1,425
Exchange gain – balancing figure 356
Carrying amount goodwill at 30 September 20X7 8,550 at CR 4.8 1,781

(4) Ethical implications for DB arising from the newspaper article
DB are not the auditor but are responsible for the group audit report on the consolidated financial
statements which will include the results of KJL. The issues may result in a material misstatement of
the financial statements.
The evidence however is presented in a newspaper article and therefore the source should be
questioned. It is important that the facts are established.
The claims are also made by a former employee and we have no knowledge of the circumstances or
credibility of this individual and the position regarding their departure from the company.
The article appears to confirm that KJL has been engaged in tax evasion by making a fraudulent
claim for a tax refund based on expenditure which was not related to R&D. The treatment of the car
used by the CEO would appear to support the presence of fraud.
There is evidence from the review of the financial statements that there is some credence to this story
and further audit procedures will be requested to be performed.
Actions for DB
DB needs to establish whether there are any obligations to report the potential tax evasion in an
overseas jurisdiction under the relevant money laundering regulations and should seek legal advice.
However, the presence of a long-standing customer does indicate that there is a potential for bribery
which would be reportable under the Bribery Act if any allegations are proven to be true that the
parties are a means of bribing customers for their business.
On completion of audit procedures, DB should discuss the matter with those charged with
governance at KJL and Zmant to establish facts; the DB ethics partner should be contacted and
involved in the resolution. Legal advice and the ICAEW helpline should be contacted. During this
process, DB and its staff should take care not to engage in any activity that could be construed as
‘tipping off’.
The integrity of management is also questionable and therefore DB should consider carefully any
reliance on evidence from KJL’s management which supports the audit opinion in the group financial
statements.
Actions for Janet
As the finance director of Zmant, and an ICAEW member, Janet must not allow herself to be
associated with fraudulent claims for tax refunds. She should discuss the matter with her board
colleagues.
Janet should be advised to consider her position and whether she wants to continue to work for
Zmant – she should contact ICAEW for advice on how she should proceed.
For Project Sound there was good discussion of IAS 38. A surprising proportion of candidates made
no comment about the strong motivation provided by the tax system to overstate expenditure. A few
superimposed actual UK tax law (eg, R&D allowances, rules on entertaining expenditure) on to the
facts of the question. There was not enough scepticism as to why the expenditure was being
expensed rather than capitalised. A significant minority of candidates did not identify the car and the
computer as PPE, rather stated they were just ‘capitalised’.
For Project Entertain most candidates appreciated that the cost should be expensed but did not
clearly state that the classification was wrong so had less to discuss on the audit issues.
For the tax receivable issue, most identified that the calculation was wrong and that the audit
approach was not appropriate.
Audit weaknesses and procedures
Only the better candidates attempted to identify a clear distinction between the audit issues to be
performed by Welzun and those by DB. Most however identified that Welzun’s application of
materiality was incorrect.
Weaknesses in the procedures were identified well. Better candidates produced additional
procedures which linked back to the audit assertions.

Weaker candidates produced generic audit procedures using vague terms such as ‘review’ or ‘obtain’
– without explaining what and why they are reviewing and what they are going to do with the
information that they obtain.
Weaker candidates failed to apply concepts of reliability of audit evidence (no attempts to obtain
third party evidence) and a lack of appreciation that “checking that the transaction has been
accounted for properly” has no actual practical credibility. Candidates should illustrate an
appreciation of why they are performing certain tests and inspecting certain documents.
(2) Financial reporting in respect of Janet’s queries
This section of the question was usually done well. Candidates gained high marks for appreciating,
and clearly illustrating, the differences between the accounting treatments in individual and
consolidated financial statements. The description of the accounting treatment of the loan was good
with many students picking up all the relevant points. The main issue missed was the deferred tax on
the exchange gain. Some candidates lost easy marks through not explaining that the gain went to
profit or loss in the individual accounts, with some even explaining that it went through OCI. Better
candidates identified that the gain would then be recognised through OCI in the group accounts.
Many candidates could identify that the client’s PURP calculation was incorrect but fewer could
discuss why. The client’s calculation included many of the errors we see in candidates’ answers and
although some candidates came up with some more errors in their ‘corrected’ calculations, many
candidates did calculate the correct figures including the deferred tax.
(3) Goodwill
Goodwill was generally calculated correctly. The most common mistake was not pro-rating the profit
correctly to arrive at the pre-acquisition reserves. Most scored full marks on this section. Some
candidates incorrectly adjusted for their findings in the previous section, which was incorrect as the
adjustments had arisen at the reporting date and not the acquisition date.
(4) Ethics
There were plenty of good answers discussing tax evasion and bribery and not enough time was
devoted to the discussion of actions. Some candidates thought, incorrectly, that Janet worked for the
auditors and so did not identify appropriate actions for her. Those who scored well identified the
points about the money laundering and taking legal advice and followed a clear structure.
54 Chelle plc
Scenario
The candidate is an ICAEW Chartered Accountant who has just been appointed as financial
controller of Chelle plc, a listed company which imports delicatessen products. The company has
been struggling and has not paid a dividend in the current financial year.
The candidate is supplied with information extracted from the draft financial statements of the
company for the year ended 30 October 20X7. This information has been prepared by the former
financial controller, who has also supplied a list of outstanding matters.
The candidate is required to explain the appropriate financial reporting treatment for each
outstanding issue: a convertible bond, and an equity investment, adjust the financial statements and
prepare a report analysing the performance and position and cash flow of the company.
Set out and explain any adjustments required to Assimilate and demonstrate understanding of a
the draft financial statements for the year ended large amount of complex information.
31 October 20X7, in respect of the outstanding Identify appropriate accounting treatments for
matters (Exhibit 2). Provide supporting journal complex transactions including convertible
entries. bond and an equity investment.

Prepare a revised statement of profit or loss for Apply technical knowledge to calculate EPS and
the year ended 31 October 20X7 and a revised diluted EPS.
statement of financial position at that date. Assimilate information and use own accounting
Include calculations of earnings per share and adjustments to prepare revised financial
diluted earnings per share. statements.
Prepare a report to the board, analysing the key Use financial statement analysis to prepare
elements of the financial position, performance relevant analysis in an appropriate format.
and cash flow for the year ended 31 October Identify potential funding gap in 20X9.
20X7, in comparison with the two previous
financial years. Use your revised financial Assimilate knowledge, drawing upon question
statements and other information provided. content and own procedures to provide a
reasoned conclusion on performance and
position and cash flow of the entity.
Calculate the amount of Chelle’s legally Assimilate information and apply technical
distributable reserves at 31 October 20X7, knowledge to determine distributable reserves.
providing explanations to support your
calculations.
Marking guide Marks
Adjustments 8
Revised SPL and SOFP 9
Legally distributable reserves calculation 3
30
Total 30
Convertible bond instrument

Although interest of £500,000 has been recognised in the draft financial statements, an adjustment is
required to increase finance costs to reflect the effective interest rate and to increase the amount of
the bond to present value.
Bond present value at 31 October 20X6: £9,603,000
Finance cost on £9,603,000 at 6.5% = £624,195, rounded to £624,000
Bond present value at 31 October 20X7: (£9,603 + £624 – £500 interest paid): £9,727,000
Journal entry required:
£’000 £’000
DEBIT Finance costs (£624 – £500) 124
CREDIT Bond 124
Equity investment
The financial controller has not recognised a gain or loss in respect of the equity instrument. The
value of the holding in Spence plc at 31 October 20X7 is £18.50 × 100,000 = £1.85m. This is an
increase of (£1,850 – £1,503) = £347,000.

The journal entry required to recognise this gain is as follows:
£’000 £’000
DEBIT Financial asset 347
CREDIT OCI/OCE 347
Current tax effects of adjustments

The adjustments made above increase the loss before tax:
£’000
Loss as stated in draft financial statements (938)
Additional finance costs (124)
(1,062)
The tax credit to be recognised is: £1,062 × 19% = £202,000 (rounded). £178,000 has already been
recognised, so an additional amount of (£202 – £178) £24,000 should be recognised.
The journal entry required is as follows:
£’000 £’000
DEBIT Tax asset 24
Revised draft statement of profit or loss and other comprehensive income for the year ended 31
October 20X7
20X7 20X7
Draft Adjust Revised
£’000 £’000 £’000
Revenue 30,600 30,600
Cost of sales (22,803) 22,803
Operating costs (8,235) (8,235)
Finance costs (500) (124) (624)
(Loss)/profit before tax (938) (124) (1,062)
Tax 178 24 202
(Loss)/profit for the year (760) (100) (860)
Other comprehensive income – 347 347

Revised draft statement of financial position at 31 October 20X7
20X7 20X7
Draft Adjust Revised
£’000 £’000 £’000
Non-current assets
Financial asset 1,503 347 1,850
55,178 347 55,525
Current assets
Trade receivables 7,710 7,710
Tax asset 178 24 202
10,658 10,682
Total assets 65,836 371 66,207
Equity
Share capital (£1 shares) 10,000 10,000
Other components of equity 1,416 347 1,763
Retained earnings 37,294 (100) 37,194
48,710 247 48,957
Long-term liabilities (5% bonds) 9,603 124 9,727

Current liabilities
Tax payable –
Bank overdraft (limit £5 million) 1,219 1,219
7,523 7,523
Total equity and liabilities 65,836 371 66,207
Note: The extract from the statement of cash flows does not change.
Earnings per share and diluted earnings per share
Chelle is loss-making therefore a loss per share is reported in respect of the year ended 31 October
20X7.
£’000
Loss before tax (as calculated above) (1,062)
Tax credit 202
Loss after tax (860)

Basic EPS is calculated as:
Profit/(loss) attributable to ordinary equity holders of the parent

Weighted average number of ordinary shares outstanding during the period
Basic loss per share = (860) ÷ 10,000 = (8.6)p per share
As there are bonds which are convertible into ordinary shares at a future date, a diluted
earnings/(loss) per share must be calculated. If the effect of the additional shares would be dilutive,
diluted earnings per share must be disclosed.
Upon maturity of the bond, the bondholders can opt to receive one ordinary share for every £10 of
bond held. The maximum number of shares that could be issued is £10,000,000/10 = 1,000,000. The
total number of shares in the denominator of the calculation is therefore 11 million.
Computation of the diluted earnings involves adding back the after-tax effect of the finance cost
saved. In the year ended 31 October 20X7 interest at the effective rate is £624,000 (calculated
earlier). The after-tax effect is (£624 × 81%) £505,000.
Diluted loss per share =
((860) + 505) ÷ 11,000 = (3.22)p per share
The diluted loss per share is reduced, and therefore antidilutive, and does not require disclosure.
Report
To the Chelle Board
Analysis of key elements of the financial statements
Position
Liquidity and efficiency
The current and quick ratios confirm that the business is not facing any immediate liquidity crisis,
although they have worsened significantly over the three-year period. The £5 million overdraft limit
helps to cushion any shortage of working capital funds. However, there are some worrying signs in
the efficiency ratios. Inventory seems to be well under control, but both receivables and payables
provide cause for concern. Receivables days are at an even higher level by the year end compared
with the previous years. Chelle’s customers include supermarket chains which are notoriously slow in
paying, but even taking this into account, 90 days is a very long element of the working capital cycle.
The trade payables collection period has worsened, too, and suppliers may be inclined to put
pressure on Chelle for payment when the average outstanding period is 101 days.
Long-term liabilities: bonds
The bonds are due for redemption or conversion in slightly under two years’ time. The share price at
the 20X5 year end must have suggested to the board that bondholders would opt for conversion on
31 October 20X9. A holder of a £10 bond at that date would be entitled to convert to a share worth
£17.11p. However, by 31 October 20X7, the conversion option has become much less attractive. At a
share price of only £9.80 a bondholder would quite probably want repayment of the bonds.
If the share price does not recover over the next two years, Chelle may be faced with the need to
raise further finance to repay the bondholders. However, if this does happen, raising further long-
term finance may not be too difficult. The strong cash flow performance would help to encourage
lenders, and Chelle’s gearing level is not particularly high at around 22% (at the end of October
20X7). Borrowing seems the most likely solution to the problem of redemption. In current conditions,
it seems unlikely that shareholders would wish to contribute further funds.
Equity investors
Chelle’s investors have seen their share price reduced at 31 October 20X7 to only 57% of what it was
two years’ previously. In the meantime, they have received a dividend of only 1p per share and 2p in
20X5 (0p in the 20X7 financial year). Chelle’s performance, at least as far as profitability is concerned,
has not been encouraging. It is arguable that the payment of a dividend, which would currently have
to be paid out of overdraft, would make little difference. However, please see the separate document
[section 4 of answer] which addresses the extent to which a distribution could be made.
Performance
The trend in business performance, as evidenced by the statement of profit or loss, has clearly been
disappointing over the last three years. Gross, operating and net profit margins have fallen, and the

increased cost of supplies from other countries has no doubt had a part to play in the disappointing
performance. However, adverse exchange rates are only one element.
One striking factor is the downturn in sales revenue. Revenue fell by almost 11% between 20X5 and
20X6, and by almost 4% between 20X6 and 20X7. This is, according to the MD, the result of
increased competition. However, it would be worth investigating this further to confirm that this is the
reason and/or to identify other factors. For example, if Chelle and the retailers it supplies have
attempted to pass on increased product costs to customers in higher prices there may have been a
consequent volume reduction in sales. There is a fall in GP% which presumably relates to the change
in exchange rates.
Operating costs have risen by 17.7% over the period 20X5 to 20X7. Presumably, most of these costs
are incurred in the UK, and therefore there would be no adverse exchange rate effects. This is an area
that would require detailed further investigation.
At its best level over the three-year period the return on capital employed in 20X5 was only 5.7%,
with return on shareholders’ funds in 20X5 even lower at 4.27%. This performance has worsened in
20X6 and 20X7. The poor return on investment from a shareholder point of view may help to account
for the fall in share price and the evident lack of shareholder confidence in the company
Cash flow
Chelle’s performance from a cash flow point of view is much better than the profitability ratios
suggest. The cash return on capital employed at around 19% has varied very little over the three-year
period. The extracts from the draft statement of cash flows show that the cash generated has been
utilised almost entirely in investing activities. As financial assets have remained stable over the three-
year period, it is evident that the investment activity has been in respect of property, plant and
equipment (PPE). The statement of financial position confirms that PPE has risen each year. However,
the PPE does not appear to have been utilised as intensively in recent periods. The non-current asset
turnover ratio has worsened significantly over the period. It may be that the non-current assets have
not been fully functional over the period, or that the nature of the investment has changed, but
further investigation is needed.
If revenue and profitability continue to decline the company’s share price is likely to continue its
downward trajectory. Any distribution threatens the company’s cash position, so it is unlikely to be
able to make a significant difference to shareholder attitudes by means of dividend. A continuing
weakening of £ sterling would make a bad situation worse as Chelle would become less competitive.
If strong competition in the market continues to be a factor Chelle’s downward slide could be very
difficult to arrest.
If the company’s cash position worsens then its status as a going concern could ultimately be
threatened. However, as noted above Chelle’s gearing level is relatively low and it may not be too
difficult to obtain further borrowings, to repay the bonds in two years’ time and to finance working
capital.
Conclusion
Chelle continues to produce strong positive cash flows, although its profitability has suffered. The fall
in sales is a matter of concern, especially when compared to the significant investments that have
been made over the last three years in property, plant and equipment. Chelle’s long-term
borrowings mature in two years’ time and it currently seems likely that bondholders will opt for
redemption. This would put Chelle into the position of having to fund a £10 million cash outflow.
Directors should start planning for this eventuality now.
Appendix: ratio calculations
Distributable profit at 31 October 20X7
For most companies, distributable profits is the total of accumulated realised profits less
accumulated realised losses. However, for public limited companies such as Chelle, there is a
potential further restriction. A public company may only make a distribution if its net assets are not
less than the aggregate of its called up share capital and undistributable reserves. Undistributable
reserves include share premium account, capital redemption reserve, any surplus of accumulated
unrealised profits over accumulated unrealised losses (known as a revaluation reserve) and any other
reserve which the company is prohibited from distributing by its constitution or any law.
Chelle has realised profits in the form of retained earnings, and also in the form of the accumulated
gains and losses on the equity investment, totalling (£850,000 + £37,194,000 revised) £38,044,000.
This can be confirmed as follows for Chelle as a public company. The company’s net assets (revised)

are £48,957,000. The net assets cannot be reduced below the total of its aggregate of called up
share capital and undistributable reserves of (£10,000,000 + £913,000) £10,913,000. So, the
distributable amount is £38,044,000 (£48,957,000 – £10,913,000).
Distributable profits is the total of accumulated realised profits less accumulated realised losses.
The amount distributable is calculated and explained in the following table:
Item of reserves Distributable Explanation
£’000
Accumulated gains and losses on 850 This is treated as a realised profit and so would be
equity investment distributable.
Other components of equity – This is likely to be the element of equity calculated under the
(remainder) ‘split accounting’ rules for hybrid financial instruments in IAS
32, Financial Instruments: Presentation.
It is not distributable.
Retained earnings 37,194 Provided that this item comprises only realised profits (which
is likely to be the case) then it is fully distributable.
Total 38,044
Chelle’s directors should bear in mind that the table above shows amounts that are legally
distributable. The constraint for Chelle in paying dividends is not the amount that is distributable, but
rather the absence of cash.
Part (1)
Most (although not all) candidates made a good attempt at working out the effect of the change in
valuation of the equity instrument. It was common to find errors in accounting for the bond. The
question stated that the bond issue had taken place in 20X1 but despite this, some candidates
accounted for the bond as a new issue in the financial statements for the year ended 31 October
20X7. Following this through, they then commented in the next part of the question about the high
gearing level and the influx of cash from the 20X7 bond issue. Even where candidates recognised
that the bond had been issued in 20X1, some still tried to account for the bond as if for the first time.
The size of the company makes it clear that it is audited. It is unlikely that the auditors of the listed
company had completely overlooked a bond issue for a period of six years since 20X1. A common
mistake was to calculate the gain as £850,000 because the existing gain in OCE was ignored.
For the tax section – the question specifically asked for deferred tax to be ignored and yet many
candidates discussed the deferred tax issues of having a loss that may not be recovered.
Part (2)
Most candidates made a reasonable attempt at this section. Sometimes the redrafting of the financial
statements was incomplete. The weaker candidates stated that there was therefore no EPS, or
incorrectly used PBT or total comprehensive income as opposed to the loss for the year.
Part (3)
Weak candidates produced very short and superficial answers which simply calculated some ratios
and then worked through them listing why they may have changed. This approach meant that they
did not link important areas of the financial statements together. However, in some cases the analysis
was done well and all the pertinent points were picked up including the fact that the bond was due
for repayment in two years – a great achievement under exam conditions.
Part (4)
A fairly common error was to ignore the legality of the dividend payment, to concentrate only upon
what the business could afford to pay (ie, not very much). However, most gained some marks for
understanding the basic rule for legally distributable reserves and for demonstrating some
knowledge of the further restrictions applied to public companies.

55 Solvit plc
Scenario
The candidate is an audit senior working for Kanes LLP, a firm of ICAEW Chartered Accountants
assigned to the audit of Solvit plc for the year ending 31 March 20X8. Solvit plc is a listed company
supplying software and related services.
Some of Solvit’s customers purchase only software but others enter into multiple element contracts,
purchasing software together with customisation, integration services and maintenance.
Solvit is a new audit client for Kanes LLP.
The candidate is presented with an extract from last year’s audit report (Exhibit 1) which includes the
key audit matter (KAM) identified by Solvit’s previous auditor, Fenn Yo LLP. This matter is in respect of
revenue recognition.
Also provided are notes from the meeting with the Fenn Yo LLP audit partner and manager (Exhibit
2) with additional information concerning these matters and a summary of points from the audit
manager’s initial meeting with the Solvit Finance Director, Sam Browne (Exhibit 3) which includes
financial reporting issues relating to the current financial year ending 31 March 20X8.
The question involves the skills of assimilation and structuring by identifying critical factors in the
scenario which lead to the selection of issues for key audit matters which ultimately require
disclosure in the audit report.
In respect of the key audit matters to be Relate different parts of the question to identify
included in our plan for the Solvit audit for the critical factors.
year ending 31 March 20X8: Interpret information provided in various
• Explain why the key audit matter identified formats and different sources.
by Fenn Yo LLP (Exhibit 1) continues to be Present the analysis in accordance with the
relevant and explain how this matter has instructions of the manager.
changed this year.
Appreciate when expert help is required to
• Identify additional key audit matters for this confirm fair values.
year’s audit and explain the factors which
have led you to select each of them as a key Recognise potential for bias and manipulation
audit matter. in management’s judgement to achieve bonus
targets.
For each of the key audit matters identified in Assimilate complex information to produce
above: appropriate accounting adjustments.
• Identify the relevant financial reporting Apply knowledge of relevant accounting
standard and explain how it should be standards to the information in the scenario.
applied to the key audit matter in Solvit’s Identify the need for further information.
financial statements for the year ending 31
March 20X8. Clearly set out and explain appropriate
• Explain the specific audit objectives of our
audit procedures to provide assurance in
respect of the key audit matter.
Marking guide Marks
Key audit matters 11

Financial reporting explanations and audit objectives 20
Marks Available 31
Maximum 28
Total 28

Matters relating to part (1) of the audit manager’s email
Revenue recognition
Why key audit matter is still relevant
• It is a presumed key risk under auditing standards and there appears to be no good reason to
challenge this in Solvit’s case.
• It was identified as a key audit matter in the prior year and there is no reason to believe that the
level of audit effort this year will be lower.
• Revenue is a very material balance in the financial statements.
• Some of the revenue transactions made by the company are complex, involving multiple
elements.
• There is judgement involved in allocating revenue to elements and this will affect the timing of
revenue recognition where not all elements have been delivered at year end.
• An audit adjustment was identified in this area in the prior year.
• There is a relatively new revenue accountant and it is this individual who made an error in the
prior year. The previous auditors raised doubts about his level of experience.
Changes this year
• There are indications that the company has struggled to apply IFRS 15. There also appears to
have been reliance on the revenue accountant whose expertise has been called into question.
• There is a new education sector product which may be sold on different terms to other products
and for which additional discounts for future maintenance have been given.
• The new product has had issues, including problems in the software which means there is a
heightened risk of returns and credit notes and reputational damage.
Allowance for aged receivables
Factors leading to selection of the matter as a key audit matter
• There was an identified mis-statement in the prior year which was not material – this was an over-
provision.
• There is a new type of customer this year – the educational sector customers and Solvit has far less
history of dealing with such customers and therefore less evidence to support any provision or
lack thereof.
• Days sales outstanding have increased significantly at 30 September 20X7.
Accounting for sale and leaseback
• This is a material one-off transaction.
• The accounting for it is not straightforward and not routine for the accounting team.
Consequently, because the Finance Director is undecided as to how to treat this transaction, it
represents an area of key audit focus.
Management bonus – incentive to manipulate results
• Last year management incentive was not identified as a key audit matter but the facts have
changed as this year Solvit is struggling to meet its plan and is not currently on target to meet the
performance targets necessary to trigger the maximum management bonus. The results for the
first half are lower than plan despite no increase in the aged debtor allowance.
• Management therefore has a much greater incentive to manipulate results and judgemental areas
(such as bad debt allowance) and one-off items such as sale and leaseback provide potential
opportunities for them to do so.

Matters relating to part (2) of the audit manager’s email
Revenue recognition
Relevant financial reporting standard
The relevant financial reporting standard is IFRS 15, Revenue from Contracts with Customers.
Under IFRS 15 there is a five-step model for revenue recognition. This requires the following:
• Identification of the contract with the client (unlikely to be an issue in the case of Solvit as we
would expect contracts with each customer)
• Identification of the separate performance obligations in the contract – in Solvit’s case there
appear to be contracts with three separate elements, all of which are also supplied separately –
software, services, maintenance. Software can be sold separately but other integration services
and maintenance will introduce complexity here as these would not be sold separately but it does
provide the customer with a separate right.
• Determine the price – that will be the total payable for all elements included in the initial
contractual arrangement and may become more complex where, for example, discounts are
offered for future years.
• Allocate the transaction price between the performance obligations – software, services and
maintenance – this will be done in relation to the stand-alone prices for each element – the price
for software sold on its own; the day rates for services sold on their own; the renewal rate for
maintenance per the standard price list.
• Recognise revenue when or as the performance obligations are satisfied, ie, when the service is
provided. For standard software that is likely to be when it is delivered. For customised software
the question is more complex and it is necessary to consider whether there is an obligation to
deliver the customised product and recognise revenue on delivery or separate obligations to
deliver standard product and then services. For maintenance, the obligation is likely to be
satisfied over time and so the revenue will be spread over the maintenance period.
Specific audit objectives of our audit procedures to provide assurance in respect of revenue
recognition
The application of IFRS 15 is the key focus of the revenue recognition risk for the 20X7/X8 audit,
although the risk is also enhanced by the operational factors.
In particular, the audit objectives of our audit procedures on this key audit matter are:
• to ensure that any prior period adjustment has been accurately calculated and that all relevant
contracts have been considered;
• to examine if software and services are separate performance obligations where Solvit is
delivering a customised software product;
• to ensure that the allocation of the total price between the elements of larger, multi-element
contracts is performed accurately using prices which are those applied when the elements are
sold separately;
• to identify if sales have been made to customers who have been given the rights to future
discounts; and
• to identify revenues where there appears to be delay in customer payment and consider whether
this is indicative of any early revenue recognition. In particular there is a risk that revenue may be
recognised for faulty software which the customer has not accepted and which is not fit for
purpose.
Our audit procedures should do the following:
• Identify contracts where not all elements have been delivered at the year end, as such contracts
are the ones where revenue recognition will be affected by allocation between delivered and
undelivered elements. They should agree that revenue has been recognised appropriately for
these contracts.
• Perform analytical procedures on the pattern of revenue recognition over the year for each type of
revenue and investigate unusual items – these might include variations in maintenance revenues
which might be expected to be spread evenly over the year or peaks in the recognition of
software or services revenues which might be indicative of cut-off issues or manipulation of the
results.

• Identify revenue postings not generated by cash, trade receivables or from reversal of a contract
liability as these are inherently unexpected transactions worthy of follow up.
Sale and leaseback
The relevant financial reporting standard is IFRS 16, Leases.
This transaction must be accounted for in accordance with the sale and leaseback rules of IFRS 16,
whereby a right-of-use asset is recognised for the rights retained and a gain on disposal is
recognised for the rights transferred. The present value of the future lease payments using the 3%
interest rate implicit in the lease is £600,000 × 8.530 = £5,118,000.
A three-stage process is applied:
Stage 1: Measure the right-of-use asset arising from the leaseback as a proportion of the previous
carrying amount of the asset that relates to the right of use retained by the seller/lessee:
Carrying amount × (PV of future lease payments at transfer date ÷ Fair value of asset at transfer date)
= 11,000,000 × (£5,118,000 ÷ £15,000,000) = £3,753,200
The remaining carrying amount of £7,246,800 (11,000,000 – 3,753,200) represents the transferred
asset.
Stage 2: Recognise the amount of any gain on the sale that relates to the rights retained by the seller:
Total gain on sale = £15,000,000 – £11,000,000 = £4,000,000
Gain relating to rights retained: £4,000,000 × (£5,118,000 ÷ £15,000,000) = £1,364,800
Stage 3: Recognise the amount of any gain on the sale that relates to the rights transferred to the
buyer:
The gain relating to the rights transferred is the balancing figure. Therefore, the gain relating to rights
transferred is £4,000,000 – £1,364,800 = £2,635,200
At 1 April 20X7, the following entries are required:
DEBIT Right-of-use asset £3,753,200

DEBIT Bank £15,000,000
CREDIT Gain on disposal £2,635,200
CREDIT Lease liability £5,118,000
The right-of-use asset will be depreciated over the lease term of ten years: £3,753,200/10 =
£375,320 (this is shorter than the estimated remaining useful life of the building, which is 20 years).
DEBIT Depreciation expense (profit or loss) £375,320

CREDIT Right-of-use asset £375,320
The lease liability is amortised, going one year further to determine current versus non-current
liability:
£
1 April 20X7 5,118,000
31 March 20X8 4,671,540
4,211,686

Amortisation for the year ended 31 March 20X8 is recognised by:
DEBIT Finance charge £153,540

DEBIT Lease liability £446,460
CREDIT Bank £600,000
Of the total lease liability at 31 March 20X8, 600,000 – 140,146 = £459,854 (capital repayment) is
current and £4,211,686 is non-current.
Specific audit objectives of our audit procedures to provide assurance in respect of the sale and
leaseback
The objective of our audit procedures is to eliminate the risk of a material misstatement arising from
the incorrect financial reporting treatment of this complex transaction. Specifically, this would
include:
• Confirmation that the disposal is a genuine sale in accordance with IFRS 15
• Confirmation of the accounting treatment of the lease arrangements under IFRS 16
– Obtain a copy of the sale and leaseback contract to confirm the parties involved, the date of
the transaction and the sale value of £15 million.
– Reconcile sale proceeds to bank statements and disposal to non-current asset register.
– Inspect contract to determine the substance of the sale and leaseback arrangement (ie to
confirm that control of the property has been passed to the buyer, who now becomes the
lessor).
– Confirm the terms of the lease with the contract (such as the rights conferred, the term, the
rental amounts of £600,000, their frequency and the implicit interest rate).
– Challenge management over the remaining useful life of the property.
– Discuss the accounting treatment of these events with the Finance Director of Solvit to agree on
the accounting entries required.
– Obtain further evidence from an independent source about the likely renewal of the lease after
10 years.
– Evaluate the need to appoint an auditor’s expert to agree fair value.
The relevant financial reporting standard is IFRS 9, Financial Instruments.
The impairment model in IFRS 9 is based on the premise of providing for expected losses. The
financial statements should reflect the general pattern of deterioration or improvement in the credit
quality of financial instruments within the scope of IFRS 9. Expected credit losses are the expected
shortfall in contractual cash flows, defined in IFRS 9 as the weighted average of credit losses with the
respective risks of a default occurring as the weights.
Solvit’s policy in respect of the trade receivables is incorrect. For trade receivables which do not have
an IFRS 15 financing element, IFRS 9 requires a simplified approach to the expected loss model. The
loss allowance is measured at the lifetime expected credit losses from initial recognition. Should a
receivable exceed the credit limit in the future it is likely that the allowance established based on
expected credit losses at initial recognition should be increased. This is a prior period error, which
should be corrected retrospectively and comparative amounts for the prior period should be
restated.
Specific audit objectives of our audit procedures to provide assurance in respect of the trade
receivables allowance
The objectives of our audit procedures are to address the following risks:
• To ensure that adequate allowance is made for receivables from educational sector clients
• To ensure that the allowance is based on the best information available or reassessed fully to
consider the balances and circumstances at 31 March 20X8

• Perform analytical procedures to identify trade receivables with a deterioration in ageing.
• Identify factors which might be distorting the ageing reported such as unmatched credit notes or
cash receipts.
• Identify any amounts on the receivables ledger which relate to the prior financial year so that the
adequacy of the prior year allowance can be fully assessed.
Management bonus – incentive to manipulate results
IAS 19, Employee Benefits sets out the measurement basis for the employee bonus. This is based on
whether Solvit has a legal or constructive obligation to pay the bonus based on achieving targets –
an expense will be recognised in the year ending 31 March 20X8 if the targets are judged to be met.
Specific audit objectives of our audit procedures to provide assurance in respect of the
management bonus
The objectives of our audit procedures are to address the following risks:
• Management understating judgemental provisions or consistently setting provisions at the lowest
acceptable point in a range, meaning that the position overall is aggressive and does not truly
represent the best estimate.
• Management making accounting entries with the sole purpose of boosting results.
• The bonus being inappropriately recognised.
• Review closing and other journal entries to identify items of audit interest. These will include
journals booked by senior management who do not normally make detailed accounting entries;
round sum amounts which might be indicative of estimates of overall adjustments; journals
booked outside of normal working hours to conceal them; journals which are unusual in some
way such as an entry in DEBIT non-current assets and CREDIT revenue which would not normally
be expected.
• Re-perform the calculation of the management bonus at the year end – agree to contracts of
employment to ensure that the calculation is in line with the contract
General points
Generally, this question was done very well and quite a lot of candidates scored high marks. The
most common reason for a candidate not scoring well was producing an unstructured answer –
mixing up the different sub-requirements of the question. So, for example, the answer would start
with a description of the key audit matters relating to revenue, but then would wander off into a
description of the financial accounting elements, with some vague audit procedures. The answer
might then develop into a description of other accounting and auditing issues, without identifying
why an area or transaction type might be regarded as a KAM. The questions are structured to help
candidates think through the issues.
(1) Key audit matters
The majority of candidates answered this requirement very well. Many candidates identified the
numerous factors making revenue a KAM as well as the separate issues arising during the period.
(2) FR issues with KAM and audit objectives and procedures
Weaker candidates missed out either the financial reporting or the audit requirement. Weaker
candidates had problems describing adequate audit procedures and objectives. Problems included
failures to identifying the relevant assertions being tested and why certain documents would be
inspected.
The rules on sale and leaseback have now changed, and the applicable standard is IFRS 16.
Candidates should use the three-stage approach in doing the calculations. A receivable is a financial
instrument and it is therefore subject to IFRS 9 and scoped out of IAS 37.

56 Vacance plc
Scenario
Vacance plc is a listed company which operates a chain of hotels. The candidate works for Atar LLP,
an international firm of ICAEW Chartered Accountants. Atar has audited Vacance for many years.
The candidate has 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
asks for assistance with performing a 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 there are concerns about
the audit team’s work. Property is a material figure in the statement of financial position, and the
candidate is provided with some extracts from the Property section of the audit file prepared by the
audit senior, Jim Green. Vacance has bought property and land in Malaysia near a small airport which
could potentially receive permission for expansion in the next 12 months. This is the first time that
Vacance has bought property outside of the UK and the first time that it has entered into the rental
property market. Jim has also told Simon about problems on the audit including a change of audit
manager, a partner who is away enjoying the client’s hotel facilities with her spouse, and a loquacious
audit junior who has told the Vacance accountant that he does not understand the audit procedures
he has been assigned to do.
Requirement Skills assessed
Explain the appropriate financial reporting Identify when the procedures completed by Jim
treatment for the £24.55 million recognised by are not evidencing audit assertions.
Vacance as investment properties (Exhibit 1) Identify whether the procedures are
and for each of the matters set out in Jim’s file appropriate given the audit risk identified.
note (Exhibit 3). Include journals.
Identify relevant key risks.
Describe appropriate audit procedures
each risk.
Prepare a revised extract from the financial Assimilate adjustments to prepare a revised
statements for property for the year ended 31 Property note extract.
May 20X1 (Exhibit 1). Assume that Vacance
selects the fair value model for investment
properties.
Identify and explain the weaknesses in the audit Identify when the procedures completed by Jim
procedures performed by Jim (Exhibit 1). are not evidencing audit assertions.
Identify and explain the key audit risks for the Identify whether the procedures are
separate plot of land and the shopping appropriate given the audit risk identified.
complex and land. Set out any additional audit Identify relevant key risks.
procedures that should be performed.
Describe appropriate audit procedures
each risk.
Explain the key factors that have affected the Assimilate information to identify:
overall quality of the Vacance audit and set out • lack of technical competency
• lack of supervision
• audit plan not reviewed by partner
• audit junior not understanding work.
Identify the ethical issues for Atar and for me. Identify the threats in the scenario to the ethical
Set out the actions Atar and I should take. principles of integrity and professional
behaviour and professional competency.

Identify potential breaches of PIE rules.

Identify actions – consult with ethics partner and
potential need to report ICAEW member for
breach of ethical code.
Marking guide Marks
Explain financial reporting treatment 17

Revised financial statement extract 3
Weaknesses in audit procedures 10
Key factors affecting quality of audit and ethical issue 10
40
Total 40
Developing your ACA Professional Skills

All four professional skills may be demonstrated by this question, with the embedded
requirements clearly broken down into financial reporting explanations and calculations,
consequent adjustments to and revision of financial statements, audit procedures, audit risk
and ethics.
Assimilating and using information

There is a great deal of information in this question, but the requirements are clear, and
should guide you through it. For example, having been asked to discuss ethical issues should
alert you to potential conflicts of interest, such as in the audit engagement partner’s husband’s
travel and accommodation being paid for by Vacance.
As regards the financial reporting issues, you will need to identify that there is an accounting
policy choice and which IFRS/IAS to apply. While the focus is on investment property, there
are a number of other issues to tackle.
Structuring problems and solutions

Structuring problems and solutions should be relatively straightforward in this question,
because the requirements set out the structure very clearly. This is not always the case, but if it
is it will make it easier for you and for the marker if you use the structure given to you. The
examiner commented that some students did not, and mixed in financial reporting and audit
aspects. If you have a format set out, it is professional to use it.
Applying judgement
Judgement may be applied, as it would in practice, in determining fair value (financial
reporting requirement), and is also needed in identifying the weaknesses in the audit
procedures followed so far, rather than just stating what should have been done. While
explaining the issues that were detrimental to the audit quality is fairly straightforward,
judgement is needed in determining what action should be taken, and there is scope for a
range of answers.

Concluding, recommending and communicating
As always, conclusions that differ from the model answer will be acceptable provided they are
clearly communicated and based on reasoned arguments. Your conclusion could include any
further information that might be needed in order to decide on a course of action (ethical
requirement). Conclusions are not necessarily just summaries or decisions; for example, the
financial reporting requirement gives rise to a conclusion and recommendation of the correct
treatment.
Part (1)
Investment properties
The entity has a choice of using either the cost or valuation model for investment properties. Vacance
has not previously recorded any investment property so the directors need to decide on the
accounting policy.
Whatever model is chosen it must be applied to the whole category. The directors cannot select
certain assets to be revalued at the year end. If the fair value method is adopted all investment
properties must be valued under the fair value model.
In order to be categorised as investment property, the asset must comply with the conditions set out
in IAS 40.
The allocation of costs on the original purchase of MYR135 million needs to be confirmed as this will
impact on the financial reporting below.
• Separate plot of land
The land can be recognised as an investment property because IAS 40.8 includes the definition ‘land
held for a currently undetermined future use’.
If the fair value model is used, the land would be revalued using the rate of exchange at the year end
to £10 million.
MYR 000 £’000

50,000 £1 = 5.5 9,091
60,000 £1 = 6.0 10,000
909
Because the exchange rate of the £ to MYR has moved at the year end, the fair value would be
translated using the year end rate. The increase in the fair value would be recognised in profit or loss.
Non-monetary items carried at fair value are translated at the date when the fair value is determined.
The movement in value attributable to movement in exchange rates should not be recognised
separately because the asset is non-monetary.
Adjustment proposed if fair value model adopted
£’000
DEBIT Investment properties 909
CREDIT P or L 909
Being increase in fair value of the land

• Office building
The provision of support services offered over and above the office space falls within IAS 40
described as ‘auxiliary services’. Considering the nature of these it would be unlikely that they could
be described as ‘insignificant’ in relation to the arrangement as a whole. The building is being used
for the provision of serviced offices and therefore does not meet the definition of an investment
property. It should be classified at cost in PPE.
The revaluation cannot be introduced as Vacance uses the cost model for its hotel properties.
Including this at revalued amount is only possible if the accounting policy for the hotel properties is
also changed.

The asset should be recorded at cost and should not be retranslated at the year end. It should be
taken out of investment property and included in PPE.
MYR 000 £’000

45,000 £1 = 5.5 8,182
£’000
DEBIT Property 8,182
CREDIT Investment properties 8,182
Being transfer of the office to PPE

Depreciation should be provided for three months – we would need to ascertain the residual value of
the property and the cost assigned to the land – The depreciation charge is unlikely to be material if
the residual value is high.
Note: Alternative answers were also accepted assuming reasoned arguments supported by
appropriate recommendation of financial reporting treatment.
• Shopping complex
This asset qualifies as an investment property under IAS 40 – as the services provided by Vacance
could be described as insignificant.
IFRS 13 establishes a three-level hierarchy for the inputs to measure fair value – this would be an
example of a level 3 input. As there are no similar or quoted prices, using the entity’s own
assumptions is a level 3 input method of arriving at the fair value.
Vacance has offered two assumptions.
The more prudent assumption results in no change to fair value as would be expected – the
calculations under the assumption that the airport expansion does not go ahead show a valuation of
MYR 40 million which is the recommended figure.
More optimistic assumptions show an increase in fair value to MYR 45 million. However due to the
uncertainty of the assumptions this is not recommended. For example, the figures provided by the
finance director include the same disposal proceeds under both scenarios – the disposal proceeds
are likely to be lower if the airport expansion is not approved – the data should be considered again
with a more realistic disposal proceeds figure under the ‘no-expansion’ option. This may indicate a
lower figure requiring a reduction of the carrying amount and a charge to profit or loss.
Budgeted: Year 1 Year 2 Year 3

MYR’000 MYR’000 MYR’000
Net cash flows 4,000 4,000 4,500
Occupancy rates 32% 20% 20%
1,280 800 900
1,280 800 50,900

DCF 0.909 0.826 0.751
1,163.5 660.8 38,225.9 40,050.2
Net cash flows 4,000 4,000 4,500

Occupancy rates 55% 80% 85%
2,200 3,200 3,825

Budgeted: Year 1 Year 2 Year 3
MYR’000 MYR’000 MYR’000
2,200 3,200 53,825

DCF 0.909 0.826 0.751
1,999.8 2,643.2 40,422.6 45,065.6
Assuming the lower valuation
MYR’000 £’000
40,000 £1 = 5.5 7,273
40,000 £1 = 6.0 6,666
Loss 607
£’000
CREDIT Investment property 607
Being the recognition of the fall in fair value of the shopping complex.
Debentures and swap
The debenture loan is a financial liability and should be recognised at amortised cost – there are no
transaction costs or premium on issue or redemption therefore the effective interest rate and
nominal rate are the same.
Therefore, the profit or loss charge for the interest will be the same as the interest payable which is
(£20 million × 4.2%) / 4 = £210,000
As this was paid after the year end a journal is required to:
£’000
CREDIT Debenture loan 210
DEBIT Debenture loan 210
CREDIT Accrued interest cost 210
Being recognition of the interest cost for three months

As Vacance has entered into a swap agreement with the purpose of hedging the fair value of its own
debt, this is a fair value hedge.
IFRS 9 conditions are met because there is:
• An economic relationship between the hedged item and the hedging instrument
• The credit risk does not dominate
• The same hedge ratio

The interest receipts and payments on the swap which are settled after the year end are a net
£15,000:
£’000
DEBIT Finance costs (20m × 3.7% × 3/12) 185
DEBIT Interest receivable SOFP 15
CREDIT Finance income (20m × 4% × 3/12) 200
Being recognition of receipts and payments on the swap

The swap is recorded at its fair value but as this was taken out at market rates there is no value to be
recorded on inception.
The change in the fair value of the swap of £302,000 is recognised as a derivative liability in the
SOFP.
£’000
CREDIT Derivative liability (swap) 302
The increase in market interest rates means increased amounts of interest are paid at variable rates
under the swap agreement that would not otherwise have been made under the original fixed rate
debenture without the swap. The swap therefore becomes a liability.
The reduction in the fair value of the debenture is also recognised:
£’000
Debenture 20,000
Change in FV of debenture (300)
19,700
DEBIT Debenture £300,000

CREDIT Other income £300,000
Under fair value hedge accounting the decrease in the fair value of the debenture (the hedged item)
is also recognised in profit or loss (ie, not at the normal amortised cost).
Therefore, the fall in the fair value of the debenture liability is recognised as a gain.
Summary of movements to profit or loss
£’000
Decrease in the fair value of the debenture liability (gain) 300
Increase in the fair value of the swap liability (loss) (302)
Finance income from swap (20m × 4% × 3/12) 200

Finance costs from swap (20m × 3.7% × 3/12) (185)
Finance costs from original debenture (20m × 4.2% × 3/12) (210)
(197)

MYR 25 million loan
The loan is a monetary liability and should be translated at the year end rate. The movement in the
exchange rate creates an exchange gain which is taken to profit or loss (IAS 21).
MYR’000 £’000
25,000 £1 = 5.5 4,545
25,000 £1 = 6.0 4,167
Exchange gain 378
£’000 £’000
DEBIT Loan 378
Forward contract
There is no value recognised on the inception of the forward contract. Change in the fair value at the
year end is measured and recognised.
The fair value of the contract at the year end is:
MYR’000 £’000
Value of contract at the year end 31 May 20X1 25,000 £1 = 6.5 3,846
Value of contract at inception 25,000 £1 = 6.0 4,167
Loss on contract 321
£’000 £’000
CREDIT Derivative liability 321
Part (2)
Land and Investment

Property buildings properties
£’000 £’000
At 1 June 20X0 100,500 −
Additions: Office building 8,182
Shopping complex 6,666 and land 10,000 –––––– 16,666
At 31 May 20X1 108,682 16,666
Land and Investment

Property depreciation buildings properties
£’000 £’000
At 1 June 20X0 2,585 −
Provided in the year 80 –
At 31 May 20X1 2,665 −

Part (3)
Investment properties
The work performed by Jim on investment properties is inadequate. There has been no verification
to the sales documentation or evidence of ownership to legal title.
He has not performed any procedures to ensure that the assets have been appropriately classified.
Information provided by the finance director later indicates that only the shopping complex and the
land qualify as investment property.
There are no procedures to confirm either the cost or fair value - or disclosure requirements under
IAS 40 or IFRS 13.
Land and buildings
Agreeing the balance to last year’s file does not ensure that the property is still owned by Vacance.
Jim should have agreed all material properties to title deeds.
Jim should have enquired about additions and disposals to ensure that there are no unrecorded
transactions, assets purchased on lease for example.
The depreciation charge is dependent on residual values and estimates of useful life. These are both
judgemental matters and therefore the assessment of materiality should not be based on the
resulting depreciation figure but on the inputs into that calculation.
No identification of investment properties in brought forward balance – The use of properties in the
brought forward PPE balance may have changed during the year and require classification.
There is no record of how the exchange rate has been confirmed.
Jim has not performed any procedures on repairs and renewals to ensure no amounts need
capitalising.
Part (4)
Key audit risks
The valuation process of fair value is inherently judgemental and will result in gains and losses being
recognised through the statement of profit or loss. Audit risks arise because of the following factors:
Plot of land
• Uncertainty over future use of land
• Uncertainty over planning permission
Both these factors will result in difficulty in establishing fair value. Although there is a market value for
the land of MYR 60 million, it is unclear how the finance director has arrived at this figure. It is
questionable whether this is a market value given the uncertainty over the outcome of the planning
permission. Therefore, an alternative measurement basis would need to be established using IFRS 13
level 2 – the directors’ best estimate of the market value.
Procedures
Enquire and determine how the directors have arrived at the valuation.
Confirm or challenge the valuation by obtaining more information concerning the source of the
market value from local estate agents/surveyors by agreeing to external sources and either
completed sales of similar plots of land or land advertised for sale in the area. Obtain further
evidence by use of auditor’s expert to confirm the valuation.
Shopping complex
The estimates produced by the finance director use forecasts of occupancy rates and future rentals
under two alternative scenarios. The valuation therefore using level 3 is inherently judgemental as it
involves forecasts of certain inputs such as occupancy rates, rentals and discount rates. The sales
proceeds is a very significant figure and again is based on estimates.
Procedures
Test the integrity of the information provided by management by agreeing key inputs for occupancy
and rental income to source documents, ie rental agreements.
Obtain market data on rentals and occupancy in similar shopping complexes in Malaysia and
compare to the estimates produced by the finance director.

Challenge the assumptions made by the finance director regarding the discount rate and the
probability of the outcome of planning permission.
Research comparable transactions in analogous industries.
Obtain and evaluate the advice of an auditor’s expert particularly in relation to the estimated sales
proceeds.
Part (5)
The audit plan has not been signed off and there appears to be an inadequately qualified
engagement manager involved in the audit – the audit senior lacks the appropriate level of
knowledge.
Audit juniors are inadequately briefed and are unaware of the significance of the procedures they
are being asked to complete.
The scenario says that the audit manager is unable to explain what the juniors should be doing.
The audit partner has not helped by being absent and slow to respond to queries.
There is a tight deadline for completion of the audit which could threaten the audit quality.
Recommendations
There is an urgent need for the appointment of a suitably qualified audit manager to the team and
the junior staff need to be interviewed and reminded of the importance of their role on the team.
Training needs for the team should be assessed and training courses implemented as soon as
possible. Any staff not suitably qualified should be removed from the team.
Harriet should be contacted as soon as possible and a meeting arranged to discuss the progress of
the audit – the firm should consider removing Harriet as engagement partner from the audit.
Part (6)
Harriet the audit partner is away touring hotels and all expenses are being paid for by Vacance. This
is a clear example of both self-interest and familiarity threats as well as an apparent failure to uphold
the ethical principles of integrity and professional behaviour which may be in breach of PIE rules on
entertaining and would also potentially come within the Bribery Act if the entertaining influences
Harriet’s decisions.
Independence and familiarity threats arise from the audit team establishing close relationships with
members of the client’s finance department (after work drinks).
There is a management threat because the finance director has little idea of financial reporting and is
relying on the auditor to assist in accounting policy choice.
Actions
Atar has already commenced a second partner review so Atar has gone some way to mitigate the
risks arising from the scenario.
You should report to the ethics partner – the firm should consider removing Harriet from the role of
engagement partner in light of her forthcoming retirement.
There needs to be action taken to provide further training for the loquacious audit junior and a
progress meeting with his line manager in accordance with the firm’s disciplinary procedures.
Candidates who presented this in random order with audit sections scattered through FR made life
very difficult for markers and risked losing marks as there was no coherent train of thought.
Separate plot of land
A significant number of candidates demonstrated a poor understanding of the classification of land
as ‘held for a currently undetermined future use’ and instead classified it as PPE. Candidates
incorrectly concluded that the separate plot of land should not be treated as investment property as
its use was uncertain, rather than that this was precisely the rationale for why it should be treated as
IP until its use became more certain. Credit was given for reasonable discussion of alternative
classification but many candidates then incorrectly adopted a revaluation policy for PPE.

Office building and land
Many candidates incorrectly classified this as an investment property, ignoring the significance of the
services provided. Some credit was given for a well-reasoned conclusion and consistent financial
reporting treatment. Those candidates who did conclude that the office should be classified in PPE
often then incorrectly went on to revalue it and/or retranslate it at the closing rate. They however
correctly identified the need to depreciate PPE.
Shopping complex
Whilst a significant number of students correctly identified this as an investment property, the
financial reporting treatment was less robust. Most candidates were able to deal with the
computational aspects of this section reasonably well, including some attempt at a DCF calculation in
relation to the shopping complex. Marks were awarded for journals that were consistent with the
candidate’s conclusions in relation to the FR treatment.
PV calculations were frequently inaccurate and only a minority of candidates prepared PV
calculations for the two options (with and without airport expansion).
Retranslation of the fair value at the year end was generally well done and the loss was correctly
taken to the profit or loss account.
Issue of 4.2% debentures and swap
Answers to this part of the question were very mixed.
The majority of candidates correctly accounted for the debentures and accrued interest but were less
skilled at hedge accounting. Most candidates correctly identified that a hedging relationship existed
between the debenture and the swap, although a significant number identified this as a cash flow
hedge rather than a fair value hedge. Many correctly calculated some or all of the interest and fair
value movements, with marks being lost for failing to pro-rate the interest for only three months and
identifying fair value gains as losses and vice versa. The question stated that the financial liability had
fallen in value – however, many candidates identified this as a loss instead of a gain.
Loan and forward contract
As with the debentures, answers to this part of the question were mixed. The gains/losses on the loan
and derivative liability were generally well done. Journals for this transaction were often inaccurate
and the derivative was often incorrectly treated as an asset. A majority of candidates incorrectly
linked the loan and forward contract, concluding that a cash flow hedge existed, despite there being
little information in the question to support the intention to hedge.
Candidates who produced weak answers:
• Failed to consider the elements of the investment properties separately.
• Did not provide the required journals.
• Ignored the FX issue completely and some translated only the movement in MYR and not the
entire balance.
• Failed to make a decision on whether an element was IP or not and then “hedged their bets” and
presented two alternative answers.
• Did not offer any explanation for their classification conclusions in relation to both the office
building and the shopping complex.
Some candidates wasted considerable time criticising the Vacance directors for the valid accounting
policy choice in respect of investment properties of fair value.
(2) Revised financial statement extract for property
Most candidates were able to attain at least 3 of the 4 marks available for this element of the
question using their own figures and conclusions from part a). Marks were lost where the tables were
incomplete or where the table did not follow from the candidates’ earlier conclusions.
(3) Weaknesses in audit procedures and key audit risks
Whilst most candidates were able to provide a reasonable discussion of the procedures that should
have been performed by Jim, few were able to correctly articulate these as weaknesses in the
procedures that had been performed, as was required in the question.
Most candidates were able to correctly identify that the key audit risks here related to classification of
the land as Investment property or PPE and valuation of both the land and the shopping complex.
The better candidates were able to correctly link these to the uncertainty over the use of the land as a

result of the pending planning permission for the airport expansion and fact that the director’s
valuation of the shopping complex is inherently judgemental.
Candidates provided a good selection of audit procedures covering both the land and the shopping
complex. No marks were awarded where audit procedures were listed for other parts of PPE and
marks were lost where the audit procedures were more general in nature or did not link the
procedure to a risk. Further, little credit was given for over-reliance on management representations
as audit evidence where more credible third-party evidence would be available.
However, a reasonable selection of audit procedures and the headroom available meant that most
candidates were able to obtain close to full marks for this section.
(4) Audit quality and ethical issues
Most candidates were able to identify the factors that were impacting audit quality including the
absence of the partner, lack of sign off of the audit plan and inexperienced new manager.
Most also correctly identified the potential self-interest and independence threats as well as potential
bribery implications from Harriet’s apparent hotel stays at the company’s expense and the social
relationship between the two teams. Some also provided a good selection of recommendations to
deal with these implications.
The best responses identified the need for further information before any conclusions were drawn or
actions decided, particularly in relation to Harriet’s position.
57 JKL plc
Scenario
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.
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 only revise its offer 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. The candidate is
JKL’s newly-appointed accountant, and reporting to JKL’s finance director, Kylie Schmidt. The
candidate is required to assimilate information and provide the journal adjustments to account for
the curtailment gain for the pension liability, the deferred tax adjustment on the fall in the pension
liability, and the disposal of a controlling interest in a subsidiary company.
Explain the impact on MiTek’s financial Assimilate and demonstrate understanding of a

statements for the year ending 30 September large amount of complex information.
20X7 arising from the information provided by Identify appropriate accounting treatments for
MiTek’s pension scheme actuary (Exhibit 2). complex transactions including the curtailment
of a defined benefit pension scheme and the
deferred tax implications of the fall in pension
liability.
Prepare a revised forecast statement of Assimilate information and use own accounting
comprehensive income for MiTek for the year adjustments to prepare revised extracts from
ending 30 September 20X7. the financial statements.

Explain the effect on JKL’s forecast consolidated Explain complex transactions including the
financial statements for the year ending 30 recognition of sale of shares crossing the
September 20X7 of JKL’s sale of 15 million control boundary from subsidiary to investment.
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).
Prepare a revised forecast consolidated Explain complex transactions including the

statement of comprehensive income for JKL for recognition of sale of shares crossing the
the year ending 30 September 20X7. Include control boundary from subsidiary to investment.
the adjustments required from (1) and (3)
above.
Marking guide Marks
Impact on financial statements 9

Revised forecast SPLOCI 5
Effect on forecast consolidated financial statements 11
Revised consolidated SPLOCI 5
30
Total 30

The requirements of this question each test at least two professional skills, as will be
demonstrated. The most important is structuring problems and solutions: although the
requirements give the overall structure for your answer, within each requirement, particularly
the first, it is important to think about the structure of your answer before launching in.

As always, there is a lot of complex information to assimilate, and it will all be relevant. For
example, when told about the sale of the 15 million MiTek shares, you should be asking
yourself whether or not this results in a crossing of the control boundary. You should readily
identify that there is a curtailment of the pension scheme and that this has deferred tax
implications.
Later in your answer (second and fourth requirements) you will be required to use the
information that you have generated in order to produce revised financial statements.

It is important that you produce a logical structure and layout for your answer to the first
requirement. The model answer has a table followed by explanatory notes, but you may find it
easiest to do the notes/explanations first, then put the numbers in a table.
One way to structure your answer to the third question requirement might be to draw out a
group structure with a timeline. The model answer achieves this by means of narrative.

Applying judgement
Judgement may be applied in determining the amount of current and deferred tax to be
recognised in profit or loss or other comprehensive income (first requirement) and any
reasonable basis for allocation would be permitted. Judgement is also used in the selection of
the order of workings and narrative in the first and third requirement.

A conclusion may take the form of a table of required adjustments, as in the pension issue, or
the revision of financial statements. Communication is particularly important in explaining
complex issues such as the interaction of deferred tax and pensions or the crossing of an
accounting boundary. Even if you make a mistake in the calculations, the marker will be
impressed if you can demonstrate that you know what the correct treatment should be.
Part (1)
The additional information received enables adjustments to be made to MiTek’s financial statements
as follows:
Assets Obligations Notes

£m £m
Fair value/Present value at 1 October 20X6 36.0 (47.0)
Interest cost on obligation:
£47 million × 6% (2.82) 1
Interest on plan assets:
£36 million × 6% 2.16 1
Current service cost (0.2) 2

Curtailment gain 3.5
Contributions 0.8 3
Benefits paid (1.2) 1.2 4
37.76 (45.32)
Actual return on plan assets less interest 1.74 5
Remeasurement gain (balancing figure) 3.22 5
Fair value/Present value at 30 September 20X7 39.5 (42.1)
Explanation of impact on financial statements

The impact of the adjustments including the curtailment gain is that the net pension benefit liability is
reduced to £2.6 million from £11 million which is a substantial reduction.
(1) The adjustment for interest which reflects the unwinding of the liability is an increase in finance
costs and therefore a reduction in profit for the year by £0.7 million.
(2) The service cost which reflects the additional cost of providing the pension is an increase in
either admin or cost of sales and again a reduction in profit for the year. The curtailment gain is a
reduction in the liability and therefore an increase in profit of £3.5 million.
(3) The contribution paid by MiTek has been incorrectly charged to profit or loss; this should now be
reversed and hence reduce profit for the year and reduces the net pension liability.
(4) The benefits paid are both a reduction of pension assets and liability and therefore have no
impact on the financial statements.

(5) The remeasurement gains represent the difference between the expected values and actual
values of the liability and the plan assets and are recognised in reserves through other
Deferred tax on pension liability
Deferred tax must also be recognised, and the temporary difference is calculated as the difference
between the IAS 19 net defined benefit liability and its tax base. The tax base is nil. Tax deduction is
allowed when the contributions are paid.
IAS 12 requires deferred tax items relating to items charged or credited to OCI to be recognised in
OCI. It is sometimes difficult to determine the amount of current and deferred tax to be recognised
in profit or loss or other comprehensive income. The following is one appropriate basis of allocation.
The fall in the pension liability results in a fall in the deferred tax asset. The method below takes the
amount of movement relating to gains on remeasurement as a debit directly to OCI and the
remaining part of the movement as a debit to current tax in the statement of profit or loss.
£m
Net pension liability at 30 September 20X7
(£39.5 – £42.1) 2.6
Tax base (no deduction until payments made) 0
2.6
Deferred tax asset at 20% 0.52
Deferred tax asset brought forward 2.2
Movement – credit to deferred tax asset 1.68
Debited to OCI re gains (£1.74m + £3.22m) × 20% 1.0
Debited to profit or loss for the year balance 0.68
Part (2)
Revised statement of profit or loss for MiTek
Per forecast Adjustments Revised

£m £m £m
Revenue 60.9 60.9
CREDIT 0.8 to remove contribution
Cost of sales (31.7) incorrectly recorded (30.9)
CREDIT 3.5 curtailment gain
Operating expenses (20.8) DEBIT 0.2 service cost (17.5)
Finance costs (1.2) DEBIT 0.7 – net interest cost (1.9)
DEBIT 0.7 deferred tax on reduction in
Income tax (1.2) pension asset (1.9)
Actuarial gain in respect of pension scheme 4.9

Deferred tax movement on actuarial gain (1.0)
Other comprehensive income for the year 3.9
Total comprehensive income for the year to 30 September 20X7 12.6

Part (3)
Under IFRS 3, a gain or loss on disposal occurs when one entity loses control over another which is
when its holding decreases to less than 50%.
JKL owns 18 million shares in MiTek which gives a 90% shareholding. MiTek has therefore previously
been correctly consolidated with the results of JKL’s other subsidiaries in the consolidated statement
of profit or loss.
If JKL sells 15 million of its MiTek shares to Fym its shareholding will be reduced to 3 million shares
which will leave it with a 15% shareholding in MiTek. The impact of the sale is that the holding has
now crossed the control boundary as it will have disposed of a controlling interest.
The impact on the financial reporting is that JKL should include MiTek’s results in the statement of
profit or loss up to the date of disposal. The non-controlling interests must be time apportioned and
a gain or loss on disposal is included in the profit or loss for the year.
On disposal any remaining shareholding is measured at fair value on the date that control is lost. This
fair value is used in calculating the gain or loss on disposal and also becomes the carrying amount
for the investment in MiTek on the consolidated statement of financial position.
As the disposal is mid-year, a working is required to calculate both the net assets and the non-
controlling interests at the disposal date. Goodwill is the original goodwill less any impairment losses
to date.
To calculate goodwill at acquisition, the fair value of consideration is compared with the net assets
acquired:
WORKINGS
(1) Calculation of goodwill
£m
Cost of investment 50.0
NCI at acquisition 4.3

54.3
Less: Net assets at acquisition (43.0)
Goodwill at acquisition 11.3
Impairment loss in 20X4 (6.0)
Goodwill at disposal 5.3
(2) Net assets of MiTek and non-controlling interests
At disposal At acquisition
£m £m
Share premium 7.0 7.0
Retained earnings at 1.7.20X1 16.0
Retained earnings at 1.10.20X6 23.0 ––––
Net assets at acquisition 43.0
Comprehensive income for the period to 30 September

20X7 £12.6 million × 11/12* 11.6
Net assets at disposal 61.6

* The assumption is made that profits, losses and gains accrue evenly – alternative assumptions
could also be considered valid.
£m
At acquisition 4.3
Share of reserves since acquisition (£61.6 – £43.0) × 10% 1.9
Non-controlling interests at disposal 6.2
Gain on disposal
The gain on disposal to be recognised in the consolidated profit or loss is calculated as follows:
£m £m
Fair value of consideration 65.0
Fair value of remaining 15% shareholding 6.0
71.0
Less: amounts recognised before disposal
Net assets of MiTek (Working 2) 61.6
Goodwill (Working 1) 5.3
Less: NCI at disposal (Working 3) (6.2)
(60.7)
Profit on disposal 10.3
Part (4)
Per forecast MiTek adjusted × 11/12 Revised

£m £m £m
Revenue 200.1 (60.9 × 11/12) = 55.8 255.9
Cost of sales (128.7) (30.9 × 11/12) = 28.3 (157.0)
Gross profit 71.4 27.5 98.9
Operating expenses (53.0) 17.5 × 11/12 = 16.1 (69.1)
Exceptional item
Profit on disposal of investment in MiTek 10.3
Finance costs (1.4) (1.9 × 11/12) = 1.7 (3.1)
Profit before tax 17.0 9.7 37.0
Income tax (2.9) (1.9 × 11/12) = 1.7 (4.6)
Profit for the year 14.1 8 32.4
Attributable to:

Non-controlling interests (8 × 10%) 0.8
32.4

Other comprehensive income for the year ending 30 September 20X7
JKL: consolidated (inc. MiTek)

£m
Profit for the period 32.4
Actuarial gain in respect of pension scheme (4.9 × 11/12) 4.5
Deferred tax movement on actuarial gain (1.0 × 11/12) (0.9)
Other comprehensive income for the period 3.6
Total comprehensive income for the period 36.0

Attributable to:
Non-controlling interests (0.8 + (3.6 × 10%)) 1.2
36.0
*The assumption is made that profits, losses and gains accrue evenly – alternative assumptions could
also be considered valid.
Part (1)
Most candidates made a good attempt at the calculation of the re-measurement gains on the
pension assets and obligation. The most common mistake was the inclusion of the curtailment
impact as a loss rather than a gain. Some also incorrectly identified the re-measurement gains as
losses. Many were able to provide a reasonable discussion of the deferred tax impact of the
movement in the net pension liability, with the best candidates then going on to include some
discussion of the allocation of that charge between income statement and other comprehensive
income. Errors were sometimes made in the posting of the deferred tax impact, with incorrect
posting of the deferred tax impact outside the Income tax line, or incorrectly posting the closing
balance as the movement in the period. The question asked for an explanation of the impact on the
financial statements; listing journals usually without descriptions does not provide an explanation.
Part (2)
The majority of candidates were able to score most of the available marks here. Credit was given for
inclusion of the service cost and curtailment impact in either ‘cost of sales’ or ‘operating expenses’.
The most frequent error was to record the curtailment gain incorrectly as a debit or to provide no
adjustment to remove the contribution from cost of sales.
Part (3)
Most candidates were able to identify correctly that this part disposal had resulted in the
shareholding in MiTek passing the control boundary such that the company was no longer a
subsidiary and provided a sensible discussion of the remaining level of control such that the
shareholding should be treated as an investment held at fair value. Some candidates spent a good
deal of time debating whether the remaining 15% would be an associate or investment despite there
being little in the scenario to lead them to this debate and concluding that this was a discontinued
area of the business so IFRS 5 applied. No marks were lost for such an approach.
Most were able to achieve the majority of marks for the calculation aspects of this section with follow
through marks being awarded where errors were made in one element. The most common areas
where candidates lost marks were in the calculation of the net assets at acquisition and disposal,
picking up the wrong figures from the background section of the question. A frequent error was
using the profit for the 11-month period instead of their TCI. There were some good attempts at
describing the effect of the disposal of the shares.

Part (4)
Most candidates were able to score well on this section, correctly consolidating 11 months of the
MiTek revised profits on a line by line basis and a profit on disposal of the 75% interest in MiTek on 1
September. Some incorrectly included the gain or loss on disposal in OCI.
Few were able to correctly calculate the profit attributable to the parent and NCI using their own
figures. Marks were also lost where the consolidation was only undertaken at PBT level and did not
include OCI.
58 Roada Ltd
Scenario
The candidate is an audit senior working for DWE LLP, a firm of ICAEW Chartered Accountants and
has been assigned to the audit of Roada Ltd for the year ended 31 May 20X9. Roada builds new
roads and supplies related raw materials, such as cement and gravel, to other road builders. The
candidate is working on the audit of Roada’s revenue. Roada implemented IFRS 15 for the first time
in the year ended 31 May 20X9. The interim audit documented that Roada has two key revenue
streams and the candidate is provided with Roada’s revenue recognition policies. Roada has also
sold a quarry and is experiencing problems with a contract where Roada is acting as a subcontractor
to the main contractor, Pott Construction. No assessment was made at the interim audit of the
revenue recognition policies and no detailed audit procedures were planned.
Analytics on revenue were carried out by the DWE data analytics team and an analysis of the
analytics is provided for the candidate. The candidate is required to explain how Roada should
recognise revenue for the two revenue streams and the sale of the Brightfield quarry and to justify
and explain the elements of revenue which have a high risk of material misstatement. The candidate
is also asked to set out audit procedures for the Pott contract.
Explain how Roada should recognise revenue Assimilate complex information to produce
for the two revenue streams identified in our appropriate accounting adjustments.
interim memorandum (Exhibit 1) and also for Apply knowledge of relevant accounting
the sale of the Brightfield quarry (Exhibit 3). standards to the information in the scenario.
Identify any additional information you require
to reach a conclusion. Identify the need for further information.
Apply professional scepticism to identify
potential for creative accounting.
Identify and justify the elements of revenue Appreciate and apply the concept of
which have a high risk of material misstatement. materiality.
Use Janice’s file note (Exhibit 2) together with Relate different parts of the question to identify
the other information provided. critical factors.
Use technical knowledge and judgement to
identify risks.
Set out the audit procedures we should Use technical knowledge and judgement to
perform on the Pott road-building contract determine appropriate audit approach of
(Exhibits 2 and 3). substantive analytical procedures or tests of
detail.

Marking guide Marks
Recognise revenue for the two revenue streams 12

High risk of material mis-statement 8
Audit procedures 10
30
Total 30

Unusually, this question is largely concerned with one issue: revenue. However, it tests a
variety of different issues: performance obligations satisfied over time, audit risk and analytical
procedures, weaknesses in management controls and professional scepticism, so there is
plenty of scope to develop all four of the professional skills listed in the skills grid.

While the question as a whole requires a considerable amount of information to be
assimilated and used, and the information is from multiple sources, this professional skill
applies particularly to the requirement: “identify and justify the elements of revenue which
have a high risk of material misstatement”. You should use the numbers in the question to
identify the potential manipulation by management through, for example, special deals and
credit notes, the cut off risks, the sale of the quarry – is it genuine?

The first requirement (recognising revenue from the two streams) is an instance of where the
structure is given to you by the relevant IFRS. IFRS 15 gives a five-step procedure, and you
should, of course, apply it. However, at Advanced Level, you would gain no marks for simply
copying from the text – detailed application to the scenario is needed.
Applying judgement
Revenue is an area where judgement is often needed. IFRS 15 was brought in to reduce the
subjectivity and inconsistency in accounting for revenue that was a feature of the previous
standards on the topic. However, some scope for judgement remains, and in the first
requirement this is needed in deciding when control passes, or indeed, in the case of the
quarry, if control passes.
The requirement to identify elements of revenue with a high risk of material misstatement also
requires judgement, both in this exam and in real life.

The requirement to set out the audit procedures that should be carried out on the Pott
contract provides a good way to develop your professional skills of concluding,
recommending and communicating. Examiners often comment in relation to audit procedure
questions that candidates too often give generic procedures and fail to apply them to the
scenario in the question. An important professional communication skill is to be specific.

Part (1)
Revenue from road-building
IFRS 15 sets out a five-step process to be applied in considering revenue recognition:
• Identification of the contract with the customer
There is likely to be a separate written contract for each road-building project setting out all key
terms although a copy of the contract(s) is needed to confirm this. One element which might require
consideration is whether it is probable that Roada will collect the consideration it is entitled to, as at
least one of its customers is in financial difficulty. This will need further consideration on a customer
by customer basis as, under IFRS 15, a customer’s credit risk is included in the assessment of the
amount of revenue to recognise.
• Identification of the separate performance obligations in the contract
Under its road-building contracts, Roada has performance obligation(s) to build either one or
multiple stretches of road. Whether there is one or multiple obligations will depend on the terms of a
contract and will require careful consideration – review of individual contracts will be needed to
confirm this. It is clearly possible for distinct stretches of road to be sold separately but they may or
may not have a distinct function as one stretch of road will be linked with another, which may or may
not have been built by Roada under the same contract. In addition, they may or may not have distinct
profit margins as there will be fixed costs associated with equipment, accessing and preparing the
site etc which may relate to more than one stretch of road.
• Determine the transaction price
The transaction price will be set out in the contract and should be clear. However, there may also be
variations to this which will need careful consideration. These will be due to Roada if certain
conditions arise and so can be regarded as variable, contingent revenue.
Under IFRS 15, such revenue is only recognised where it is highly probable that there will not be a
reversal of revenue when the uncertainty is resolved.
Roada’s policy is to recognise certified revenue and revenue from variations only when agreed by the
customer. Any uncertified work is recognised only to the extent that an offer has been made by the
customer to pay for it or at cost. Further information is needed to assess whether it is highly probable
that an amount at least equal to cost will be recovered. If not, then it may be necessary to limit the
amount recognised to the amount offered for uncertified work by the customer.
This is a subjective area requiring judgement and is open to creative accounting.
• Allocate the transaction price to the performance obligations
This may be necessary if there are deemed to be multiple performance obligations under one
contract. As each stretch of road will be unique, there will be no standard price, although there may
well be per mile / kilometre prices for each type of road / surface. Some judgement and estimation
may therefore be required in estimating the stand-alone price for each obligation.
• Recognise revenue as a performance obligation is satisfied.
As the road building activity will give rise to an asset(s) on the customer’s site and which will have no
alternative use for Roada, it is likely that the appropriate way to recognise revenue is over time rather
than at a point in time. This argument is supported by the fact that work is certified at each month
end and Roada has an enforceable right to payment for certified work.
Even at the early stages of a contract, it should be possible for the work to be certified although this
may not be so easy in any set-up phase. Further information is required to evaluate this.
Revenue from the supply of raw materials
Revenue recognition for the supply of raw materials is much simpler. Again, there are likely to be
written contracts in the form of purchase orders and agreed prices for each product, largely
determined by weight.
The point of revenue recognition will be when control of the goods passes to the customer. For UK
customers, this will generally be when they are collected from Roada’s sites.
For international customers, the point of revenue recognition is when the goods are loaded on to
vessels owned / chartered by the customer as it is at that point, rather than when the goods are
weighed on leaving the site that control passes.

Sale of the Brightfield Quarry
The key question here is whether a performance obligation has been satisfied by the transfer of
control to the customer. The fact that Roada continues to operate the quarry raises the question of
whether control has in fact passed and whether the sale is genuine. IFRS 15 requires that the
substance of the transaction is considered by looking at the transaction as a whole.
Roada has received cash of £15.5 million but is yet to satisfy its obligation of extracting and
supplying gravel from the site. It retains control of the site and, while there is a commitment to supply
gravel to Buildit, Roada can sell excess gravel to other customers. As gravel is sold at market value
(but see also below) it can also expect to make a normal level of profit on the gravel extracted.
In addition, in 5 years when the gravel reserves are exhausted, Buildit can require Roada to take back
the site and it is Roada who will incur the costs of any clean-up operation.
The substance of this arrangement is that Buildit has made an up-front payment of £15.5 million for
gravel with a market value of up to £20 million. The discount may reflect the bulk nature of the
purchase or the time value of money or both, but the performance obligations are only satisfied as
and when Roada delivers gravel to Buildit.
The £15.5 million should not be recognised as revenue but deferred on the balance sheet.
The only revenue to be recognised in the year ended 31 May 20X9 will be for gravel delivered to
Buildit from 1 November 20X8 to 31 May 20X9. This will be at market value less the discount offered
to Buildit having taken into account the time value of money. Buildit clearly has an incentive to collect
gravel up to £20 million in value, even if it then sells it on, so we have to assume it will do this.
One other item to take into account is the need for a provision for rectification costs as these are
likely to fall on Roada. This will need to be discounted for the time value of money and the
discounted value unwound over time. Further information is required in respect of these estimated
costs.
Part (2)
The risk of material misstatement will depend on factors such as the level of inherent risk in the
balance, together with the extent to which that risk is addressed by Roada’s own control processes.
All revenue
• It is clear from the information provided that there is pressure on Roada management to meet
revenue targets and therefore the incentive to mis-state or accelerate revenue.
As a result, we will need to focus on revenue recorded at the end of the year and large revenue
transactions in the last month.
• Roada appears to have customers who may have difficulty in paying. Under IFRS 15, customer
credit risk is factored into the initial consideration of the revenue to be received and we need to
understand how and to what extent this has been done.
Our work will need to consider in particular those customers with overdue balances or a history of
late payment, including those, like Pott, who are dependent on receiving cash from an ultimate
customer to pay subcontractors like Roada.
Revenue from the supply of raw materials
Elements of revenue which have a higher risk of material misstatement can be identified as follows:
• There is higher cut-off risk associated with sales to international customers as the revenue
recognition point should not be when the product leaves the site but when it is loaded on to the
customer’s vessel at the docks. Janice’s procedure notes suggest that the invoice is generated not
at this point but when the product leaves Roada’s site, thus giving potential for revenue to be
recognised too early.
We will need to consider the potential delay between invoicing and control of the product passing to
the customer and to focus on sales to international customers in the last few days of the year.
At present the analytics do not distinguish between UK and international sales – it might well be
helpful to have this analysis to identify more accurately any unexpected trends or monthly
fluctuations.
• There is higher risk associated with revenue at quarter ends when special deals are given to
customers. For the purposes of the statutory audit our key focus will be on any deals in the final
quarter as these are the ones where accurate recognition is most likely to affect the total revenue
for the year ended 31 May 20X9.

We will need to obtain details of the deals offered and to consider the impact on revenue recognised
and the potential for subsequent returns, refunds etc.
• The completeness of the year end credit note provision has higher than normal risk associated
with it as there are typically higher credit notes issued in the month after any quarter end. The
prior year provision was £2 million but the credit notes issued in June 20X8 were at nearly twice
that level. They may have related in part to invoices issued post year end, but the overall material
level of credit notes gives rise to a higher level of risk that the provision is not adequate.
We will need to focus on credit notes issued after year end and ensure that those relating to pre-year
end sales have been adequately provided for. We should also gain an understanding of the key
reasons for the issue of credit notes as the overall level of £11.25 million seems high given total
revenue of (£118.8 less one-off item £15.5) £103.3 million and suggests that either there are errors in
invoicing or that there are complex deals which need to be fully understood.
Sale of the Brightfield quarry
• The one-off transaction for the sale of the Brightfield quarry is material and unusual and therefore
inherently of higher risk. This will require focus both in determining the correct accounting
treatment and ensuring that it is recorded in the right period.
Revenue from road-building contracts
• The Pott contract is clearly an element with a higher risk of material mis-statement. It is material
and there are issues with the customer and potentially with the work done. This will require
considerable audit focus.
• There is also £4.7 million of revenue relating to uncertified work on other contracts. This is a
material amount and there is likely to be some judgement involved in what amount to record. In
addition, there is some question over whether Roada’s accounting policy is appropriate when the
amount recognised equates to cost. Our audit focus should therefore be on uncertified amounts
which have been recognised in revenue with particular focus on any which are old or where there
appears to be a significant dispute.
• The analysis does not identify whether amounts relate to completed or incomplete contracts, nor
does it show what amounts have been paid. Higher risk will be associated with unpaid balances
and with contracts which are still ongoing. Our work should include specific consideration of any
material contracts where there are disputes or delays in payment.
Part (3)
The outcome of the contract is uncertain and therefore the procedures which are relevant are largely
those for auditing an estimate or judgement. The relevant procedures are as follows:
• Obtain a copy of the contract and examine the key terms and conditions, including in particular
the payment terms and the process to be followed if there is any dispute over the work done.
• Obtain copies of the latest certificates and ensure that these substantiate the amount of revenue
recognised as certified to date.
• Obtain and confirm latest estimates of total costs on the contract to supporting documentation to
ascertain whether the contract is still expected to make a profit. Test costs to date by agreeing to
third party documents (invoices) and client costings and review future estimates in the light of
actual cost incurred.
• Evaluate the status of the contract and the issues arising to ensure that both financial and
operational management understand the facts and judgements.
• Examine and confirm how similar disputes have worked out in the past and whether, in similar
circumstances, Roada has been able to recover at least the costs it has incurred.
• Evaluate what has happened in respect of negotiations with Pott since the year end and
determine what impact this has on management’s expectations concerning the amount of
revenue to be earned under the contract.
• Obtain and examine legal correspondence regarding the contract and, in particular, whether
Roada’s decision to cease work on the contract might be regarded as a breach which has
weakened its overall negotiating position. Circulate any lawyers used for their assessment of the
amounts recoverable under the contract and also of any costs which might be incurred in
resolving the issue.

• Obtain copies of the reports provided by the independent adjudicator and challenge the extent
to which there is an argument that the specifications in the contract were not followed. Consider
whether an auditor’s expert needs to be involved to provide an independent assessment as to
whether or not Roada has fulfilled its contractual obligations.
• Determine a range of possible outcomes and evaluate whether the amount of revenue and costs
recognised represent the best estimate of the outcome on the contract.
• Identify whether there is any indication of management bias in the estimates made in the light of
indications that Roada is under pressure to deliver target revenue. It does appear to have
followed its accounting policy but may have underestimated the effects of potential / actual
breaches of the contract on its part.
• Obtain evidence of whether Pott has the ability to pay Roada and ensure that credit risk is built
into any estimate of the revenue to be recognised. This needs to reflect also the risk that Pott will
not receive cash from Develop UK as without that cash it cannot pay Roada.
Part (1)
Most candidates made a good attempt at this requirement, discussing the IFRS 15 conditions for
revenue recognition, identifying that the road building revenue should be recognised over time
using the output method and that there was a difference between the timing of recognition for the
sale of raw materials to UK and international customers.
However, sometimes the rules for revenue recognition in IFRS 15 were copied from the text with
poor application. When the five steps were mentioned they were not always linked to the scenario in
the question. Understanding of variations and how to deal with multiple obligations was not
answered well (some described the previous standards, IAS 18 and IAS 11). Discussions about the
provisions for bad debts being under IAS 37 is worrying.
In relation to the sale of Brightfield quarry, although most candidates were able to identify that, due
to the retention of control and the requirement to clean up the site etc, this was not a direct sale of
the quarry itself, very few then went on to conclude that it was an upfront payment for gravel and set
out the financial reporting implications correctly. The most common conclusion was that this was a
sale and leaseback of the quarry.
Part (2)
This section required candidates to highlight risks of material misstatement in relation to Roada’s
revenue, which many did well scoring the maximum marks. Candidates were able to use the
numbers in the question to identify the potential manipulation by management through, for
example, special deals and credit notes, the cut off risks, the sale of the quarry and the issues with
Pott (including uncertified work and the risk of non-payment).
Additional marks were available where candidates illustrated their points with figures and analysis
from the question.
Part (3)
Candidates provided a reasonable selection of audit procedures covering the Pott contract using
strong verbs such as examine, confirm and evaluate to describe what needed to be done. More
could have been mentioned on the progress since the year end and how Roada have managed
situations like this in the past.
However, many procedures were very high level and generic, not focusing on the Pott contract risks
and not sufficiently linking the procedure to the risk. Credit was not given for generic audit
procedures that were not linked to the Pott contract. Weaker candidates wasted time on procedures
for other elements, including more general areas such as going concern which did not answer the
question. Few if any marks were awarded for weak procedures such as “discuss” or “obtain
management representations” unless they were focussed and clearly providing assurance.
The weaker students listed a set of revenue procedures, rather than applying them to the dispute in
the scenario. Candidates should answer the question asked rather than copying lists from their notes
and hoping for the best.

59 Your Nature plc
Scenario
The candidate is an audit manager working for TC, a firm of ICAEW Chartered Accountants and is
assigned to the audit of Your Nature plc (YN) for the year ending 31 December 20X6. YN is an AIM-
listed 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%. TC will audit BBO for the first time for the
year ending 31 December 20X6.
The candidate is provided with a forecast consolidation schedule for YN and BBO for the year ending
31 December 20X6 and notes containing details of the acquisition of additional shares in BBO. The
schedule contains errors as the client is unsure about how to complete the consolidation.
The client has identified some unresolved financial reporting matters relating to the forecast financial
statements of BBO for the year ending 31 December 20X6 and details are also provided to the
candidate. These unresolved issues include a potential provision or contingent liability disclosure,
impairment of development costs, impairment of a division, revaluation of land and a SAR scheme
and a receivables issue.
The candidate is required to explain the financial reporting implications for each issue for both the
individual financial statements of BBO and the implications for the consolidation schedule. The
candidate is also required to identify the errors made by the client in preparing the consolidation
schedule and to calculate goodwill and non-controlling interests. These requirements test a wide
range of both technical knowledge and skills in assimilation and using information to structure
recommendations about financial reporting treatments.
Extracts are provided from YN’s five-year sustainability plan which will form part of the strategic
report in the YN Group’s annual report for the year ending 31 December 20X6. The candidate is
required to explain the audit issues and set the audit procedures and implications for the audit
report arising from these disclosures. YN has now taken control of a subsidiary which has unresolved
accounting issues which show that some of the BBO business practices conflict with the stated
sustainability plan disclosed by YN in the front section of its financial statements. This raises audit
issues around the YN brand valuation and the going concern assumption.
The candidate receives an email from a former TC partner involved in the YN audit in previous years.
There are ethical threats arising for the candidate and pressure to reveal potential problems arising
concerning the future of BBO in terms of employee relations, closure of division and environmental
issues.
Explain: Assimilate and demonstrate understanding of

• any adjustments required to the financial complex information.
statements of BBO for the year ending 31 Evaluate the adequacy of disclosure of the
December 20X6 in respect of the financial contingent liability note.
reporting matters identified by Elsie Penn Explain the appropriate treatment for
(Exhibit 2). Provide appropriate journal impairment of development costs and SARs.
adjustments; and
• the impact of these matters for the adjustments.
consolidation of BBO in the YN group
financial statements for the year ending 31
December 20X6.
Identify and briefly explain any errors in the Identify errors and suggest appropriate
forecast consolidation schedule prepared by financial reporting treatment.
Elsie Penn (Exhibit 1).

Evaluate inconsistencies in information

provided from multiple sources.
Explain complex transactions including the
recognition of acquisition of shares crossing the
control boundary from financial asset at FVTOCI
to subsidiary.
Calculate the goodwill and non-controlling Assimilate adjustments to prepare key workings
interests to be recognised in the forecast for the consolidation of BBO with YN.
consolidated financial statements for the year
ending 31 December 20X6. Take into account
the adjustments you have proposed.
In respect of the extracts from YN’s five-year Explain the nature of a range of different
sustainability plan (Exhibit 3) to be included in assurance engagements.
the YN Group’s annual report and consolidated Evaluate the evidence necessary to report at the
financial statements for the year ending 31 appropriate level of assurance.
December 20X6:
Evaluate risk in relation to the nature of the
• Set out the audit procedures that you would assurance engagement and the entity or
perform. process for a given scenario.
• Describe the implications for the audit Design and determine procedures necessary to
report. attain the relevant assurance objectives in a
potentially complex scenario.
Explain the ethical implications for you and TC Evaluate the ethical implications of making
arising from George’s email, and set out the information available including confidentiality
actions you should take. and transparency.
Marking guide Marks
59.1 Adjustments to financial statements and impact 12

Identify errors in forecast consolidation schedule 3
Goodwill and NCI 8
Audit issues, procedures and implications 14
37
59.2 Ethical implications 8
8
Total 45

This question, at 45 marks, is longer than usual and very wide-ranging, giving you a chance to
demonstrate the four professional skills in relation to a business combination achieved in
stages and various financial reporting issues, some of which affected the goodwill and some
being post-acquisition. You also had to identify errors and perform key workings. On the audit
side, the client’s sustainability plan was inconsistent with the information revealed in the
financial reporting issues. Finally, there was a potential ethical conflict. All four professional
skills were needed, but the requirement to assimilate information and the use of judgement
were the most important.

There is a great deal of information to assimilate in this question. Key facts to note before
moving to the detailed financial reporting issue is that a control boundary has been crossed in
the acquisition of the further shares in BBO, that the acquisition takes place part way through
the year and that there are unresolved financial reporting issues that may conflict with YN’s
sustainability plan.

Despite the length of the question, structuring your answer should not be too difficult, as the
requirements are in a logical order to enable you to do so. There is no good reason to depart
from this order, for example, you need to know how the outstanding financial reporting issues
affect the consolidation schedule, and the errors made in Elsie’s draft of the schedule before
you can perform the necessary goodwill and non-controlling interests calculations.
Applying judgement
YN’s sustainability plan contains elements of subjectivity and judgement, and in your exam
role as auditor you will also need to apply judgement in assessing whether the plan conflicts
with the financial information. In particular, some of the figures are of concern already, but
could potentially mislead because they do not include BBO. Judgement will be needed over
whether TC can provide assurance over the numbers in the strategic report, or whether an
assurance expert will be needed.

A large proportion of your answer will be in narrative form, and your professional
communication skills will be exercised, not least because some of the issues are sensitive. It is
essential that you break your narrative into short paragraphs, for example, separately
identifying the impact on the consolidation schedule. Your conclusions on the ethical issue
need to be clear and decisive.
59.1 Part (1)

(1) Employment legal proceedings
IAS 37 states that a provision should be recognised if an entity has a present obligation as a
result of a past event which will result in a transfer of economic benefit which will be probable,
and a reliable estimate can be made of the amount of the obligation. Therefore, the directors
are correct in not including a provision if it is not probable that the company will pay the
£500,000.
IAS 37 also deals with contingencies. It requires that entities should not recognise contingent
liabilities – but should disclose them, unless the possibility of an outflow of economic resources
is remote (IAS 37.86).
A contingent liability is defined as:
• a possible obligation depending on whether some uncertain future event occurs; or
• a present obligation but payment is not probable, or the amount cannot be measured
reliably.
As no disclosure is proposed, the directors’ judgement on this matter should be challenged by
the auditors.
Implications for consolidation schedule
If the matter is disclosed as a contingent liability this will have an impact on the consolidation
schedule as contingent liabilities are measured in the calculation of the fair value of the assets

acquired. Further information is required to determine whether the amounts should be
disclosed and whether the amounts should be adjusted in the calculation of goodwill.
The development costs are recognised by BBO correctly at cost and the carrying amount at 1
April 20X6 was £3.2 million.
The carrying amount at 31.12.20X6 is now £3 million – which suggests amortisation of just
£200,000 in nine months.
The news report represents an impairment indicator that the fair value has fallen.
In BBO’s individual financial statements, comparing the carrying amount with the fair value it is
still lower than the estimated fair value of £4 million.
It may be that the useful life should be reappraised given the bad publicity and the claims
made by the BBO research technician.
Implications for the consolidation schedule
On consolidation, the development costs should be adjusted to fair value. As the consolidation
has been completed incorrectly, and no adjustment has been made on the draft in Exhibit 1 for
the fair value of the development costs, these should now be measured at £4 million at 1 April
20X6. Hence there is an impact on the calculation of goodwill at acquisition.
There should also be a subsequent adjustment to amortisation and an estimate of useful life
would be required for this adjustment.
(3) Impairment of Norfolk division
An impairment arises as the recoverable amount is lower than the carrying amount. The
recoverable amount is £5,500,000 which is the higher of the selling price £5,500,000 and the
value in use £4,144,000. The fair value of the assets should be reduced by £1,500,000.
£ £
DEBIT Profit or Loss 1,500,000
Calculation of value in use
31 March 20X7 20X8 20X9 Total

£’000 £’000 £’000 £’000
Future cash flows 2,300 1,500 1,000
9% 0.917 0.842 0.772
Present value 2,109 1,263 772 4,144
As no announcement has been made regarding redundancy costs, no provisions are

recognised in the financial statements for the year ending 31 December 20X6.
Implications for the consolidation schedule
This would be post-acquisition as no irreversible decision was made at the point of acquisition
– therefore no impact on goodwill.
(4) Land impairment
The land is not impaired on best alternative use basis, therefore, no adjustment is needed. As
BBO does not have a revaluation policy, no revaluation should be included in its financial
statements.
Implication for consolidation schedule
This will affect the goodwill calculation as the assets acquired are adjusted to fair value.
(5) Share appreciation rights
IFRS 2, Share-based Payment requires that an expense is recognised in respect of the share
appreciation rights in the profit or loss. This is a cash-settled share-based payment.

For the three years to the vesting date, the expense is based on the entity’s estimate of the
number of SARs that will vest. However, the fair value of the liability is remeasured at each year
end.
At 31 December 20X6 an expense and liability should be recognised as follows:
Expected to vest = (500 – 50) = 450 × 400 × £12 = £2,160,000 × 9/36 = £540,000
£ £
DEBIT Profit or Loss 540,000
CREDIT Liability 540,000
(6) Receivables
Further information is required to determine whether an allowance is required for this
receivable.
Disclosure may be required as a related party transaction within IAS 24 if the director is a
member of the key management of Beauty Inc and a significant shareholder. If this were
sufficient to give effective control then could be deemed to be a related party and the
disclosure requirement should be brought to YN’s attention.
Part (2)
The consolidation schedule is not correct because the accountant has simply added the entire
profit or loss for the whole year. BBO became a subsidiary partway through the year and only
the P or L since acquisition is consolidated 100%.
Goodwill
There is no calculation of goodwill.
At 1 April 20X6, BBO becomes a subsidiary because YN now has a controlling stake (70%).
This means that goodwill arises on the transaction. The non-controlling interests have been
recognised at the wrong amount.
The consideration for goodwill should take into account the consideration paid to achieve
control including the contingent consideration, the remeasurement of the fair value of the
original investment and the fair value of the net assets in BBO.
Remeasurement of original investment
There is no recognition of the change of the financial asset at FVTOCI to a subsidiary – a profit
or loss should be calculated on the existing shareholding and the gain or loss recognised
through OCI in equity. The proceeds including the contingent consideration form part of the
When control is achieved:
• Any previously held equity shareholding should be treated as if it had been disposed of
and then reacquired at fair value at the acquisition date.
• Any gain or loss on re-measurement to fair value should be recognised in other
comprehensive income in the period because the original investment was at FVTOCI.
As the shares in BBO were previously classified as being at fair value through other
comprehensive income, any gains in respect of it which were previously recognised in other
comprehensive income may not be reclassified from other comprehensive income to profit or
loss and any gain arising on derecognition is also recorded in other comprehensive income.
Therefore, the following journal is required in YN’s financial statements to dispose of the
shareholding in BBO before consolidation:
£’000 £’000
DEBIT Investment in BBO 150
Other comprehensive income and other components
CREDIT of equity 150
To recognise the gain on the disposal existing prior to control being obtained.

Elsie has correctly recorded this adjustment. The fair value of the 5% shareholding immediately
before disposal is £950,000.
Contingent consideration
The contingent consideration should be measured at fair value (IFRS 3). A liability should be
recognised by YN for (£650,000 × 0.842) £547,300 at acquisition 1 April 20X6.
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 £547,300. This sum should be added to
consideration when calculating goodwill. The total consideration paid to achieve control is
£13.547 million.
Subsequent recognition of the liability requires that the discount should be unwound for nine
months to the SOFP date, giving a charge of £36,943 (£547,300 × 9% × 9/12) to profit or loss,
and increasing the liability by the same amount.
£ £
DEBIT Goodwill 547,300
DEBIT P or L 36,943
Fair value adjustments

The assets of BBO should be remeasured to fair value at the acquisition date in respect of the
land. The land should be valued in accordance with IFRS 13 at its highest and best use.
Therefore, a fair value adjustment to goodwill is required for the land of £750,000.
The impairment of the Norfolk division assets and the SARs happened after the acquisition and
therefore are not adjusted when goodwill is calculated.
Trade receivable allowance and the contingent liability arising from the employment tribunal
Both these issues require further information - see above but could also impact on the
The deferred income account needs investigating – although no adjustment may be required -
there may be fraudulent activity.
Note: Journals and detailed explanations were not required.
Part (3)
£’000
Goodwill
Consideration transferred to acquire 6,500,000 shares 13,000
Deferred consideration 547
13,547
Non-controlling interests at fair value 3,000,000 × £1.90 5,700
Fair value of previously held equity at acquisition date 950

20,197
Net assets acquired at fair value 25,200
Bargain purchase on goodwill (5,003)
Post-acquisition profits (£26,910,000 – £25,200,000) = £1,710,000

WORKING
Net assets of BBO
At acquisition At year end

£’000 £’000
Less: profit for 9 months (3,750) –––––
Net assets at 1.4.20X6 23,650 27,400
Adjustments post-acquisition
SAR (540)
Impairment of assets (1,500)
Highest and best use of the land 750 750
Development costs 800 800
25,200 26,910
Note: Adjustments for the contingent liability using an estimate of fair value were also
accepted.
Non-controlling interests £’000 £’000

Share of net assets at year end £26.910 million × 30% 8,073
FV of NCI at acquisition 5,700 5,700
NCI share of net assets at acquisition 7,560
£25.2 million × 30%
(1,860)
6,213
FV of NCI at date of acquisition 5,700
NCI share of post-acquisition profits

£1.71 million × 30%
513
6,213
Note: Both calculations were accepted.

The bargain purchase on goodwill can be recognised in profit or loss – IFRS 3 requires a review
of assets and liabilities to ensure that they are stated at fair value.
Part (4)
Audit issues
• Auditor responsible for information published in the financial statements
CA 2006 requires the inclusion of information relating to the environment, employees and
social and community and human rights issues including details of the company policies
and their effectiveness in the strategic report.
YN has a duty to ensure that information published in the strategic report does not conflict
with other information in the audited financial statements.

• Report excludes BBO statistics
The sustainability plan does not include BBO statistics despite the fact that both companies
sell under the same brand name and hence may have been misleading in the previous
financial statements. BBO is now a subsidiary and therefore should now be included on that
basis alone.
BBO is now part of the group and issues have been identified with both employment and
treatment of staff and biodegradable claims for its products.
A 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. BBO has a serious pollution
incident which would have received publicity in the local area.
Therefore, if BBO is using products which do not meet YN’s definition of biodegradable, the
report will be misleading.
Also, in respect of the staff turnover targets – these will now be inaccurate as the closure of
the division at BBO will mean that these targets are no longer being achieved.
BBO has a high staff turnover rate and absenteeism due to work-related stress. Feedback
from employees suggests that this is due to difficult working conditions, high accident rates
and excessive expectations of performance by management. BBO is being sued for
unequal pay issues.
Including BBO within the sustainability report would mean that the current progress
towards these targets would be less likely to be achieved.
YN will need to ensure that the targets include realistic expectations which include BBO.
• Brand valuation
YN has a valuable brand on its SOFP – Nature&U has a carrying amount of £8,500,000 and
therefore any adverse publicity which contradicts the five-year plan once it is published and
YN’s stated ethos of using environmentally-friendly ingredients and processes may impact
on the carrying amount of the brand. The acquisition of BBO could have a detrimental
impact on the brand value and audit procedures should include challenges to
management’s assessment of its value.
• Assurance over the numbers
As the numbers included in the strategic report will have investor impact, assurance will be
needed over the accuracy of the numbers reported. TC may not have the skills to do this
type of assurance work.
• Qualitative nature of disclosure
The qualitative nature of the disclosures presents an audit issue as a high level of scepticism
and judgement is required. Targets such as ‘fair and appropriate’ and decent working
conditions are judgemental and difficult to measure successfully. The definition of bio-
degradable would also need to be measured and explained.
Audit procedures
Responsible production and consumption
• Re-perform the calculations to determine the accuracy of the numbers disclosed.
• Agree calculations to production records using analytics where possible to determine the
reasonableness of the disclosures.
• Determine the nature of the company’s definition of biodegradable through discussion with
appropriate personnel and ensure that this is in line with industry norms, ie, agrees with
relevant regulations.
• Confirm the definition by examining technical reports produced by the company.
• Consider the need for an auditor’s expert to be appointed to provide assurance over the
data disclosed.
Employee relations
• Re-perform staff turnover calculations and the underlying figures used in the calculations.

• Calculate the impact of including BBO on the overall targets and challenge management’s
disclosures.
Implications for the audit report
In the first instance, management should be asked to update the strategic report to include
BBO.
If this is not done, then the auditor is required to state when such information is inconsistent
with the information presented in the financial statements – this is unlikely to be material unless
there is a material impact on the brand valuation.
Environmental and social issues can impact on the ability of the company to continue as a
going concern – ISA (UK) 570 (Revised September 2019), Going Concern – and ISA (UK) 250
Section A (Revised November 2019), Section A – Consideration of Laws and Regulations in an
Audit of Financial Statements are relevant standards to consider. In which case there would be
further implications for the audit report depending on the outcome of the going concern
review.
Explanation of unresolved financial reporting issues
Overall candidates answered this requirement well and were able to attempt answers to each
of the six issues. Maximum marks were frequently awarded for this section. Weaker candidates
often failed to acknowledge and explain the distinction between the individual and the group
Candidates identified that the contingent liability should be given a fair value for the purpose
of the goodwill calculation and that further information would be required for this figure. Only
the better candidates distinguished between adjustments at acquisition that impacted on the
calculation of goodwill and those that arose post-acquisition. Detailed comments include:
• Development costs. Weaker candidates did not state clearly that the asset in the individual
accounts is not impaired and did not understand the 12-month cooling off period for the
fair value adjustments to goodwill. Most discussed the need for impairment of goodwill of
£6 million. There was sometimes detailed discussion of whether the development cost
meets the definition of an asset and whether it can be revalued to fair value of £4 million.
• For the impairment of the Norfolk division, many discussed at length whether this was a
discontinued activity, but few explained that the adjustment would be post-acquisition for
the consolidation.
• The accounting treatment of the land was not answered well. There was much discussion
about whether this should be an investment property and revalued to fair value. When
candidates decided that no adjustment would be made in the individual accounts, they
then went on to say that the consolidated financial statements would be unadjusted too.
Errors in forecast consolidated schedules
Most candidates managed to identify two to three errors in the consolidated working prepared
by Elsie Penn.
Goodwill and NCI
A sound understanding of concepts to calculate goodwill including implications of the step
acquisition and contingent consideration was evident from a majority of candidates – lost
marks were usually from not addressing the non-controlling interest element of the question.
Common errors included not discounting the future consideration, using the wrong number of
shares to calculate the FV of the NCI, failing to deduct a proportion of CY profit from closing
retained earnings and failing to adjust NA for the relevant FV adjustments. Using the
proportionate method rather than FV method for the NCI. There was a significant minority of
candidates who did not demonstrate the basics of consolidation techniques studies at
Professional Level.
Strategic report and sustainability
Candidates who were able to appreciate the subjectivity involved in determining YN’s use of
biodegradable materials and the indications used to assess employee relationships and the
firm’s lack of experience in these matters scored very well on this section. Key to achieving a
good mark was also to appreciate that the figures exclude BBO and that its inclusion would

increase the likelihood that the targets would not be achieved. Weaker candidates sometimes
missed out this requirement attempting more technical sections often poorly.
Candidates identified that modified opinions were unnecessary and many identified the need
for additional CA 2006 communication to draw attention to any inconsistency between the
information in the strategic report relating to sustainability and the audited financial
statements.
59.2 Ethical principles: There are threats in this scenario to client confidentiality because the former
partner is asking for information about BBO. The candidate cannot pass on any information to
George.
There is a familiarity threat because the former partner was previously the candidate’s superior
in the firm. Although the offer to go for lunch is probably well intentioned, there is a veiled
intimidation threat that the candidate may feel obliged to accept.
Jo may still feel an imbalance in power relations as George was a partner and Jo may lack
confidence to rebuff any requests for information. This could result in some intimidation.
George may be trying to go behind Kirsty’s back because he thinks he will get more
information about BBO out of the manager than the partner.
The former partner may also have ongoing financial interest in TC which means he could not
take the role, eg, through pension with the firm, and he should be advised to investigate this
further. He could not take a role at an audit client for that reason.
The clear action that the candidate should take is to politely decline the offer of lunch and
inform the former partner that they are not able to communicate any information about BBO.
The candidate should raise the matter with the firm’s ethics partner and the engagement
partner so that they are aware of the matter. Should George be appointed, TC would need to
reassess the composition of the audit team to ensure that team members were not known to
George.
Generally, this was quite well answered with a pleasing number of candidates picking up on
the potential issues regarding confidentiality, intimidation and familiarity. Weaker candidates
wasted time discussing issues for the former partner often concluding that he should not apply
for the role of non-executive director.
60 RTone plc
Scenario
The candidate is an ICAEW Chartered Accountant and the 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. 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, H-
Sound Ltd. This company is an internet-based retailer of home cinema and audio equipment.
The candidate is provided with financial information and key ratios for RTone and H-Sound for the
year ended 30 September 20X3, together with background notes.

RTone’s finance team has performed preliminary due diligence on the draft financial statements of H-
Sound and has identified some financial reporting issues which include:
• incorrect application of accounting standards (capitalising costs, loan extinguishment treated as a
modification, revenue recognition in respect of a customer reward scheme and a bundled
transaction); and
• judgement in application of an accounting standard (asset lives and residual values).
These are ‘red flags’ indicating that H-Sound management is trying to improve results.
The candidate is required to do the following:
• 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).
• Calculate revised financial information and key ratios for H-Sound for the year ended 30
September 20X3 (Exhibit 1).
• 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.
Set out and explain any adjustments required to Assimilate and demonstrate understanding of
H-Sound’s financial information and key ratios complex information.
(Exhibit 1) arising from the financial reporting Apply professional scepticism to the H-Sound’s
issues (Exhibit 2). Provide supporting journals. accounting policy for depreciation.
Identify the incorrect capitalising of wages, and
the software residual value.
Apply technical knowledge of IFRS 9 to
determine the treatment of the loan
extinguishment.
Apply technical knowledge of IFRS 15 to
understand the correct financial reporting
treatment of the customer reward scheme and
the streaming service.
Calculate revised financial information and key Assimilate the information, own calculations
ratios for H-Sound for the year ended 30 and data to adjust the financial statements and
September 20X3 (Exhibit 1). ratios.
Compare and analyse the financial performance Perform the required calculations to analyse
and gearing of RTone and H-Sound. Use your performance and gearing of RTone and H-
revised financial information and key ratios for Sound.
H-Sound together with any additional analysis. Identify changes and differences arising from
the business models and stages in business life
cycle.
Appreciate the impact of errors in financial
reporting, judgement and different accounting
policies on performance and gearing.
Marking guide Marks
Adjustments to financial information and ratios 18

Revised financial information and ratios 4
Analysis of financial performance 8
30
Total 30

Financial analysis is a significant part of the Corporate Reporting exam. This is a regular type
of question, where you are given financial statement extracts, several ratios and a number of
financial reporting issues with potential errors, and required to explain the correct treatment,
adjust the financial statements, recalculate the ratios and perform further analysis. All four
professional skills will be deployed, but the concluding, recommending and communicating
skill is particularly important.

The structure of the question as a whole is clear from the order in which the requirements are
presented. However, your answer to the financial analysis part of the question will require you
to think about structure. It makes sense to recalculate the ratios in the order they were given
to you in the question.

In this question you must not only assimilate and use the information given, but also your own
figures as recalculated. It is important to use all the information, including the background
details. Even if you feel you may have made a mistake, for example in the calculation of the
adjustments or of the revised ratios, it is essential that you approach the ‘compare and
analyse’ requirement with confidence, as if you thought you were correct, because the
examiner will give you credit for reasoned arguments.
Applying judgement
Professional scepticism is needed with regard to areas of judgement – in this case the choice
of long useful lives by H-Sound. The fact that such a long life is clearly inappropriate for
software casts doubt on the choice for the other assets.
Other accounting choices, for example capitalising software engineers’ wages and over-
recognising revenue may not just be incorrect, but could signal manipulation.

The first requirement (explain required adjustments) contains an IFRS 9 issue that is quite
specialised. It may be advisable not to get bogged down in detailed calculations relating to
the 10% rule – the examiner acknowledged that this part of the question was ‘challenging’ and
that ‘but those that applied a sensible approach were amply rewarded’.
Your comments in the ‘compare and analyse’ section need to be decisive, for example relating
the gearing to risk.
Part (1)
Non-current assets
Incorrect capitalising of wages
From the information provided the addition in respect of the software engineers’ wage costs appears
to be incorrect. To capitalise the cost, H-Sound needs to establish that it is probable that there is a
future economic benefit associated with the item. The scenario does not indicate that there is any
third-party market for these costs which appear to be bespoke to H-Sound. Although the cost can be
measured reliably, the £1,300,000 should be recorded as a cost in the statement of profit or loss.

Adjustment recommended is:
DEBIT P or L £1,300,000
No adjustment is required for amortisation as the client had not provided any in the year.
Accounting policy – directors’ judgement
H-Sound’s accounting policies regarding asset lives and residual values are a matter of judgement by
the directors of the company. Although they appear to be generous in comparison with RTone, it
would be a matter for the company’s auditors to ascertain whether the directors have chosen the
best policies and used best estimates. Judgement is involved but the residual value for software is
clearly wrong as a 10-year life with 15% residual value would appear unreasonable given the nature
of software and would indicate that PPE is not fairly stated.
If the warehouse is newly constructed and well maintained, a high residual value is not unreasonable.
However, there appears to be insufficient depreciation being charged on equipment and software
and for a like for like comparison, and for analysing the data and ratios an adjustment would be
recommended as follows:
£
£1,500,000 / 5 years 300,000
£2,100,000 / 3 years 700,000
1,000,000
Less: already charged (£179,000 + £60,000) 239,000
Additional depreciation 761,000
Recommended adjustment
DEBIT P or L £761,000
CREDIT PPE £761,000
Loan finance
If a new loan is agreed between a borrower and a lender, or the two parties agree revised terms for
an existing loan, the financial reporting treatment depends on whether the original liability should be
derecognised and a new liability recognised, or whether the original liability should be treated as
modified.
A new liability should be recognised if the new terms are substantially different from the old terms.
The terms are substantially different if the present value of the cash flows under the new terms,
including any fees payable/receivable, discounted at the original effective interest rate, is 10% or
more different from the present value of the remaining cash flows under the original terms. There is
said to be an ‘extinguishment’ of the old liability. In these circumstances:
• the difference between the carrying amount extinguished and the consideration paid should be
recognised in profit or loss; and
• the fees payable/receivable should be recognised as part of that gain or loss.
If the difference between the two present values is below this cut-off point, there is said to be a
modification of the terms. In these circumstances:
• the existing liability is not derecognised; and
• its carrying amount is adjusted by the fees payable/receivable and amortised over the remaining
term of the modified liability.
The carrying amount of the existing loan at 30 September 20X3 is £5,892k.

Workings not required.
b/f 7% Cash 6%
£’000 £’000 £’000 £’000
20X2 5,797.00 405.79 360.00 5,842.79
20X3 5,842.79 409.00 360.00 5,891.79
H-Sound is required to compute the present value of the new arrangement using the effective
interest rate of the old loan (7%). The present value was given in the scenario as £6,583,700 and the
working is set out below:
Discount at 7%
£’000 £’000
30.9.20X3 Fee 300.0 1.0 300.0
30.9.20X4 Interest 480.0 0.935 448.80
30.9.20X5 Interest 480.0 0.873 419.04
30.9.20X6 480.0 0.816 391.68
30.9.20X7 480.0 0.763 366.24
30.9.20X8 480.0 0.713 342.24
30.9.20X9 Interest and principal 6,480 0.666 4,315.68
Net present value of the modified loan 6,583.68
Carrying amount at date of change 5,891.8
This represents 111.74% of the carrying amount of the old debt.

This is more than 10% so the modification is to be treated as an extinguishment.
This will involve derecognising the existing liability and recognising a new liability. The difference
between the carrying amount of the extinguished loan and the fair value should be recognised in the
statement of profit or loss. The fees payable should be recognised as part of the loss.
From 1 October 20X3, the new loan should be recognised at fair value and amortised at its own
effective interest rate, not that of the original loan. The transaction costs of £300,000 should be
written off to Profit or Loss. The transaction costs have been debited to a receivable account which is
incorrect – this should be corrected.
£’000
Recommended adjustment:
Fair value of new loan 6,000
Old loan 5,892
Increase the loan by 108
Journal £’000 £’000

DEBIT Original loan 5,892
DEBIT Loss on extinguishment 108
DEBIT P or L transaction costs 300
CREDIT New loan 6,000
CREDIT Receivable 300

Customer reward scheme
The relevant accounting standard is IFRS 15 which requires a five-step process to identify the relevant
contract and performance obligations.
The points provide a material right to customers that they would not receive without entering into a
contract. The reward programme creates a performance obligation because it provides a material
right to the customer. Consequently, the scheme to provide points to the customer is a performance
obligation and H-Sound must allocate a portion of the transaction price to the loyalty programme.
Revenue will be recognised when the performance obligation is satisfied (eg, when the loyalty points
are redeemed or expire). The stand-alone selling price of one point is £0.95 per point making a total
of £1.425 million based on the estimated likelihood of redemption.
H-Sound allocates the transaction price (£15 million) to the product and points on a relative stand-
alone selling price basis as follows:
Product sales £13.7 million (£15 m × (£15 m stand-alone selling price ÷ £16.425 m))
Points £1.3 million (£15 m × (£1.425 m stand-alone selling price ÷ £16.425 m))
At the year end 300,000 points have been redeemed and assume that the entity continues to expect
1,425,000 points to be redeemed in total.
The entity recognises revenue for the loyalty points of £273,684 [(300,000 points ÷ 1,425,000 points)
× £1.3 million and recognises a contract liability of £1.026 million (£1.3 million – £0.274 million) for
the unredeemed points at the end of the first reporting period.
The journal adjustment required is:
DEBIT Revenue £1.026 million

CREDIT Liabilities £1.026 million
Z-Audio and music streaming contract

As with the customer loyalty scheme, IFRS 15 requires application of a five-step process.
Step 1 Identify the contract with the customer – customers are required to sign the contract with H-
Sound.
Step 2 Identify the separate performance obligations – in this contract there are two distinct
performance obligations: the obligation to deliver the Z-Audio product; and the obligation
to provide a 12-month streaming service.
Step 3 Determine the transaction price – this is the £4,800 the customer pays.
Step 4 Allocate the transaction price to the separate performance obligations in the contract – this
is calculated by reference to the standalone price for the produce and the service. That is
the stand-alone price of the Z-Audio £4,600 and the stand-alone price of the streaming
service £50 × 12 = £600 =
Performance Stand-alone Revenue = relative selling price

obligation selling price % of total £4,800 × %
£ £
Z-Audio 4,600 88.5% 4,248
Streaming service 600 11.5% 552
5,200 100 4,800
Step 5 Recognise revenue when the performance obligation is satisfied.

When the Z-Audio is supplied to the customer – H-Sound should recognise £4,248

When the streaming service is supplied – probably a monthly basis would be an appropriate
method
£’000
500 × £4,248 2,124
500 × £552 = 276,000 /12 Only 1 month 23
2,147
Revenue recognised already 2,400
253
Recommended adjustment:
DEBIT Revenue £253,000

CREDIT Receivable £253,000
Part (2)
Issue 3
Reward Issue 4
Before Issue 1 PPE Issue 2 Loan scheme Revenue After RTone
£’000 £’000 £’000 £’000 £’000 £’000 £’000
Revenue 49,211 (1,026) (253) 47,932 93,531
Gross profit 7,873 (1,026) (253) 6,594 19,640
Depreciation 279 761 1,040 100
Lease rentals - 1,737
Finance cost 407 108 + 300 815 30
Net profit before tax 4,504 *(2,061) (408) (1,026) (253) 756 6,250
Equity 6,855 *(2,061) (408) (1,026) (253) 3,107 15,691
Net debt 5,892 108 6,000 608
ROCE 38.5 17.3% 38.16
Gearing 46.2% 65.9% 3.87
Revenue per
employee 328,073 319,547 311.77
Employees 150 150 300
Net profit before

interest and tax 4,911 1,571 6,280
Equity plus net debt 12,697 9,107 16,299
GP% 16.00 13.8 21.00
Net profit margin 9.15% 1.59% 6.71%
EBITDAR 5.45% 8.7%
*Assumption that £1,300,000 wages of software engineers not treated as a cost of sales – alternative
assumptions are valid.
Part (3)
The two businesses are in different stages of the business life cycle with different business models –
high street v internet based – and financing structures. Therefore, ratios are of limited use in
comparing the two businesses. RTone is also larger than H-Sound in terms of revenue.

Performance
Before the adjustments the performance of RTone and H-Sound appeared similar – ROCE was 38.5%
for H-Sound and 38.5% for RTone. The adjustments reduce the profit before tax and equity – after the
adjustments the ROCE for H-Sound is 17.3%.
The ROCE can be analysed by calculating the net profit margin.
RTone H-Sound
Net profit before finance and 6,250 + 30/93,531 = 6.7% Before 4,504 + 407/49,211 = 10.0%
tax After 756 + 815/47,932 = 3.28%
Before the adjustments H-Sound has a higher net profit margin at 10% – however this is now 3.28%
after adjusting for financial reporting errors and the like for like change to the depreciation.
H-Sound achieves a lower gross profit margin than RTone at 16% compared to RTone at 21%.
Suggesting that H-Sound is more competitive on price. However, after the adjustments, because of
the errors in revenue recognition, H-Sound’s GP % falls to 13.8%.
Overall, H-Sound appeared to have been performing better than RTone in terms of net profit and
ROCE but after making the adjustments as set out above, its performance in terms of net profit %,
gross profit % and ROCE is worse than RTone.
Gearing
Because RTone operates from leasehold property on leases of less than 12 months, it has relatively
less net debt. Therefore, its gearing ratio is 3.8%. H-Sound before adjustments had a gearing ratio of
46.2%. The impact of the adjustments arising from the financial reporting issues results in a fall in H-
Sound’s equity and an increase in net debt and therefore the gearing ratio has increased to 65.9%
making H-Sound a highly geared company.
However, RTone currently applies the IFRS 16 recognition exemptions in respect of leases for 12
months or less, which keeps its liabilities off the statement of financial position. As H-Sound owns
property, any comparison between the two companies is limited by the different asset base and
hence the numbers are less comparable. A useful measure would be EBITDAR. This ratio is more
comparable at 5.45% for H-Sound and 8.7% for RTone.
In the year ended 30 September 20X4, RTone will lease retail properties for 10 years, which means
that the IFRS 16 recognition exemptions will no longer apply. RTone will be required to recognise a
right-of-use asset consisting of the present value of the future lease payments, plus payments at or
before commencement of the lease less any lease incentives, initial direct costs and any dismantling
and restoration costs. RTone will also need to recognise the lease liability, consisting of the present
value of the future lease payments. This will increase the gearing ratio for RTone in future years and
make the gearing ratio of RTone and H-Sound more comparable.
Adjustments to financial information and ratios
Answers to this were varied. Although most correctly identified that the salary costs should not be
capitalised fewer discussed why the depreciation policies were very generous even though the
scenario pointed the candidate in this direction. Candidates attempted to adjust the depreciation
charges in line with RTone company’s policies but only the better candidates commented on the
depreciation policy of the property.
A significant number of candidates illustrated excellent IFRS 15 knowledge when considering the
customer loyalty scheme and the discounted elements of the sale of Z-Audio product. A minority
incorrectly discussed setting up an IAS 37 provision in the context of the customer reward scheme.
The excellent answers to the IFRS 15 issues were countered by a challenging IFRS 9 scenario where
many candidates failed to appreciate whether an extinguishment or modification of the loan was
required. Some candidates were aware of the 10% rule in IFRS 9 B3.3.6 but those that applied a
sensible approach were amply rewarded.
Revised financial information and ratios
This was generally well answered. However, some candidates lost marks for either showing no “audit
trail” for the adjustments or failing to add them across to a final revised total. Candidates are to be
reminded that markers cannot see the workings in the spreadsheet cells.

The candidates were asked to revise extracts and there are a woeful number of candidates who failed
to reflect adjustments made to profit or loss in retained earnings (Equity) showing a basic
misunderstanding of double entry.
Analysis of financial performance
The standard of answers was weak, with answers showing no real justification for the differences in
the financial statements of the two companies. Candidates often failed to use the scenario which
presented two businesses in the same industry but with different business models and financing
structures.
Most candidates came up with a basic comparison of the ratios of the two companies, but it was
disappointing that relatively few focused on the impact of the leased assets held by one company
(especially in the light of IFRS 16).
Many simply compared the ratios but did not link the fact that these were companies that traded in
different ways and were of different stages. The better candidates linked the points about one being
retail and the other being online.
61 Gentri plc
Scenario
In this question, the candidate is an audit senior, dealing with partner review comments at the late
stages of a group audit.
Financial reporting and auditing issues are integrated together covering a range of topics including:
management of group audits and the level of direction, documentation and input required from the
group team, consolidation adjustments, the audit of tax and calculation of deferred tax, and the audit
and critical review of the statement of cash flows.
The successful candidate needed a good grasp of financial reporting; an understanding of the audit
documentation required and the ability to identify focused and efficient audit procedures for a given
area and set of circumstances.
For each of the three partner review notes Assimilate complex information to produce
raised by Joe Long (Exhibit 2): appropriate accounting adjustments.
(a) Explain the relevant financial reporting Apply knowledge of relevant accounting
issues and set out the appropriate financial standards to the information in the scenario.
reporting treatment. Identify the need for further information.
Apply technical knowledge and professional
scepticism to identify errors in the statement of
cash flow.
(b) Describe the key audit procedures we Appreciate and apply the concept of
should perform. materiality.
Use all available information. You are not Relate different parts of the question to identify
required to adjust the consolidated statement critical factors.
of cash flows. Use technical knowledge and judgement to
identify risks.
determine appropriate audit procedures or
tests of detail.

Marking guide Marks

Audit procedures 15
25
Total 25

Although this question appears to be mainly about audit, or even the competence of the
component auditors, it requires sound technical knowledge of financial reporting issues. Of
the four professional skills needed for this question, concluding and communicating appear
to be the most relevant.

Your information comes from several sources, and some of it second hand, for example the
email to the subsidiary audit team about materiality. Not all the information is correct, for
example there are cut-off errors and items missing from the statement of cash flows, and you
will need to apply professional scepticism in your explanations and recommendations for the
appropriate financial reporting treatment (Requirement (a)).

The structure is signalled in the way the requirements are set out – you would need to deal
with each partner review note in turn, with the financial reporting issues first and the audit
procedures second. You may need a further section in some cases for ‘other issues’, having
dealt with the specifics, particularly on the group aspects.
Applying judgement
In this scenario, it could be argued that the group auditors have relied too readily on the
judgement of the financial controller and perhaps the component auditors, without proper
documentation or procedures. This appears to be particularly the case regarding deferred tax.
In the exam, and if auditing in practice, you would need to apply judgement in determining
whether this reliance was appropriate.

Communication has been less than perfect in this scenario, and your role here is to provide
clarity. In particular the tone of some of the people in the question has been somewhat
defensive and this is your chance to show neutrality and professionalism in your
communication.
Review note 1: Gentri group audit team’s management of subsidiary audit team
Financial reporting issues and treatment
Intra group sales:
We know from the clearance memo that there were goods in transit from CarNation to Gentri at the
year end and there may also be other goods purchased from CarNation and still held in Gentri’s
inventory. In both cases, a consolidation adjustment needs to be made to eliminate the profit /loss on
such sales and we need to ensure that this is done.

There will also be a deferred tax impact from this adjustment. This will be a temporary deductible
timing difference. This will be equivalent to the unrealised profit element at the rate of tax paid by
Gentri.
As the goods were in transit at the year end it is also possible that Gentri has not recorded the
purchase and therefore there is a cut-off error. Both the supplying and receiving group companies
need to record the sale in the same period so that intercompany balances and transactions can be
eliminated correctly.
Impairment loss:
An impairment loss has been recorded by CarNation. While this may be correct for the individual
company, it raises broader questions for the group audit team as it suggests that Gentri is about to
discontinue production of some engines. That may well have implications for the carrying amounts of
PPE and of inventory within Gentri. We need to ensure that appropriate adjustments are made.
It is also possible that accelerated depreciation would have been more appropriate than a one-off
impairment charge but further information is needed to evaluate this. In CarNation, the tax treatment
mirrors the accounting treatment so any adjustment to the impairment in CarNation will have a
consequent effect on current tax at the rate of 30%.
In addition, unless the overall group cash flows have been taken into account it is unlikely that the
provision calculated in CarNation will be the same as that at a group level where the cash inflows will
take into account any profit in the holding company but there may also be further assets to take into
account. We will need to consider cashflows for the range of engines rather than just the parts that
CarNation makes. Adjustments at group level may well give rise to deferred tax assets or liabilities.
Audit procedures
Cut-off
Confirm that the shipment on 29 September has been correctly and consistently recorded by both
parties such that the intercompany balances between Gentri and CarNation agree.
Unrealised profit
Determine which parts are supplied by CarNation and ascertain the value of the inventory of such
parts at year end. Confirm whether they are recorded at “cost” to Gentri or whether any provisions
have been made against them.
Make enquiries from CarNation as to the costs of manufacturing the relevant parts and ask the
CarNation audit team to perform work to test this information or to tie it into testing already done.
Calculate the amount of unrecorded profit / loss within the inventory (including goods in transit of
£15 million) and raise an adjustment to eliminate this from the group accounts. Include in this
calculation of the relevant deferred tax provision.
PPE – Impairment
The impairment charge made is certainly material at group level and will also be judgmental. There
needs to be discussion between the group audit team and CarNation audit team about the basis for
the impairment charge, the forecasts used to support it and the audit work done. There also needs to
be consideration of whether the information used is consistent with that used for the Gentri audit as
Gentri is the entity which makes all external sales and generates cashflows from revenue.
The Gentri team need to follow up with group management the suggestion that a new range of
engines is to be introduced and ascertain whether there are other assets in the group whose carrying
values might be affected or evidence that the provision required at group level is different. If the
team were previously unaware of this and it is significant, it may cast some doubt on the openness of
management and this will need careful consideration.
Other group issues
• CarNation appears to be a significant component of the Gentri group, contributing 20% of profit
and holding assets (PPE and inventory) which are clearly material to the group.
• The group audit team is required to document its assessment of the component auditor, to set
component materiality (which it has) and to determine the extent of work on significant
components such as CarNation. We will need to ensure that there is a scoping document on file
assessing the significance of CarNation and the extent of procedures required. An assessment of
the professional competence of the subsidiary audit team should also be made. The fact that we
have prior experience of working with them is helpful but not in itself sufficient.

• The email correspondence that the engagement manager has found needs to be put on the audit
file so that it forms part of the audit working papers.
• In addition to the brief clearance, the CarNation team should be asked to report specifically on
the significant risks of material misstatement; to report instances of non-compliance with laws and
regulations; to provide a list of uncorrected misstatements above the clearly trivial threshold; to
identify any indicators of management bias and to highlight deficiencies in internal control or
other significant matters.
• As CarNation is a significant component, there should also be evidence that there has been
discussion between the group audit team and the CarNation team. This should certainly be the
case in respect of the impairment charge and also considerations regarding the net realisable
value of inventory.
• We will also need an update on post balance sheet events from the CarNation team at the date
we sign off the group audit.
Review note 2: Work on taxation
It is incorrect for no deferred tax movement to be recorded – there should be movements in respect
of the unrealised profit (see above) and PPE.
For PPE, the movement in the year can be calculated as follows:
£m
Tax base brought forward 43.0
Additions qualifying for capital allowances 21.0
Total 64.0
Tax depreciation per question (11.5)

Tax base carried forward 52.5
Carrying value 90.0
Taxable temporary difference 37.5
Deferred tax liability @ 19% 7.1
Deferred tax liability brought forward 6.1
Movement 1.0
An entry is needed to increase the tax expense and the deferred tax liability by this amount.
In addition, a temporary difference may arise in respect of the unremitted earnings from CarNation.
In total the difference can be calculated as follows:
£m
Tax base = cost of investment 100
Temporary difference equal to post acquisition retained earnings – £80m less £10m 70
Potential deferred tax liability at 19% (receiving company’s tax rate) 13.3
Further consideration is needed as to whether this potential deferred tax liability should be
recognised. This may not have been necessary in the past as Gentri appears to be able to control the
timing of the payment of dividends (and therefore the timing of any reversal of the temporary
difference) and, historically, appears to have made no plans for dividends to be paid. However, there
is now an expectation that a dividend will be paid, and so deferred tax should be provided to the
extent that the temporary difference is expected to reverse. Hence provision is needed for a deferred
tax liability of £50.0 million @ 19% = £9.5 million.

Note: Credit was also given here if candidate argued for full £13.3 million provision on the basis that
it is no longer not probable that the whole balance will reverse and also if the candidate argued that
no provision would be required as all the sales are intra group.
Current tax and current tax payable
The current tax expense at £27 million for Gentri plc suggests that there are other timing differences.
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. Therefore, this suggests a tax expense of £143m + £6m depreciation less £11.5m tax
depreciation = £137.5 × 19% = £26.1m – so suggesting there are some other timing differences —
these may be covered under the IRE but may also be temporary timing differences requiring a
deferred tax adjustment.
The current tax payable figure of £15 million does not agree to the £27 million tax expense. There
could be an over payment for the previous year – or a tax repayment which needs to be recognised
in the profit or loss – or the company could be making payments on account. This requires further
investigation.
Audit procedures
For the capital allowances, the calculation is relatively straightforward, but it relies on the following
factors which may require agreement to external information / further evidence:
• Confirm the rates of tax and capital allowances to supporting documentation from the tax
authorities.
• Evaluate and confirm the reasonableness of the judgement that the additions in the year all
qualify for capital allowances – the additions are significant so work needs to be done to review
this.
The requirement to provide deferred tax on unremitted earnings depends on two factors – that
Gentri can control the timing of the payment of dividends and that it is no longer probable that the
temporary difference will not reverse, at least in part.
Evaluate the evidence for this control by examining the composition of the board of CarNation and
the rights of the 100% shareholder which will be relevant factors.
Examine the evidence for the decision to request a dividend payment and challenge whether this is
probable and also whether it is a one-off – it may be that it is no longer possible to say that reversal of
the remaining temporary difference is not probable.
Other audit procedures for tax more generally
It is not acceptable just to take the Gentri tax computation performed by the financial controller. We
do need to audit it. The extent of work may depend on our assessment of the controller’s tax
knowledge and expertise but should include the following:
• Agree key figures to our audit file.
• Compare the nature and quantum of any adjustments to profit to those made in the prior year.
• Evaluate the completeness of adjustments, taking into account those made in the prior year and
our knowledge of any one-off items, significant transactions etc.
• Consider the need to involve our own tax expert.
• Evaluate whether any adjustment is required in respect of the tax balances brought forward as a
result of agreeing the final figures with the tax authorities.
• Reconcile the movements on all balance sheet tax accounts and ensuring that the year-end
liability for current tax agrees to the amounts still payable in respect of the current and any open
prior years.
In addition, we need to perform audit procedures to consider the completeness of the deferred tax
balances.
On a group basis we can take some assurance from the CarNation audit team but should enquire as
to whether they have considered the tax treatment of the one-off impairment charge.
We should also consider fully the tax impact of all consolidation adjustments.

Review note 3: Statement of cash flows
From a review of the cash flow statement, the following issues can be identified:
• No add back is made for any impairment charge but we know that there has been a material
impairment charge of £11.5 million in CarNation. This appears to be an error. It is not clear where
the other side of the error has been posted – it is possible that it is included in depreciation but
that seems unlikely as the depreciation figure is very similar to last year and we know that there is
£6 million for plant and equipment in Gentri alone. It may have been netted against investment in
PPE or included in creditors or elsewhere as a balancing figure. The adjustment required cannot
therefore be ascertained without further audit work.
• There are no entries for either the profit or loss or proceeds on the disposal of assets. It seems
unlikely that there were no disposals in the year so it may well be that this has been incorrectly
treated, most likely netting the carrying value of any disposals against the investment in PPE.
Again, we need to do more work to ascertain the adjustment.
• The amount shown as tax paid is equal to the tax expense for the period – it seems unlikely that
this would be the case as, even if payments on accounts are made, they will rarely equal exactly
the tax payable for the period. In addition, although no deferred tax entries have been made in
Gentri (to date) they will have been made in CarNation and deferred tax expenses have no cash
impact. A correction almost certainly needs to be made with the other side of the adjustment
being recorded within the movement on accounts payable (or possibly accounts receivable for
deferred tax).
• The loan repayment has not been shown as a financing cashflow even though a repayment of £10
million in the year would be expected. This may have been included in the movement in creditors
which does look lower than the prior year.
• In addition, there is no interest charge shown under financing cash flows so assume that this has
been included incorrectly in operating cash flows.
Audit procedures
The statement of cash flow needs audit procedures as for any other primary statement. This will
comprise:
• Agree the opening and closing statement of financial position and profit or loss account
information used to compile the cash flow statement ties into the audited primary statements and
notes.
• Reperform tests for arithmetic accuracy.
• Agree that the opening and closing cash balances are correct.
• Confirm that, in reconciling profit to operating cashflow, only the movements in accounts payable
and receivable which arise from operating cash flows are taken into account. Balances arising
from the acquisition or sale of PPE, taxation or financing loans should be excluded and we should
perform audit procedures to ensure that this is the case. Recalculation of the amounts we believe
should be included is often the most effective procedure.
• Examine the profit or loss account and statement of financial position for any other non-cash
items such as impairment and ensure that these are treated correctly.
• Confirm that the cash flows shown for loan repayments are the actual payments made; for
proceeds from sales are the actual cash proceeds received; for the acquisition of PPE are the
actual cash payments made etc.
• Evaluate the cash flow statement and related notes include all required disclosures.
The question aims to put the candidate in a more advanced role of reviewer and provides both the
partner review notes and the responses from the manager together with extracts from the financial
statements provided in Exhibit 1.
Review note 1
Partner review point 1 required the candidate to consider the financial reporting implications for the
group arising from issues raised by the CarNation auditor – goods in transit and a large impairment.
Most candidates identified a cut off issue and the basic adjustments for intra group sales and PURP.

Better candidates commented on the wider group implications of the impairment charge and the
lack of documentation relating to scoping and the component auditor. Many weaker candidates
assumed that the failings in the financial reporting and audit procedures were at the subsidiary level
whereas it was the parent and group auditors who were failing to follow through the points raised at
the subsidiary level in the UK companies.
However most did come up with appropriate audit procedures which were the best parts of
candidates’ answers.
Review note 2
Most candidates realised that deferred tax was an issue and most attempted to calculate a figure
although disappointingly few got this basic calculation correct. Again, the audit procedures part of
the question was well answered with good procedures identified.
Review note 3
A significant minority of candidates did not consider the consolidated statement of cash flows and
generally this was the least well answered part of this question. Many candidates came up with
detailed procedures which would already have been carried out as part of the audit of the statement
of profit or loss or statement of financial position. Candidates identified the missing impairment and
loan repayment most frequently and others also identified the lack of interest and PPE additions and
disposal proceeds.

62 HC plc
Scenario
The candidate is 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.
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 and she manages HC plc’s
investments and financial assets with minimal monitoring.
The HC plc finance director went on long-term sick leave on 10 March, just before Maisie joined HC
plc. As there is no replacement finance director, Maisie is acting in that role.
The candidate is provided with extracts from HC’s consolidated financial statements for the year
ended 31 May 2020, including the accounting policy note for financial assets. 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.
Maisie has carried out some transactions in financial assets and her recording of these transactions
cast doubts on her competence. Also because of a performance related bonus based on profit for
the year, there is a threat to her objectivity arising from her self-interest in achieving the bonus target.
There is also a possibility that she has used insider knowledge from her former employer.
For each of the matters in Jane Smith’s audit Assimilate and demonstrate understanding of a
notes, set out and explain the correct financial large amount of complex information.
reporting treatment in HC plc’s financial Identify the correct accounting treatments for
statements and, where relevant, the HC group financial assets.
financial statements, for the year ended 31 May
2020. Show appropriate journal adjustments Explain and recommend appropriate
and explain any implications for the accounting accounting treatments for financial assets.
policy note. Set out correcting journal adjustments.
Calculate, taking into account your journal Assimilate adjustments to prepare revised profit
adjustments, the revised profit before tax and before tax.
other comprehensive income for HC plc and for Demonstrate understanding of the difference
the HC group for the year ended 31 May 2020. between adjustments made in the parent
company and those made in the group financial
statements.
Identify and explain the additional audit risks Appreciate the significance of transactions and
arising since the audit planning was completed events which have happened after audit
in February 2020. planning was completed.
Identify relevant key audit risks.
Set out the key audit procedures that we should Describe appropriate audit procedures
perform in respect of: required to provide verification evidence for
• Konditori Ltd’s investment in Clik Ltd each risk.
• HC plc’s corporate loans Demonstrate understanding and significance of

audit scoping in the context of Konditori’s
investment in Clik.
Explain the materiality of the investment in
terms of disclosure rather than profit.

Explain the ethical implications for Welfold and Identify the threats in the scenario to the ethical
for Maisie, arising from Maisie’s roles and principles of integrity arising for Maisie if she
actions and the matters highlighted by the audit uses information from her former employment.
assistant. Set out the actions Welfold should Identify the threats for Maisie of professional
take. behaviour and professional competency arising
from accepting and advising in roles she is
clearly not qualified to accept.
Identify the self-interest threat for Maisie from
the profit related bonus scheme.
Explain the self-interest threat for Welfold
arising from the retendering of the audit.
Explain the actions for Welfold including
consult with ethics partner and potential need
to report ICAEW member for breach of ethical
code.
Explain the scenario from different
perspectives.
of contributing to the profession & appreciating
the ethos & culture of the accountancy
profession.
Marking guide Marks
Explanation for each matter in Jane Smith’s audit notes 18

Revised PBT and OCI 4
Additional audit risks arising since the audit planning was completed 3
Key audit procedures 7
Ethics 8
40
Total 40
Part (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).
Investments in subsidiary companies
The accounting treatment of these investments in the parent company is correct and complies with
the accounting policy note and IAS 27.
Sale of shares in Alma plc
800,000 shares were initially recorded at cost of £6,000,000.
The fair value (FV) at 31 May 2019 was £10,000,000, hence as per the accounting policy note
£4,000,000 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 each reporting date.
The fair value of the investment has been correctly removed from the statement of financial position;
however, the profit has been incorrectly recorded in the statement of profit or loss.

While the gain/loss on derecognition of an equity instrument at FVTOCI is recognised in profit or
loss, in practice this should normally be a nil amount, assuming the disposal is at fair value. The
asset’s carrying amount is remeasured to fair value at the date of derecognition (IFRS 9: para 3.2.12)
immediately prior to the disposal. Any change resulting from such a remeasurement is recognised in
OCI.
The accumulated gains of £4,000,000 are not reclassified to profit or loss on disposal of the
investment, so the total gain for the year is (800,000 shares × £17 per share = 13,600,000 less
£10,000,000) = £3,600,000 which should be recognised through OCI.
A correcting journal is required of:
£’000 £’000
DEBIT Retained earnings (statement of profit or loss) 3,600
CREDIT OCI – gain recognised immediately before disposal 3,600
Investment in VLA plc shares

Maisie’s proposed accounting treatment is not in agreement with the accounting policy. The
accounting policy states that an irrevocable election is made to classify investments in equity
instruments at FVTOCI – this should be clarified with the directors as to whether there has been a
change in accounting policy.
The investment in VLA plc has been recognised at the offer price of £56.72 at 3 April 2020
(£18,150,400/320,000 shares = £56.72), which if this investment is to be treated at FVTPL, the
acquisition of 320,000 shares should have been initially recorded at bid price of £55.45 per share, a
cost of £17,744,000.
The bid-offer spread of 1.27p reflects a transaction cost and if the investment is classed as at fair
value through profit or loss, this cost of £406,400 should have been expensed to profit or loss for the
year.
A correcting journal is required of:
£’000 £’000
DEBIT Retained earnings (statement of profit or loss) 406
CREDIT Other equity 406
In addition, as the investment is classed as at fair value the investment should have been re-
measured to its fair value at the year end. The fair value used should be the year-end bid price is
£54.45. The fair value of the investment at the year-end should therefore be £17,424,000 with a loss
of £320,000 being recorded through P or L.
The journal adjustment required is:
£’000 £’000
CREDIT Other equity investments 320
An alternative answer could be that Maisie cannot change the accounting policy and therefore the
investment should be recognised at FVTOCI – in which case all £726,000 representing the
transaction costs and fair value loss would be recognised in OCI. Credit given for either approach.
Investment £25 million
This is in fact a loan made by HC to its subsidiary Konditori to provide finance for and investment in
Clik Ltd and therefore in HC’s own financial statements the amount should appear as a loan to a
subsidiary company and not as an investment.
Konditori has then invested in a joint venture with a national supermarket to form a joint venture
called Clik Ltd. In the group financial statements, Clik is a joint venture of the group. This is because
as 50:50 shareholders, neither Rosen nor Konditori will have control.

Also, Clik will have its own assets and liabilities and the arrangement is therefore a joint venture
rather than a joint operation. It should be accounted for using the equity method in the consolidated
accounts for the HC group.
The relevant accounting guidance to consider is that concerning joint arrangements. Clik is a
separate entity and will have Articles setting out the contractual arrangements between the parties.
The amount that should be recognised is as follows:
£’000
In the statement of financial position
Cost 25,000
Share of post-acquisition loss
(18,000) × 50% (9,000)
16,000
In the statement of profit or loss
Share of post-acquisition loss after tax
(18,000) × 50% (9,000)
I would need to ensure that transactions between Clik and Konditori have been accounted for
correctly.
Konditori – Start-up costs
The start-up costs relate to the new company set up with Rosen and appear to relate to an amount
subscribed as initial capital. It therefore appears incorrect that this should have been treated as an
operating cost.
The initial capital represents an investment in the JV and should have been shown in the statement of
financial position for Konditori as an investment and not accounted for as an operating cost.
This will also impact on the group results because Konditori is a subsidiary and its results are
included in the consolidated financial statements.
£’000 £’000
DEBIT Investments 25,000
In Konditori’s separate financial statements, the investment will be recognised in accordance with IAS
27, and will be held at cost less any impairment in value as per the group accounting policy. An
impairment should be considered as Clik has made a loss.
The loan from HC plc would be recognised as a liability due to the parent company and would
cancel on consolidation.
Corporate loans
£12.5 million bond in Reggs plc
HC is holding the corporate bond within a business model whose objectives are met by holding the
loans to collect contractual cash flows. Therefore, the current classification of amortised cost is
correct.
Maisie has not recognised the profit on the sale of half of the bonds. She has simply posted the
proceeds against the value of the bonds on the statement of financial position and not recognised
any gain or loss.

The amortised cost at the time of the sale was as follows:
Amortised cost at Interest income at Amortised cost at

the beginning of 10% – profit or the end of the
the year loss Interest received year
£’000 £’000 £’000 £’000
31-May-19 10,000 1,000 (590) 10,410
31-May-20 10,410 1,040 (590) 10,860
Gains on disposal of financial assets measured by amortised cost method are recognised in the
statement of profit or loss. This is calculated as follows:
£6,000,000 – (£10,860,000 × 50% = 5,430,000)
The following adjustment is recommended to record the gain on the sale:
£’000 £’000
DEBIT Bond £6,000,000 – (£10,860,000 × 50% = 5,430,000) 570
Being profit on sale of 50% of the bond.

Loan to JUP – impairment loss allowance
The loan to JUP is held within a portfolio where the business model objective is achieved by
collecting their contractual cash flows. The cash flows are straightforward interest at 8% pa and
repayment of principal on 31 December 2020. Therefore, the loan to JUP should be measured at
amortised cost.
On 31 May 2019, 12-month expected credit losses of £20,000 (2% × £1.00 million) were correctly
recognised. Because the balance is classified as amortised cost, impairment losses are debited to
profit or loss and the credit balance is set off against the balance of the loan. The loan is classified at
stage 1. This adjustment has been done in the previous year.
The information from the credit rating agency implies that there has been a significant change in the
credit rating, at a minimum, that there has been a significant increase in credit risk and potentially
that the loan has moved into stage 2 ie, that there has been an increase in credit risk of JUP.
The impairment loss should be calculated based on the lifetime expected credit loss = £1,000,000
less £20,000 previously recognised = £980,000.
Adjustment recommended is:
£’000 £’000
DEBIT Impairment loss (statement of profit or loss) 980
CREDIT Loan asset 980
Part (2)
Adjusted extracts
HC Parent financial
statements HC Group
£’000 £’000
Alma plc shares – profit has been incorrectly
recorded (3,600) (3,600)
VLA shares – incorrect price (406) (406)
VLA shares – fair value adjustment (320) (320)
Konditori – write back of investment in Clik-online 25,000

HC Parent financial
statements HC Group
£’000 £’000
Gain on disposal of bonds in Reggs 570 570
JUP impairment loss (980) (980)
Share of post-acquisition loss of Konditori
(18,000) × 50% ––––– (9,000)
3,764 106,864
Alma – gain immediately before disposal 3,600 3,600
Part (3)
Significant transactions have been undertaken since the initial assessment of risk for financial assets
was performed in February 2020.
No separation between finance department and treasury department – Maisie has control over the
performance of treasury functions and the recording of those transactions.
The bonus structure creates a significant risk because Maisie’s bonus is based on HC’s profit before
tax.
No authorisation of the transactions – no agreement at board level?
Transactions are speculative – why has she invested in VLA on the advice of former colleague?
Maisie has not made any adjustments for a significant investment within her portfolio entered into
before she was appointed – £25 million loan to Konditori which has been treated incorrectly in the
financial statements of both HC plc and the group – this is a material transaction and the head of
treasury would have been expected to have found out about this.
Part (4)
Konditori Ltd’s investment in Clik Ltd
Audit procedures are required both at subsidiary and group level.
Subsidiary level – Konditori audit
The investment in Clik will be held at cost less impairment as Konditori is not required to prepare
consolidated financial statements as it is a 100% subsidiary.
Therefore, the key audit procedures would be:
• to ensure that the cost is correctly stated by agreeing to bank transfer from HC.
• to ensure appropriate authorisation by agreement to board meetings and direct confirmation with
the HC plc board; and
• to ensure that no impairment of the investment is required. A key impairment procedure would
be to obtain forecasts of results to check recoverable amount of the £25 million investment is the
higher of valuein use and net selling price of the investment.
Group level
The results although in terms of profit are not significant the impact on group is likely to be material
and disclosure requirements of the joint venture will also need to be audited.
The HC group auditors will need to perform a scoping exercise to determine the level of procedures
required. This would include confirmation of the appointment of auditors for Clik and an assessment
of the auditor’s qualifications. The 3-months results are likely not to have been audited and therefore
depending on the outcome of the scoping exercise, Welfold would need to carry out its own audit
procedures on the results included within the group financial statements.

Audit procedures for HC plc corporate loans
Reggs
To ensure ownership and valuation:
• confirm the proceeds and interest rates to supporting third party documentation
• re-calculate the effective interest rate and confirm the year-end balance
• evaluate the need for any impairment of the debt by examining Reggs plc financial statements
and analysts reports
JUP
It is insufficient to download the credit rating document and to do nothing with it.
• Confirm that the details of the rating have been correctly reported in the financial reporting of the
loan
• Evaluate the expected recovery of the loan
• Verify the source and content of the credit rating document using external confirmation
Part (5)
Issues
Maisie is an ICAEW Chartered Accountant and is bound by the ethical codes. She may be using
contacts for insider information – VLA shares were a former client from her time at the investment
bank. There is a threat to her integrity.
Maisie has a threat to her objectivity due to the self-interest threat created by the bonus structure.
There is potential therefore to be influenced in her judgement to report profits accurately – the
adjustments required have reduced the profit from £8.5 million to £3.8 million and the bonus target
of £7 million is no longer achieved.
The bonus structure, lack of segregation of duty are examples of weak corporate governance.
Maisie is breaching professional competence and due care due to her lack of experience. Her lack of
financial reporting knowledge is evident from the mistakes she has made and therefore she has
accepted a role for which she is clearly incompetent.
There is a self-interest threat for Welfold arising from the retendering of the audit as the firm may be
influenced in the actions.
Actions
Welfold may have duty to report an ICAEW member – It should establish whether there are any
grounds to consider that Maisie has used insider information – the value of the VLA shares has in fact
fallen. Discuss at the end of the year.
The marks for the corporate reporting exam are awarded based on the demonstrations of skills and
not just for technical knowledge. This question demanded a high level of skills to be applied to the
scenario. The technical topics (part (1)) covered accounting standards IAS 27, 28, IFRS 11 and IFRS 9
and required candidates to appreciate the difference between group financial statements and
individual parent financial statements, the accounting treatment of investments in joint ventures and
financial instruments. Most candidates were able to compare the accounting treatment against the
accounting policy to decide whether the treatment and or the policy were appropriate. A similar
structure was used for Vacance (July 2019) which also presented candidates with an accounting
policy for a different technical area (PPE) but tested similar skills.
Also tested was the ability to provide correcting journal adjustments. Key skill marks were available
for assimilation (part (2)) and for applying structuring skills to identify the change in audit risk by
events since audit planning was carried out ie, the bonus structure and change in personnel (part (3))
and to focus on key audit procedures (part (4)). This question also contained the ethical scenario
which again demanded judgement and assimilation skills to be applied to the scenario (part (5)).
The question addresses the learning outcome in the syllabus (2 c): formulate and evaluate
accounting and reporting policies for single entities and groups of varying sizes and in a variety of
industries controls to mitigate risk and governance procedures with the client. Seek advice from
Welfold’s Ethics partner concerning need to report ICAEW member.

Part (1)
Explanation for each matter in Jane Smith’s audit notes
Overall, candidates coped extremely well with this requirement, and were able to attempt answers to
each of the five accounting issues and as a result, maximum marks were frequently awarded.
Weaker candidates struggled with some of the more basic financial asset issues covered eg, the use
of amortised cost for financial liabilities was frequently incorrectly applied or not discussed.
Some candidates missed out on identifying that the investment in the subsidiary held at cost less
impairment in the parent’s financial statements was the correct treatment. Time was then wasted by
detailing how to then treat the investment when preparing the group accounts, ie eliminating the
investment and replacing the assets/liabilities line-by-line and even explaining the goodwill and NCI.
This was not asked for in the requirement – candidates need to be able to distinguish between
correct and incorrect accounting treatment which is a much higher skill.
This was further examined in the joint venture section and weaker candidates struggled to see the
movement of the £25 million from the parent company to the subsidiary to the JV. However, the
majority of candidates coped very well with this and some excellent answers were provided.
It was good to see so many stating the journals, including the values although weaker candidates
struggle to provide correcting journals when requested to do so.
Part (2)
Revised PBT and OCI
Another area in which candidates often achieved maximum marks. Typically, well attempted with
application of own figure rule.
Weaker candidates demonstrate a lack of understanding of parent company financial statements and
the difference between the individual financial statements and the group. This is a key area which is
tested in this exam as opposed to basic consolidation adjustments examined at professional level.
Part (3)
Additional audit risks arising since audit planning was completed in February
Maximum marks were again often achieved here. Identification of the audit implications caused by
the bonus and change in key staff were commonly identified. Weaker candidates often wrote
extensively about the risks caused by every financial reporting issue instead of focussing on higher
level issues. This could have caused time pressure later in the exam.
Part (4)
Key audit procedures
A very pleasing overall performance as candidates were regularly using strong verbs to describe
their testing and were able to appreciate the need for 3rd party evidence across both the joint
venture acquisition and the corporate bonds. Weaker candidates struggle with identifying key
procedures and tend to write overall objectives instead.
Part (5)
Ethics
Overall, well attempted and many candidates considered the independence issues arising from the
bonus and the tender.
However, the insider dealing issues and legal implications were less frequently considered as were
the governance issues arising from the dual roles undertaken by Maisie and lack of board oversight.
Weaker candidates tend to focus on one side of the issue instead of seeing the perspective from
both Maisie and Welfold’s positions. Many suggested calling the ICAEW helpline for advice but did
not identify advice they wanted. Few suggested reporting Maisie because she is breaching the code
and potentially breaking the law with insider dealing. There was however some good application of
the principles of the code to the scenario.

63 React Chemicals plc
Scenario
The candidate is working as a financial accountant at React Chemicals plc (React), an AIM-listed
company based in the UK. React manufactures and supplies chemicals to customers in the UK. It
prepares financial statements to 31 July.
The board has set out two proposals for the year ending 31 July 2021 and needs to understand the
financial reporting implications of these proposals.
Proposal 1 relates to the distribution of chemicals and the board is considering two alternative
contracts, A and B
Proposal 2 relates to a new share option scheme which will be open to all employees
Forecast financial information, including information about tax treatments, for the year ending 31 July
2021 is provided which does not include any impact from the board’s proposals.
The candidate is required to set out the financial reporting treatment of both proposals. The question
covers the recognition of a right of use asset and liability under the IFRS 16, IFRS 2 share options and
deferred and current tax.
Set out and explain the appropriate financial Assimilate and demonstrate understanding of a
reporting treatment, including the impact on large amount of complex information.
current and deferred tax for: Evaluate the appropriate accounting treatments
• Proposal 1 – Distribution costs (Exhibit 1). for complex transactions including leases and
Address both Contract A and Contract B; share options.
and Recommend appropriate accounting
• Proposal 2 – Share option scheme (Exhibit 2). adjustments in the form of journal.
Include relevant journal adjustments. Evaluate the impact of the transactions for the
financial reporting of deferred and current tax.
Interpret the impact of the recommended
financial reporting treatment on the
presentation of the financial statements and
ratios.
Assuming that React signs Contract B with Assimilate adjustments to prepare the revised
Dutton, figure for income tax to be reported in the
• Calculate the tax expense to be shown in the statement of profit or loss and the current and
statement of profit or loss for the year deferred tax balances in the statement of
ending 31 July 2021 and the current tax and financial position.
deferred tax liabilities as at 31 July 2021.
Prepare revised extracts from the financial Assimilate information and use own accounting
statements for the year ending 31 July 2021, adjustments to prepare revised extracts from
including your adjustments. the financial statements
Marking guide Marks
Appropriate financial reporting treatment 18

Tax expense, current tax and deferred tax liabilities 6
Revised extracts from financial statements 6
30
Total 30

Part (1)
Briefing paper for the React board
Subject The financial reporting implications for each of the proposed changes (Exhibit 1) and
recommendation of the appropriate financial reporting treatment including the impact on current
and deferred tax.
Distribution costs
The key financial reporting implication with Contract A and B is to determine whether the contract
results in a right of use asset and an associated liability under IFRS 16. Key questions to ask are as
follows:
(1) Is there a contract between a supplier and a customer? Can you identify an asset or group of
assets or part of an asset?
(2) Does the customer have ‘right of use’ - can the customer direct what happens to the asset? Does
the customer have the economic benefits of the identified asset? Or can the supplier benefit
from the asset when the customer is not using it.
(3) Does the supplier have ‘substitution rights? i.e. can the supplier use the asset for its other
customers?
Contract A
Identified assets?
The first criterion to be assessed is to determine whether the contract between the customer and the
supplier contains a lease and whether there is an identified asset which the customer controls.
With Contract A it could be said that there is an asset which will be explicitly identified in a contract.
Either the tankers or the containers could be said to be identified assets as they are made available
for use by the supplier (TrensFar) to the customer (React).
Right to direct the use?
However, even if a contract specifies a particular asset, a customer does not have the right to direct
the use of that asset if the supplier has a substantive right to substitute the asset throughout the
period of use.
Substantive substitution rights?
TrensFar does have substantive right of use because:
• TrensFar has the practical ability to substitute alternative assets throughout the period of use -
TrensFar can collect the containers from React’s premises when they are not in use; and
• TrensFar would benefit economically from the exercise of its right to substitute the asset – for
example by using it for a different client.
Although it may be the case that because the containers are located at React’s premises, the cost to
collect the container may outweigh the benefit to TrensFar and this would need to be confirmed.
Also, the cost to clean the containers may not make the substitution economically viable. This is an
important point because IFRS 16 requires that when it is not readily determinable whether a supplier
has substantive substitution rights, a lessee must presume that any substitution right is not
substantive.
Conclusion: No right of use asset and related liability should be recognised.
However, assuming that TrensFar has substantive substitution rights, the recommended financial
reporting treatment is to treat the costs arising under the contract as a debit to profit or loss account
and a credit to cash/trade payables.
Because the accounting treatment and the tax treatment are the same the impact of the cost will be
to reduce the current tax expense by £5,000,000 × 25% = £1,250,000.
£’000 £’000
DEBIT Distribution costs 5,000
CREDIT Cash 5,000
DEBIT Tax liability 1,250

Contract B
Supply of containers
In this contract the identified asset could be said to be the 15 containers available to React (the
customer) for 9 years which have been provided by the supplier (Dutton).
Right to direct the use?
With contract B the containers are specific to the customer, React. The containers are stored at
React’s premises when not in use and they have been specially constructed for the particular
chemical produced by React.
Substantive substitution rights?
Apart from cleaning and repairs, it does not appear that Dutton has substitution rights from which it
can benefit economically.
The above would therefore lead to the conclusion that the contract contains a lease for the 15
containers.
The recommended financial reporting treatment is that React should treat the 15 containers as a right
of use asset and set up an associated liability.
Accounting entries for a right of use asset and associated liability
A ‘right of use asset’ is measured at the present value of the minimum lease payments.
The discount rate used to determine present value should be the rate of interest implicit in the lease.
However, if this is not known the entity’s incremental borrowing rate can be used.
(1) The lessee recognises a right-of-use asset and a lease liability.
£’000 £’000
DEBIT Right of use asset (£4,000,000 × 6.802 (DCF 9 years @ 6%)) 27,208
CREDIT Lease liabilities 27,208
Being the recognition of a right-of-use asset measured at the amount of the lease liability
(2) The ‘right of use asset’ would also include the following amounts, where relevant:
• Any payments made to the lessor at, or before, the commencement date of the lease, less any
lease incentives received.
• Any initial direct costs incurred by the lessee.
• An estimate of any costs to be incurred by the lessee in dismantling and removing the underlying
asset, or restoring the site on which it is located.
In relation to Contract B, the £80,000 payable by React at the start of the lease should therefore be
included in the cost of the right of use asset.
£’000 £’000
DEBIT Right of use asset 80
CREDIT Cash 80
Being inclusion of any initial direct costs incurred by the lessee.

(3) The lessee measures the right-of-use asset using the cost model or revaluation model if it relates
to a class of PPE to which the lessee applies the revaluation model - the asset will then be
depreciated. Assuming that the containers have a useful life at least equal to the lease term, they
should be depreciated over 9 years.
£’000 £’000
DEBIT Profit or Loss – depreciation expense (£27,208 + 80 / 9 years) 3,032
CREDIT Right of use asset – accumulated depreciation 3,032

(4) Lease liability subsequent measurement
£’000 £’000
CREDIT Cash 4,000
Being payment of lease rental to the lessor

(5) Interest is then charged using the amortised cost method
£’000 £’000
DEBIT Profit or loss – finance cost £27,208 × 6% 1,632
Being finance interest using the rate implicit in the lease.

The liability will be presented as non-current and current liability
Non-current Current
Year b/f Interest Cash C/f liability liability
£’000 £’000 £’000 £’000 £’000 £’000
1 27,208 1,632 (4,000) 24,840 22,330 2,510
2 24,840 1,490 (4,000) 22,330
Tax implications:
The finance interest will reduce both accounting and taxable profits and tax relief will be available of
25% × 1,632,000 = £408,000
The depreciation cost will be disallowed for tax purposes and replaced by tax depreciation at 30% –
therefore the impact on current tax will be tax relief of £27,208,000 × 30% = £8,162,400 × 25% =
£2,040,600.
Deferred tax
Because the rate of tax relief is faster than the rate of depreciation, a deferred tax adjustment will be
required as follows:
£’000
Carrying amount of right of use asset
£27,288 – £3,032 24,256
Tax base of the right of use asset
£27,288 – (£27,288 × 30% = £8,186) 19,102
5,154
Increase in deferred tax liability – Timing difference at 25% 1,289
Transport to React’s customers

There is no specific identified asset in this element of the contract, and therefore it does not contain a
lease. The cost of transporting the containers to React’s customer and returning the container to
React’s premises should be charged to profit or loss.
Because the cost is treated the same for accounting profits and taxable profits, the cost will reduce
the amount of current tax payable by £1,000 × 25% = £250,000.

£’000 £’000
DEBIT Distribution costs – profit or loss 1,000
CREDIT Cash/ trade payables 1,000
DEBIT Tax liability 250
Share options
This is an equity-settled share-based payment scheme and is therefore measured at the fair value of
the option on grant date in accordance with IFRS 2.
The directors predict that the non-market-based condition will be met by 31 July 2022 and their
accounting treatment is incorrect to not measure an expense. Therefore, React will recognise an
expense each year for the consumption of the employee services given in consideration for the share
options granted as follows:
100 × 2,600 options × £3.60 = £936,000 / 2 years = £468,000
£’000 £’000
CREDIT Equity 468
Deferred tax asset

The company will not receive a tax deduction until the share options are exercised. Therefore, a
temporary difference arises, and IAS 12, Income Taxes requires the recognition of deferred tax.
A deferred tax asset results from the difference between the tax base of the services received (a tax
deduction in future years) and the carrying amount – which is zero. IAS 12 requires the measurement
of the deductible temporary difference to be based on the intrinsic value of the options at the year
end. This is the difference between the fair value of the share and the exercise price of the option.
If the amount of the estimated future tax deduction exceeds the amount of the related cumulative
remuneration expense, the tax deduction relates not only to the remuneration expense but also to
equity. If this is the case the excess should be recognised in equity.
The difference between exercise price and market price of the share at July 2021 is £4.80 (£8.60 –
£3.80).
100 × 2,600 × £4.80 = £1,248,000/2 years = £624,000
Tax at 25% = £156,000
The cumulative remuneration expense is £468,000 which is less than the estimated tax deduction of
£624,000.
Therefore:
• A deferred tax asset of £156,000 is recognised in the statement of financial position.
• There is deferred tax income of £468,000 × 25% = £117,000; and
• the excess of (156,000 – 117,000) = £39,000 = goes direct to equity.
£’000 £’000
CREDIT Equity 39

Part (2)
Calculation of current income tax liability
£’000
Less:
Dutton contract distribution cost (1,000)
Dutton contract depreciation (3,032)
Dutton contract finance cost (1,632)
Share-based payment charge (468)
Revised profit before tax 7,003

Add: depreciation 3,562
Add: share-based payment 468
Less: tax depreciation (£2,666 + 8,186) (10,852)
Taxable profit 181
Current tax liability at 25% 45
Alternative working £’000

Profit before tax per question 13,135
Less finance costs (1,632) and transport costs (1,000) for Dutton contract (2,632)
Add: depreciation 530
Less: tax depreciation (£2,666 + £8,186) (10,852)
Taxable profit 181
Current tax liability at 25% 45
PPE
£’000
Carrying amount of PPE 21,247
Add: Carrying amount of right-of-use asset
£27,288 – £3,032 24,256
45,503
Tax base of PPE
£14,813 – (£14,813 × 18% = £2,666) 12,147
£27,288 – (£27,288 × 30% = £8,186) 19,102
At 31 July 2021 31,249
Taxable timing difference 14,254
Deferred tax liability at 25% 3,564
Movement to profit or loss 1,823

Calculation of deferred tax liability
£’000
Movement to profit or loss arising from PPE 1,823
Deferred tax income arising from share options (117)
Deferred tax movement taken to equity – share options (39)
Deferred tax liability at 31 July 2021 3,408
Tax expense per statement of profit or loss
£’000
Current tax 45
Deferred tax movement to profit or loss arising from PPE 1,823
Deferred tax income arising from share options (117)
Income tax expense 1,751
Tax reconciliation
£’000 Tax rate 25% £’000

Accounting profit 7,003 × 25% 1,751
Increase in taxable temporary difference
Depreciation 3,562
Tax depreciation (10,852)
-7,290 × 25% -1,823
Increase in deductible temporary difference
Share based payment 468 × 25% 117
Taxable profit 181 45
Part (3)
Right-of-use asset Share options Tax Revised
£’000 £’000 £’000 £’000 £’000
Revenue 23,731 23,731
Operating costs (6,384) (1,000) (468) (7,582)
Depreciation (530) (3,032) (3,562)
Finance costs (125) (1,632) (1,757)
Income tax ––––– (1,751) (1,751)
Profit after tax 13,135 5,252

Right-of-use Share
asset options Tax Profit
£’000 £’000 £’000 £’000 £’000 £’000
Non-current assets
Property, plant and equipment 21,247 24,256 45,503
Current assets 26,567 (5,080) 21,487
TOTAL ASSETS 47,814 66,990
Equity
Share capital (£1 shares) 11,810 11,810
Share option reserves 468 39 507
Retained earnings 17,290 *(13,135) 9,407
**5,252
29,100 21,724
Borrowings and other financial

liabilities 4,264 4,264
Deferred tax liability at 1 August

2020 1,741 -156 1,823 3,408
6,005 30,002
Current liabilities
Current tax payable (to be

completed) ––––– 45 45
12,709 15,264
TOTAL EQUITY AND

LIABILITIES 47,814 66,990
*old profit
**new profit

General comments
This question examined two technical areas only examined at advanced level – deferred taxation (IAS
12) and share based payments (IFRS 2). It also tested leases and IFRS 16 which is level A at advanced
level, by asking candidates not just to calculate the adjustments but also to interpret the scenario –
this distinguishes advanced level from professional level.
Part (1)
Financial reporting treatments including current and deferred tax
The lease scenarios were well attempted. Knowledge of IFRS 16 and its application to the scenario
was generally of a high standard. The accounting entries and their subsequent journals were good.
Common mistakes included, failure to discuss the decision as to whether a lease existed or not,
discussion of finance lease and operating leases as per the old standard and omission of any
deferred or current tax issues.
Most candidates handled the share-based payment well including appreciation of the need for a
deferred tax asset. The implication of the excess tax relief held in equity was identified only by the
stronger technical candidates.
Overall, the standard of answers was high although weaker candidates were unaware of the
introduction of IFRS 16.
Part (2)
Tax reconciliations
This was the least well attempted requirement with candidates often neglecting to attempt it
altogether. Another mistake was failing to show the actual tax expense calculation in favour of
focusing on deferred tax issues only. IAS 12 is an advanced level financial reporting topic; deferred
tax and current tax are financial reporting issues. An ACA should understand the basics of how tax is
reported by entities.
Only the exceptional few were able to put together a coherent overall tax position with proper
interaction between current and deferred tax and an explainable overall tax expense. Adding back
depreciation and deducting capital allowances in the current tax computation was particularly rare.
Those who attempted this question properly scored very well and picked up some easy marks.
Part (3)
Revised forecast information
Typically, well attempted with application of own figure rule. A plea to future candidates – if the
adjustments to a SOFP or a P or L are not added across and the SOFP not balanced – the marker
cannot judge whether the adjustments are included the correct way around. Easy marks are lost here
by too many candidates.
64 Hyall and Forbes

Scenario
The scenario is an audit planning scenario for a company with many divisions which has expanded
by addition of new divisions in the current year. The candidate is required to analyse the divisional
information given and to use it to identify possible areas of audit risk; to scope the audit, identify
significant components and set out the extent of work at each division/site; and assess the extent of
the segmental reporting required.
There has also been a reported fraud and the candidate is asked to suggest specific procedures
which can be performed to address this and controls which the company might implement to
minimise the risk of such frauds in the future. The successful candidate will use the information in the
question, referring back to it for each part of the answer and keeping focused on the scenario.

Calculate relevant accounting ratios as Perform relevant calculations, explaining or

preliminary analytical procedures on the stating the issues.
summary information from the management Using the data & information given: analyse the
accounts (Exhibit 1) data and information to support requirement.
Use technical & professional knowledge to
analyse the data.
Use your analysis, together with the other Appreciate and apply the concept of
information provided, to: materiality.
(1) identify any matters that you believe Hyall Use technical knowledge and judgement to
and Forbes should investigate further as we identify risks.
plan the audit of NuTyre for the year ending Apply knowledge of relevant accounting
30 September 2020. standards to the information in the scenario.
(2) produce an extract from the audit plan Assimilate complex information to produce
which, for each manufacturing and retail appropriate accounting adjustments.
division:
Identify the need for further information.
– states whether that division is a significant
component and why; and Clearly set out and explain appropriate
– outlines the extent of the audit
procedures we should perform at that
division.
(3) 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.
Respond to Jud’s request regarding the fraud Use technical knowledge and judgement to
allegations from the Belgium employee (Exhibit determine appropriate audit approach of
2), setting out: substantive analytical procedures or tests of
(1) the specific procedures Hyall and Forbes detail.
could perform to investigate the Explain the additional procedures required.
occurrence and extent of the alleged fraud; Relate different parts of the question to identify
and critical factors.
(2) the controls which NuTyre could introduce Identify potential weakness in controls and the
to minimise the likelihood of a fraud of this ability of management to override controls.
nature being committed by a divisional
manager.
Marking guide Marks
Calculate relevant accounting ratios 8

Audit issues 14
Fraud allegations procedures and controls 8
30
Total 30

Part (1)
Product*
Revenue
Operating profit
Total assets
Revenue – % of total
Revenue mix
Operating profit = % of total
Operating margin %
Assets – % of total
Return on total assets

£’000 £’000 £’000 % % % % % %
Man.
– UK E 4,061 51 2,395 24.5 1.9 1.3 17.1 2.1
– India T 4,801 1,680 3,484 29.0 63.4 35.0 24.8 48.2
Total man. ** 8,862 1,731 5,879 53.5 65.4 41.9
Retail
– UK E 2,051 428 2,018 25.3 49.0 28.2 20.9 14.4 37.1
T 2,135 320 51.0 15.0
– India E 723 291 1,539 20.6 21.2 41.5 40.2 11.0 71.3
T 2,692 807 78.8 30.0
– France E 626 234 410 6.5 58.3 13.4 37.4 2.9 86.3
T 448 120 41.7 26.8
– Germany E 253 27 781 9.0 17.0 -0.3 10.7 5.6 -1.0
T 1,239 -35 83.0 -2.8
– Sweden E 477 97 954 11.1 26.1 11.3 20.3 6.8 31.4
T 1,354 203 73.9 15.0
– Other *** E 1,093 208 2,182 27.5 24.0 27.5 19.0 15.6 33.4
T 3,466 520 76.0 15.0
Total retail ± 16,557 3,220 7,884 100.0 121.6 56.2
Total man.
and retail 25,419 4,951 13,763 153.5 187.0 19.5 98.1 36.0
Less: Inter-
divis. –8,862 0 0 -53.5 0.0

Product*
Revenue
Operating profit
Total assets
Revenue – % of total
Revenue mix
Operating profit = % of total
Operating margin %
Assets – % of total
Return on total assets

£’000 £’000 £’000 % % % % % %
Less: head
office
costs 0 –2,303 263 0.0 –87.0 1.9
Total from
ext’l
cust’rs 16,557 2,648 14,026 100.0 100.0 100.0
Summary by
prod’t E 5,223 1,336 50.5 25.6
T 11,334 3,615 136.5 31.9
HO 0 –2,303 –87.0
16,557 2,648 407.0 100.0
* Products: E = exhaust, T = tyres, HO = head office

** Total manufacture from intra-divisional sales
*** 8 small divisions
± Total retail to external customers
The above is one suggested analysis – any reasonable format was given credit in the marking of
candidates answers.
Part (2)
Matters Hyall and Forbes should investigate further
Operating profit margins are relatively low in the UK both for manufacturing and for retail and
relatively high in India for both. This may be because of the prices those retail divisions are able to
charge but could also suggest some manipulation of transfer pricing as UK has a relatively high tax
rate and India a low one. It would be an issue to charge different prices to different countries unless
justified by differences in the operating model, distribution costs etc.
It is unclear how individual retail divisions benefit from the reconditioning of tyres as all the benefit
appears to go to the manufacturing division in India. This needs further investigation to determine
whether it is appropriate and also whether it incentivises the behaviour that the entity wants. Transfer
pricing therefore needs further consideration from both an audit and company perspective. From an
audit perspective there may be additional liabilities for tax or penalties which should be recognised.
The margins are also very high in France, especially given that we know that equipment has been
treated as a cost rather than capitalised. This may again be due to differential pricing and needs
further investigation.

The sales of tyres compared to exhausts in France seems unusual, and there is a particularly low
margin in Germany (though explainable in the fact that it is new).
Return on assets is high in France (explained by fact they write off rather than capitalising costs) but
also in India which needs to be fully understood.
Head office costs look very high – are there costs in here which should be allocated between the
divisions?
There is no inter-divisional profit elimination which looks incorrect – would expect there to be inter-
divisional profit in inventory as tyres and exhausts are supplied by the manufacturing divisions.
No information is given on gross margins, so it is impossible to assess whether the differences in
profitability arise from different margins or from differences in operating costs or scale. This is
important in assessing the performance of the divisions.
Comparative information for staffing, inventory levels etc. would allow Hyall and Forbes to identify
divisions where there appear to be inefficiencies.
In a number of countries, the operations are new, and it would therefore be useful to see month by
month information, indicating whether the business is growing.
Also, helpful to know the number of sites for each country to assist in analysing performance and
determining whether there are anomalies which need to be investigated.
Need information on FX rates and movements which will affect results in £.
Extract from the audit plan which, for each manufacturing and retail division:
• states whether that division is a significant component and why; and
• outlines the extent of the audit procedures we should perform at that division.
General principles
• We need to perform sufficient work to ensure that we are satisfied that we have addressed the risk
of material misstatement for the Company as a whole.
• We will need to identify the divisions which are significant components by considering their
contribution to revenue and profit and their assets and also any other risk factors which make it
more likely that a material misstatement could occur.
• All divisions which are significant components will need full audit procedures and we will also
need to ensure for those divisions that we visit sufficient sites to obtain appropriate coverage of
key balances which require physical verification or other on-site work.
• The divisions all share a common accounting system, but controls differ across divisions. In
addition, each division has its own finance manager. Hence, we cannot conclude that there is a
common control environment.
• We will need to set a component materiality for each significant component, and this will be lower
than group materiality as a whole. Overall company materiality is £130,000 and this has been
used in assessing each division below:
– Taking each division in turn:
Proposed extent of work
UK manufacturing Significant component based on revenue and assets. Operates from

one site which we should visit and perform a full scope audit using
component materiality.
India manufacturing Significant component based on revenue, profit, and assets. Operates
from one site which we should visit and perform a full scope audit
using component materiality.
Retail
UK Significant component based on revenue, profit, and assets. Full scope

audit using component materiality. The division operates from multiple
sites so there will be a need for further assessment about the site visits
required to verify assets, count inventory etc. Need more information
on number and relative size of sites to be able to assess this.

Proposed extent of work
India Significant component based on revenue, profit, and assets. Full scope
audit using component materiality. The division operates from multiple
sites so there will be a need for further assessment about the site visits
required to verify assets, count inventory etc.
France Much smaller entity based on key measures so may not be considered
a significant component on that basis. However, we are aware that its
results are potentially incorrect in that equipment which should have
been capitalised may be being written off to the profit and loss
account. This could be material and may also be indicative of tax fraud
and so specific procedures should be performed on this.
Germany Immaterial division contributing only a very small percentage of the

operating result, although its revenue is more significant, and this may
mean we wish to perform specific procedures on revenue and maybe
certain assets. This is a new division formed in the year which means
that we should visit it and perform at least some procedures at some
sites.
Sweden New division representing more than 10% of profit and revenue and
hence a significant component – full audit to component materiality.
The division operates from multiple sites so there will be a need for
further assessment about the site visits required to verify assets, count
inventory etc.
Other: 8 small divisions Each of these is immaterial but together they contribute over 25% of
profit and revenue so we will need to visit at least some of them (4-6
divisions seems appropriate). Others will be subject to analytical
review only.
Important to visit Belgium given the allegations of fraud there and
therefore increased risk of misstatement. Also need to look at analysis
of results by division to assess whether any other divisions look
unusual or have indicators of enhanced risk.
Head office Need to assess whether there is a risk of material misstatement in costs
or assets or whether analytical procedures are likely to be sufficient.
Elimination adjustments These will need to be audited, including ensuring that any profit in
inventory is eliminated along with inter-divisional sales and balances.
Need further information to determine whether the work proposed above will give sufficient
coverage of each key account balance – may need to do additional procedures to obtain sufficient
coverage of inventory etc.
Guidance on the divisional financial reporting disclosures that should be included in the NuTyre
financial statements for the year ending 30 September 2020
NuTyre is a listed company and so is required to include in its financial statements segmental analysis
in accordance with IFRS 8, Operating Segments. Competitive disadvantage is not sufficient reason to
avoid disclosure.
The standard envisages that the segmental information might be by product or geographical.
A segment is defined as a component of an entity:
• That engages in economic activity from which it may earn revenues and incur expenses (including
from transactions with other components)
It is clear that each of the divisions does this.
• Whose operating results are regularly reviewed by the entity’s chief operating decision maker to
make decisions about resources to be allocated and to assess performance.

Jud has told us that the analysis in the management accounts is reviewed monthly by the
executive management team and used to assess the performance of the divisions, to make
decisions about any further investment and to set prices for inter-divisional sales.
• For which discrete financial information is available
There is information available for each of the geographical divisions and also split between the two
products.
It is therefore clear that NuTyre does have segments it needs to report and the key emphasis appears
to be on geographical segments so that will form the basis of the primary segment analysis.
A segment is reportable if it meets the definition of an operating segment (each country division
does as shown above) and its revenue, profit or assets represent 10% or more of the total.
On that basis the following divisions are segments:
Total revenue >10% Operating profit >10% Assets >10% *
UK M 4061 16% Yes 51 1% No 2395 17% Yes Yes
Ind M 4801 19% Yes 1680 34% Yes 3484 25% Yes Yes
UK R 4186 16% Yes 748 15% Yes 2018 15% Yes Yes
Ind R 3415 13% Yes 1098 22% Yes 1539 11% Yes Yes
Fra. 1074 4% No 354 7% No 410 3% No No
Ger. 1492 6% No –8 0% No 781 6% No No
Swe. 1831 7% No 300 6% No 954 7% No No
8 oth. 4559 18% 728 15% 2182 16%
25419 100%** 4951 13763 100%
Profit 4959
Loss –8
M = manufacturing, R = retail
* IFRS 8 segment?
** Includes roundings
• UK – Both manufacturing and retail – these cannot be aggregated because they have very
different customer bases – one sells to retail divisions and the other to end customers – qualifies
on basis revenue and assets are greater than 10% of the total and also on profit grounds for the
retail division
• India – Both manufacturing and retail – revenue, profit and assets
• France – No – less than 10% on all criteria
• Sweden – No – less than 10% on all criteria
None of the smaller divisions is large enough to qualify as a reportable segment
Head Office incurs common costs and is not itself a segment as it does not generate any revenues.
All of the above analysis is based on data for 9 months – it might change when the year-end financial
information is reviewed.
Because the total of the reportable segments identified is less than 75% of revenue, additional
segments must be identified even though they do not meet the definition of segments.
More information is needed to determine whether it would be acceptable to aggregate two or more
of the smaller divisions to form one reportable segment. It may be possible to do so if they have
similar long-term financial performance (such as similar gross margins) and are similar in the majority
(but not necessarily all) of the following:
• Nature of products and services – this is the same at all retail divisions
• Nature of production process – not applicable for retail divisions

• Type/class of customer – the model is similar in all countries with depots supplying and fitting
tyres and exhausts to individual car-owners
• Methods of distribution – similar as set out above
• Regulatory environment – this is different in each country as Jud explains
Hence, providing rates of profitability are similar, it may well be possible to aggregate two or more
smaller segments into one segment, possibly achieving coverage of 75% of revenue.
Non-reportable segments are then combined and disclosed as “all other segments”.
NuTyre will need to disclose the factors used to determine its reportable segments and the fact that
all segments derive their revenues from the sale of tyres and exhausts. It will also have to disclose
segment assets and liabilities and also items such as revenue which are regularly provided to the
executive decision makers.
Hence would expect to see by geographical segment (with manufacturing and retail also separate):
• revenue
• operating profit
• any other profit and loss measures included in the management information
• assets
• liabilities
Although the geographical segments are the primary segments for NuTyre, the revenue for each
product should be reported for the company as a whole as this is an additional disclosure
requirement.
Part (3)
(1) Procedures to evaluate extent of fraud
NuTyre is a public company so we need to be careful that any additional procedures and non-audit
work remain within fee limits, independence rules and any additional criteria set by the Audit
Committee.
It is always difficult to evaluate the extent of something which is omitted from the financial
accounting records – such as refurbished tyres which are not sent back for refurbishment but instead
sold by the manager. Procedures which might suggest the extent to which this is happening are:
• Compare the volume of tyres sent back from Belgium for refurbishment with that from the other
similar sized divisions (or pro-rata to revenue across all divisions). Such an analysis would provide
an idea of the expected number of refurbishments for Belgium but would need to be treated with
caution as regulatory or cultural differences might influence decisions about which tyres are
suitable for refurbishment. However, if the number of tyres sent from Belgium is lower than
expected, that would potentially support the claim that not all tyres are sent back.
The Belgium division is new to NuTyre so it is not possible to look back at historic information which
may have shown the trends for numbers of tyres sent for refurbishment – a change in this would have
been of interest.
Also, important to consider what is normal business practice in the country – it may be that the
manager considers it a ‘perk’ of the job and would not consider it fraud. Establishing clear company
guidelines is important here.
• reconcile the total number of replacement tyres fitted with the total of tyres returned for
refurbishment and records of those which have been scrapped.
The division obtains a tyre which has potential for refurbishment whenever it replaces a tyre for a
customer and therefore it should be possible to perform this reconciliation.
• Identify whether there are any lifestyle indicators – such as new car; expensive holidays; property
investments etc – which suggest that the Belgium manager may have come into additional cash.
Such indicators are not in themselves conclusion but can add to a pattern of evidence as to
whether the fraud is occurring and to what extent.

There are also allegations that the finance manager is making payments to a company owned by his
wife, Pinot Ltd. Procedures to investigate this could include:
• Obtain company searches to find out who owns Pinot Ltd and, if publicly available, its accounts.
• Perform analytics to show the total amount paid to Pinot Ltd since the Belgium Division was
established.
• Request invoices to support the amounts paid to Pinot and ascertain whether these are for bona
fide services or goods.
• Compare the operating costs and other key ratios in Belgium to those of other similar divisions to
determine whether there are any indications that profits are effectively being syphoned off or the
results distorted in some way.
• Review all consultancy costs and look at what reports or other input has been provided in return
for the amounts paid.
• Performing analytics to determine whether there are any other payments being made into the
bank accounts used for Henri’s payroll or Pinot Ltd. This could indicate a more widespread fraud.
(2) Controls
NuTyre needs to consider preventative, detective and monitoring controls which can be put in place
at head office and should also impose common controls across all divisions wherever practical.
Preventative controls might include:
• Clear policies about which tyres should be returned for refurbishment and what the divisions
should do with any tyres they believe cannot be refurbished. There should also be regular
reporting with the total number of tyres returned and scrapped reconciled to the number of tyres
replaced by the division.
• Ensuring that there are common policies across the company and that these are clearly set out
and communicated to all divisions, especially new divisions.
• Reviewing authorisation procedures for payments and for adding new suppliers to the payables
Masterfile such that no one person acting alone can do this and any finance manager would only
be able to commit a payment fraud of this type with the collusion of another employee.
• Introducing an independent review of a supplier before any payments can be made to that
supplier.
Detective and monitoring controls might include:
• A company-wide review of metrics on a monthly basis so that any anomalies can be promptly
identified and followed up
• Spot checks on records for inventory or scrappage of tyres – following through from an invoice for
a replacement tyre to what has happened to the tyre replaced
• Spot checks on payments at head office level, asking periodically for the back up for a payment
and details of the supplying entity
• Considering setting up an internal audit function which visits divisions, checks whether controls
are operating properly and shares best practice
General comments
This question examines IFRS 8 which is an accounting standard which is exclusively examined at
Advanced level – it is combined with financial statement analysis which is not examined in the
professional level FAR exam and the identification of significant components – which from an audit
perspective is very much in the advanced level syllabus.
Markers commented that all too often weaker candidates struggled with calculating percentages.
Part (1)
Accounting ratios
Most were able to provide ratios incorporating both the margins and the assets for each segment. If
a candidate calculated the ratios this then allowed them to score well analysing them in the next
section. Weaker candidates concentrated on the split of tyres and exhausts and then found it difficult

to write anything sensible in part (2). When geographic ratios were given, they often concentrated on
the operating profit and sometimes revenue. Not all thought to look at the assets.
Part (2)
Audit issues
Candidates were able to score well on this requirement. Pleasingly, numerous answers focused on
the specific issues within the scenario eg, transfer pricing issues in the Indian segments and the
incorrect accounting treatments in France. However, even if the candidates were not able to spot
these points, high scores were still achieved if they answered all three elements of the requirement.
Detailed points include
• Weaker candidates demonstrated little understanding of how to scope a group audit. While many
candidates made a reasonable job of identifying significant components, the concepts of “full
scope audits”, “specific procedures” and “analytical procedures” appeared rarely and “component
materiality” very rarely indeed.
• There were some alarming comments about “auditing in UK because easier”; “not auditing a
material component this year because we went there last year”; and “relying wholly on controls
testing or analytical review” for a significant component division.
• Time was often wasted listing copious specific audit procedures which were not asked for.
• There was at times some confusion between a significant audit component and a disclosable
segment.
Part (3)
Fraud allegations – procedures and controls
This requirement was well attempted. It was pleasing that candidates were able to deal with a
forensic rather than audit assignment and were comfortable identifying specific procedures focusing
on the payments and theft of tyres.
Even when candidates struggled with the procedures, they were able to suggest relevant controls to
minimise future similar fraudulent activity. Weaker candidates produced answers listing generic
controls not applied to the scenario.

65 SSD
Scenario
The candidate is an audit manager and ICAEW Chartered Accountant, working for Harris and
Henshaw (HH), a firm of ICAEW Chartered Accountants 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. A colleague, Sheena Green, the former audit manager on the SSD audit, has been moved
to another audit assignment. Sheena identified three audit risk areas which are likely to be key audit
matters and the candidate is provided with the working papers for these risk areas as follows:
• Intangible assets (Exhibit 1)
• Issue of bond (Exhibit 2)
• Sale and leaseback transaction (Exhibit 2)
The working paper for intangible assets includes extracts from the draft financial statements and the
accounting policy; Sheena’s assessment of audit risk in which she identifies (not entirely correctly)
that the main focus is on the additions to intangible assets; and her workings to date on these
additions to intangible assets.
The candidate is required to evaluate the appropriateness and completeness of SSD’s accounting
policy note for intangible assets; explain the correct financial reporting treatment for the additions to
intangible assets; evaluate the adequacy of Sheena’s assessment of audit risk; and set out the key
audit procedures that HH should perform.
From the audit work on intangible assets, the candidate discovers that a company called ZMedd plc,
an international pharmaceutical company, has expressed interest in SSD’s Textel product which
therefore becomes commercially viable. The product appears also to be financially viable due to the
finance raised during the year. The second working paper includes details of this finance; a bond
issue issued to ZMedd and a sale and leaseback transaction. The candidate is required to explain the
correct financial reporting treatment in SSD’s financial statements for the year ended 30 September
2020; and recommend appropriate journal adjustments.
Ethics
The candidate is 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 HH audit client. The inexperienced junior sends the candidate an email with information
about SSD and Textel which he has come across during the ZMedd audit. The provision of the
information creates a confidentiality issue and also highlights business trust issues. ZMedd stands to
gain significantly from over prescribing of its best-selling heart drug resulting from patients wearing
SSD’s Textel product. A press report highlights the dangers of over prescribing to patients’ long-term
health.
For intangible assets: Assimilate and demonstrate understanding of a

• evaluate the appropriateness and large amount of complex information.
completeness of SSD’s accounting policy Identify any information gaps.
note; and Evaluate corporate reporting policies, estimates
• explain the correct financial reporting and disclosures in a scenario in order to be able
treatment for the additions to intangible to assess whether they are in compliance with
assets. accounting standards and are appropriate in the
context of audit objectives.
Formulate, implement and evaluate corporate
reporting policies.
Formulate the appropriate financial reporting
treatment for intangible assets.

Evaluate and apply technical knowledge from

several accounting standards which are
simultaneously applicable and interact.
adjustments.
• Evaluate the adequacy of Sheena’s Identify any information gaps.

assessment of audit risk; and Use multiple information sources.
• Set out the key audit procedures that HH Interpret information provided in various formats.
should perform.
Identify relevant key audit risks.
Describe appropriate audit procedures required
to provide verification evidence for each risk.
For the issue of a bond and the sale and Identify inappropriate accounting treatments for
leaseback transaction: the bond and the sale and lease back transaction.
• explain the correct financial reporting Explain complex transactions for the bond and
treatment in SSD’s financial statements for lease back transaction.
the year ended 30 September 2020; and Recommend appropriate accounting
• recommend appropriate journal adjustments.
adjustments. Filter information provided to identify critical
facts.
Identify and explain the ethical issues for HH, Identify and explain ethical issues.
Chris Yang and you, the audit manager arising Recommend and justify and determine
from Chris Yang’s email (Exhibit 3). Set out the appropriate actions and ethical safeguards to
actions that you should take. mitigate threats.
Identify the solution which is the best fit with
criteria and objectives.
Marking guide Marks
65.1 Intangible assets – appropriateness of SSD’s accounting policy note and financial
reporting treatment of additions 12
Sheena’s assessment of audit risk and key audit procedures HH should perform 12
Bond and sale and leaseback – correct financial reporting treatment and journals 10
34
65.2 Ethical issues 8
8
Total 42
65.1 Part (1)

Assessment of the adequacy of accounting policy note
Recognition
In terms of recognition, the accounting policy note appears to be in accordance with IAS 38.
The purchased intangible assets are recognised at cost less amortisation. It is also appropriate
to recognise internally developed intangible assets which meet tightly defined criteria.

Amortisation
The cost less residual value of an intangible asset with a finite useful life should be amortised
on a systematic basis over that life and this should reflect the pattern of benefits. If the pattern
cannot be determined reliably, amortise by the straight-line method is appropriate. The
amortisation method for purchased intangible assets therefore appears appropriate. However,
the 40-year life is very long for technology and therefore should be challenged as to its
appropriateness.
The note should also refer to the fact that the residual value is assumed to be zero and it is
incomplete in this respect.
The accounting policy refers to databases having indefinite lives and therefore not subject to
amortisation - although theoretically possible that there is no foreseeable limit to the period
over which the asset is expected to generate net cash inflows for the entity, we would need to
confirm that the database has applications outside of the current research project. This is
highly unlikely given the specific nature of the database.
SSD uses a revenue-based method for development costs and this is not considered to be an
appropriate method since revenue represents the generation of expected economic benefits
rather than the consumption of economic benefits. Therefore, the policy for internally
generated assets is not compliant with IAS 38 and the directors should be challenged on this
too.
Impairment
IAS 38 also requires consideration of impairment in accordance with IAS 36. The accounting
policy appears to address this and identifies the correct period for the review and an
appropriate method of discounting. Although the policy specifies only development costs
when this should apply to all intangible assets if there are impairment indicators.
The impairment review should compare carrying amount with recoverable amount which is
higher of fair value less costs to disposal and value in use. The policy note states that the
carrying amount is compared with VIU when this should state recoverable amount.
The policy does not comment on subsequent expenditure.
Part (2)
Taste Database costs £87 million
The initial writing off of the costs £22 million in 2019 and £65 million in the current financial
year is correct as the project, as the scenario suggests, is still in the research phase.
Due to the nature of intangible assets, subsequent expenditure will only rarely meet the criteria
for being recognised in the carrying amount of an asset. Subsequent expenditure should be
recognised in profit or loss as incurred.
However, the adjustment made by SSD appears to reverse the previous accounting treatment
and has included a ‘fair value’ adjustment for the database.
An entity must choose either the cost model or the revaluation model for each class of
intangible asset.
Intangible assets may be carried at a revalued amount (based on fair value) less any
subsequent amortisation and impairment losses, only if fair value can be determined by
reference to an active market. Such active markets are expected to be uncommon for
intangible assets.
However, it is not clear whether there is an active market for the database technology and
there is no indication of what the asking price and hence market value is likely to be.
Assuming that a change to fair value model is possible and this would require a change in the
accounting policy, under the revaluation model, revaluation increases are recognised in other
comprehensive income and accumulated in the “revaluation surplus” within equity and not as a
credit to profit or loss as in the case of SSD’s adjustment.

Recommended journal
£m £m
DEBIT Operating costs 87
CREDIT Purchased intangible assets 87
Being reversal of adjustment to fair value

Project Smart £13 million
Management calculations and assumptions with regards to the cashflow forecasts of project
Smart development costs are not accurate.
The figure for the year ended 30 September 2020 is discounted by a full year (ie 7,250/1.1 =
6,590). However, there is only 10 months between the cash flow date of 30 Sept 2020 and the
NPV date of 1 Dec 2019.
The discounted figure should have been 7,250/1.1(10/12) = 6,696
The projections were carried out at 1 December 2019 and the projection to 30 September
2020 is already inaccurate – actual cashflows were £4.2 million.
The technology has now been copied by a rival which would also cast doubt on the reliability
of the projections.
Scenario A uses a 7-year forecast, IAS 36 requires a 5-year forecast period and is also contrary
to their stated accounting policy which requires a 5-year period.
Scenario B produces a higher value in use because it uses a perpetuity based on a constant
revenue stream which is also not permitted under IAS 36.
The calculation of weighted cost of capital is over 12 months out of date and is likely to change
given the increase in debt arising from the bond and the adoption of IFRS 16.
There is no indication whether the cashflows are pre-tax or post-tax.
Revising the calculation for the September 2020 cashflows and taking a five-year period would
indicate that an impairment loss of £23 – £18 = £5 million should be recognised.
Year ending 30 September £000 DCF at 10% £000

2020 4,200 0.909 3,818
2021 8,600 0.826 7,104
2022 4,250 0.751 3,192
2023 3,378 0.683 2,307
2024 2,400 0.621 1,490
17,911
However, as the Smart has been copied by a rival after these projections were made, the
figures for subsequent years should be challenged as these are likely to be significantly lower.
More information is needed to propose an adjustment.
Project Textel £79 million
SSD has recognised all expenditure on this project in the year ended 30 September 2020 as
development costs although the point at which the project has become commercially viable
and the future economic benefits certain are not clear. One point could be 1 March 2020 but
as the project’s success relies upon additional financing which was secured in April 2020 there
is an argument to say that 6 months and not 7 months of the costs should be capitalised.
If an entity cannot distinguish the research phase of an internal project to create an intangible
asset from the development phase, the entity treats the expenditure for that project as if it
were incurred in the research phase only. Further information is required but a correcting
journal of Dr operating costs, Cr intangible assets with at least £32 million is required.

Part (3)
Adequacy of Sheena’s assessment of risk
Because of the significant amount of judgement in this area, Sheena has correctly identified
the risk of incorrect capitalisation and the identification of potential financial reporting errors
would support this.
After applying the recommended accounting treatment additions to intangible assets are now:
£m
Per draft 214
Less:
Taste database – Enhancement costs – incorrect subsequent recognition at fair
value (87)
Project Smart – impairment (5)
Project Textel – initial recognition of costs (32)
90
However, of these three errors, only Project Textel related to initial recognition. SSD’s incorrect
subsequent recognition at fair value and impairment calculations indicate that the audit risk
exists also over amortisation and subsequent valuation.
Capitalised development costs are internally generated assets. This area is inherently
judgemental with respect to subsequent recognition including technical feasibility, intention
and ability to complete the intangible asset and to generate future economic benefits.
It involves management’s assessment of the value in use and any impairment includes
judgement about the future results of the projects and the discount rates applied to cash flow
forecasts.
This results in a risk that expenditures may not only be inappropriately capitalised but also
amortised or subsequently valued.
Amortisation rates for purchased intangible assets indicate useful lives of around 37 years
(£447m / £12m) which is unrealistic in this industry.
Similarly, amortisation of development costs would indicate that project costs have been
capitalised but not being amortised. An amortisation charge of £5 million would appear very
low in comparison to cost of £257 million.
Audit procedures
Taste database £87 million
The key risk here is that subsequent costs have been incorrectly capitalised. The original
database cost of £150 million has not been amortised and it is apparent that the project may
now be impaired because key personnel have left the company.
Key procedures:
(1) Evaluate the accounting policy and methodology for capitalisation of expenditures and
ensure it complies with IAS 38.
(2) Challenge management over the change to fair value, quantify the impact (£87 million)
and propose an adjustment – this is a material amount and exceeds planning materiality.
(3) Determine the control procedures for triggering an impairment review at the appropriate
time – enquire about the state of the project and the need for impairment.
There is a high risk of disconnect between the research technical team who understand the
project and the accounting team who understand the accounting but not the technical issues.
Make enquiries of key technical personnel to ensure that £150 million acquisition cost of the
database is fairly stated to determine whether the conditions for amortisation have been met.
Project Smart £13 million
The key audit risk here is the risk that the costs should be impaired.

Audit procedures should include:
• Reperform calculations of amortisation for both purchased intangible assets and
development costs.
• Challenge management over the amortisation method for development costs.
• Assess whether the method is appropriate and refer to audit partner for discussion with
audit committee.
• Quantify the potential misstatements and evaluate the impact on the financial statements.
• Challenge management about the adequacy of useful lives of specific assets and projects.
• Use audit analytics to compare SSD amortisation rates to industry statistics for comparator
companies.
• Determine the appropriate after-tax discount rate for the year ended 30 September 2020
considering the impact of the additional debt raised to finance project Textel.
• Test the use of the discount rate on impairment calculations performed by management.
• Evaluate management assumptions of cashflows for impairment reviews – agree to
budgets/profit forecasts.
• Determine the control procedures for triggering an impairment review at the appropriate
time –management have used an outdated cashflow and do not seem to respond to
impairment indicator provided by the copying of the Smart device.
Project Textel £79 million
The key risk with this project is that costs are incorrectly recognised on initial recognition.
Key procedures include:
• We should identify the processes and test controls for the capitalisation of internally
generated intangible assets.
• We should evaluate the accuracy and valuation of amounts capitalised to assess that costs
are directly attributable and necessary to create, produce, and prepare the asset to be
capable of operating in the manner intended by management.
• Evaluate management’s criteria for determining the point at which the project becomes
commercially viable.
• Obtain confirmation of audit evidence from relevant technical personnel in the firm.
Part (4)
Issue of Bond
The bond is a ‘deep discount’ bond and is a financial liability of SSD. It is measured at
amortised cost. Per IFRS 9, financial liabilities that are classified as amortised cost are initially
measured at fair value minus any transaction costs.
Although there is no interest as such, the difference between the initial cost of the bond and
the price at which it will be redeemed is a finance cost. This must be allocated over the term of
the bond at a constant rate on the carrying amount.
The correct financial reporting treatment is to recognise an interest cost of £1.21 million × 6/12
= £605,000. This is calculated as follows:
Interest @ 6%
£m £m £m
1 April 2020 Bond issued for 20.25
Less: transaction costs 0.10
Year 1 20.15 1.21 21.36
Year 2 21.36 1.28 22.64
Year 3 22.64 1.36 24.00
The bond has been recorded incorrectly as the transaction costs should be deducted from the
liability and not expensed to profit or loss.

Journal adjustment
£
CREDIT Bond 505,000
Sale and leaseback transaction

The journal entries are incorrect and do not reflect the requirements of IFRS 16 – SSD has
recognised all the gain on the asset and incorrectly recognised the right of use asset.
The transfer of the asset is a sale because it meets the requirements of IFRS 15 Revenue from
Contracts with Customers.
Correct financial reporting treatment
The lease liability has been correctly calculated at 27.8m representing the 10 annual payments
discounted at 5%.
(1) SSD should measure the right-of-use asset arising from the leaseback as a proportion of
the previous carrying amount of the asset that relates to the right of use it has retained
This is calculated as follows:
PV of future lease payments at transfer date

Carrying amount ×
Fair value of asset at transfer date
£27.8 million
£30 million × = £20.85 million
£40.0 million
(2) SSD should only recognise the amount of any gain or loss on the sale that relates to the
rights transferred to the buyer.
WORKING
Calculate the total gain on the sale:
(1) Calculate the total gain on sale:
£m
Fair value 40
Carrying amount 30
Total gain 10
(2) Then determine the gain that relates to the rights retained:
PV of future lease payments
Gain × = Gain related to rights retained
Fair value of asset at transfer date
£27.8m
£10m × = £6.95m
£40.0m
(3) The gain relating to the rights transferred is the balancing figure:
Gain on rights transferred = total gain (W1) – gain on rights retained (W2)
£10.0 – £6.95 = £3.05m
The right-of-use asset continues to be depreciated as normal, although there may be a revision
of the useful life required. The right of use asset is depreciated over the shorter of the lease
term or the asset’s useful life.
An estimate of the depreciation charge would be:
£20.85m/10 years = 2.085 × 6/12 = £1.04m

A finance cost for 6 months also will be charged:
£27.8m × 5% = £1.39m × 6/12 = £0.70m
Therefore, the correct journal entries should have been:
£m £m
DEBIT Cash 40.00
CREDIT Non-current assets (Carrying amount) 30.00
CREDIT Gain on rights transferred (P or L) (W2) 3.05
DEBIT Right of use asset 20.85
CREDIT Lease liability 27.80
The following correcting journal entry is required:
£m £m
CREDIT Non-current assets (Carrying amount) 6.95
DEBIT Gain on rights transferred (P or L) (W2) 6.95
DEBIT Depreciation (P or L) 1.04
DEBIT Finance cost 0.70
CREDIT Right of use asset – accumulated depreciation 1.04
CREDIT Lease liability 0.70
Part (1)
This proved to be one of the most challenging parts of this question. Most candidates wasted
time regurgitating the accounting treatments of intangible assets and failed to critique the
note. However, specific points re the long UEL and the inappropriate calculation of Value in use
were commonplace. Less common was appreciation of the inappropriate allocation of
amortisation based on revenue rather than consumption. However, candidates were able to
compensate for weaker performance here by scoring well on the next requirements.
Part (2)
Generally, well attempted. Maximum marks were often achieved with answers that addressed
issues for each of the 3 main projects. There was a tendency by weaker candidates to just
quote sections of IAS 38 rather than apply it or to provide an answer to only one of the three
projects.
Part (3)
Most candidates realised that simply focusing on the additions to IA was inadequate and many
correctly identified amortisation and impairments as other key risks. For the procedures many
simply set out very bland tests relevant to any intangible assets without focusing on the
specific scenarios given in the question. Those who linked procedures to the 3 categories of
additions generally produced good answers.
Part (4)
This requirement was well answered with many candidates able to score the maximum marks.
This is pleasing as financial liabilities are a core syllabus area and sale and leaseback under the
new standard being a more recent addition to the syllabus. Many calculated all the numbers
correctly although a common error was failing to time apportion interest and depreciation. A
small minority thought the bond was an asset and that the sale and leaseback was actually
some form of secured loan. Many struggled to set out the correcting journal often just showing
what the original entries should have been.
One common disappointing mistake made by weaker candidates was to inexplicably treat the
bond as a hybrid instrument.

65.2 Ethical issues
For candidate:
Inappropriate communication between audit teams
Candidate has become aware of information about the client which may impact on the
financial reporting – there is a threat therefore to candidate’s professional behaviour and
objectivity
• SSD may have received the loan as part payment for future sales and therefore accounted
for incorrectly.
• There may be incorrect disclosure in the strategic report and financial statements.
• Potential impairment of intangible assets and additional provisions to consider.
For HH
Two of its clients may have engaged in behaviour which may breach regulations. HH is
therefore in a position where professional behaviour could be threatened if these breaches are
not dealt with appropriately.
Excessive entertainment by ZMedd – may be considered an attempt to bribe the SSD research
team and directors.
SSD is not transparent about the terms of the loan – the loan again may be a form of bribe.
The product that SSD has developed and marketed by ZMedd may lead to overdiagnosis and
harm to patients for commercial gain by ZMedd and ultimately SSD – there may be a breach of
regulations over drug use.
The connections between the two clients also create a potential conflict of interest for HH as
the auditor of both clients. Appropriate safeguards need to be put in place in order to evaluate
whether objectivity could be compromised.
Junior staff seem unaware of the need for confidentiality which indicates a lack of training and
creates an audit quality issue for audit firm HH.
For Chris Yang:
Chris is a trainee – he may not be aware of the need for confidentiality unless he has
undergone ethics training on joining the firm.
Actions for you
(1) Speak to Chris.
(a) Explain the confidentiality rules – the information concerning approval of the bond
should not have been shared without the client’s permission. The information
obtained from the article is however in the public domain and can be shared with the
SSD team – however again there is a potential confidentiality issue as Chris cannot
disclose the ZMedd’s board view regarding the potential increase in sales.
(b) Explain, as an audit manager yourself, that although this is not your assignment, you
can give the general audit review advice now that that Chris has raised it with you, that
Chris should review the loan agreement because reviewing the terms of the loan
agreement could lead to discussions with SSD and the adequacy of disclosures in the
financial statements particularly with respect to the strategic report.
(c) Be clear that on any further matters relating to the ZMedd audit, Chris should speak to
his line manager on that audit.
(d) Answer Chris’s question with regard to who he should speak to with regard to the
excessive entertainment expenses, telling him that he must follow this up with his line
manager on ZMedd’s audit.
(e) Explain that Chris should separate out what Chris wants to talk to you about as mentor
and specific issues re clients for which he should speak to the senior team on that
audit.

(2) Similarly, as a member of the SSD audit team:
(a) You will review the SSD board minutes and evidence of authorisation of the bond
would also be apparent there, which would lead to discussion of ZMedd and the
relationship.
(b) The implications of the article for the SSD team could provide evidence for the
impairment of the Textel development costs and also lead to provisions and
contingent liability disclosures and should therefore be discussed with the SSD board.
(c) You will follow up the issue that has now been drawn to your attention with regard to
the SSD board members and research team’s conference costs. This will involve
consulting with the SSD Audit partner.
(3) Ensure that Chris receives training in ethics. As Chris’s mentor you should explain to Chris
that whilst it is absolutely the right thing to do to bring ethical issues to the forefront, it is
vital that Chris follows proper channels and respects confidentiality. You should remind
Chris that there is the ICAEW Ethics helpline he can contact if he needs advice.
(4) Obtain advice from the firm’s ethics partner and quality assurance partner.
(a) Explain the potential conflict of interest threat and objectivity threat that have arisen
and discuss potential safeguards.
(b) Explain also the risks to professional behaviour that have now arisen for HH in you
becoming aware of potential business trust issues that breach regulations as well as
ethical business conduct, and seek advice as to what you should now do in this
circumstance.
(5) If not satisfied with the above, you could contact the ICAEW Ethics helpline.
There were lots of aspects to this ethical scenario and it gave the candidate lots to think about.
The good candidates performed excellently and appreciated the difficult ethical conundrum
presented by Chris.
Weaker candidates did not attempt to split the issues from the three prescribed perspectives.
A lot of candidates failed to identify that Chris had breached any ethical issues, failing to
appreciate that disclosure between audit teams is still a confidentiality breach and wasted time
and effort focussing on issues from the perspective of the two clients involved with the
extravagant entertaining costs (the lavish treatment of the customer being identified as a self-
interest threat to retain the contracts being a commonly made statement which was irrelevant
from the auditors’ perspective). Those that missed the point managed to salvage marks
through descriptions of the actions taken.
66 Beta World
Scenario
The candidate works 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.
BW plc decided to buy 45% of the ordinary shares in Flyline, a listed airline based in Australia. 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.
Flyline has 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.
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 has asked for help with the consolidation of Flyline and advice about some financial reporting
issues.

The financial accountant is 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. She has asked for advice regarding the
recognition of the purchase of an aircraft and a hedged transaction.
In respect of the acquisition of Flyline: Identify and determine whether and how different
• Explain why Flyline should be treated as a types of investment are recognised and measured
subsidiary in the BW consolidated as business combinations.
financial statements for the year ended 30 Demonstrate understanding of the business
September 2020. context.
• Set out and explain how the investment in Filter information provided to identify critical facts.
Flyline should be recognised in the BW
plc individual company financial
statements for the year ended 30
September 2020.
Set out and explain the appropriate financial Demonstrate, explain and appraise how foreign
reporting treatment of the issues identified exchange transactions are measured and how the
by the BW plc financial accountant for the financial statements of foreign operations are
year ended 30 September 2020. Include translated.
relevant journal adjustments. Explain how different methods of recognising and
measuring assets and liabilities can affect reported
financial performance.
Identify business and financial issues from the
scenario.
Prioritise key issues.
Calculate the goodwill on the consolidation Assimilate adjustments to prepare key workings
of Flyline to be included in the BW for the consolidation of Flyline with BW.
consolidated financial statements at 30
September 2020; and
Prepare revised draft extracts for the BW Assimilate information and use own accounting
consolidated financial statements for the adjustments to prepare revised extracts from the
year ended 30 September 2020 including financial statements.
your recommended adjustments for (1), (2) Present analysis and recommendations in
and (3) above. Identify separately the amount accordance with instructions.
attributable to the non-controlling interests
at 30 September 2020.
Marking guide Marks
Acquisition of Flyline – consolidated and individual financial statements 6

Financial reporting treatment of the issues identified by the BW plc financial
accountant 9
Goodwill on the consolidation of Flyline 5
Revised draft extracts for the BW consolidated financial statements 10
30
Total 30
Part (1)
A subsidiary is defined by IFRS 10 Consolidated Financial Statements as ‘an entity that is controlled
by another entity’.

In accordance with IFRS 10, an investor controls an investee when “the investor is exposed, or has
rights, to variable returns from its involvement with the investee and has the ability to affect those
returns through its power over the investee”.
Through its 45% shareholding in Flyline, it is clear that BW is exposed to variable returns dependent
on the performance of Flyline. The key question is whether BW has the power to affect those returns,
rather than just influence decisions.
At acquisition BW has the right to appoint all board members which gives control over the board
decisions.
At the acquisition date and at the year end, BW can only vote at shareholder meetings with 45% of
the ordinary shares. If it were to exercise its options it would be able to vote with 75% of the ordinary
shares and exercise control.
IFRS 10 paragraph 12 states that “an investor with the current ability to direct the relevant activities
has power, even if its rights have yet to be exercised”. IFRS 10 paragraph B47 also requires an
investor to consider potential voting rights in considering whether it has control over another entity.
The potential voting rights are considered only if they are substantive i.e., if the holder has the
practical ability to exercise the right.
Based on the information provided, the options appear to be ‘in the money’ as fair value per share
has risen by 17% since acquisition (from A$5.55 to A$6.5 per share) and there is a required exercise
premium of 5% per share below the price per share for the 45% shareholding.
Consequently, the options seem likely to be exercised and BW does have a ‘current’ ability to direct
the activities of Flyline, as it only requires the options to be exercised (which it can do at any time up
to the exercise date, it does not need to wait for the end of the exercise period) to take control
through a majority shareholding.
Therefore, Flyline should be accounted for as a subsidiary of BW in the consolidated financial
statements.
Recognition of the investment in BW plc individual financial statements
When BW prepares its separate financial statements, Flyline as an investment in a subsidiary can be
subsequently measured at cost or in accordance with IFRS 9. Under IFRS 9 the investment would be
measured at fair value including transaction costs and gains and losses are recognised in the
statement of profit or loss unless an irrevocable election is made to recognise gains and losses
through OCI.
Flyline can account for the investment, at 30 September 2020, in its individual company financial
statements per IAS 27, para 10 using any of the following:
• At cost
• IFRS 9 valuation
• Equity accounting
Where relevant, IFRS 5 applies to valuations at cost or using equity accounting.
The cost of the investment does not appear to have been calculated correctly. IFRS 3 requires that
the initial investment in the subsidiary is recognised in BW plc’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 £9 million legal costs must therefore be
expensed.
In BW plc financial statements:
JNL 1 £000 £000

CREDIT Cost of investment in Flyline 9,000
Issue of shares
The cost of the investment correctly includes the full £40,000,000 - however the difference between
the nominal value of the shares of £1 and the fair value of £8 should be recorded as share premium.
This adjustment has not been made correctly and a journal is required to.

JNL 2 £000 £000
DEBIT BW plc share capital 35,000
CREDIT BW plc share premium 35,000
Part (2)
Purchase of aircraft
The purchase has been correctly recorded by Flyline using the rate of exchange ruling 1 May 2020
A$000 A$000
DEBIT PPE 20,000
CREDIT Payables 20,000
Being the cost of the aircraft in A$56,000,000/2.8 = A$20m

IAS 21 requires that the asset should be recognised initially at the date of the transaction. The aircraft
are non-monetary assets and the carrying amount stays at the original translated value.
Depreciation should be charged from when the asset was first brought into use and is translated in
the same way as the asset at the rate when it was purchased. As the asset was only brought into use
on 1 October 2020 no depreciation is required.
Therefore, the asset is correctly translated at 56,000,000 / 2.8 = A$ 20,000,000 and no further
adjustment is required.
On 1 July 2020 a payment was made to Petang KL of A$ 8,125,000 which was the equivalent of RM
26,000,000 – an exchange rate of A$1: 3.2. This has been incorrectly recorded and Flyline should
record a gain as follows:
A$000 A$000
DEBIT Payables 26,000,000/2.8 9,286
CREDIT Cash 8,125
At the year end 30 September 2020, the liability is recalculated using the year end rate. A further
gain of A$ 1,623,000 has been made and will be recorded
A$000
1 May : Purchase of aircraft 20,000
1 July : Repayment (see above) 9,286
10,714
Gain to profit or loss 1,623
RM 56,000,000 – RM 26,000,000 = RM 30,000,000 / 3.3 9,091
The following working is also acceptable with explanation:

A$11,875,000 – (RM56 – RM26 = RM30/3.3 =) A$9,091,000 = A$ 2,784,000
Therefore, a correcting journal JNL 3:
A$000 A$000
DEBIT Payables 1,161 + 1,623 2,784

Hedged transaction
This is a hedge of a firm commitment in relation to foreign currency and can therefore be treated
either as a fair value hedge or as a cash flow hedge in accordance with IFRS 9.
By 30 September 2020, the hedge transaction has made a profit of A$2,000,000. Assuming it is
treated as a fair value hedge and the IFRS 9 conditions for hedge accounting are met then:
At 1 June 2020
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.
However, the existence of the contract and associated risk would be disclosed from this date in
At 30 September 2020
The profit is recognised as:
A$000 A$000
DEBIT Forward contract – Financial asset 2,000
To recognise the increase in the fair value of the hedge instrument (which is the forward contract,
A$000 A$000
CREDIT Firm commitment 2,000
To recognise the increase in fair value of the hedged item (i.e., the previously unrecognised firm
commitment) in relation to changes in forward exchange rates and to recognise a debit entry in profit
or loss, which offsets the profit previously recognised in respect of the gain on the derivative financial
asset. The assumption made here is that it is a perfect hedge.
Any further profit or loss is similarly recognised at 10 November 2020.
If the transaction is treated as a cash flow hedge then the increase in the fair value of the hedged
item (the firm commitment) is not recognised in the financial statements at 30 September 2020.
At 30 September 2020
To recognise the increase in the fair value of the forward contract (i.e., a derivative financial asset) and
to recognise the gain on the forward contract in other comprehensive income the following entries
would be made.
A$000 A$000
DEBIT Forward contract – financial asset 2,000
CREDIT Reserves (through OCI) 2,000
The gain is reclassified from OCI (Other Comprehensive Income) in the next accounting period.
The directors do not want the hedged accounting method to change the profit or loss and the
reserves for the year ended 30 September 2020 - in which case the hedged transaction should be
treated as a fair value hedge as the net impact on profit or loss is A$ nil.
The cash flow hedge results in a credit to reserves.

Part (3)
Goodwill £1: A$ 2 £1: A$ 1.75

At 1 April 2020 At 30 Sept 2020
A$000 £000 £000
Cost of the investment 45%
Shares in BW £40,000 × 2 80,000
Cash 140,000
Contingent consideration 50,000 –––––– ––––––
270,000 135,000 154,286
NCI at acquisition 55% 55,000,000 ×
A$5.55 305,250 152,625 174,429
575,250 287,625 328,714

Net assets at Acquisition
Share capital 100,000
Retained earnings at 1 October 2019 173,800
6 months to 1 April 2020
72,500 × 6/12 (Note) 36,250
–––––– –––––– ––––––
310,050 155,025 177,171
Goodwill 132,600 151,543
Increase to OCI 18,943
Note: The exchange gain on the purchase of aircraft of A$2,784,000 occurs post-acquisition.
Part (4)
Revised draft statement of profit or loss and OCI BW group

£000
Revenue 580,723
Cost of sales 352,670
Operating expenses 93,635
Finance costs 15,000
Profit/loss before tax 119,418
Tax 23,855
Exchange differences on translating foreign operations
Restatement of goodwill (see above) 18,943
Exchange gain in year (W1) 23,688

Revised draft statement of profit or loss and OCI BW group
£000
WORKINGS
(1) Calculate exchange differences on retranslation of subsidiary
A$000 £000
Net assets at acquisition 310,050 At Acq rate 2.00 155,025
At CR rate 1.75 177,171
22,146
Profit for 6 months to 30 Sep 2020
A$72,500/2 + A$2,784 exchange
gain 39,034 At Acq rate 1.88 20,763
At CR rate 1.75 22,305
1,542
23,688
£000
Non-controlling interests (55%)
Share of profit for the 6 months to 30 September 2020
A$36,250 + A$2,784 = A$39,034 /1.88 (average rate) = £20,763 × 55% 11,420
Share of goodwill restatement
£18,943 × 55% 10,419
Share of exchange gains on retranslation of net assets
£23,688 × 55% (W1) 13,028
34,867

(3) Translate and adjust for 6 months – and consolidate with BW
Flyline 12 Flyline 6
BW months × 6/12 months Avg. rate months Consol.
£000 A$000 A$000 £000 £000
Revenue 427,000 578,000 289,000 1.88 153,723 580,723
Cost of sales 254,000 371,000 185,500 1.88 98,670 352,670
Operating expenses *63,600 115,716 **56,466 1.88 30,035 (93,635)
Finance costs 15,000 (15,000)
Profit/loss before tax 119,418
Tax (19,600) (16,000) (8,000) 1.88 (4,255) (23,855)
*£54,600 + £9,000 (professional fees) = £63,600

** A$118,500/2 = 59,250 – 2,784 (foreign currency gain) = A$56,466
Part (1)
Answers to this question were clearly divided along the lines of the two requirements. Most
candidates performed well on the description of the treatment of the subsidiary, were able to discuss
control using the standard and appreciated the impacts of the options, dispersed shareholding and
board representation.
Answers to the impacts in the individual financial statements of BW (the parent) were less positive.
Many candidates neglected to discuss the individual accounts at all, and a disappointing number
incorrectly discussed consolidation issues, eg, goodwill recognition, 100% addition of assets and
liabilities. Better answers identified the recognition of an investment at cost and discussion of IFRS 9
treatments were commonplace. Few, however, outlined the varying treatments per IAS 27.
Part (2)
In the main this was well answered. The forex loan was regularly awarded maximum marks. The
hedging less well answered but most candidates were able to appreciate that the highly probable
future commitment could lead to both methods of hedge accounting being applied. Most chose
cash flow hedges rather than the FV hedge but still scored well.
Part (3)
This requirement regularly achieved maximum marks. Those who did not would fail to calculate the
goodwill in the currency used by the subsidiary, therefore missing out on any credit for translating
and determining forex gains or losses on goodwill.
There were some very basic errors such as including the NCI on the proportionate basis and/or
failing to include the appropriate proportion of CY profit in reserves at acquisition.
Part (4)
This was one of the least well performed areas of the paper. Weaker candidates were more likely to
omit the requirement. Those making attempts were able to score for appreciating the impacts of the
mid-year acquisition, the translation at average rate and the OFR marks for adjustments. Only the
best scripts were able to manage the forex gains or losses on translation and subsequent split
between NCI and parent.

67 GlamFood
Scenario
This is an auditing, financial analysis and financial reporting question set in a scenario where the
candidate is the audit manager on an audit of a catering company which is nearing completion. It
uses a number of red flags associated with recent business failures and tests candidates’ ability to
spot and deal with these.
The financial reporting covers revenue and share options. The successful candidate should consider
each of these using the very specific facts given in the question. The candidate is also asked to
identify specific audit risk factors for each issue.
The financial analysis element focusses on interpretation of substantive analytical review procedures
performed by the audit assistant on revenue and journal entries. The candidate is asked to identify
key items of audit interest from the results presented and also to identify what further analysis is
required.
Again, the successful candidate will focus on doing this in the context of the scenario set.
The final element of the question is an audit focussed question on going concern. The candidate is
presented with a far from adequate going concern paper prepared by the client and is asked to
evaluate this paper and identify any concerns. In this part of the question, a good mark can only be
earned by using all of the information assessed in parts 1 and 2 of the question as it is this which
allows the candidate to identify many of the shortcomings in the client’s paper. When that evidence is
taken into account it becomes clear that there is significant doubt about the entity’s ability to
continue as a going concern despite the positive headline figures presented by the client.
For each of the matters of concern identified in Assimilate complex information to produce
Exhibit 1: appropriate accounting adjustments.
• Set out and explain the correct financial Apply knowledge of relevant accounting
reporting treatment, identifying any standards to the information in the scenario.
additional information you require; and Identify the need for further information.
• Explain the key audit risks which arise. Clearly set out and explain appropriate
identify risks.
Using the information in Exhibit 2: Apply professional scepticism to identify

• Identify and justify which entries should be potential for creative accounting.
the subject of further audit investigation; Relate different parts of the question to identify
and critical factors.
• Set out and explain the additional key Use technical knowledge and judgement to
substantive analytical procedures that GR determine appropriate audit approach of
should perform on revenue and on journal substantive analytical procedures or tests of
entries. detail.
For each of the elements of the GlamFood Evaluate the relevance of information provided.
finance director’s paper on going concern: Use multiple information sources.
• Evaluate the finance director’s comments Filter information provided to identify critical
and identify any factors you believe give facts.
rise to significant doubt about GlamFood’s
ability to continue as going concern; and Structure and analyse financial and nonfinancial
data to enhance understanding of business
• Set out any additional information you issues and their underlying causes.
require to complete your assessment of
going concern. Present analysis in accordance with instructions.

Marking guide Marks
Correct financial reporting treatment and key audit risks 9

Entries for further investigation and additional key substantive analytical procedures 7
Going concern issues 12
28
Total 28
Part (1)
GlamFood Club
Financial reporting
The arrangements for the new club give rise to three streams of revenue to consider in light of the
guidance in IFRS 15:
• The membership fee of £500 per member which GlamFood has recognised in full in the year
ended 30 September 2020
• The revenue for the first event booked by the member which gave them the right to join the club
• The discounted revenue for any subsequent event booked by a club member – in the year ended
30 September GlamFood has recognised £1.5 million in respect of the deposits taken on these
events.
Key to determining the correct financial reporting for these three streams is to appreciate that the
recognition of revenue should take place when the performance obligation has been satisfied which
is when the event takes place not at the date of booking the event.
Considering first the membership fee:
• This is a fee which entitles members to future purchases at a reduced rate.
• It should not be recognised immediately (as GlamFood appears to have done) but on a basis
which reflects the timing, nature and value of the benefit, as required by IFRS 15.
• In this case, there is potential benefit for a period of one year so an amount representing the
value of the benefit should be deferred over that period. A longer period could also be
considered as the discounted events need to be booked within one year and not take place in
that period.
• The discounts already earned by club members on orders placed is equivalent to £3.0 million ×
0.2 / 0.8 = £750,000. As some members have at least another six months to place further orders it
seems likely that the total benefit from the membership fee will exceed the amount of the fee.
• In addition, it seems unlikely that a customer will pay a £500 membership fee and not then book
another event so the proportion of members who take up the benefits can be expected to be very
high.
• Hence the full amount of the membership fee paid should be deferred over a period of one year.
This will mean that only a proportion of the £900,000 should be recognised as revenue in the year
ended 30 September 2020. Although one method could be to consider deferring this on a time
basis, recognising the fee when the event takes place would reflect the satisfaction of the
• In order to determine the amount of the £900,000 to be recognised we would need to know how
many of the events booked under the discount scheme had actually taken place during the year
ended 30 September 2020. This further information would allow us to refine this estimate but it is
clear that not all of the fees should have been recorded as revenue in the year ended 30
September 2020.
• A further consideration is that the Club membership entitles the customer to book more than one
event at the discounted price – this would therefore need to be factored into the estimate of how
much of the £900,000 to defer. Given that events can be booked up to 31 March 2021 but not
actually take place until September 2022 the £900,000 may need to be deferred over two further
financial years.

• We would also need to consider whether the 20% is a real discount (ie, the customer really pays
20% less than they would have done) or whether in fact the prices are inflated before applying it
and they pay much the same as they would have done. If there is not real discount then the
analysis above might change although there would need to be very good evidence to support
recording the club fee as revenue on receipt.
Moving on to the revenue from the first event booked by the member giving them the right to join
the club. There is no indication that the amount paid for this was any less than the “normal” revenue
and so it should be recognised when the service is performed, and catering provided.
Likewise, the discounted revenue for the second and subsequent events should be recognised when
the service is performed, and the catering provided. The deferred revenue from the membership
fees should offset the lower than normal revenue for each individual event.
The 50% paid in advance should be deferred and recognised only when the event takes place and
the performance obligation satisfied. GlamFood has recognised £1.5 million in respect of deposits
for booked events under the scheme – some of these events may have taken place in the year ended
30 September 2020 and therefore the recognition is correct – however we would need further
information to determine how many of the events have taken place by 30 September 2020 to
propose an adjustment.
Specific audit risks
• There is high risk of cut-off error for revenue between the order date and the delivery of the
event.
• The revenue from the new membership scheme has been recognised incorrectly and there is a
risk that there are other new schemes or arrangements which have also been accounted for
incorrectly.
• There is a risk that the membership arrangement is more complex than currently understood and
that there are other performance obligations for GlamFood which need to be considered and
which may affect revenue recognition.
• Management has an incentive to overstate revenue and it may be that the revenue from
membership was deliberately overstated.
Share options
Financial reporting
Under IFRS 2, share options issued to third parties such as suppliers are usually recorded at the fair
value of the goods and services received in return, unless the value of those goods/services cannot
be measured reliably.
The cost should be recorded when the goods/services are received which appears to be during the
year ended 30 September 2020. Hence it is incorrect to record no entry for the options issued. If the
estimated value of £1.2 million is a reliable estimate, that cost should be recorded with a debit to
expense and a credit to equity.
Specific audit risks
• The key risk here is accurate valuation of the goods and services as the evidence for this seems
limited at present.
• Transactions such as these with suppliers also appear unusual and there is a risk that the
arrangements may be more complex than they first appear with other obligations and terms
which need to be considered. The reason for settling supplier accounts in this way does also need
to be understood.
• There is also the risk that there may be other similar contracts which have not been identified and
may have been accounted for incorrectly.
• Also need to understand how the share options would affect control of the company were they all
to be exercised.
Part (2)
Revenue entries
• It is to be expected that most entries to revenue would come from sales invoices – hence these
are not high-risk items.

• Credit notes are also to be expected. However, the level of credit notes is high at over 12% of
invoice value and the reasons for that need to be investigated. It may be they are linked to the
potential issues with duplicate invoicing. If more than 10% of invoices are reversed it is highly
likely that some provision for credit notes is required and the adequacy of that will need to be
tested.
• Entries from cash directly into revenue are unusual and need to be investigated further to
understand how these arise and why there appear to be no sales invoices. It may be that there is
appropriate documentation but the invoices are paid immediately so no debtor entry is required
however this needs further investigation.
• Entries between revenue and deferred revenue are to be expected for a business which typically
invoices in advance. However, unless revenue is rising the net effect of revenue deferrals and
reversals in the year would be expected to net out. The chart shows that 4,091/30,285 × 100 =
13.5% of total revenue was generated by the net reversal of income deferrals in the year. This is
high and further investigation is required to ensure that there have not been cut-off errors with
revenue recognised on invoice and not deferred until the date of the event. Directors may have
an incentive to do this given the bonus scheme.
• Other journal entries to revenue are by nature unusual and any significant items need
investigation.
Duplicate entries
The duplicate entries are unexpected and material and we cannot rely on the accountant’s assurance
that it was not unusual to have a series of stage payments for the same amount. One invoice would
be expected for each event with multiple payment dates. If the explanation were correct, far more
instances would be expected. Further investigation is needed.
Day of journal posting
Unless they are reversing journals or other automated journals, it would generally be unusual to have
significant journals posted at the weekend – this needs further investigation (see suggested
additional analytics below) as it could be indicative of the manipulation of the results.
In addition, the overall value of journals posted is very high. This may be justified by monthly
reversing journals for deferred income, accruals etc but further work is required to confirm that.
In particular the value of journals posted at the weekend is higher than those posted during the week
Average value at weekend
Saturday 1,902 / 12 = £158,500
Sunday 1,615/5 = £323,000
Average value on a Friday as comparison is £38,000
Unexpected double entry
This entry is unusual and again the terms need to be fully understood. Not all of the amount
advanced would be expected to be offset by revenue and the nature of the transaction appears to
be a financing arrangement rather than a revenue transaction. It is also at a very high rate of interest
(especially when the offset arrangements are taken into account) and we need to understand why
such an arrangement was made. It seems likely that it would only have been entered into if there
were a real and immediate need for cash.
Key additional analytical procedures
Revenue
• Analysis of revenue per month or even per week to see whether evidence of year end
manipulation. Do this separately for regular and one-off sales as would expect different patterns.
• Revenue by customer so that the revenue for key regular customers can be compared to an
expectation based on contract terms.
• Further analysis of revenue journals showing who posted them and when.
• Comparable data and analysis for the deferred revenue balance at prior year end, each month
end and year end to look for trends and any obvious omissions from the year-end balance.
Journals
• Search for the most material journals, particularly with an effect on profit or revenue as there are
indicators that there might be manipulation given the other entries noted

• Analysis of who has posted journals with key focus on management with any incentive to mis-state
the results, such as potentially the finance director
• Analysis of any journals to suspense accounts or other ‘holding accounts’
• Journals to infrequently used accounts which may reflect one-off or unusual transactions which
are worthy of further analysis
• Unusual posters – starters and leavers
• Focus on year end or month end close journals where there is most likely to be manipulation
Part (3)
Note: Take into account your findings in (1) and (2).
Revenue
• A number of matters identified in the course of the audit cast doubt over the director’s statement
that revenue has increased by 5% (£1.44 million). Included in this figure are the following
balances which certainly need further enquiry and may well be errors:
– Membership fees for club £900,000 and deposits under the scheme may have been
recognised incorrectly
– Other journals £1,028,000 seem unusual
– Entries direct from cash = £3,805,000 which may be inappropriate
– Likely under-provision for credit notes as yet unquantified
– Duplicate invoices £476,000
– Likely under-deferral of income as only £300,000 of deferred income other than the “financing
arrangement” which seems improbably low.
• It is also important to note that the revenue reported “met market expectations” as this may mean
that the directors were incentivised to manipulate the revenue reported in order to earn their
bonus and maintain the share price.
• There is evidence that manipulation may have taken place in the number of journals posted at
weekends, although this still needs further assessment.
• Although we cannot quantify the actual adjustment it is possible that actual revenue has
decreased this year.
• There would therefore have to be a significant turnaround for the revenue to increase by 5% in
each of the next two years. This may be an over-optimistic assumption which is based on a false
starting point or one which has been deliberately manipulated. In addition, we know that
significant discounts will be given to Club customers and these may not have been factored in.
• If an aggressive revenue assumption like this is needed to show that GlamFood can generate
enough profit and cash to continue as a going concern then this is a concern.
Profit
• Similar concerns arise about the profit figure. The revenue comments above remain relevant and,
in addition, we know that the profit for the year ended 30 September 2020 is / may be mis-stated
due to the fact that no cost has been included for the good / services paid for with share options.
• The profit forecasts rely on a cost-cutting programme which we are aware may be cutting the
quality of produce and the level of staff input to the point where customers and staff are
dissatisfied and under pressure. It may well be therefore that the company cannot rely on its “loyal
customer base”.
• Again, market expectations may only have been met by manipulation.
Cash
• Little detail is given about the cash flow analysis but it is not very reassuring if the best that can be
said is that the predicted cash balance does not go below zero.
• The year-end balance of £1.9 million is less than the £2.0 million ‘loan’ received on the last day of
the year and there is therefore evidence that it would have been negative without it.
• You would expect a business like GlamFood to be cash rich as it collects half of its revenue on
order and before any costs are incurred.

• Presumably the cash flow forecasts will be reduced if revenue and profit forecasts are adjusted
and this may give rise to much greater concern about whether there is sufficient cash.
• It also seems likely that the level of obligations to be paid may well have been understated – see
below.
Obligations
• While it may be true that there are no loans in the balance sheet, there is clearly an obligation to
pay back in one year the ‘financing’ from the customer which is included in deferred income. This
needs to be taken into account.
• There may also be a need to consider the availability of additional financing given that an
adjusted cash flow forecast may well show the need for this.
• Cutting back pension contributions, accepting an unusual loan with a very high interest rate and
paying for goods and services with share options all suggest that the company is experiencing
cashflow difficulties and that the Finance Director is seeking to hide this. This is a big red flag in
terms of the Company’s true sustainability and performance. It is also unlikely that the regulator
and Trustees will accept this.
Additional information required:
• Justification of why two years is an appropriate period for the directors to consider in their going
concern assessment.
• Detailed forecasts for the two-year period for both profit and cash.
• Assessment of what are the key judgements made, the key assumptions in the forecasts and the
risk factors (both internal and external) affecting those forecasts.
• Evidence to support the forecast sales and costs.
• Assessment of what sources of finance the Company could utilise were it to need additional cash
and confirmation that such sources are indeed available and that the lenders do have sufficient
funds.
• A full understanding of what pension contributions are payable in 2020/21 and 2021/22 and
whether those have been agreed with the Trustees.
• An understanding of actual performance since 30 September 2020, including the level of
customer orders and how those compare to previous periods.
• Detailed terms for the financing agreement and other unusual transactions.
• Minutes of Board meetings to understand what operational challenges the company is facing and
its ability to meet unfulfilled customer orders.
Part (1)
Candidates were able to apply IFRS 15 well to the many complicated revenue streams of GlamFood
and scored well. The recognition as performance obligations were satisfied pleasingly formed the
basis of most answers.
Many candidates achieved maximum marks for the equity settled share-based payment. Weaker
candidates wasted time treating the payments as a share-based payment to an employee by
spreading the payment over vesting periods, others failed to appreciate that the direct method
should be used and valued the payment at £1.1 million.
Audit risks were well attempted overall.
Part (2)
This requirement proved to be rich pickings for the candidates. Most that attempted were able to
achieve maximum marks. The duplicate entries, journals out of hours, credit notes and incorrectly
recorded loan were all regularly discussed.
Part (3)
Many candidates performed well here and were able to link the potentially damaging impacts of the
issues from part 2 to the forecast growth assessments. The pension scheme impacts were also
commonly identified.

68 Panther Metals Ltd
Scenario
The candidate is 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.
The candidate is provided with Advance Information about an audit client called Panther Metals Ltd
which comprises:
(1) a document which includes the scenario, background information and a schedule of audit
issues; and
(2) the nominal ledger data for Panther for the 11 months ended 30 November 2020, contained
within the audit data analytics platform.
The audit issues identified in advance relate to proforma invoices and bill-and-hold transactions.
Extracts are also provided from the strategic report which indicate price volatility for Nickel and
supply issues with Cobalt.
An audit junior has identified two transactions in Account 4000 Nickel based alloy sales which were
posted by Alain an employee who left the company. The two transactions cancel proforma invoices.
The candidate has the opportunity to interrogate the audit data analytics platform for other similar
transactions. A proforma invoice transaction is discoverable posted by Alain in Account 4003 Nickel
in April 2020 for £165k which appears to be duplicated by Sunil in August 2020. These transactions
are identified for the candidate in the exam paper together with two further audit issues relating to a
bill-and-hold sale of Chromium to YYM and goods in transit to GTEX. A schedule of preliminary
analytical procedures for revenue and details of a potential hedging transaction are also provided.
Specifically, the candidate is required to:
(1) In respect of each of the three audit issues identified by Jason Green (Exhibit 1), review relevant
transactions in the audit data analytics platform:
– set out and explain the appropriate financial reporting treatment, including correcting journal
entries; and
– identify and explain the key audit risks.
(2) From Jason’s preliminary analytical procedures for revenue (Exhibit 2), select three accounts
which you regard as 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.
(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 and explain whether the suggested hedging transaction would
In respect of each of the three audit issues Assimilate and demonstrate understanding of a
identified by Jason Green (Exhibit 1), review large amount of complex information.
relevant transactions in the data analytics Distinguish between appropriate and
software; and inappropriate accounting treatments.
• Set out and explain the appropriate financial Explain and recommend appropriate
reporting treatment, including correcting accounting treatments for financial assets.
journal entries.
Set out correcting journal entries.
• Identify and explain the key audit risks.
Critically review and identify the audit risks.

From Jason’s preliminary analytical procedures Apply scepticism to identify further errors in the
for revenue (Exhibit 2), select three revenue data set.
accounts which you regard as having the Perform relevant calculations; explaining or
highest audit risk. For each of these three stating the issues.
accounts:
Using the data and information given analyse
• Explain and justify why you have selected the data and information to support
the account. requirement.
• Identify individual transactions which give Use technical and professional knowledge to
rise to key audit risks and explain the nature analyse the data and identify audit risks.
of these risks.
• Set out the information and explanations
that you need from Panther’s management.
Determine and justify an appropriate level of Relate different parts of the question to identify
performance materiality for the audit of critical factors.
Panther’s revenue. Use technical knowledge and judgement to
determine appropriate performance materiality.
Set out and explain the financial reporting Assimilate and demonstrate understanding of a
treatment for the illustrative example hedging large amount of complex information.
transaction proposed by Paul (Exhibit 3). Recommend appropriate accounting
You should include relevant journals. Explain treatments for the hedge transaction.
how the suggested hedging transaction may Set out journal adjustments.
Marking guide Marks
Appropriate financial reporting treatment and key audit risks for each of the following:
Pro forma invoices, sale to YYM, goods in transit 18
For three separate revenue accounts: explain and justify your selection, identify
transactions giving rise to audit risks, information and explanations required 9
Determination of performance materiality
Justification for amount calculated 4
Financial reporting treatment for hedge
Appropriate journals
Explanation of how hedge addresses volatility 9
40
Total 40
Part (1)
Audit issue 1 Proforma invoices
Appropriate financial reporting treatment
Method using data analytics software to identify the issue.
The Advance Information sets out an issue with Alain posting proforma invoices. By using the DAS
(Stacked bar chart of bump chart or heat map) – a proforma invoice posted by Alain in Account code
4003 Nickel can be identified.

Transaction Description Debit Credit Account Effective User ID
ID code dates
132852 Proforma 0 165,424 4003 24/04/2020 Alain

invoice
In August, Sunil has posted a further sales invoice to the same account for the same amount (this was
discoverable in the advance 11-month DAS). Jason has now ascertained that the proforma invoice
has been duplicated in August by the following transaction.
Transaction ID Description Debit Credit Account code Effective

dates
140552 Adjustment 0 165,424 4003 25/08/2020
There has been no credit note posted to cancel the duplication as the stacked bar chart for Account
code 4003 Nickel highlights.
Line Count Net Primary Variable: Seco
Stacked Bar Charts Effective Period Users
Income Selection
160K
140K
120K
100K
Net
165K 165K
80.0K
60.0K
40.0K
20.0K
Sunil
6.35K Alain
0.00
Apr 2020 Aug 2020 Oct 2020
This is evident by examining the only other three entries processed to this account.
IFRS 15 requires revenue to be recognised when performance obligations are satisfied, normally
when control passes to the customer. This is also the nature of the commercial contracts with
Panther’s customers. The proforma invoice posted in April 2020 should be cancelled by a sales credit
note or by journal.
JNL 1 Correcting journal entry
£ £
DEBIT 4003 – Nickel 165,424
CREDIT 1100 – trade receivables 165,424
Being correction of double counting of proforma invoice.

Audit risks
Duplication of transactions
The audit risk is that revenue and receivables may be overstated through early recognition of such
transactions or double counting the revenue due to recording both the proforma invoice and also
the actual invoice on delivery of the goods.
There is also an audit risk that revenue is being recognised early if proforma invoices are recognised
before control passes – this appears to be a significant risk as a further proforma invoice has been
posted by Julie in December 2020.
The following transaction can be identified by using the heat map.

dates
140553 Proforma 0 1,458,552 4000 27/12/2020

invoice

Cut off
There is also an audit risk of cut off as the goods may also be recognised in inventory at the year end
if the goods have not been dispatched to the customer or are in transit and included in inventory as
goods in transit.
A control risk also arises in how Alain has been able to process proforma invoices. This increases the
potential for fraud and deliberate manipulation of the results.
Audit issue 2 Contract with YYM
Account code 4012 Chromium
Appropriate financial reporting
The sales transaction posted by Julie can be identified in the 12-month DAS as follows:

dates
140554 Bill and hold 0 342,556 4012 1/12/2020

YYM
This is a bill-and-hold arrangement. However, Panther has recognised the transaction as both a credit
to revenue for £342,556 and a credit to cost of sales by including the inventory for £270,500. The
transaction is there in both revenue and in inventory.
There is no credit note posted to this account in the DAS to cancel this invoice therefore this is an
error since Panther should not recognise the transaction in both revenue and inventory. This
potentially overstates revenue and inventory and hence profit.
In order to propose an adjustment, I would need to be sure that it is correctly reflected as revenue.
The advance information sets out the criteria under which Panther should be recognising revenue
from bill-and-hold arrangements which do comply with the requirements of IFRS 15 – see below
under audit risks.
Applying the criteria to the scenario:
(1) The reason for the bill-and-hold arrangement must be substantive (for example, the customer
has requested the arrangement).
This criterion would appear to be satisfied as in the sales contract YYM agreed to assume risk for
the chromium and had the rights to control the destination and timing of distribution.
(2) Products can be physically identified separately as belonging to the customer.
Panther are storing the goods in the warehouse and assuming that the metal can be separately
identified then this criterion is also met.
(3) Products must be ready for physical transfer to the customer.
(4) Products cannot be used or directed to another customer.
YYM has already identified a customer, Zeinn, so both these criteria also are met.
JNL 2 Correcting journal entry
Assuming that the transaction meets these criteria – Panther should enter the following correcting
journal:
£ £
DEBIT 5201 – closing inventory (Cost of sales) 270,500
CREDIT 1001 – closing inventory (SOFP) 270,500
Being correction of double counting of bill-and-hold invoice as both revenue and inventory.

Audit risks
A key audit risk here is that the arrangement may not meet the criteria for revenue recognition and
therefore revenue is overstated. This is a control risk – there is lack of oversight and inexperienced
personnel are dealing with complex transactions.
A further key risk is cut off particularly if transactions are entered into around the year end – there
may be other such transactions where ‘double-counting’ has occurred and inventory belonging to
customers has been recognised as inventory resulting in a risk of over or understating inventory.
Audit Issue 3 Goods in transit
There are two issues here:
The first issue is that the GTEX receivable balance may need to be impaired. The customer has made
a payment on account of £150,000, in respect of an outstanding invoice of £352,411. I would need
to ascertain whether the outstanding balance of £202,411 is impaired at 31 December 2020 and
whether any other invoices are outstanding with this customer.
The second issue here is that the goods are still controlled by Panther at the year end and should be
included in inventory. The proforma invoice for £450,562 has been correctly excluded from the
revenue account for Tungsten (4007), (there are no proforma invoices in the DAS Account Code 4007
Tungsten) – the financial reporting issue is not that there is potentially duplication of revenue but no
cost has been recognised in inventory.
JNL 3 Correcting journal entry for inventory
£ £
DEBIT 1001 – closing inventory (SOFP) 395,500
CREDIT 5201 – closing inventory (cost of sales) 395,500
Being inclusion of goods in transit in closing inventory.

Paul has raised journals at the year end to include consignment and transit inventories in account
5201 Closing inventory and account 1001 Inventory – see transactions 139237–139238 and 139239–
39240. It is possible that these goods in transit have already been taken into account in this journal
and I would need to ask for further information about these transactions.
Transaction Id Description Debit Credit Account Codes Effective Dates User Ids
139195 - 139196 JE01 - Reversal Nov 2020 Inventories 14.587.949 0 5201 01/12/2020 Paul
139235 - 139236 M12(2020) - Site Physical Inventories 0 12.235,411 5201 31/12/2020 Paul
M12(2020) - Consignment Inventories at

139237 - 139238 0 576,200 5201 31/12/2020 Paul
Customers
139239 - 139240 M12(2020) - Transit Inventory from overseas 0 2,265,018 5201 31/12/2020 Paul
M12(2020) - Own Inventories at suppliers for

139241 - 139242 0 923,247 5201 31/12/2020 Paul
processing
139954 - 139955 SH Inventory Review 06/03/2020 0 425,649 5201 31/12/2020 Paul
139980 - 139981 Inventory-FOREX TRANSLATION (OANDA 0 13,043 5201 31/12/2020 Paul

RATES)
140244 - 140245 DDR 0 252.862 5201 31/12/2020 Paul
Audit risks
The audit risk is that inventory is understated and that the cut off on similar transactions will be
incorrect.
There is also a risk that appropriate receivables allowance has not been made for the GTEX balance
and other customer balances.

Part (2)
Tutorial Note
Screenshots from DAS are included here for illustration purposes only – candidates were not able
or expected to include screenshots but were expected to describe transactions found in DAS.
There are different methods for arriving at key transactions. Using the Heat map for revenue
identifies five large transactions which candidates could use in answering question 1.
Transaction Id Description Debit Credit Account Codes Effective Dates User Ids Document Types Created Dates
132863 - 132865 JE02-2020 Sales Provision (WASA & Forex) 155,174 155,174 7902, 4014, 1100 01/01/2020 Paul Manual Journal 12/05/2020 11:34:06
140552 Adjustment 165,424 165,424 1100, 4003 25/08/2020 Sunil Sales Invoice 28/08/2020 10:04:55
140553 Proforma Invoice 1,458,522 1,458,522 1100, 4000 27/12/2020 Julie Sales Invoice 27/12/2020 14:35:12
140554 Bill-and-hold - YYM 342,556 342,556 1100, 4012 01/12/2020 Julie Sales Invoice 01/12/2020 10:12:25
140555 Bill-and-hold arrangement 301,520 301,520 1100, 4001 10/12/2020 Paul Sales Invoice 10/12/2020 17:12:35
Show 10 lines
Another approach could have been used to detect the module.
4000 Nickel based alloys

Why?
The first account I would select for review is Account code 4000 Nickel based Alloys. The reason why
I would select this account is that revenue has increased by £6.1 million which represents a 102%
increase on the previous year. The revenue from Nickel based alloys represents £12 million out of
£35 million revenue for the year (34%). It is therefore a very significant and material balance.
Individual transactions and key audit risk
Examination of the stacked bar chart visualisation in the data analytics software shows a large
increase in revenue in December 2020 of £1,866,470 – analysing the detail of this and £1,458,522
(transaction 140553) relates to a posting with the description ‘proforma invoices’. This has been
posted by Julie on Sunday, 27 December 2020. The date and time of this posting is highly unusual.
This transaction almost certainly looks incorrect and needs investigating.
Alain a former employee had also incorrectly posted proforma invoices in 4003 Nickel. And in the
Advance Information, there are two transactions cancelling pro forma invoices in account 4000 – this
is further evidence that this is clearly a key risk of overstating revenue.
The transactions posted earlier in the year by Alain were posted as manual journals – this transaction
140553 is a sales invoice – this would make it difficult to detect other similar incorrect entries.
Account 4000 Nickel based alloy – visualisation for information only:
Alain - Jun 2020: 1,303,196

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Detail of transaction posted by Julie:

dates
140553 Proforma 0 1,458,522 4000 27/12/2020

invoice
Nature of audit risk is that revenue recognition is potentially overstated – and revenue could be
recognised before control has passed to the customer.
Reviewing the sales posted in this account indicates that many are dollar related sales which are
subject to currency fluctuation and there is an audit risk that receivables at the year end are
incorrectly translated.
(1) If the transaction above has not been corrected by credit notes before the year end, revenue
could be overstated by £1,458,522 – excluding this transaction, the increase in Nickel based
alloy sales would be £4.7 million and the percentage increase 77%. I would need to ascertain
whether control of the inventory in relation to this transaction has passed to the customer and
how the goods have been treated in respect of the inventory count. I would need to examine
any other pro forma invoices and ensure appropriate treatment in the accounting records.
(2) The comment made in the strategic report refers to an increase in price of Nickel used in the
alloys (see Advance Information) but also comments that the price fell in the second half of the
year. The impact of the change in price and also in the dollar rate on sales would enable better
analysis of the movement.
The purchase price of Nickel, which is used in many alloys, increased during the first half of the
year due to supply concerns but it fell during the second half of the year.
Therefore, I would want further information on the selling prices and also volumes of sales in this
account.
I would question management on how this has impacted on the sales of Nickel and the inventory
balance.
(3) Nickel alloys expense only went up by 31% – we do not know the movement in Nickel Alloy
inventory, but unless it has fallen considerably this rise seems inconsistent with that for Nickel
alloy sales given the question states both are affected by market price. I would require further
information regarding the nickel based alloy inventory to assess audit risk.
4002 Cobalt based alloys
Why?
The second account I would select is account code 4002 Cobalt based alloys – sales of cobalt have
increased by £840,981 which represents a 55% increase on the previous year and is specifically
referred to in the strategic report as experiencing price volatility. In the advance information, the
extract from the strategic report stated:
“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 to match customer needs.”
Using the Heat Map the following transaction can be identified in Account code 4002:

dates
140555 Bill and Hold 0 301,520 4002 10/12/2020

arrangement
This transaction in December 2020 which is described as a bill-and-hold transaction for £301,520
requires further investigation to ensure correct cut off.
A cut off error has already been discussed relating to Account code 4012 Chromium – (see Audit
issue 2) where goods sold on bill and hold basis were incorrectly included in inventory and therefore

this transaction 140555 indicates an audit risk of further cut off errors and should be investigated to
ensure a similar error has not occurred and that cut off is correct.
• The strategic report refers to the difficulty of supplies at some points of the year. Using the
stacked bar chart, it can be seen that this pattern is reflected in the visualisation which shows
consistent sales up to May 2020 and a fall for the months of June to October.
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However, revenue increases in October and December 2020 seem to conflict with the information in
the strategic report. An explanation could be that sales in those months is driven by pent up demand
from those when orders could not be filled. Management should be questioned on this sales pattern.
• Examining the stacked bar chart for cobalt purchases indicates that Panther purchased most of
cobalt in July and therefore would support the comment in the strategic report. Also purchases
have increased by 99% compared to revenue increase of 55% – explanation should be obtained
for this difference.
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• I would need to obtain the contract to support the above bill and hold transaction to confirm that
the revenue has been correctly recognised and the goods are not included in inventory by
examining the inventory records. Also confirm the details of any other contracts signed on these
terms to ensure excluded from inventory by agreeing to inventory records.

4014 Tantalum
Why?
Sales of Tantalum have fallen by £2,826,785 representing a 43% fall. Paul the accountant could not
explain the fall in sales.
There is a large credit note in January 2020 for £155,174 which is referenced as a ‘JE20-2020 Sales
Provision WASA and Forex’ which should be investigated to confirm whether there had been an
allowance for this in the previous year financial statements. There is a risk that the opening balance
on receivables may be incorrect or a similar provision may be required at the year end.
The detail of the transaction is as follows:

dates
132863-5 JE20-2020 155,174 0 4014 1/1/2020

Sales
Provision
WASA and
Forex
Cobalt revenue compared to Cobalt purchases

There have been very few sales after July 2020 and no explanation was provided by the client.
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However there is a significant purchase in December 2020 of £562k – sales in December are
however only £10k. It is not unexpected that a matching sale would happen in the same month but
confirmation should be obtained that this metal purchased in December is included in inventory.
Interrogate sales staff at client for an explanation.
Detail of the sales provision posted on 1 January 2020 and confirmation that it was covered by an
allowance for sales returns in 31.12.2019.
Enquire about the large purchase of Tantalum in December and check the cut off of this purchase – is
it included correctly in closing inventory?
4013 Molybdenum could also be chosen as one of the three key accounts
Why?
The third account I would select is account code 4013 Molybdenum – sales increased by £2,016,101
which represents a 58% increase on the previous year.

Individual transactions
The month of October shows a large increase in sales.
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This increase would have been higher by £140,652 but for an unusual posting of a purchase invoice
in this revenue account.
Transaction '137348'
Transaction Id Account Code Amount Effective Date Document Type Journal Description User Id Line Description Entered Date
137348 4013 140,652 27/10/2020 Purchase Invoice $205000.00 Sunil Cancel 10/11/2020
137348 2201 0 27/10/2020 Purchase Invoice $205000.00 Sunil Cancel 10/11/2020
137348 2100 -140,652 27/10/2020 Purchase Invoice $205000.00 Sunil Cancel 10/11/2020
Using the tree map to identify other purchase invoices posted to this revenue account indicates that
the above transaction has been cancelled by a purchase credit note.
Transaction '139166'
Transaction Id Account Code Amount Effective Date Document Type Journal Description User Id Line Description Entered Date
139166 2100 140,652 27/10/2020 Purchase Credit Cancel - see tran 137348 Sunil Cancel 10/11/2020
139166 2201 0 27/10/2020 Purchase Credit Cancel - see tran 137348 Sunil Cancel 10/11/2020
139166 4013 -140,652 27/10/2020 Purchase Credit Cancel - see tran 137348 Sunil Cancel 10/11/2020
Key audit risk

These two transactions indicate that there is a control risk over the potential posting of purchase
invoices to the wrong account and that invoices can be omitted from the nominal ledger.
I would need to confirm the controls over posting of sales and purchase invoices and identify any
further errors.
Tutorial Note
Candidates could also have chosen other accounts as key revenue accounts but received limited
marks if the justification was not appropriate and a significant transaction not identified. For
example, Account 4003 Nickel – this account has been discussed in audit issue 1 and a candidate
may identify that there is a comparative debit balance on this account which requires further
examination. However, there are no significant transactions other than those identified in issue 1.
Candidates who selected more than three accounts received no marks for the discussion of the
fourth account.

Part (3)
5% of profit before tax and 1% of revenue are the most commonly used measures for calculating
materiality.
From the DAS – the profit is £3,381,566 and materiality would be 3,381,566 × 5% = £169,078. The
materiality for the overall engagement was £165,000.
However, using this materiality figure which relates to the financial statements as a whole, the error
found above in Issue 1 would not have been detected – therefore a performance materiality for
revenue should be set at a lower level than £165,000.
1% of revenue – in the case of Panther this would indicate a planning materiality of 35.3 million × 1%
= £353,000 – which would be too high to identify the transactions above – would suggest a lower
materiality given the nature of errors found.
I would suggest a lower performance materiality figure for revenue equal to error on the proforma
invoice found in the AI of £145k.
Part (4)
Panther is hedging the volatility of the future cash flow from selling nickel alloy currently held in its
inventory.
The nickel content is the major component of the nickel alloy and is a recognised non-financial asset.
However, all of the cash flows of the entire item (nickel alloy) may be designated as the hedged item
and hedged for only one particular risk, commodity price risk.
The nickel commodity futures contract is the hedging instrument so can be accounted for as a cash
flow hedge in respect of those inflows, providing the criteria for hedge accounting are met. There is
historic evidence that this type of contract is an effective hedge.
The gain on the forward contract should be calculated as:
£
Forward value of contract at 30 September (540 × £14,000) 7,560,000
Forward value of contract at 31 December 2021 (540 × £13,500) 7,290,000
Gain on contract 270,000
The change in the fair value of the expected cash flows on the hedged item which is not recognised
in the financial statements should be calculated as follows:
£
At 30 September 2021 sales value of nickel alloy 7,540,000
At 31 December 2021 sales value of nickel alloy 7,330,000
Loss 210,000
As the change in the fair value of the expected cash flows on the hedged item is less than the gain
on the contract, the hedge is not fully effective and only £210,000 of the gain on the contract should
be recognised in other comprehensive income.
£
Debit Financial asset 270,000
Credit other comprehensive income 210,000
Credit profit or loss 60,000
Rebalancing
A hedging relationship continues to qualify for hedge accounting if it is effective. In this case, an
economic relationship continues to exist between the hedged item and hedging instrument (since
they are both nickel), and the effect of credit risk does not dominate the value changes that result
from the economic relationship.

The third criterion for hedge effectiveness is that the hedge ratio of the hedging relationship is the
same as that resulting from the quantity of hedged item that the entity actually hedges and the
quantity of hedging instrument that the entity actually uses to hedge that quantity of hedged items.
Since this hedge relationship results in a gain on futures contract of £270,000 but a loss on hedged
item of only £210,000, it appears that the relationship should be rebalanced.
The current hedge ratio is 1:1 (with hedged item and hedging instrument both based on 540 tonnes
of nickel); to maintain 100% effectiveness this should be reset by reducing the quantity of hedging
instrument to 420 tonnes (210/270 × 540) or increasing the quantity of hedged item to 694 tonnes
(270/210 × 540).
Profit volatility
Profit for the year is affected but only to the extent that the hedge is ineffective, the gain or loss is
taken to OCI and recycled when the impact of the cash flow is recognised in the profit or loss.
The gain on the futures contract is matched in the same accounting period as the loss in the sale of
the goods.
In respect of the three audit issues, review relevant transactions in the DAS and:
• Set out and explain the appropriate financial reporting treatment, including correcting journal
entries.
• Identify and explain the key audit risks.
This was the first use of AI and interrogation of DAS and this requirement was attempted
enthusiastically and most candidates scored well. Marks reaching or close to the maximum were
often awarded.
Most candidates were able to successfully identify the main financial reporting issues and describe
the audit risks caused by the proforma invoices, sales to YYM and goods in transit. It was pleasing to
see how candidates were able to scrutinise the DAS to discover details only presented within the
impact information for December 2020.
Candidates who were less successful often failed to identify the direction of audit risk associated and
were unable to identify for example whether inventory was overstated (in the bill and hold
arrangement) or understated (as in the goods in transit situation) and also commonly incorrectly
identified overstated revenue as a risk for all of the scenarios.
Common areas where candidate performance could be improved include the following:
• Some candidates lost marks on audit risks as they failed to express clearly what the risk was – ie,
what was potentially under or over stated and why. A description of what has gone wrong is not
the same as specifying what is the consequent audit risk. In general, long and expansive
descriptions often repeating the question or AI wasted time and gained few marks.
• Under the GIT issue, surprisingly few spotted that there was also a potential issue concerning the
recoverability of receivables. Those who did often concluded that the whole amount should be
written off rather than recognising the level of judgement likely to be required.
• Those who included audit procedures were given no credit for these as they were not asked for.
• Journal entries only gained marks if the amounts were shown – general entries with no value were
given no marks.
Three revenue accounts with highest risk
Another very well attempted requirement. Most candidates correctly focused on the Nickel alloy
account. Encouragingly, many candidates that chose this account identified the significant
transaction in December totalling £1.4 million posted by Julie, out of hours, as a contributing factor
to the increased audit risk. This was presented within the impact DAS, highlighting candidate’s
abilities to react to the receipt of new data.
Candidates who were less successful would either fail to discuss three revenue accounts, spent
disproportionate amounts of time discussing each account (One account with a good discussion
followed by two with one liner attempts) or highlighted lower risk or accounts already covered in
Issue 1 and 2 (eg, Nickel, Monel, 17/4 ph type).

Many candidates wasted time setting out audit risks and procedures which were not asked for in the
question. The additional information required was that to assess audit risk and not to complete the
audit procedures.
No marks were awarded for suggesting that management should be asked for detailed analyses
already available in the DAS.
Performance materiality
Many candidates scored maximum marks here, being able to link the effects of the heightened risk
surrounding revenue and the current materiality levels of £165k to the required performance
materiality to be used on the audit of revenue.
Weaker answers simply calculated materiality based on typical benchmarks on revenue, net assets or
profits, negating the increased risks already discovered and presenting performance materiality
levels considerably in excess of current materiality level and the numerous mistakes already
discovered. Very weak candidates stated that because of the increased risk performance materiality
should be higher.
Financial reporting treatment of the hedging
This was the part of the question with the weakest candidate performance, which would be as
expected as it tested a technical area of the syllabus. However, many candidates successfully
identified cash flow hedging and correctly calculated the movements in the hedge item and
instrument. Better candidates were able to identify the over-hedge recorded in profit or loss.
Repeating sections of the manual gained no marks unless applied to the particular scenario.
Very few candidates at all identified that a reassessment of the hedge quantities was necessary to
make the hedge effective.
69 E-Van Ltd
Scenario
E-Van Ltd is a component manufacturer for the electric vehicle industry. The Sennhauser family own
100% of E-Van’s ordinary shares and the board is comprised entirely of Sennhauser family members.
The candidate is an assistant to Hanna Sennhauser, the finance director. The candidate and Hanna
are both ICAEW Chartered Accountants.
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.
The board wants to present E-Van’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. The board has requested
a review of the financial reporting treatment of the following three areas:
• property, plant and equipment (PPE)
• investment property
• the net defined benefit pension liability
The ethical dilemma for the candidate is that the company would like to show the results favourably
but still comply with IFRS – however the candidate’s manager stresses the importance of maximising
profit over compliance with IFRS – this communication is also verbal and not in writing which places
the candidate in a difficult position in trying to present results fairly and at the same time manage
pressure from above.

Specifically, the candidate is required to:
(1) For each of the three areas identified above, set out and explain your recommended financial
reporting treatment for E-Van’s financial statements for the year ended 30 June 2021 which
complies with IFRS but still maximises reported profit. Justify any differences from my proposed
adjustments.
(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.
(3) Explain the ethical implications for you arising from Hanna’s comment and the actions you
should take.
Set out and explain, for each of the three areas Assimilate and demonstrate understanding of a
identified above, your recommended financial large amount of complex information.
reporting treatment in E-Van’s financial Evaluate, using judgement and scepticism, the
statements for the year ended 30 June 2021. appropriate accounting treatments for complex
The recommended treatment should comply transactions including PPE, investment property
with IFRS while maximising reported profit. and a Net DBO.
Justify and calculate any differences from my
proposed adjustments. Include journals. Recommend appropriate accounting
adjustments in the form of journal.
Prepare revised draft financial statements for E- Assimilate information and use own accounting
Van for the year ended 30 June 2021 (Exhibit 1), adjustments to prepare revised extracts from
which reflect your recommendations. Show the financial statements.
your workings.
Explain the ethical implications for you arising Identify the threats in the scenario to the ethical
from Hanna’s comment and the actions you principles of professional behaviour and
should take. objectivity arising from Hanna’s request.
Identify the self-interest threat for you from the
telephone call and explain how you should
respond to Hanna.
Explain the actions for you including contacting
ICAEW for advice, discussion with Hanna to
resolve the situation, recognising that speaking
to the board may not be helpful as comprises of
family members.
Explain the scenario from different
perspectives.
profession.
Marking guide Marks
69.1 Recommended financial reporting treatment 16

Revised draft financial statements for E-Van (including workings) 6
22
69.2 Ethical implications from Hanna’s comments and responses to ethical issues
raised 8
8
Total 30

69.1 Part (1)
Recommended financial reporting treatment in E-Van’s financial statements for the year
ended 30 June 2021
Note 1 specialist plant and equipment
The useful life of the asset can be revised, as this needs to be assessed every year. In addition
to this, the residual value of the asset can also be re-assessed if there are reasons to suggest it
may differ.
To determine the revised useful life and whether it is appropriate to use the industry average, I
would need to consider whether E-Van has the same types of assets as the industry in general
and uses and maintains them in the same way.
The useful life of an asset reflects the item’s usefulness to that specific entity, which may well
mean that the useful life is shorter than its economic life.
Here, the industry average may not be relevant as an informed person, the production
manager, has stated that the demand for the parts will cease after four years.
Therefore, the asset would then be depreciated prospectively from its depreciable amount
over the remaining useful life.
The key issue is the policy determined for the individual assets. We could look at evidence of
historic profits or losses on disposal of similar assets.
Also, would need to consider why E-Van is applying this change only to this specialist
equipment, does it hold similar assets at other production facilities?
The production manager’s view is that the industry average would not apply to E-Van’s
production line as demand is expected to cease in 2024 – but that is their judgement.
Justify and calculate any differences from Hanna’s proposed adjustments
Using the production manager’s estimate, this would suggest the following adjustment:
£’000
Depreciable amount (32,000 – 8,000) 24,000
Depreciate over four years to 2024 6,000
Depreciation already charged (36,000 – 8,000) / 7 years 4,000
Increase in depreciation 2,000
Journal
DEBIT Operating profit (retained earnings) 2,000

CREDIT PPE 2,000
Hanna’s proposal is to use the industry average from 1 July 2020. This would result in a write
back of the depreciation charged during the year.
IAS 16 says that as the change is prospective, we should calculate the new depreciation charge
(and carrying amount) using the carrying amount at the date of the change (36m – one year
depreciation = 32m). The revised useful life of eight years would mean that there are seven
years remaining at 1 July 2020.

Revised depreciation charge at 1 July 2020
£’000
Depreciable amount using original residual
32,000 – 8,000 24,000
Depreciation charge
7 out of 8 years remaining 3,428
Depreciation already charged 4,000
Reduction in depreciation (571)
Depreciable amount using revised residual of 30%
32,000 – 10,800 21,200
Depreciation charge
7 out of 8 years remaining 3,029
Depreciation already charged 4,000
Reduction in depreciation (971)
Tutorial Note
Detailed calculations of Hanna’s suggestions not required if candidate assumes that should
use production manager’s suggestion – either of the above calculations are acceptable on
an own figure principle if the candidate goes with Hanna’s suggestion.
Revised residual value?

While the industry average may be 30%, the calculation of residual value should still be based
on the best estimate for this specific item. It is unclear if the reduced useful life of the asset has
an impact on its residual value, now that the asset usage is ceasing earlier. If so, this could be
incorporated into the calculation. If the asset is being used less than originally planned, it may
be reasonable that the residual value is higher than the original estimate of £8m. In the
absence of further information, this will be assumed to still be £8 million.
Conclusion
It is difficult to conclude on this adjustment without further information. Currently Hanna’s
proposal would increase profit by £571k but using the estimate provided by the production
manager would result in a reduction of profit by £2 million.
Note 2 investment property
This is an accounting policy choice permitted by IAS 40 which would apply to all investment
property. This appears to be the only property so the board can make this choice.
The reclassification from PPE to investment property seems appropriate. It is acceptable to use
the fair value model for investment properties if the entity believes this will result in a more
reliable and relevant presentation of information about the asset. The entity should not simply
select the policy which gives the highest profit, but the one producing the most relevant
information for the user. However, it is reasonable that an appropriately calculated fair value
could be justified a more reliable and relevant presentation of information about the asset than
the current policy of depreciated historic cost.
The property has already been transferred to investment property as can be seen on the draft

On 1 July 2020, the building was recognised as an investment property at its IAS 16 carrying
amount of £24.75 million.
£’000
The office building was bought on 1 July 2015 27,500
At 1 July 2020 the office building had a carrying amount of:

£27.5 m × 45/50 24,750
At 30 June 2021 the carrying amount is £24.2 million and £550,000 depreciation was
recognised in the statement of profit or loss.
£24.75m × 44/45 24,200
Therefore, to reflect the adoption of fair value at 1 July 2020, the depreciation charged during
the year should be reversed which will increase reported profit for the year.

CREDIT Operating profit (retained earnings) 550,000
Fair value should reflect the actual market state and circumstances as of the date of
recognition [IAS 40.38]. The best evidence of fair value is normally given by current prices in an
active market for similar property in the same location. The valuation of £35 million should not
be used because the buyer was not knowledgeable of local conditions and therefore not a
market participant in an orderly transaction.
Per IFRS 13 fair value represents a price that would be achieved in an orderly transaction
between market participants. The public auction would be using Level 2 inputs being a similar
asset with market corroborated inputs.
The IAS 16 carrying amount should be adjusted to reflect the fair value at 1 July 2020 of £30
million. The revaluation gain of £5.25m (£30,000 – £24,750) is recognised according to IAS 16
and is recognised in reserves as a revaluation surplus though OCI.
£’000
Fair value at 1 July 2020 30,000
Change to reserves 5,250

CREDIT OCI – revaluation reserve 5,250
As the fair value is assumed to be unchanged at 30 June 2021, there is no further adjustment
to be made.
If the value had changed the difference would have been recognised in profit or loss for the
year ended 30 June 2021.
The difference between my recommended treatment and Hanna’s is that Hanna would have
credited an additional £5 million to OCI. I can justify my treatment because it complies with
IFRS and Hanna’s is in contravention with IAS 40 with respect to using the higher fair value – the
write back of the depreciation charge would be the same under both my recommendation
and Hanna’s proposed adjustment.

Note 3 net defined benefit pension liability
Interest rate
It is unlikely that using the BBB bonds would be acceptable, as the AA rated corporate bonds
would be seen by any objective user as a better indication of high-quality corporate bonds.
Even if the BBB bonds were used, it would actually reduce the current year’s profits.
The opening net liability of £51 million would be increased by the interest rate of 4.2% rather
than 2%, giving a net interest cost of £2.142 million rather than the £1.02 million currently
shown by the actuary. This would therefore result in a reduced profit of £1.122 million.
It is true that the year-end net liability would be lower because of a higher discount rate, but
the resulting change would go through Other Comprehensive Income as part of the
remeasurement component and would not affect the current year profit. It does however result
in lower net defined benefit pension liability on the SOFP.
An increase in the discount rate decreases the present value of the obligation. This is because
a higher interest rate means future cash outflows in paying pensions are discounted at a higher
rate resulting in a lower present value. This explains why the present value of the obligation is
estimated to fall from £72 million to £35 million.
I would therefore recommend that the AA rate is used and not adopt Hanna’s proposal.
Curtailment gain
The curtailment gain of £3.8 million would reduce the obligation because there will be a lower
obligation in the future as pensioners will not be given increases in their pensions in the future.
The adjustment for the curtailment gain would credit profit or loss with £3.8 million and reduce
the net defined benefit obligation. However, I would need to confirm whether the curtailment
had actually occurred by the year end and whether the actuarial valuation of £54 million would
also need to be reconsidered. Any change would go to OCI. Given the scale of the amount an
actuary would be required to confirm the amounts as appropriate.
Hanna is proposing an increase in the discount rate and a curtailment of the future rights of the
scheme’s members would result in an additional interest cost of £1.122 million and a
curtailment gain of £3.8 million.
If these were recorded, it would result in a remeasurement gain of £12,842 million (see table
below), which would be shown in Other Comprehensive Income, replacing the current
remeasurement loss.
My recommended treatment would be make no adjustment to the net defined benefit
obligation as further information is required from the actuary.
Revised remeasurement gain
Net defined benefit pension

liability
£’000
At 1 July 2020 per question (51,000)
Interest 4.2% (2,142)
Contributions paid 3,500
Current service cost (2,000)
Past service gain 3,800
(47,842)
Revised net defined benefit per question (35,000)
At 30 June 2021 12,842

Part (2)
Revised draft financial statements for E-Van for the year ended 30 June 2021
Tutorial Note
Adjusted financial statements below assume that the depreciation is increased by £2 million
for PPE and the investment property is adjusted to £30 million for issue 2 and no
adjustment is proposed for issue 3. Own figure principle applied for different adjustments.
Candidates are expected to use the spreadsheet function in the exam software to
demonstrate the correct direction of the adjustments and impact on the revised financial
statements. Adjustments which change the profit or loss must be reflected in retained
earnings. Adjustments recognised through OCI must be reflected in reserves.
Draft Note 1 Note 2 Note 3 Total

£’000 £’000 £’000 £’000 £’000
Revenue 50,353 50,353
Operating profit 10,655 -2,000 550 9,205
Finance costs -6,150 -6,150
Other comprehensive
income:
Remeasurement (loss) on net
defined benefit
obligation -3,480 -3,480
Gain on revaluation 5,250 5,250
£’000 £’000 £’000 £’000 £’000

Assets
Non-current assets
Property, plant and
equipment 83,700 -2,000 81,700
+550 +
Investment property 24,200 5,250 30,000
Current assets 39,500 39,500
Total assets 147,400 151,200
Equity
Ordinary share capital (£1
shares) 50,000 50,000
Other reserves 5,000 5,250 10,250
Retained earnings 12,600 -2,000 550 11,150
67,600 71,400
Net defined benefit pension
liability 54,000 54,000

£’000 £’000 £’000 £’000 £’000
Non-current payables and
provisions 7,000 7,000
61,000 61,000
Current liabilities 18,800 18,800
0
Answers to this question were, in general, disappointing with a minority of candidates
engaging in any meaningful way with the scenario or comparing the valid accounting
treatment with what has been suggested by Hanna.
Despite the first section relating to assumed knowledge from Financial Accounting and
Reporting, a worrying number of candidates did not know how to apply the provisions of IAS
16. A significant failing was thinking changes in accounting estimates were accounting policy
decisions and attempted to retrospectively apply changes in residual values and useful lives.
The calculations of depreciation were often inaccurate. Common errors included a failure to
take account of residual value; the belief that residual value was deducted from carrying value
in the financial statements; and a complete failure to apply the change in rates prospectively
even where the candidate had clearly stated that this should be done.
For PPE, some candidates wanted to make a prior year adjustment and others thought that
there was an impairment rather than a change in estimated life.
The investment property section was generally answered better, with many candidates
demonstrating good knowledge of the accounting principles and applying them correctly to
the given scenario. However, few made any explicit comment on the effect of Hanna’s
proposed adjustment.
Those who did poorly on this section often wrongly focused on lease accounting.
A surprising number of candidates failed to see that the transfer to investment property had
already been made in the financial statements.
Answers to the pension element of the question were mixed. Many candidates rightly spotted
that the proposed change in discount/interest rates was inappropriate, although less were able
to articulate why or went on to discuss what the effect of the change would have been (as
required by the question). Those who did spot that it would have increased the interest charge
to the P or L scored well.
Some candidates wasted time by setting out general accounting principles for pensions rather
than addressing the question or by reproducing journals for accounting entries already made.
This scored no marks.
Only a small number of candidates demonstrated understanding that the actuary’s calculation
of discounted future liabilities would have used the discount rate and many candidates made
clear statements that the rate would not affect the net pension liability.
Most candidates made a reasonable attempt at the past service element but there were a
significant number who proposed journal entries which made no sense or did not balance or
who believed that there would be a charge rather than a credit to P or L.
There were a few candidates who identified the right accounting treatment and then
concluded they should do what Hanna requested as it increased profit. No marks were
awarded for such conclusions or entries.
Despite this, there were also some excellent answers.
Many candidates scored well gaining full marks for preparing revised financial statements on
an own figure principle.
Many candidates used the spreadsheet functionality to produce adjusted financial statement
but marks were lost for posting adjustments in the wrong direction or which did not balance.

Those who failed to add across and present restated figures as required were awarded no
marks.
Also, it is extremely disappointing that a significant number of candidates failed to recognise
the effect on retained earnings of P or L adjustments. This is very basic and with the use of the
spreadsheet in the exam software is easily avoided.
69.2 Most of Hanna’s proposed adjustments, other than the adjustment to interest rate for the
pension liability, show improvements in the profit for the year.
This may not be an issue if there is full disclosure of the assumptions made to the acquisition
team (eg, revision of useful lives and fair value of investment property), except in the case of
the adjustments which are directly not in compliance with IFRS (proposed interest rate change
for the defined benefit liability).
Jo is facing potentially a threat to her professional behaviour and objectivity arising from a self-
interest threat – Jo may be offered a job if Hanna recommends her.
Hanna is demonstrating a lack of professional competence, objectivity and professional
behaviour.
The selection of accounting policies should be made based on providing the most relevant
and reliable information for the users. Selecting the policies to give the highest profit figure is
not an appropriate basis. Similarly, any accounting estimates used must reflect the best
estimate of management based on the facts at hand. Here it appears that Hanna is deliberately
attempting to select estimates which would increase the reported profit figure. Hanna clearly
has a self-interest threat, as she stands to benefit financially from a higher sales price of the
entity. Any adjustments she makes to increase the profit figures are likely to increase the sale
price and the benefit she will gain.
As most of the proposed treatments from Hanna appear to have the aim of improving profits,
this casts doubt over her integrity and objectivity. As Hanna is an ICAEW Chartered
Accountant, she has a duty to be honest in business dealings and produce unbiased figures.
In addition to this, some of the treatment suggests she is operating with a lack of professional
competence and due care. Her suggestions for the adjustment to the pension liability seem to
suggest she may not be familiar with some of the more technical aspects of accounting, and
her knowledge may be out of date. The hint towards Jo being offered a promotion represents
a self-interest threat, and possible intimidation threat as she is being incentivised to overlook
some subjective judgements and incorrect treatment by a person in a superior role.
Hanna’s telephone call to Jo, creating the threats as described above, does not represent
professional behaviour on Hanna’s part, neither in what she is wanting to achieve, nor in the
way she is trying to ensure this. She is a fellow member of the ICAEW and this behaviour would
be likely to discredit the profession if known about. As well as acting appropriately in terms of
the accounts, Jo therefore also needs to act in terms of Hanna’s behaviour.
As Hanna is retiring, she is unlikely to be interested in any form of CPD. Normally Jo would
consider reporting this to an independent member of the board or a non-executive director.
As the board consists entirely of Hanna’s family, this is unlikely to be possible. Due to this
nature Jo should ring the ICAEW helpline for confidential assistance.
Actions:
Jo should:
Document clearly the assumptions in preparing the working paper and draw attention to the
fact that these should be made available to the acquisition team.
Be sure to make a definitive statement with regard to the net defined benefit pension
obligation that the adjustments are not in compliance with IFRS. Discuss with board. This will
require professional judgement to carefully but confidently present what is technically accurate
and to confirm that of course as ICAEW professional accountants that must be uppermost.
Discuss concerns over her competency with Hanna. Point out to Hanna, in as helpful a way as
possible, what the current technical rules are on the valuations.
Contact the confidential ICAEW helpline for assistance with regard to how Hanna is behaving
and also for support in what is a difficult situation.

Very well attempted ethics requirement with most candidate producing good answers
identifying the issues surrounding self-interest and intimidation threats and suggesting some
sensible actions.
A common mistake in the weak candidates was to fail to consider the specific scenario and fall
into ‘audit autopilot’ when discussing actions. As the scenario was set from the perspective of
Jo Maine, an employee of E-Van’s (and not the auditor of E-Van), actions such as ‘consult the
ethics partner’ or ‘refuse the engagement’ were irrelevant and did not score marks.
70 Hughes Watson LLP

Scenario
The candidate is 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. The candidate has been assigned to the group audit of Numilla for the
year ended 30 June 2021.
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 and the Numilla financial controller has set out his preliminary calculation of
goodwill arising on the acquisition of Localex.
The candidate is responsible for interim audit work at a listed client which has just made an overseas
acquisition. The question is focussed on accounting for that acquisition and specifically the goodwill
calculation. The candidate is presented with a calculation performed by the client which includes
multiple errors and omissions. A successful candidate will need to apply their technical knowledge of
acquisition accounting, fair valuation determination and the goodwill calculation to identify and
evaluate these errors and omissions. They are then required to set out a revised and corrected
calculation.
Finally, the candidate is asked to identify audit risks and to design and explain audit procedures for
the goodwill, requiring a good knowledge of procedures for judgemental matters and accounting
estimates in particular.
In respect of the calculation of goodwill on the Using the data & information given analyse the
acquisition of Localex: data and information to support requirement.
Identify and explain fair value adjustments and Use technical & professional knowledge to
any errors or omissions made by the Numilla analyse the data.
financial controller. Where possible, quantify the
effect of each fair value adjustment, error or
omission on goodwill, showing all relevant
figures.
As far as the information permits, set out a Perform relevant calculations, explaining or
corrected calculation of goodwill in the stating the issues.
functional currency and the amount to be Assimilate complex information to produce
recognised in Numilla’s consolidated statement appropriate accounting adjustments.
of financial position at 30 June 2021.
Where appropriate, use an annual discount rate
of 5%.
Explain the key audit risks HW should address Use technical knowledge and judgement to
in its audit of the goodwill arising on the determine appropriate audit approach of
acquisition of Localex. For each key audit risk substantive analytical procedures or tests of
identified, set out the appropriate audit detail.
procedures for the year ended 30 June 2021. Explain the additional procedures required.

Relate different parts of the question to identify

critical factors.
Marking guide Marks
Identify and evaluate FV adjustments, errors and omissions, and quantification of

amounts, showing all relevant items 13
Correct calculation of GW 5
Key audit risks in respect of GW and identify appropriate audit procedures 12
30
Total 30
Part (1)
Errors and omissions made by the Numilla financial controller
Introduction
Goodwill arising from the acquisition of a foreign operation is a foreign currency asset. It should
initially be calculated in the functional currency ($) of Localex as subsidiary and then be treated as an
asset of the foreign operation and translated at the closing rate each year. Numilla’s financial
controller has done the calculation in £, although in this case the period end 30 June 2021 is the
same as the acquisition date so there is no retranslation. The financial controller has not calculated
goodwill in this way.
The carrying amount of goodwill in the consolidated financial statements is in the presentation
currency (£).
Adjustments made to the fair values of assets and liabilities of a foreign operation under IFRS 3
should be treated in the same way as goodwill. The adjustments are recognised in the carrying
amounts of the assets and liabilities of the foreign operation in its functional currency. The adjusted
carrying amounts are then translated at the closing rate.
Consideration – errors and omissions
• The financial controller has omitted to include the contingent consideration payable in shares if
Localex achieves average growth in profit before taxation of 10% or more per annum over the
three years ending 30 June 2024. Contingent consideration should be included in the goodwill
calculation at fair value at acquisition date, even if it is not deemed probable that it will be paid.
• The contingent consideration will be valued at its fair value based on the acquisition date share
price but adjusted for probability and discounted = 500,000 shares @ £4.2 per share × 40% =
£840,000. This should be converted into dollars for the calculation of goodwill £840,000 × 0.8 =
$672,000.
• Further consideration may also be required as to whether any element of this contingent
consideration is really a bonus to Mattie given that he continues to work in the business.
• The financial controller has included in error the acquisition costs of £100,000. If these relate to
due diligence work and general professional fees they should be expensed through profit or loss.
If they are costs relating to the issue of shares then they should be accounted for in accordance
with IFRS 9.
• Treating the costs correctly will result in a reduction of £100,000 in the goodwill figure.
• The financial controller has correctly used the group policy to calculate the non-controlling
interests but has taken 20% of the net assets from the financial statements rather than calculating
the fair value of the net assets and then taking 20% of that figure.
• See below in part 2 for correct calculation of this once fair values corrected too.

Net assets
• The financial controller has treated the net asset figure in $ as if it is in UK £ and has not correctly
translated it into UK £ at the exchange rate of £1 : $ 0.8.
• For example, if translated correctly, the net asset figure should be $5 million = £6.25 million
reducing the goodwill figure by £1.25 million. However, we need first to adjust for fair
adjustments.
• In all cases adjustments to the fair value of the net assets will affect also the amount attributed to
the non-controlling interests – because the NCI is calculated on the carrying amount adjusted for
fair values.
• The Financial Controller has rightly considered whether there are identifiable intangible assets
which should be recognised separately from goodwill and has identified the licence to supply
energy as one such intangible. This appears to arise from a contractual or legal right and so would
meet the definition of an identifiable intangible.
What is less clear is whether it has been correctly valued. It appears that the financial controller
has performed an NPV calculation himself and has not involved any experts. Further information is
needed on the basis of valuation to be able to evaluate whether this valuation is correct.
• It is incorrect to include the post-acquisition cost of acquiring a UK patent in the calculation of
goodwill because it is post acquisition, although it is possible that this will form part of the
consideration of the fair value of the MiniMax intangible – see below.
Fair value adjustments – omissions
• No fair value adjustment has been made in respect of the freehold property. While this is already
held at valuation this may not be the same as the fair value on acquisition as, under IFRS 13, this
should be valued at its highest and best use. While there is a presumption that this will be its
current use, that is not the case where market factors suggest otherwise. An external valuation is
also required to support the fair value of an asset of this nature.
• Fair value of plant and equipment also needs further consideration as this may not be equal to
depreciated historic cost.
• Included in Localex’s net assets is an intangible relating to development costs for the MiniMax
wind turbine. These have presumably been capitalised at cost which is unlikely to be equal to
their fair value so it appears that the Financial Controller has omitted to make a fair value
adjustment where one should be made. Further information is needed to determine both the
bases for valuation and the valuation amount.
• Numilla intends to continue and indeed to extend the supply of the MiniMax. However, to
measure the fair value of the project at initial recognition, the highest and best use of the project
would be determined on the basis of its use by market participants. IFRS 13 presumes that an
entity’s current use of an asset is its highest and best use, unless market or other factors suggest
that a different use of that asset by market participants would maximise the value of that asset.
That seems unlikely to be the case here as Numilla clearly intends to extend the benefit from the
asset but it does still need to be considered. Even if current use is appropriate as a basis,
measurement is likely to be different from cost as it will be based on the net cashflows to be
generated from the product and its continuing development. Whether this will increase or
decrease goodwill is difficult to assess.
• There may also be other intangible assets which have been omitted altogether and that needs
further consideration.
• In the financial statements of Localex, the decommissioning liability will have been measured on
the basis of a discounted best estimate as required by IAS 37. On acquisition it needs to be
measured at fair value which is equal to the expected NPV of what it would cost to transfer its
liability to a willing market participant. This has been calculated as $3.3 million which needs to be
discounted at 5% per annum (0.784) for five years = $2.58 million. This will increase the liability by
$1.08 million.
The adjustment would probably go to PPE – potentially there is no overall impact on net assets unless
there is a deferred tax adjustment.

Deferred tax on fair value adjustments
• No tax effect has been recorded in respect of any fair value adjustment – this is an error.
• The fair value adjustments will not impact either taxable profits or the tax base for Localex.
However, for the Numilla group, they do result in taxable temporary differences as the asset or
liability in the group accounts will be different to that in the Localex financial statements, which is
equal to the tax base of that asset or liability in Utopia. Deferred tax will be calculated on the net
total fair value adjustment at Localex’s rate of tax – 7.5%. Some of this will go to OCI. See part 2 for
calculation.
Part (2)
Corrected calculation of goodwill
$’000
Consideration
Cash 1,000
2 million shares @ £4.20 6,720
Contingent consideration (500,000 × £4.2 (also accept £5 discounted)) 672
Professional fees incurred in respect of the acquisition and associated issue of
shares 0
Non-controlling interests (6,036 × 20%) 1,207
Total consideration 9,599
Net assets
As reported in the Localex draft financial statements at 30 June 2021 5,000 5,000
Fair value adjustments:
Contractual right to supply power and equipment in Utopia 1,280
UK patent costs 0
Increase in PPE for decommissioning liability 1,080
Increase in decommissioning liability -1,080
Total FV adjustments 1,280
Deferred tax at 7.5% (96)
1,184
Total net assets 6,184
Goodwill 3,415
@ £1 = $0.8 = £4,268,000
Part (3)
Key audit risks HW should address in its audit of the goodwill arising on the acquisition of Localex
• The Localex financial controller has made a lot of errors in calculating goodwill so there is a higher
level of audit risk associated with the basic calculation than usual. All figures will need to be
agreed to supporting documentation and there needs to be careful consideration of the currency
in which balances are reported.
• Valuation of the contingent consideration is a key audit risk as determining this value requires
consideration of the probability that the consideration will be paid. This will depend on how
achievable the increase of 10% per annum in profit is.

• Audit procedures will include:
– Review of forecasts to see if targets met
– Review of the historic accuracy of forecasting to see whether forecasts likely to be reliable
– Inspect the sale and purchase agreement to confirm details of circumstances in which the
additional consideration will be paid, in what form it will be paid and when
– Inspect Mattie’s contract of employment to assess whether it rewards him fully for his ongoing
service or whether some element of the contingent consideration is really a bonus.
• Valuation of Localex’s assets and liabilities at fair value is a key audit risk with particular focus on
those involving judgements or accounting estimates.
• Guidance on audit procedures for all accounting estimates is set out in ISA 540. This requires
auditors to consider inherent risk; complexity and subjectivity and to exercise greater levels of
professional scepticism.
• Scepticism is particularly important in this case as Mattie has a large amount of contingent
consideration riding on future profitability and therefore an incentive to reduce the value of net
assets on acquisition.
• Specifically there is risk in separately identifiable intangible assets for development costs and the
contractual right to supply power in the following respects:
– Whether they meet the definition of identifiable assets
– Whether the right basis of valuation has been used for the identifiable assets
– Whether data included in the valuation models is reliable
• Specific audit procedures on intangible assets will include:
– Involving auditor experts on both the method of valuation and the inputs to the models used
– Reviewing the contract for power supply and ensuring that there is appropriate input from local
advisors in interpreting it
– Conducting sensitivity analysis to determine which assumptions have most effect on the
valuation of the assets
– Comparing any forecasts included in the models with historic data for the same or similar
projects
– Considering the assumed lifetime for MiniMax revenues and comparing this to similar products
taking into account the changing market and technological advances
– Consideration of the experience and expertise of those who have produced the valuations – it
may be that the financial controller has appropriate expertise to value the contract for supply
but he may not
– Consideration of factors which might affect the market for power in Utopia or the market for the
MiniMax in Utopia and the UK
• Another area of judgement and estimate is in the valuation of the property (and potentially the
plant and equipment). Specifically there is risk in:
– assessing the highest and best use
– valuing the property on that basis
– obtaining an appropriate understanding of an overseas property market
• Specific audit procedures will include:
– obtaining expert valuations
– assessing the qualifications of the valuer
– considering the evidence as to whether there is a higher and better use than the current use of
the site as an industrial site
– considering whether there is any element of bias in the valuations adopted or assumptions
used

• There is also judgement in assessing the fair values of the liabilities for decommissioning. There
will be assessments made of the probability of various outcomes, the costs and time scales
associated with those outcomes, and the profit/premium any willing market participant would
require to take on the liability and its associated risks. These are complex and subjective matters
and involve a lot of judgement. They are made more complex here in that they involve legal
matters in an overseas environment which may not be familiar to the local team so it is important
local experts are involved as necessary.
• Specific audit procedures will include:
– Obtain and check the accuracy of the client calculations of liability and review them as for other
models used to produce estimates. Agree to third party evidence to support the estimate
– Review relevant contracts and obtain an understanding of relevant local law
– Review correspondence with lawyers, claimants etc
– Obtain input from Localex’s legal advisors to provide evidence of the estimate
– Examine the outcome of any similar contractual obligations or cases in the past
• There is less judgement associated with the deferred tax balance but it will still be necessary to
gain our own understanding of the local tax regime and rules and not simply rely on the client’s
summary.
• A tax expert should be involved in considering whether there are any tax issues or provisions
required and also in the deferred tax calculations and the basis for them.
• The NCI % appears to be straightforward here but it is still important to review the sale and
purchase agreement and to ensure that there are no unusual provisions regarding control etc.
Part (1)
While most candidates made a reasonable attempt at this element of the question, surprisingly few
showed any real understanding of the determination of fair values for assets on acquisition. In
particular, there was a commonly held view that internally generated assets such as development
costs would be considered as they would be for normal financial reporting, rather than considering
what separable intangible assets existed and how they should be valued on acquisition.
The FX elements of this question were complex and, while some candidates addressed them really
well, others missed the point and failed to notice at all that the calculation was in a mixture of £ and $.
This was a challenging question with a lot of issues to manage and assimilate. However, the number
of issues involved (forex, omitted consideration, a variety of fair value adjustments, incorrectly
recorded provisions and professional fees) meant that candidates were able to demonstrate
knowledge and skills without always getting answers fully ’correct’. Very short answers for the
discussion element were common traits of weaker answers.
Part (2)
Most candidates attempted corrected goodwill calculations incorporating their conclusions and so
were able to chip away at marks. Common errors included not recalculating NCI based on the
adjusted net assets, muddling £ and $ figures (or not making it clear which currency the calculation
was in) and translating individual figures incorrectly.
Part (3)
There were many good answers to this section. Those who scored well focused in on the key risks
and judgemental areas rather than taking a more scattergun approach to procedures.
No marks were awarded for auditing figures (such as R&D at cost) which would have no relevance in
a goodwill calculation, or the future need to consider impairment.

Those whose procedures comprised ‘discussions’ or ‘management representations’ did not score
well.
While some mention of the audit of the Localex figures on which the calculation was based was
rewarded, there were limited marks for this and undue focus on a component auditor wasted time
and gained little credit.
Another common problem with answers to this section was that candidates would waste time
describing general consolidation risks and failed to appreciate that the requirement was specifically
aimed towards the testing of the goodwill balance.
Candidates spent time suggesting audit procedures that did not actually give an audit procedure
and that failed to consider the principles of reliable audit evidence eg, ‘check the foreign currency
rate is correct, check the calculation of the decommissioning liability’ etc, and therefore did not score
marks.

71 Llama Ltd
Scenario
The candidate is an audit senior working for Morton LLP, a firm of ICAEW Chartered Accountants.
Morton is the auditor of Llama Ltd for the year ended 30 June 2021.
The candidate is provided with Advance Information about Llama which comprises:
(1) a document including the scenario, background information and a schedule of audit issues; and
(2) the nominal ledger data for Llama for the 11 months ended 31 May 2021, contained within the
data analytics software.
The audit issues identified in the advance information relate to PPE. Audit planning has been
prepared using the 11-month data and Ben, the audit junior has raised two matters concerning two
accounts 0010 leasehold improvements and 0040 Furniture and fixtures with the client.
The examination provides the candidate with the full 12-month data set and audit procedures carried
out by Ben on PPE and intercompany balances and information concerning leases entered into by
Llama.
The instructions for the candidate are set out in a separate exhibit. The candidate is required to:
• identify and explain any weaknesses in the audit procedures performed by Ben Boreham (Exhibit
1); and
• set out and explain the key audit risks and any additional audit procedures we should perform to
address each risk. Use the data analytics software to identify specific key transactions which
• set out and explain the appropriate financial reporting treatment for the property leases in Llama’s
financial statements for the year ended 30 June 2021;
• summarise the impact of your adjustments on Llama’s profit or loss for the year ended 30 June
2021 as shown in the data analytics software.
Ignore any further adjustments for current tax and deferred tax.
(1) In respect of the audit of each of: (a) Assimilate and demonstrate understanding of a
additions to PPE; and (b) the depreciation large amount of complex information.
charge: Distinguish between appropriate and
• identify and explain any weaknesses in the inappropriate accounting treatments.
audit procedures performed by Ben Explain and recommend appropriate
Boreham (Exhibit 1); and accounting treatments for PPE and leases.
• set out and explain the key audit risks and Set out correcting journal entries.
any additional audit procedures we should
perform to address each risk. Use the audit Critically review and identify the audit risks.
software to identify specific key transactions
which require further investigation.
(2) Set out and explain the key audit risks, Use technical & professional knowledge to
including inherent risks, arising from analyse the data and identify audit risks.
transactions and balances with CCC (Exhibit 2).

(3) Using the information about property lease Relate different parts of the question to identify
agreements (Exhibit 3): critical factors.
• set out and explain the appropriate financial Explain and recommend appropriate
reporting treatment for the property leases accounting treatments for PPE and leases.
in Llama’s financial statements for the year Assimilate and demonstrate understanding of a
ended 30 June 2021; large amount of complex information.
• prepare correcting adjusting journal entries; Recommend appropriate accounting
and treatments for the lease transaction.
• explain the impact of your adjustments on Set out journal adjustments.
Llama’s profit for the year ended 30 June
2021 as shown in the audit software.
Marking guide Marks
Weaknesses in audit procedures and audit risks 22

Key audit risks from transactions and balances with CCC 6
Financial reporting treatment of leases, correcting journal entries and adjustments to
Llama’s profit 12
40
Total 40

This 40 mark question was set in such a way as to allow you to demonstrate a variety of skills,
not least your ability to navigate the dataset for the purposes of performing data analytics
routines to support your answer. The first requirement was looking for candidates to be able
to challenge the work already completed on the audit and justify further work from using a
combination of the advance information, the exhibit and the data analytics software, very
typical for this level. Candidates were then required to consider further audit risks and
demonstrate suitable technical prowess from the remaining exhibits and the data analytics
software as required. While all four professional skills have been built into this question (as
you would expect) the need to combine data from different sources would have meant that
your ability to assimilate and use information was especially important for success.

It is only to be expected that you will need to demonstrate this skill in the Corporate Reporting
exam, but as there is now a live dataset to interrogate as well as the advance information and
the exhibits, this is perhaps the most important one to master.

While there may be a lot of data to manage in this question, the traditional approach of the
need to respond to clear instructions given by the audit engagement manager does assist
candidates in terms of the structure that their answers should follow.

Applying judgement
As there are a number of marks awarded for identifying weaknesses in the audit work
performed, this professional skill is clearly examined in the first part of the question. However,
judgement is also required in determining the extent that the various sources of information
presented should be used in candidates’ answers to the rest of the question.

Determining how to convert your thoughts and analysis into something coherent is also a
challenge, and candidates’ need to focus on their ability to produce clear and logical
explanations of weaknesses, risks and procedures, not to mention their accounting treatment
and the supporting detail.
Overall comments
This question was attempted well with most candidates able to identify numerous weaknesses in the
audit work performed by Ben Boreham and demonstrate skills of using the DAS and accounting for
leases. Answers of weaker candidates would often be long and repetitive and lacking in focus –
sometimes to the detriment of later questions illustrating poor time management. The shorter
focused answers tended to be the ones which scored the most marks.
Good candidates were able to incorporate the issues identified within the Advance Information as
part of their answer and also spotted issues raised through the impact information in the exam.
Evidence of focussed use of the DAS was also shown with many candidates finding the month 12
transactions ‘transfer to assets’ transaction ID 74653 £50,000 and the impairment charge transaction
ID 72501 £19,314.
Weaker candidates often focused on the exam information exclusively with no appreciation for the
issues raised from the June data and rarely linked information from the scenario set out in the
Advance information.
• identify and explain any weaknesses in the audit procedures performed by Ben Boreham
(Exhibit 1); and
• set out and explain the key audit risks and any additional audit procedures we should perform
to address each risk. Use the data analytics software to identify specific key transactions which
0010 Leasehold improvements – Additions to PPE
Weakness in procedures
Ben has not confirmed that the capital expenditure on the refurbishment has been authorised and
correctly measured. Existence also not confirmed. He has agreed four amounts for interim
applications to an interim valuation – he has also seen an unsigned contract. He has gained
inadequate assurance from the fact that 80% of the amounts posted to the account are by Pierre, the
finance director and has not obtained independent third-party verification of the amounts. Agreeing
to an unsigned contract does not provide audit evidence; a budget (see Advance information), which
is internally generated and a surveyor’s interim valuation are of limited value for audit evidence
purposes. No work procedures have been performed on the substantial number of other
transactions.
Audit risk and specific transactions of audit interest
Management override
The key risk here is management override – an internal control risk. As explained in the Advance
information, Pierre is both responsible for the negotiation and oversight of the project and for the
recording and payment of interim invoices to contractors. This is a small company and although it is

expected that the finance director would be involved in the day-to-day operations of the business,
the audit procedures should be designed to ensure that this risk is minimised.
Overstatement of assets
The four transactions Ben has examined are:
Transact Description Debit Effective date User ID

ion ID
46667 ALD interim application no. 2 134,200 23/9/2020 Pierre Delvenne
46700 Interim application no. 1 151,500 1/9/2020 Pierre Delvenne
571,400
Examining the relevant account in the audit software using the stacked bar chart shows that two of
the interim application invoices are for the same amount £142,850 and are both described as
‘Interim Application no. 3’ – and therefore there is a question over whether this amount is a
duplication. A key risk exists that the additions are overstated. Audit procedures are necessary to
ensure that assets are not overstated.
It is not clear what threshold Ben has applied in selecting the four interim application amounts
above. However, there are a further two large payments which he has not examined which have been
posted by Pierre.
Interim payment no. 4 for £40,351 and Stamp duty and Land tax £30,799. Both these transactions
give rise to audit risk and should be investigated further.
Transaction ID Description Debit Effective User ID

date
44498 Stamp duty and land tax 30,799 1/9/2020 Pierre Delvenne
Also, Ben has only examined additions posted by Pierre. Amounts over materiality have also been
processed by Dianna. A review of invoices posted to 0010 using the stacked bar chart (settings
effective periods for both primary and secondary variables) reveals that a lease premium for
£150,000 is included in 0010 Leasehold improvements. This has been processed by Dianna. This is a
key transaction of audit interest which Ben should have identified.
Transaction ID Description Debit Effective date User ID
44697 Project – Property lease 150,000 10/8/2021 Dianna Stevens

Premium
Further enquiry is required about the nature of the lease for which this premium has been paid.
Existence
Ben has not confirmed existence of the assets. With a contract of this size, it is expected that there
would be a completion statement to verify that total costs recorded are as agreed and that the works
are complete.
Understatement of right-of-use asset and liability
There is a clear risk that liabilities and assets are omitted from the statement of financial position.
Llama has entered lease arrangements for the restaurant properties.

007100 Rent account shows the following balances:
2021 2020
£ £
007100 Rent 391,560 5,000
The financial reporting of these lease transactions is almost certainly incorrect. Given the nature and
investment in the restaurants it is unlikely that Llama would have signed a short-term lease for the
properties.
There is no balance for right-of-use asset and no lease liability in the DAS.
In summary the additional procedures Ben should perform include:
• Reconcile and confirm interim payments on the contract to completion statement signed by both
the contractor and authorised by the Llama board.
All interim payments should be agreed to a signed contract authorised at board level and to
invoices provided by the contractor. The invoices should be reconciled to the contract to
eliminate the possibility of over payment. A completion statement certifying the work should also
be agreed to the contract. The contract should also be examined to identify any retention
payments which may be due and which Llama has not recognised.
• Scrutinise Llama board minutes to obtain evidence of authorisation for the project and the
budgeted expenditure.
• Obtain a copy of the lease contracts, agree the lease premium to the contract and ensure that the
leases are correctly recorded. Agree any legal fees related to the lease to third party evidence.
• Scrutinise asset accounts for material, unusual (ie, duplicated amounts) and tax sensitive items.
• Agree stamp duty payment to supporting documentation and ensure correctly recognised.
Additions in Account 0040 Furniture and fixtures
Weaknesses in Ben’s procedures
A review of 0040 has been performed by Ben at the planning stage when he identified a large
transaction for £101,116*(see Advance information), but as Ben merely agreed this transaction to a
purchase order, procedures were inadequate. There has been no follow up of this transaction at the
final audit.
A second transaction for £43,000 described as Interim application 1 has been identified by Ben at
the final audit in 0040 Furniture and fixtures.
There is already a transaction described as an Interim application no 1 for £151,500 ID 46700
included in account 0010 and further confirmation should be obtained that the invoice is correctly
described and recorded and not a duplication.
Ben has not performed any procedures on the remaining £470k of additions to this account on the
basis that individually the amounts are below materiality. A scan of these items indicates that a
significant number of the transactions are not capital additions but repairs and therefore incorrectly
recognised as assets resulting in profit being overstated.
Ben has not verified that the assets exist by physical inspection.
Key risks and specific transactions of audit interest
As stated above, the key risk is that assets are overstated and profit understated because of the
repairs, hire charges etc, as capital items.
Reviewing the transactions in account 0040 shows that there are many items which are described as
repairs/hire costs. Here are examples of this type of error entered by each staff member.

For example:
41447 Gas leaks in ovens – assessed 1,432 25/07/2020 Dianna

damage and replaced valves Stevens
50020 10 Week Hire. 5 instalments 18,758 20/11/2020 Pierre

Delvenne
55722 Bar and equipment hire 4,750 12/1/2021 Susan Chu
Individually the amounts are small but collectively could represent a material adjustment to profit.
Using the Tree Map to review all manual journals posted to this account shows that some of the
smaller transactions have been credited as manual journals and debited to CCC the intercompany
loan.
Using the audit software Heat Map, the following transactions recorded in June 2021 are of audit
interest because they suggest that Pierre has capitalised £50,000 of expenses.
See Transactions ID 74653 entered by Pierre in June 2021 and described as ‘transfer to assets’.
Effective date
Credit
7552 Computers & Software -30,000 27/06/2021
8208 Venue decorations -20,000 27/06/2021
Debit
0055 Computer Equipment 30,000 27/06/2021
0040 Furniture and Fixtures 20,000 27/06/2021
Asset additions in Account 0055 Computer equipment

Weakness in Ben’s procedures
Ben has not performed any audit procedures on Computer Equipment 0055 – the company
capitalisation policy suggests that this includes tablets and handsets. These are unlikely to last for
more than 12 months and therefore again the increase of £42,550 may largely comprise items that
should be expensed.
In summary the additional procedures Ben should perform include:
• Select a sample of additions to 0055 and 0040 and agree to invoices ensuring that the items are
appropriately classified as an asset.
• Quantify the amount of the potentially incorrect capitalisation of repairs.
• Enquire and obtain supporting documentation for the journals posted by Pierre in June.
• Agree the invoice for £101,116 identified at the planning to documentation. Follow up on Susan’s
comment that this was part of a leasing arrangement with ECC and ensure that appropriate
adjustments are included in the financial statements.
• Select a sample of additions and physically verify.
Weaknesses in audit procedures for Account code 008000 Depreciation
Ben’s analytical procedure provides some comfort that the depreciation has been appropriately
calculated according to the asset useful lives provided by Pierre. However, in his analytical
procedure, Ben does not ensure that the depreciation charge included in the financial statements is
appropriate for the types of assets. Simply comparing the SOFP movement with the expense account
does not provide audit evidence that the assets and the depreciation charge are fairly stated.
There is an audit risk that subsequent measurement of PPE is incorrect. The asset lives appear to be
excessively long given the nature of the assets and the accounting policy should be challenged with
management. Ben has not done this.

There is a risk that management has deliberately manipulated the financial statements due to
pressure to obtain finance after the year end. Llama is under pressure to provide audited financial
statements to the bank which show the company in a favourable light. This increases the pressure on
management to manipulate the profit figure and understate liabilities. The audit risk here from
pressure to report a profit leads to an understatement of depreciation charge and an overstatement
of profit.
Specific transactions of audit interest
The stacked bar chart for 008000 identifies the following transaction recorded in June 2021.
72501 Tee-pee impairment 19,314 23/06/2021 Susan Chu
This transaction is of audit interest because it is described as an impairment. Ben has not identified
this transaction and not enquired about the nature of this impairment. There may be other
impairments required and assets may therefore not be fairly stated.
Audit procedures to be performed include:
• Investigate the reason for the impairment charge and confirm whether any further impairment
charges are required.
• Recalculate depreciation based on asset lives used for the year ended 30 June 2020 and quantify
the difference.
• Challenge management about the asset lives which appear to be excessive particularly in respect
of leasehold improvements.
Weaknesses in procedures
This requirement was typically well attempted with most candidates able to identify numerous
weaknesses in the audit work performed by Ben Boreham.
Some candidates failed to appreciate the importance of third-party evidence – the reason why
agreeing to the budget is a weakness in audit procedures is not because the budget can be
manipulated, as many candidates surmised, but because it is an internally generated document.
Failure to check the qualifications of the surveyor is not necessarily a weakness in the audit
procedure; it is because the valuation provided little evidence of audit assertions of existence,
ownership nor measurement. It would have been good to see more explanation about why the audit
procedures were poor. For example, the fact that the contract was not signed was often identified but
many did not go on to explain why this is a problem.
Audit risks
Candidates at times did not always step back and look at the big picture. If they had identified
immediately that the big risk was to overstate profit for funding purposes, they would have written
more succinctly about what the key issues were and use the DAS to provide evidence of this.
Answers often worked through the points in the question in order discussing each as they went so
duplicating the fact that assets would be overstated rather than stating the risk and providing the
evidence. It would have been good to see further development of the point to explain that as a result
of the incorrect application of IFRS 16, the liabilities could be understated too.
It was often noted that Pierre was posting transactions that he should not have been but not many
went on to discuss why this could be override of controls leading to overstatement of profit.
Weaker candidates failed to spot that lengthening the life of the lease resulted in understating the
depreciation. They missed the big picture of why the client may be trying to do this – overstatement
of profit. Weaker candidates thought the extension would decrease profit.
Significant transactions
It was good to see evidence that some candidates had prepared and examined the data in advance
of the examination. However, often transactions were not clearly described – descriptions should be
of a standard that would be expected in preparing a working paper for audit purposes. This was an
area of weakness for many candidates and as the DAS content in part 1 increases in future sittings,
should be improved in candidates’ answers. Many identified that PPE contained costs best described
as repairs and could explain the implication of this. Transaction ID 74653 £50,000 ‘Transfer to assets’

was identified as a June transaction and candidates scored well when the transaction was identified
and the implications explained.
Audit procedures
Weaker candidates listed procedures as ‘view the invoice’ without explaining why this would be
useful. Often the procedures were limited to ‘talking to Pierre’ – even though earlier the candidate
may have described the risk of management override as being a key audit risk. Again, there was a
lot of duplication and with a little planning, answers could have been briefer and more focused.
The audit procedures recommended were at times vague, such as ‘check that…’ or ‘confirm…’ or
‘speak to…’. Often procedures were missing the source document to find, or the reason it was being
looked for. Weaker candidates failed to demonstrate the ability to challenge management for
example on the change of useful lives. Answers showed that some candidates are too trusting of
information given to them and are not being sceptical enough.
balances with CCC (Exhibit 2).
Llama is reliant on support by its parent company CCC. This is a related party and there is an audit
risk that disclosures are misleading.
The background information suggests that this support may be withdrawn and Llama is seeking a
bank loan after the year end which raises a going concern risk.
There is a risk that the financial statements are incorrectly stated arising from the lack of interest
charge in the DAS. According to the loan agreement interest is charged at 8% but no interest
appears to have been recorded in the DAS for Llama in respect of this loan for the year ended 30
June 2021.
The interest charge is not fairly stated. The charge to the interest account 007903 shows a fall in
comparison with the previous year.
2021 2020
£ £
007903 Loan interest paid 5,203 30,041
Key transactions of audit interest

Examining the double entry for the transactions on account 007903 for the year ended 30 June 2021
indicates that £5,203 relates to the bank loan in account 002300 and no interest on the intercompany
loan is recorded.
The Account code 2103 CCC intercompany contains many transactions – an example of a transaction
of interest is the following:
A large debit transaction ID 61893 relates to cash received from Aurora leasing for £272,133 on
13/2/2021.
61893 Aurora leasing cash received 272,133 13/2/2021 Susan Chu
This is a key transaction because it refers to a leasing contract which may be incorrectly recognised.
See also the Account code 2310 HP Transaction ID 61310 £253,086 Cash received Agreement
restaurant fitout and refit, which suggests that there is a sale and lease back of catering equipment.
Tutorial Note
Any transaction adequately described and explained why it is an audit risk was accepted in the
marking.
Candidates were provided with the terms of the loan with the parent company CCC. Only a minority
used the DAS to identify that an interest charge had not been recorded in the interest account
007903 – given the size of the account balances with CCC this would have been a very material

transaction. (The large change in the interest account code 007903 was identifiable in advance of the
examination.)
Weak answers just suggested that the loan may not have been accounted for correctly but did not
get into anything more specific. It was good to see that many identified the loan renewal as a
potential going concern issue.
Most candidates picked up marks for looking through Account 2103 and identifying large cash
transfers and unusual transactions and demonstrated awareness of the potential for money
laundering. However, sometimes descriptions of the transactions were too vague for markers to
award marks.
Weaker candidates wasted time by listing audit procedures which were not asked for in the question.
• set out and explain the appropriate financial reporting treatment for the property leases in
Llama’s financial statements for the year ended 30 June 2021;
• summarise the impact of your adjustments on Llama’s profit for the year ended 30 June 2021 as
shown in the audit software.
Initial measurement
Under IFRS 16, a contract is deemed to be a lease if it conveys the right to control the use of an
identified asset for a period of time in return for consideration. The terms of the leases for the
restaurant properties satisfy this definition therefore Llama should recognise a right-of-use asset and
a lease liability.
The right-of-use asset is measured at cost which includes the initial measurement of the lease liability
plus any direct costs incurred relating to the asset. This includes the legal fees, the lease premium
£150,000 and stamp duty £30,799 included in Account code 0010 Leasehold improvements.
The right-of-use assets should be measured at the commencement of the lease as follows:
Llama One and Two Llama Three

£ £
Present value of future lease payments
£249,996 × (DCF 8% for 10 years) 6.71 1,677,473
£118,548 × (DCF 8% for 15 years) 8.559 1,014,652
Direct costs
Lease premium £150,000 and stamp duty £30,799 180,799
Legal fees 6,443 2,738
1,021,095 1,861,010
Tutorial Note
Some payments are made quarterly in the data but as a reasonable approximation the
calculations have been annualised. Strictly the quarterly interest rate is 1.081/4 = 1.943% (approx.).
Reasonable calculations were accepted.
Subsequent measurement
The lease is amortised at the rate stated in the lease agreement. Payments made in respect of the
lease will reduce the liability and should not be charged as rent. IFRS 16 requires total finance
charges to be allocated to each period during the lease term so as to produce a constant periodic
rate of interest on the outstanding lease obligation. For the purpose of this calculation the payments
are assumed to be in arrears although they have actually been paid quarterly in respect of the Llama
One and Two lease and monthly in the case of the Llama Three lease.

Llama One and Two Llama Three Total
£ £
Present value of future lease payments 1,014,652 1,677,473 2,692,125
Add interest calculated at 8% 81,172 134,198 215,370
Less: Payments included in the rent account (118,548) (249,996) (368,544)
Lease liability at 30 June 2021 977,276 1,561,675 2,538,951
Depreciation
The right-of-use asset will be measured at cost less accumulated depreciation and impairment losses
in line with IAS 16 PPE. The right-of-use asset is depreciated over the shorter of the lease term and
the useful life of the asset – unless the asset is expected to be transferred to the lessee at the end of
the lease term. In that case, the asset will be depreciated over the useful life of the property.
The lease does not contain a legal option to buy the property therefore depreciation should be
calculated over the lease term as there is no other information concerning the life of the assets.
Leasehold improvements are depreciated over 25 years; therefore the board needs to set an
accounting policy for leasehold property. For the purpose of illustration, I have used 15 years for the
Llama One and Two leases and 10 years for Llama Three lease. Depreciation should commence when
the asset is brought into use – which I would need to determine. A full year has been used in the
calculations below.
Llama One and Two Llama Three Total

£ £
Present value of future lease payments 1,014,652 1,677,473 2,692,125
Direct costs 6,443 183,537 189,980
Right-of-use asset 1,021,095 1,861,010 2,882,105
Depreciation 15 years / 10 years (68,073) (186,101) (254,174)
Carrying amount at 30 June 2021 953,022 1,674,909 2,627,931
Tutorial Note
Calculations amortising Llama Three from November were accepted.
Journal entries required:
£
DEBIT Right-of-use assets 2,692,125
Being recognition of right-of-use asset at PVFLP
£
DEBIT Right-of-use asset 189,980
CREDIT Rent 007100 9,181
CREDIT 0010 Leasehold improvements 180,799
Being transfer of direct costs to right-of-use asset

£
DEBIT Interest 215,370
CREDIT Rent 368,544
DEBIT Depreciation 254,174
CREDIT Accumulated depreciation 254,174
Being adjustments to profit for interest, rent and depreciation

Net impact on closing loss for the year ended 30 June 2021 as shown in the data analytics software
increases to £119,873
£
Loss for the year per Inflo (20,054)
Decrease loss by Legal fees 9,181
Decrease loss by Rent 368,544
Increase loss by depreciation (254,174)
Increase loss by Interest (215,370)
Overall increase in loss of (91,819)
Revised loss (119,873)
This was answered well, with many achieving full marks.
Some candidates lost marks for not explaining the impact on profit as shown in the DAS.
Common mistakes for those that performed less well would be to fail to capitalise the legal costs or
to capitalise them within both the right-of-use asset and the lease liability.
72 Eastoak plc
Scenario
Eastoak plc is an AIM listed company that manufactures building products for the construction
industry.
Eastoak has a 30 September year end. It does not have any subsidiary companies. Its functional
currency is the £.
Eastoak has three divisions which each produce a separate product line:
• Ventilation division (based in UK)
• Lighting division (based in UK)
• Insulation division (based in France).
Shareholders have been concerned for some time about the results of Eastoak.
After extended discussion the Eastoak board decided to close the Insulation division. The division
was closed on 1 July 2021.
Despite the closure, shareholders remained concerned and, following a board meeting in
September 2021, the finance director and CEO resigned. A new CEO has been appointed and the
candidate has been seconded to assist with the preparation of the financial statements.

A junior member of the finance team has prepared a draft analysis of overall performance of Eastoak
for inclusion in the management commentary. The CEO expresses concerns in the scenario. He did
not think the junior’s interpretation was appropriate or complete. The candidate is required to:
(2) Prepare a revised statement of comprehensive income for Eastoak for the year ended 30
September 2021 (Exhibit 1), suitable for publication, which includes your adjustments from 1.
(3) Evaluate Georg May’s draft analysis of Eastoak’s overall performance and its divisions (Exhibit 2).
Include any relevant additional analysis. Use your revised statement of comprehensive income.
(1) Set out and explain, for each of the three Assimilate and demonstrate understanding of a
issues in Exhibit 1, your recommended financial large amount of complex information.
reporting treatment in Eastoak’s financial Evaluate, using judgement and scepticism, the
statements for the year ended 30 September appropriate accounting treatments for complex
2021. Include correcting journal entries. transactions including closure of a division,
refinancing arrangement and a share-based
payment.
(2) Prepare a revised statement of Assimilate information and use own accounting
comprehensive income for Eastoak for the year adjustments to prepare revised extracts from
ended 30 September 2021 (Exhibit 1), suitable the financial statements.
for publication, which includes your
adjustments from (1) above.
Show your workings.
(3) Evaluate Georg May’s draft analysis of Relate different parts of the question to identify
Eastoak’s overall performance and that of its critical factors.
divisions (Exhibit 2). Include any additional Use technical knowledge and judgement to
analysis. Use your revised statement of determine appropriate performance materiality.
Set out and explain the financial reporting Perform relevant calculations, explaining or
treatment for the illustrative example hedging stating the issues
transaction proposed by Paul (Exhibit 3). Using the data & information given analyse the
You should include relevant journals. Explain data and information to support requirement
how the suggested hedging transaction may Apply scepticism to identify errors and
reduce the volatility of future reported profits. omissions in the narrative
Marking guide Marks
Financial reporting treatment including correcting journal entries 18

Revised statement of comprehensive income including adjustments 6
Evaluation of Georg May’s draft analysis plus any additional analysis 6
30
Total 30

You can expect to be asked to demonstrate your accounting and reporting skills in the
Corporate Reporting exam. This is a regular type of question, where you are given information
and required to explain and demonstrate the correct treatment. All four professional skills will
be deployed, and will be required for different aspects of the question.

It is essential in questions of this kind to work logically through all the exhibits and consider
them in the context of the requirements.

Note that the examining team pointed out the importance of comparatives when producing
answers to part 2 – this is an illustration of the importance of fully reading the requirement so
you understand the task and complete all parts of it.
Applying judgement
It should be noted that the requirements include the need to produce correcting journals and
adjustments, reinforcing the need for the demonstration of sound judgement and
professional scepticism when answering this question.

Note that the examining team was unimpressed with the generic nature of some candidates’
answers to part 3 of the question – remember that your ability to communicate your
conclusions is as vital a skill as being able to apply the technical knowledge in the first place.
Disposal of Insulation division
Loss from discontinued operations
The Insulation Division is a substantial and separate part of Eastoak’s business as it is one of only
three divisions and it is a profit centre where revenues and costs are therefore separately identified.
In accordance with IFRS 5 it is therefore a component of the entity which has been closed and should
be treated as a discontinued operation as a single line entry on the face of the statement of profit or
loss. Eastoak should make appropriate presentation and disclosure of the effect of the division
closure in the year ended 30 September 2021. It should also adjust the comparative figures to reflect
the closure.
The allocation of administrative expenses needs investigating – it would seem unusual that the
allocation of costs should increase when revenue for the division has fallen. Particularly as there is a
separate line item for closure costs. Also, the division was closed on 1 July 2021 so a 12-month
allocation would be incorrect. The costs identified as part of the discontinued operation should be
those that will no longer be incurred when the division is disposed of. Therefore, further investigation
is needed with regard to the nature of the administrative costs before I can recommend an
adjustment. See below for detailed analysis. Allocated costs are not disclosed as part of discontinued
operations.
The provision for redundancy appears to meet the conditions under IAS 37 as a formal
announcement has been made.

Retraining costs should not be provided as these relate to on-going business. There may be other
costs as they have relocation costs.
Journal adjustment required
Journal 1
£’000
DEBIT: Provisions 800
CREDIT: Closure costs 800
Asset disposals – Held for sale

Plant and equipment appears to qualify as a held-for-sale asset in accordance with IFRS 5 from the
date they are marketed (ie, advertised for sale) – 1 July 2021.
At this date, according to IFRS 5, the assets of the Insulation division should be stated at the lower of:
(1) their carrying amount, less depreciation up to the time it is classified as held for sale; and
(2) their fair value less costs to sell
The fair value is measured using the euro exchange rate at the date of sale.
Eastoak should charge depreciation up to the time of classification and then no depreciation for the
last three months. Therefore, three months depreciation should be reversed out.
It is not a disposal group as assets are to be sold separately to a property developer and a
competitor.
If fair value is lower than the carrying amount then an impairment charge should be made. In the
case of plant and equipment the comparison results in a gain therefore the carrying amount is not
adjusted and £7,632,000 (see working below) should be recognised as a current asset.
As Eastoak has adopted the revaluation policy, the land and buildings should be revalued
immediately before being reclassified and the gain will be taken to the revaluation surplus through
OCI.
On reclassification, the selling costs would be included in the statement of profit or loss as an
impairment charge of £455k (€500k/1.1).
Thus, the land and buildings held for sale should be recognised as a current asset and measured at
£12,272,000. The details are shown in the working below together with the journals required to be
processed.
Plant and
£’000 £’000 £’000
Depreciation charged for the 9 months to 30 June
2021 140 × 9/12 / 1,290 × 9/12 ––––– (105) (968)
Carrying amount at 1 July 2021 5,000 5,775 7,632

Land and buildings
Carrying amount before reclassification (£5,000,000
+ £5,775,000) 10,775
Revalue land and buildings immediately before sale
Fair value €14 million @ £1 = €1.10 12,727
Revaluation gain recognised in revaluation reserve
through OCI 1,952
Fair value before reclassification 12,727

Plant and
£’000 £’000 £’000
On reclassification the €500,000 selling costs would
be recognised as an impairment loss in the
statement of profit or loss
€500,000 @ £1 = €1.10 (455)
Carrying amount at 30 September 2021 is the fair
value less costs to sell 12,272
Plant and equipment

Fair value less selling costs
€9.7 million – €100,000 = 9.6 million
£1 = €1.10 8,727
Therefore, the carrying amount is the lower of the
original carrying amount and the fair value less
costs to sell 7,632
Journal 2
£’000
DEBIT Plant and equipment accumulated depreciation (1,290 – 968) 322
DEBIT Property accumulated depreciation (140 – 105) 35
CREDIT Administrative expenses (discontinued operations) 357
Being write back of depreciation for three months on reclassification of division assets to held for
sale.
Journal 3
£’000
DEBIT Property (1,952 – 455) 1,497
CREDIT Revaluation reserve through OCI 1,952
DEBIT Administrative expenses (discontinued operations) 455
Being revaluation and impairment of land and property on reclassification of division assets to held
for sale.
Journal 4
£’000
DEBIT Current assets – held for sale 19,904
CREDIT Property 12,272
CREDIT Plant and equipment 7,632
Being transfer of assets held for sale.

Refinanced bank loan
The original loan is measured at amortised cost. The initial fees and transaction costs are minimal so
the effective interest rate (EIR) of the original loan is equal to its nominal rate of 5% pa.
If a new loan is agreed between a borrower and a lender, or the two parties agree revised terms for
an existing loan, the financial reporting treatment depends on whether the original liability should be
derecognised (extinguished) and a new liability recognised, or whether the original liability should
be treated as modified.

A new liability should be recognised if the new loan terms are substantially different from the terms
of the original loan. The terms are substantially different if the present value of the cash flows under
the new loan terms, including any fees payable/receivable, discounted at the original effective
interest rate (of 5% pa in this case), is 10% or more different from the present value of the remaining
cash flows under the original terms. There is said to be an ‘extinguishment’ of the existing liability. In
these circumstances:
• the difference between the carrying amount extinguished and the fair value of the new loan
should be recognised in profit or loss; and
• the fees payable to the bank should be recognised as part of that gain or loss.
If the difference is below this cut-off point of 10%, there is said to be a modification of the terms. In
these circumstances, the existing liability is not derecognised; and its carrying amount is adjusted by
the fees payable/receivable and amortised over the remaining term of the modified liability.
The present value of remaining cash flows is compared with the present value of cash flows under
the new terms. The present value of the cash flows arising on the old terms is £20 million:
Original loan cash flows (2015 to 2020)
£’000
£1m DCF 5 years at 5% 4.329 4,300
£20m 0.784 15,700
20,000
New loan
(2020 to 2025)
Principal = £30 million DCF 5 years at 5% 0.784 23,500
Fees 1.0 500
24,000
Tutorial Note
Figures include roundings – using a calculator will produce different numbers but will not change
the conclusion.
Discounting the new loan, for this purpose, uses the effective interest rate on the original loan of 5%
pa.
The fees of £500,000 are required to be treated as integral to the cash flows of the new loan for the
purposes of comparing it with the original loan. These fees are therefore expensed immediately as
part of the extinguishment loss and do not form part of the fair value of the new loan in future
reporting periods. The fees have already been expensed in the financial statements.
The increase in cash flows represents more than a 10% change from £20 million.
Therefore, the original financial liability is derecognised and a new financial liability on the new terms
is recognised.
The new financial liability is initially measured at fair value in accordance with IFRS 9 and any
difference between this amount, plus fees, and the derecognised financial liability is recognised in
profit or loss.
Fair value of the new loan is £22.418 million.

Journal 5 for the extinguishment is:
£’000
DEBIT Original loan (carrying amount) 20,000
DEBIT Loss on extinguishment (profit or loss) 2,418
CREDIT New Loan – fair value 22,418
£500,000 fees have already been recorded in profit or loss and should be added to the loss on
extinguishment.
New loan
The fair value of the new loan is recognised at its fair value on 1 October 2020 of £22.418 million.
The fees of £500,000 do not form part of the loan liability, having been recognised in profit of loss as
part of the extinguishment loss.
For the year ended 30 September 2021, the finance charge is 6% × £22,418k = £1,345k
Journal 6 for the finance charge for the year ended 30 September 2021 is:
£’000
DEBIT Finance charge 1,345
CREDIT New loan 1,345
Share-based payment
Because the employees – the recipients – have the right to choose the form settlement will take, IFRS
2 regards the transaction as a compound financial instrument to which split accounting must be
applied.
This means that the entity has issued an instrument with a debt component in so far as the recipient
may demand cash and an equity component to the extent that the recipient may demand settlement
in equity instruments.
IFRS 2 requires that the value of the debt component is established first. The equity component is
then measured as the residual between that amount and the value of the instrument as a whole.
The fair value of the cash route at grant date is: £4,760,000 = £4 (share price) × 700 (employees
expected to satisfy the vesting conditions) × 1,700 (number of shares)
The fair value of the share route at grant date is: £4,900,000 = £3.50 (estimated fair value) × 700
(employees expected to satisfy the vesting conditions) × 2,000 (number of shares)
The fair value of the equity component is therefore: £4,900,000 – £4,760,000 = £140,000
Year ended 30 Sep Workings Liabilities (£) Equity (£) Expense (£)
2021 (1/4) × 1,700 × £4.5 × 600 1,147,500 1,147,500
£140,000 × (1/4) 35,000 35,000
1,182,500
Note: As the number of shares expected to vest change, the amount recognised in equity may be
adjusted to £35,000 × 600/700 = £30,000.
Journal 7
£
DEBIT Compensation expense (income statement) 1,175,500
CREDIT Liability 1,147,500

(2) Prepare a revised draft statement of comprehensive income for Eastoak for the year ended 30
September 2021 (Exhibit 1) suitable for publication, which includes your adjustments from 1
The post-tax loss for the division amounts to £792,000 and is shown in Working 1 below.
£’000
Loss for the year (1,494)
Journal 1 remove provision for retraining 800
Journal 2 remove depreciation for 3 months 357
Journal 3 include impairment charge for land and buildings (455)
(792)
2021 2020
£’000 £’000
Revenue
385,000 – 76,600 308,400
376,000 – 99,416 276,584
Cost of sales
283,388 – 52,088 231,300
263,200 – 69,591 –––––– 193,609
92,120 + Jnl 7 1,183 – 24,357 (68,946)
82,720 – 21,872 (60,848)
Closure costs
2,000 – Jnl 1 – 800 – 1,200 –––––– ––––––

Finance costs 500 + Jnl 5 + 2,418 + Jnl 6 1,345 (4,263) (1,100)
Income tax expense
1,328 + 351 (1,679)
5,506 – 1,511 –––––– (3,995)
Profit for the year from continuing operations 2,212 17,032
Loss from discontinued operations (792) –
Jnl 3 Revaluation gain on reclassification 1,952
1,952 ––––––

(3) Evaluate Georg May’s draft analysis of Eastoak’s overall performance and that of its divisions
(Exhibit 2). Include any additional analysis. Use your revised statement of comprehensive income
Georg says:
“Overall revenue has increased by 2.39% but this hides a 23% fall in revenue from the Insulation
division and an increase of 11.5% in the revenue for the Ventilation and Lighting divisions.”
Georg’s calculations are accurate, and revenue overall has increased
(£385k – £376k) /£376 × 100 = 2.39%
and the Insulation division revenue has fallen by 23%
(£76.6k – £99.4k) /£99.4 × 100 = 23%
The revenue for Ventilation and Lighting divisions have increased by 11.5%
(£308.4k – £276.6k) /£276.6 × 100 = 11.5%
However, it does not represent a fair picture of the performance in terms of revenue generation of
the three divisions:
Lighting and ventilation Insulation Company

% Increase/ (decrease) in revenue 11.50% (23.0%) 2.39%
The Insulation division was closed on 1 July 2021 and therefore the 9-month results for Insulation for
2021 are not comparable with 2020.
A like-for-like period would have resulted in a comparable level of revenue.
£’000
2021 Revenue £76,600 × 12 months / 9 months 102,133
2020 Revenue for 12 months 99,416
Georg should have made clear in the analysis that the revenue for the Insulation division was for a
shorter period.
Georg notes that:
“The revenue for the Ventilation and Lighting divisions has increased due to a 15% increase in
demand for these products compared to the year ended 30 September 2020.”
If the revenue for the Ventilation and Lighting divisions is flexed to reflect the increase in demand in
order to produce a comparison, it shows that the increase in demand has been achieved potentially
through a fall in price.
Like for like volume

2021 308,400 × 100/115 268,174
2020 276,584 276,584
Fall due to price? 8,410
So, Georg’s statement may be accurate but does not explain what has caused the increase in
demand which may have been a fall in price.
Georg notes that the Insulation division’s prices have fallen due to currency movements. These are
probably outside the Insulation division management’s control, but Georg does not make this clear.

Recalculating the division’s revenue, controlling for 20% price fall shows only a small fall in volume
comparing 9 months to 12 months results.
£’000
2021 Revenue 76,600 × 100/80 95,750
Fall due to volume 3,666
And using the full 12 months as a comparison indicates that potentially demand has increased.
£’000
2021 Revenue 76,600 × 12 months/ 9 months × 100/80 127,667
Increase due to volume 28,251
Georg states:
“The impact of currency movements on the prices charged by the Insulation division have
contributed to a fall in the gross profit for the company from 30% to 26.4%.”
Gross profit % Lighting and ventilation Insulation Company

2020 30.00% 30.00% 30.00%
2021 25.00% 32.00% 26.40%
Georg is correct again in saying that the GP has fallen from 30% to 26.4% – but analysing the
divisions’ gross profits shows that the Insulation division GP has actually increased, and the
Ventilation and Lighting has fallen.
Further investigation would be needed to explain the movements in gross profit – which is only partly
explained by currency movements. The Insulation division may have benefited from the potential
upside of currency movements on purchases.
Georg also says:
“The Insulation division has made a loss for the year ended 30 September 2020 of £1,494,000
compared to a profit of £6,442,000 for the year ended 30 September 2020.”
Much of the fall in the division’s profit can be explained by Eastoak allocating a full year of
administrative overheads to the division and also incorrectly recognising retraining costs of £800k.
For 2020, the company appears to have allocated the overheads based on revenue.
Lighting and ventilation Insulation

£’000 £’000 £’000
Allocation based on revenue
82,720 × 276,584/376,000 60,848
82,720 × 99,416/376,000 21,872 82,720

For 2021, the method has been changed and the company allocated 2021 administrative expenses
in the proportion of administrative expenses allocated in 2020. (The analysis below does not include
the adjustment for compensation expense – JNL 5 – this would affect continuing operations only.)
Lighting and ventilation Insulation

£ £ £
Original allocation based on previous
year
92,120 × 60,848/82,720
92,120 × 21,872/82,720 67,763 24,357 92,120
Allocation if based on revenue
92,120 × 308,400/385,000 73,791
92,120 × 76,600/385,000 –––––– 18,328 92,120
(6,028) (6,028)
Putting through the adjustments as noted above shows that the division’s loss is £792,000; this would
become a profit of £5,236,000 if the administrative expenses had been allocated based on revenue
which appears to have been the basis used in 2020.
Georg refers to the Insulation division making a loss but does not mention that the continuing
operations profit has also fallen. His analysis is incomplete.
In summary
Evaluating Georg’s comments indicate that his analysis is not fair and incomplete.
There are four factors which Georg has not been balanced and fair in his analysis.
(1) 9-month period vs 12-month period
(2) Volume/price changes and gross profit
(3) Implications of euro and exchange rates
(4) Allocation of administrative expenses
(1) Set out and explain recommended financial reporting treatments for three issues
This question included the explanation of three financial reporting issues:
(1) a disposal of the insulation division
(2) a refinancing of a financial liability
(3) a choice of settlement share-based payment
Disposal of insulation division
Generally answered well with candidates demonstrating good knowledge and application of IFRS 5.
A point of confusion was where the land and buildings because it was held under the revaluation
policy, needed revaluing under IAS 16, and many candidates deducted the selling costs to reflect the
new valuation of the land and buildings instead of treating these as an impairment.
Candidates’ answers tended to go straight to the PPE and missed the points on the provisions for
redundancy and retraining and whether these are in line with IAS 37.
Refinanced bank loan
Many calculation errors here especially on those for the present value on the existing terms and on
the new ones. An astute candidate should have noticed that as the coupon is 5% and there is no
redemption value, the PV will be £20m. For the new loan it was often discounted at 6% and the fees
were ignored.
Knowledge about the rules was clearly explained. Marks were given for follow through.

Share-based payment
Most identified the compound instrument but failed to apply the rules for valuing the transaction at
the date of issue and at the end of the first year. Despite writing that the equity element is valued at
the grant date, a minority of candidates went on to recalculate using the share price at the year end.
Some candidates adjusted for the estimated number of employees (600) expected to meet the
vesting conditions calculating an equity element of £30,000; others used 700 employees producing
an equity element of £35,000. Both were accepted in the marking.
(2) Prepare revised financial statements
Most candidates failed to appreciate the need for comparatives in published accounts and so missed
the marks available for the presentation of 2020 figures and the appreciation of the adjustments
required to them.
Those that successfully stripped out the discontinued operations (and there were lots that did) and
provided totals in line with published content would easily pass their attempt at this section.
(3) Evaluation of comments
Answers were often uninspired and provided the candidate’s own generic analysis of ratios with little
or no evaluation of Georg’s currently existing work.
Those that were able to highlight the distorting factors that weakened Georg’s analysis eg, 9 months
vs 12 months, the allocation of overheads, scored well. They were few and far between unfortunately.
73 Circeon plc
Scenario
The scenario is a Group which is considering selling either all or 40% of its investment in a wholly-
owned subsidiary to an MBO team or to the subsidiary’s CEO who is also a member of the MBO
team. The candidate is asked to explain the accounting for each potential transaction in both the
consolidated accounts and the separate accounts of the parent. The candidate works for an audit
firm which has not previously audited the subsidiary in question but has been asked to do so for the
current year. The candidate is asked to identify the risks which arise for this audit, many of which are
directly linked to the fact that the financial statements will be used to determine the price at which
the MBO team acquire the shares.
Ethics
The ethical element of the question arises from an email which makes it clear that the subsidiary
CEO, a member of the MBO team, is in possession of information which might affect how
development costs are presented in the financial statements and the price negotiated for the deal.
The candidate is asked to assess the issues arising for the CEO and the audit firm and to set out
actions the audit firm should take.
of shares in Thetaron (Exhibit 1) for each of:
(a) offer 1; and
(b) offer 2,
for each of:
– the separate company financial statements of Circeon plc; andthe consolidated financial
statements of the Circeon Group.
– the consolidated financial statements of the Circeon Group.
For each offer (a) and (b), include relevant calculations and assume that the disposal of the
shares takes place on 31 December 2021 and that Thetaron’s results are in line with the forecast
provided (Exhibit 2).
(2) In respect of HZ’s audit of Thetaron’s financial statements for the year ending 31 December
2021:
(a) explain the key audit risks to be addressed; and
(b) set out the audit procedures for research and development costs.
Assume the completion date is 31 December 2021.

(3) Explain the ethical issues for both HZ and Sam that arise from the information in the email I have
received (Exhibit 3). Set out any actions that HZ should take.
(1) Explain the financial reporting treatment for Using the data & information given analyse the
the year ending 31 December 2021 of the data and information to support requirement
disposal of shares in Thetaron (Exhibit 1) for Use technical & professional knowledge to
each of: analyse the data
a) Offer 1; and Perform relevant calculations; explaining or
b) Offer 2 stating the issues
in both: Assimilate complex information to produce
• the separate company financial statements appropriate accounting adjustments
of Circeon plc; and
• the consolidated financial statements of the
Circeon Group.
For both (a) and (b), include relevant
calculations and assume that the disposal of the
shares takes place on 31 December 2021 and
that Thetaron’s results are in line with the
forecast provided (Exhibit 2).
(2) In respect of HZ’s audit of Thetaron’s Use technical knowledge and judgement to
financial statements for the year ending 31 determine appropriate audit approach of
December 2021: substantive analytical procedures or tests of
a) explain the key audit risks to be addressed; detail
and Explain the additional procedures required
b) set out the procedures for the audit of the Relate different parts of the question to identify
research and development costs. critical factors
(3) Explain the ethical issues for both HZ and Identify the threats in the scenario to the ethical
Sam that arise from the information in the email principles of professional behaviour and
I have received (Exhibit 3). Set out any actions objectivity arising from the information
that HZ should take obtained
Identify the conflict of interest for HZ from the
and explain how HZ should respond
Explain the actions for you including consult
with ethics partner and ICAEW
Explain the scenario from different perspectives
profession
Marking guide Marks
Financial reporting treatment – explanations and calculations 12

Key audit risks and procedures 10
Ethical issues and actions HZ should take 8
30
Total 30

This question is a challenging blend of group accounting and auditing with a dash of ethics
thrown in for good measure. Candidates can expect to see questions of this type in the
Corporate Reporting exam so being prepared is essential for success: all the professional
skills can be demonstrated here and proficiency will be expected for those who want to pass.

The ability to navigate and absorb the contents of the exhibits was the key to being successful
here: any type of preparation of financial information is going to demand that candidates can
identify what they need quickly and this was no exception. When required, the specific
information necessary for the other parts was more clearly delineated, but careful reading is
always important in a time-pressured situation.

While the requirement to this question was detailed, a logical application to each of the tasks
set would have allowed candidates the opportunity to work through it methodically.
Applying judgement
Although given different challenges (audit risks and ethical issues) the need to display sound
professional judgement, supported by strong technical knowledge and exam technique, was
consistently tested throughout and candidates would therefore have benefited from
remembering the importance of being able to display good judgement in this context.

Questions that test a variety of syllabus content (such as this one) definitely need a clear voice
in communicating conclusions so in line with the structure adopted, answers need to
efficiently convey the points drawn from the work undertaken in order to convince the marker
that the right points have been made.
of shares in Thetaron (Exhibit 1) for each of the offers in both the separate and consolidated
OFFER 1
In individual financial statements of Circeon plc
Offer 1 is the disposal of Circeon’s entire shareholding in Thetaron. The shares were all acquired at
par and have a carrying amount in Circeon plc equal to their cost of £1 million.
The additional consideration of 1% of revenues from 1 January 2022 is based on revenues being
generated and represents for Circeon contingent consideration which, under IFRS 3 and IFRS 10 is
measured at FVTPL determined as per IFRS 9 and IFRS 13. The treatment in the seller’s accounts will
mirror that in the buyer’s accounts. Therefore, the right to receive the 1% of revenues is a financial
asset to be recognised at its fair value of £400,000.
The additional consideration clearly compensates for the low upfront initial consideration and is
therefore part of the purchase price and therefore impacts the amount of the gain on disposal.
The cash proceeds received under Offer 1 will be £1.7 million, which together with the additional
consideration is £2.1 million. This results in a gain of £1.1 million which will be recognised in Circeon
plc’s individual statement of profit or loss.

The fair value calculation includes consideration of the expected sales (which cannot be estimated
with certainty for such a new device), probabilities of outcomes and discounting. It is a judgemental
figure which needs to be challenged and is likely to change.
As Circeon’s loan to Thetaron is repaid in full as part of this offer, there is no need to consider
whether any provision for impairment is required. Interest income for the year of £165,000 will be
included in the Circeon plc statement of profit or loss.
In consolidated financial statements of Circeon Group
In the group accounts, Thetaron’s results will have been consolidated. It is a 100% subsidiary and so,
at 31 December 2021, the net liabilities included in the Group accounts immediately prior to the
disposal transaction will be those forecast by the Thetaron Finance Director of £1.8 million.
Thetaron’s loss for the year of £1.9 million will be included in the group consolidated profit and loss
account as Thetaron was owned for the year. The interest of £165,000 will be eliminated on
consolidation.
The loan from Circeon to Thetaron will be repaid on completion so there will be no balances to be
eliminated. Repaying the loan will not affect the net assets of Thetaron.
When net liabilities of £1.8 million are compared to proceeds of £2.1 million (1.7 million +
£400,000), there is a gain of £3.9 million. This will be reflected in the group statement of profit or
loss. The gain included in the individual financial statements of Circeon plc will be eliminated on
consolidation.
There is no goodwill balance to be taken into account because no goodwill arose on the acquisition
of Thetaron as it was incorporated by Circeon and would have had cash equal to share capital on
incorporation.
OFFER 2
In individual financial statements of Circeon plc
Circeon plc has now disposed of only 40% of its shareholding in Thetaron. The cost of 40% was
£400,000 and this is compared to the proceeds of £700,000 giving rise to a gain of £300,000 which
is recognised in Circeon plc’s statement of profit or loss.
Circeon retains a 60% interest in Thetaron which will be carried at its cost of £600,000 and must be
reviewed for impairment.
The loan to Thetaron remains and will also need to be considered for impairment given the losses
incurred by Thetaron, although the offers made for the company and information available suggests
that the company’s long-term prospects are good. It will also be important to consider what security
has been given for the bank borrowing and whether this weakens the likelihood of repayment for
Circeon’s loan.
In consolidated financial statements of Circeon Group
If Offer 2 is accepted, Circeon retains 60% ownership and Thetaron is still a subsidiary with its results
consolidated for the whole year. Because there is no loss of control, no gain or loss on disposal is
calculated or reflected in the consolidated statement of profit or loss. Instead the difference
between the proceeds received (£700,000) and the change in non-controlling interests is accounted
for in shareholders’ equity. Goodwill is calculated as at the original acquisition date and therefore
remains as nil – there is no recalculation of goodwill.
Before the transaction, there was no NCI. After the transaction the NCI is 40% of Thetaron’s net
liabilities of £1.8 million = £720,000 DR. Hence there is a net decrease of £720,000 in NCI to be
added to the proceeds, resulting in a credit of £1.42 million to equity.
The loan between Circeon and Thetaron will be eliminated on consolidation.
(2) In respect of HZ’s audit of the completion accounts of Thetaron at 31 December 2021:
Explain the key audit risks our audit planning and procedures should address.
Management over-ride
The most significant over-riding risk is one of management over-ride of controls. The CEO of
Thetaron and 3 other directors are on the MBO team which will pay less for the company if the net
assets (before loan) in the company’s financial statements are reduced. There is therefore a huge
incentive to manipulate the results to the MBO team’s advantage. There is therefore a risk of
understatement of assets and overstatement of liabilities.

First time through audit
Although HZ will have knowledge of Thetaron from the review procedures it will have performed in
the past as group auditor, 2021 is the first year it will have audited the entity. It will therefore need to
ensure that adequate procedures are performed on opening balances and additional work to gain a
full understanding of the entity.
Materiality / significance of each adjustment
The other over-riding risk is that, because there is a £ for £ adjustment for the difference in net asset
value, there may be unrealistic expectations of the audit process which can only ever be expected to
identify material adjustments and difficulty in assessing an appropriate materiality level to apply.
Audit work is aimed at a true and fair view not a single pinpointed result.
From this over-riding risk, a number of other key risks arise:
Capitalisation of development costs
The risk that development expenditure is being expensed rather than capitalised. Under IAS 38,
development expenditure must be capitalised once certain tightly defined criteria are met.
Development costs are capitalised only after technical and commercial feasibility of the asset for sale
or use have been established. This means that the entity must intend and be able to complete the
intangible asset and either use it or sell it and be able to demonstrate how the asset will generate
future economic benefits.
The point at which this stage is reached for a particular product is always judgemental but there are a
number of factors which suggest this point was reached during 2021 for the BSM49 – the Circeon
board is of the view that the product is commercially viable and the email reporting Sam’s views
reports that there has been marketing activity and suggests that the company may be close to a deal
with a customer. The offer which includes contingent consideration also makes it clear that sales are
expected within the next year which is a reasonably short time period and may suggest that the
development phase, rather than the research phase has been reached.
Development costs are very significant and capitalising even a proportion of them could materially
affect the net assets and thus the purchase price. The MBO team have an incentive not to capitalise
the expenditure and there is therefore a risk that they may seek to emphasise only that evidence
which supports expensing the costs.
Overstatement of liabilities
As the Thetaron management team have an incentive to reduce net assets, it is possible that they will
seek to include accruals and provisions for items which are future costs, rather than valid expenses
for the year ending 31 December 2021. Cut-off is therefore a risk but this should be focussed on
over-statement of liabilities rather than the more common risk that liabilities are understated.
Taxation
The other balance which has a significant effect on net assets is the recognition of tax receivable. The
note to the financial statements suggests that this has been prudently estimated and represents
group relief receivable for the surrender of some of Thetaron’s tax losses to other group companies.
It is possible that the treatment of research and development costs for tax purposes will lead to
significant tax allowances and possibly have deferred tax implications. It also seems odd that only
part of the losses can be surrendered although this may be due to the capacity of other group
companies to use them. There is a significant risk that this balance is mis-stated and that the actual
tax which can be recovered is either higher or lower.
Tangible fixed assets
The PPE balance looks low as the company must have premises it operates from and laboratories for
development work. There is a risk that expenditure on tangible fixed assets has been expensed as
part of development costs.
In addition, rent for leased premises may be being expensed through the statement of profit or loss
rather than the lease being capitalised appropriately under IFRS 16.

Set out procedures for the audit of the research and development costs.
• Perform enquiries to understand fully the status of the project to develop BSM49 and whether it
does or does not meet the criteria for capitalisation under IAS 38. Steps to reach a full
understanding will include
– Discussions with the development team, including, if at all possible, those who are not involved
in the management buyout team
– Review of minutes of management and board meetings
– Review of the results of any trials completed to date and gaining a full understanding of what
trials are required for a medical device of this type and what stage has so far been reached
– Consideration of any relevant articles in the medical press, opinions from experts or claims in
the media that other companies have made advances in developing similar or competing
technologies or devices
– Review of up-to-date budgets for future costs and revenues to assess commercial viability and
also the stage of completion
– Review of correspondence or agreements with potential suppliers or customers to assess the
stage which the project has reached
• Test the costs that have been included in expenditure for the year:
– For payroll costs incurred, consider the roles of those charging time to the project and ensure
that there is evidence they have spent their time working on the device. Agree costs to payslips,
payroll summaries etc.
– For consumables, agree costs to invoices and ensure by discussion and review that the items
purchased have reasonably been treated as costs of the project.
– For allocated overheads, review the basis for allocation and ensure that it is reasonable.
• To test completeness of costs:
– Review operating costs and test a sample to determine whether they should be allocated to
research and development costs.
– Review post year end invoices and costs incurred to determine whether cut-off is correct and all
costs for the period correctly accounted for.
(3) Explain the ethical issues for both HZ and Sam that arise from the information in the email I
have received (Exhibit 3). Set out any actions that HZ should take.
Issues for HZ
HZ is in possession of information which suggests that Sam as the CEO of a subsidiary has not been
entirely open with his shareholder (Circeon) and that he may be manipulating results and the timing
of commercial deals for his own personal advantage. Whether he has an obligation to share
prospective information with the shareholder proactively is debatable but he should certainly not
deliberately lie when asked for information.
The information about marketing and prospective sales would clearly be of interest to Circeon, HZ’s
customer but Circeon is aware that it is negotiating with the MBO team and have an obligation to
ensure that appropriate due diligence is performed before agreeing the sale price. HZ can only
share the information it now has with care as it was arguably received by the audit manager in a
personal capacity rather than as part of his work.
HZ also has information which may well contradict evidence presented during the course of the audit
but from an unsubstantiated source which it may not be possible to name.
Issues for Sam Heran
Sam is an ICAEW Chartered Accountant and is thus required to act with integrity, objectivity and
confidentiality.
He is facing a situation where there is a conflict of interest between his position as CEO of a wholly
owned subsidiary of Circeon and his role as a member of an MBO team trying to buy the Thetaron
shares from Circeon. That makes it very difficult for him to act objectively. This conflict will be well
understood by all concerned as it will always arise in an MBO bid.
However, there will still be an expectation that Sam will act with integrity and the fact that he appears
to be failing to share information which might inform the value of the Circeon shares is evidence that
he may not be doing this.

Sam has also reportedly made comments about Thetaron’s trials and potential revenues to a
personal acquaintance and has thus breached the requirement that he maintains confidentiality.
A ‘benchmark’ for Sam’s own ethics under the ICAEW Code should be that any conduct that might
discredit the profession, would breach the principle of professional behaviour as well as the specific
principles mentioned here as being at risk.
Actions for HZ
(1) The HZ audit team should maintain professional scepticism throughout the audit, remaining
mindful of the conflict of interest which exists and seeking corroborative evidence from external
sources wherever possible.
(2) The HZ team should seek to corroborate (or otherwise) the information provided in the friend’s
email concerning the results from trials and the interest from potential customers. It will be much
easier to share this openly with Circeon if evidence has come from audit procedures rather than
an unsubstantiated email.
(3) HZ should ask specifically for representations from the Thetaron Board in connection with the
audit of Thetaron that all information relevant in assessing the status of the BSM49 has been
shared with the audit team. This means that Sam and his team will have deliberately concealed it
if it is not shared.
(4) If evidence cannot be found which either confirms or refutes the information provided then it
may be necessary to challenge Sam and his team about what the team has heard, without
revealing the source. HZ too has to respect confidentiality.
(5) The situation should be discussed with the audit partner on the Circeon audit and with the firm’s
ethics partner.
(6) The information and breach of confidentiality should then be reported to those charged with
governance.
(1) Explain the financial reporting treatment of two disposals in the individual accounts of the
parent and the group financial statements
Answers to this question were mixed. Strong candidates were able to identify and distinguish
between the disposal where control was lost, and the control-to-control disposal. Weaker candidates
were unable to distinguish between the impact of the disposal on the individual company financial
statements and the consolidated financial statements. The technical knowledge of some candidates
shown here in a core area of the syllabus was very disappointing.
Despite the question clearly stating that candidates should assume results were in line with the
forecasts given, many wasted time calculating unnecessary figures for net assets and/or adjustments
to sale proceeds. Some candidates did not seem to realise that there would be no goodwill and were
thrown by the impact of having negative net assets.
Subsequently, answers for the implications to the group accounts for both offers were well answered.
(2) Key audit risks for Thetaron and audit procedures for research and development
This was the best performed requirement with many candidates scoring maximum marks.
Weaknesses included an insistence on describing audit procedures in relation to all the audit risks
identified rather than focussing on the audit of research and development and the repeating
problem of only offering unreliable audit evidence eg, board minutes, discuss with directors,
management representations. Candidates need to consider the quality of audit evidence in their
answers. The most common mistake was to assume development costs had been capitalised
incorrectly despite the extracts to the FS clearly showing that they had all been expensed.
Weaker candidates spent too long explaining the impact of the disposal on the parent company and
the group and failed to notice that this was about the subsidiary. In addition, some candidates noted
that the main risk was that the assets would be overstated when here that is not the case.
(3) Ethics for HZ and Sam. Actions for HZ
Some good attempts were made on this requirement. Many candidates appreciated the
confidentiality issues and self-interest issues for Sam. Most identified that Sam was an ICAEW
member and discussed the principles of the code that applied to him. Fewer candidates noted that
there was a conflict between his roles as CEO and MBO buyer.

The more intricate issues faced by HZ were less well acknowledged. Despite this, marks for the
actions of HZ provided marks for most candidates who attempted the question.
Weak answers focussed only on Sam’s ethical issues and talked around the issue from the narrative
details provided without directly applying the ethical principles to the scenario.
Advice could also be sought from the ICAEW helpline and from the governance of Circeon – the
Audit Committee/Board.

74 Gazelle Ltd
Scenario
The candidate is an audit senior working for MFE LLP, a firm of ICAEW Chartered Accountants. MFE is
the statutory auditor of Gazelle, for the year ended 31 December 2021.
The candidate is provided with Advance Information about an audit client called Gazelle Ltd which
comprises:
(1) a document which includes the scenario, notes of a meeting with Paula Elliott, Gazelle Ltd’s
finance director, and a working paper prepared by an MFE audit assistant; and
(2) the nominal ledger data for Gazelle for the 11 months ended 30 November 2021, contained
within the audit data analytics platform.
In the Advance Information, the candidate is provided with information about Gazelle which was
written shortly after MFE was appointed as auditor in April 2021. The information was obtained by
the engagement partner from a meeting with the finance director. The information sets out the
services provided by Gazelle and the functions of the individuals in the finance team.
From the Advance Information the candidate learns that there is a new head of permanent
recruitment appointed just after the meeting in April 2021 and is told that there will be changes to
the contracts for permanent job recruitment services.
Examining the data analytics software for the three revenue accounts for permanent job recruitment
services (4001, 4006, and 4013) indicates that sales have increased for these three accounts in the
months immediately after the appointment of the new head. Also discoverable is that sales credit
notes have increased in the second half of the year.
From the Advance Information, the candidate establishes which members of staff are responsible for
the recording of each line of business. This is important because the client uses one account
(Account code 4000) to record revenue from both ‘employed temps’ (sales and credit notes posted
by Melissa) and ‘company temps’ (sales and credit notes posted by Leo and Paula).
The client also uses one cost account – Account code 6002 – to record total payroll costs which
include the cost of employed temps (posted by Arianna ) and company temps (posted by Leo
assisted by Melissa). Leo transfers the costs of Gazelle’s own staff to 7002 core staff salaries.
The Advance Information includes analysis showing the gross profit for employed and company
temps for the year ended 31.12.2020. This information identifies that the company temp business
makes only a small profit. The candidate can replicate this analysis using the 11 months to November
2021 data analytics software to identify that at 30 November 2021, company temp’s services are
making a small loss. The Advance Information also notes that Paula prepares accruals for invoices
which have not been recorded in the accounting system. Examining the 11-month data analytics
software shows that the deferred income account code 2109 has increased from the previous year.
In the exam paper, the candidate is presented with information about transactions which have
occurred since the partner’s meeting in April 2021 in the form of three notes:
• Permanent job recruitment services: a change to contract terms – the candidate should link to the
increase in revenue in May–July and the increase in credit notes in the data analytics software from
October–December to identify and explain the audit risks.
• An adjustment for WIP – the adjustment for £160k is discoverable in the data analytics software
and presents a risk that costs are understated.
• Introduction of bonus scheme for company temp’s recruiters – the candidate should find the
transaction (£75k) which is discoverable in the data analytics software and link the incentive
created by the bonus to audit risks.
Other significant transactions discoverable in December are: two large transactions in December in
account 4000 for accrued income and a credit note provision.
A separate exhibit contains information about an investment in QM relevant to the second
requirement.

Using preliminary analytical procedures (see • Assimilate and demonstrate understanding

guidance below) and other information, identify of a large amount of complex information.
and explain the key audit risks for revenue and • Distinguish between appropriate and
related costs. inappropriate financial reporting treatments.
For each audit risk identified: • Critically review and identify the audit risks
• Explain the appropriate financial reporting
treatment for the year ended 31 December
2021.
• Identify any information and explanations
that you require from management in
respect of the audit risks identified.
For Gazelle’s investment in QM (Exhibit 2): • Using the data & information given, analyse
• Set out and explain the financial reporting the data and information to support
treatment in Gazelle’s financial statements requirement.
for the year ended 31 December 2021 • Recommend appropriate and financial
• Set out key audit procedures MFE should reporting treatment for the investment.
perform. • Assimilate and demonstrate understanding
of a large amount of complex information.
• Use technical & professional knowledge to
analyse the data and identify key audit
procedures.
Marking guide Marks
Key audit risks for revenue and related costs 26

Investment in QM - financial reporting treatment and audit procedures 14
Marks Available 40
40
Total 40

This question is for 40 marks, which is often the case for Question 1. The audit client is a
recruitment agency. You will need to demonstrate the four professional skills in relation to
issues with contract changes and increased credit notes. Revenue classification is an issue,
with risk of overstatement and inadequate application of IFRS 15. You had to identify errors
and perform key workings. You also had to identify and explain the financial reporting
treatment of a joint venture. On the audit side, you were required to identify audit risks
backed up by data from the software. All four professional skills were needed, but the
requirement to assimilate information was the most important, as it is likely to be for a
question involving data analytic software.

The question is long, and requires you to get to grips with a great deal of information in a
relatively short time. It is important to use the data analytics software to drill down to specifics
rather than getting lost in it. You would be wise to use your time well before the exam to get
used to the software so that it becomes second nature.

The structure is given for you in Exhibit 3, which is effectively the requirement – always look for
the requirements first, bearing in mind that these are often embedded. You are given a list of
relevant accounts for revenue and costs, so these are the ones to use. The second
requirement may be more familiar from your earlier studies.
Applying judgement
While some issues are clear cut, for example incorrect classification of revenue, others may
require you, in your role as audit senior, to apply judgement, for example about audit risk, and
what information to request from management. If you had, incorrectly, concluded that the
30% investment was a joint operation, you would still have got some marks for applying IFRS
11 and considering the issues.

Particularly in Question 1, which is very wide ranging and contains a lot of information, it is
vital that you express yourself clearly and back up your arguments. The examiners
commented that weaker candidates had a “scattergun” approach, particularly on audit
procedures. You need to be clear about the purpose of the audit procedures and why you are
recommending them.
(1) Preliminary analytical procedures – Revenue

Overview
Using financial statement view: Taking the whole year, there is an increase in revenue of 15% overall
compared with the prior year (2021: 20,548k, 2020: 17,856k).
Using accounts view to summarise the revenue accounts, and rearranging the revenue accounts by
business operation, the following movements can be identified.
Prior year Fieldwork
Perman’t job Perman’t job %

recr’mnt Temps Total recr’mnt Temps Total change
£’000 £’000 £’000 £’000 £’000 £’000
4000 Temps UK 15,772 15,772 18,214 18,214 15%
4001 Perms Science 999 999 1,631 1,631 63%
4006 Perms Clinical 570 570 154 154 -73%
4007 Temps Europe

Perms 226 226 344 344 52%
4013 Engineers 62 ––––– 62 23 ––––– 23 -63%
Total 1,631 15,998 17,629 1,808 18,558 20,366 16%
9% 91% 100% 9% 91% 100%
6002 Temps costs UK 13,447 13,447 15,293 15,293 14%
6007 Temps costs

Europe 215 215 –––– 301 301 40%
13,662 13,662 15,594 15,594 14%
Overall GP 2,336 3,967 1,808 2,964 4,772 20%
% 15% 16%

Prior year Fieldwork
Perman’t job Perman’t job %

recr’mnt Temps Total recr’mnt Temps Total change
£’000 £’000 £’000 £’000 £’000 £’000
Europe – Company
temps only
4007 Temps Europe 226 344 52%
6007 Temps costs

Europe 215 301 40%
GP 11 43
5% 13%
UK – Employed and
company temps
4000 Temps UK 15,772 18,214 15%
6002 Temps costs UK 13,447 15,293 14%
GP 2,325 2,921
14.7% 16%
Overall temps UK and

Europe
4007 Temps Europe 226 344 52%
4000 Temps UK 15,772 18,214 15%
15,998 18,558 16%
6007 Temps costs

Europe 215 301 40%
6002 Temps costs UK 13,447 15,293 14%
13,662 15,594 14%
GP 2,336 2,964
% 14.6% 16% 27%
The table above shows:

• Revenue overall increased by 16%.
• The mix of permanent and temp recruitment fees is consistent at 9% and 91% of total revenue.
• GP calculated using the two cost accounts 6007 and 6002 has increased marginally from 15% to
16%.
• There has been an increase in the GP of Temps Europe from 5% to 13% however the changes in
absolute terms are not material.
The analysis above does not identify specific audit risks and further analysis is required.
Analysis of account codes 4000 and 6002 by employed and company temps
The revenue from services supplied by employed temps and company temps are included in
Account 4000. The related costs for both income streams are posted in the account 6002.

Further analysis is required to separate these income streams as follows:
Account code Employed Temps Company Temps Total

£’000 £’000 £’000
4000 – Temps (revenue)
Employed temps revenue – Recorded by
Melissa 8,967 8,967
Company temps revenue 9,247 9,247
Total for account code 4000 8,967 9,247 18,214
6002 – Temps costs UK
Payroll costs recorded by Arianna 8,080 8,080
Less:
Account code 7003 core staff salaries (2,066) (2,066)
Company temp purchase invoices/credit
notes – 9,279 9279
Total for Account code 6002 6,014 9,279 15,293

GP 2,953 -32 2,921
GP% 33% (0.4)% 16%
2020 per Advance Information
GP 2,216 109 2,325
GP% 27.3% 1.4% 15%
The analysis above indicates that the GP% for employed temps has increased from 27.3% to 33%.
The analysis shows that there is a loss for company temps compared with a small profit of £109k for
the year ended 31.12.2020. This small margin is in contrast to Europe company temps where the GP
has increased from 5% to 13% and further information is required to explain this.
The above analysis has limitations – the GP ignores other payroll costs and the comparative cost
figure may not have been calculated on the same basis.
However, these changes indicate evidence of audit risks that costs and/or revenue may be under or
overstated and are not being matched in the same period (Cut off risk).
Cut off cost risk
From the Advance Information, the company temp submits an invoice which is recorded by Gazelle
from which a sales invoice is then prepared. The sales invoice is not recorded in Gazelle’s accounting
system until it is approved by its client. Further information should be obtained regarding the
controls over the cost recorded for the company temp’s work and as there is an audit risk that
unauthorised payments could be made to the company temp leading to overstatement of costs and
understatement of revenue.
For employed temps, there is less risk that payments are made to employed temps for work not
performed since the timesheet must be approved by the client before submission to Gazelle.
However, the authorisation process by Gazelle is not clear and presents a risk that costs are not
recoverable. The timesheet generates payment to the temp and a sales invoice to the client.
However, a risk exists if the timesheet is delayed at the year end leading to further cut off risks.
In December 2021, Paula has processed a temp’s cost accrual for ID 485958 £38,620.
This indicates that there is a timing difference between the recognition of costs for temps and the
recognition of revenue and further explanations should be obtained regarding how this system is
controlled. In particular, what is the nature of the costs included in this transaction ID 485958?

Revenue cut off risk
The Advance Information identifies that there is sometimes a delay between receiving the invoice
from the company temp and the approval of Gazelle’s sales invoice by the end client. Sales invoices
for the provision of company temps cannot be processed until the invoice is approved by the client.
Paula notes that this delay has worsened as clients have been slow to approve invoices.
In December 2021, Paula accrued the following amounts for Company temps in Account 2109
Accrued income and Account 4000 Temps (revenue):
See transactions
Transaction ID Account code Amount Effective date Created date
486146/147 2109/4000 £107,438 31.12.2021 14.1.2022
486862/863 2109/4000 £98,195 31.12.2021 25.1.2022
Total = £205,633. This is a significantly larger amount accrued than in previous months and the
largest movement in the year on Account code 2109.
Year on year, the balance on Account code 2109 Accrued Income has increased from £179,061 to
£217,456, representing a 21% increase.
Reviewing the transactions in December in Account 4000 Temps shows debit transactions reversing
sales invoices posted several months after the income was accrued. This is an expected transaction
but the description indicates further evidence for the delay in posting company temp sales invoices.
See transactions:
4000 486129 £20,945 31/12/2021 14/01/2022

Oct Sales posted in Dec
4000 486131 £7,452 31/12/2021 25/01/2022

May Sales posted in Dec
Financial reporting
Company temp invoices and costs for employed temps should be matched to sales invoices to the
client in the correct period.
The Advance Information indicates that Gazelle bears the financial risk from the provision of
company temps to their clients and acts as principal rather than agent in the arrangement. The low
margin achieved on the provision of company temps could indicate a commission arrangement and
this should be clarified further with management. The basis of revenue recognition of the company
temps should be reviewed to ensure that the accounting policy is in line with IFRS 15.
• Breakdown of account 2109 to establish correct adjustment for accrued income at the year end
• Explanation of how Paula controls cut off on company temps – breakdown of transactions
486146/147 and 486862/863
• Post balance sheet date credit notes to ensure appropriate adjustment
• An understanding of the reasons for the delays in approval and processing sales invoices
• Confirmation of the treatment of company temp’s revenue in line with IFRS 15

Analysis of permanent job recruitment services
2020 2021 Increase/decrease % change

4001 Perms 999,011 1,631,289 632,278 63%
4006 Perms clinical 569,688 154,111 (415,577) (73%)
4013 Perms Engineers 62,268 22,749 (39,519) (63%)
1,630,967 1,808,149 177,182 10.8%
Number of recruiters
employed by Gazelle –
from AI 10 9
Average revenue per
recruiter 163,097 200,905 23% increase per recruiter
Overall, there has been an increase in revenue from permanent job recruitment services of 10.8%
although there are falls in revenue from clinical and engineers. No invoices were posted for Perms
clinical after May 2021 and for 4013 Perms engineers after July 2021.
Potentially therefore sales invoices could have been recorded in the wrong revenue account and this
would need to be clarified with Gazelle’s management.
The average fee per recruiter has increased from £163k to £201k (23%). This equates to
approximately six additional placements per recruiter over the entire year.
Following the appointment of a new head of recruitment, changes were introduced to the terms of
permanent recruitment contracts entered into from 1 May 2021.
20% of the fee is now recognised when a suitable applicant is shortlisted for interview.
Using the data analytics software, the number and amount of transactions increased in May to July
2021.
Average value
£’000 No. of invoices £’000
January 125 28 4.46
February 135 27 5.00
March 127 24 5.29
April 144 24 6.00
May 218 39 5.59
June 204 32 6.38
July 208 35 5.94
Although the increase in number of invoices could be expected due to the 20% upfront fee, the
increase in average value in June and July is not expected. Further information on this should be
obtained to explain this change.
Note: Permanent job recruitment services – changes to contract terms.
Geri introduced two changes from May 2021: a sales invoice is raised and recognised for 20% of the
fee for permanent recruitment services when a suitable applicant is short listed for interview. The
refund period was extended from three months to six months.
Two audit risks arise from this change and the evidence provided by the above analytical
procedures:
• There is an audit risk of overstatement of revenue – recognising 20% of the fee is unlikely to satisfy
the performance obligation and the policy is therefore not in compliance with IFRS 15.
• There is an increase in the audit risk of inadequate provision from credit notes/refund liability and
receivables may not be recoverable.

Revenue recognition – Performance obligation
The new contract between Gazelle and its clients should be examined to confirm whether a
performance obligation has been established on the basis of providing candidates for interview.
performance obligation is satisfied.
The performance obligation is met on the appointment of an applicant with the client, so an initial
recognition point at the date on which the applicant is shortlisted is unlikely to satisfy the
There is insufficient information to make a judgement here concerning the 20% upfront payment, but
if a performance obligation is not satisfied at this point and Gazelle expects to refund some or all of
the fee, the amount should not be recognised as revenue.
With respect to the refund period and its extension to six months for applicants who leave their job
within this period, based on the information in the advance information, Gazelle rarely needs to
refund a client. Therefore Gazelle would normally not need to consider whether the transaction price
should be adjusted for a variable consideration. The most likely outcome is that the applicant, once
appointed, remains in post and no refund is required.
With the extension of the refund period, Gazelle should revisit this and further information is required
regarding the expected number of refunds. Given that the new contracts were introduced in May
2021, there should be post year end information now available to make this judgement.
In addition, Gazelle should review receivables from permanent recruitment clients for impairment
and appropriate allowance made.
Credit note provision
Setting the stacked bar chart to effective period and document type shows that no credit notes were
issued in the first seven months of the year.
However, there is an increase in credit notes in October (38k), November (13.3k) and December
2021 (17.4k), suggesting that clients are either requesting refunds on the money back guarantee or
more likely, the credit notes could also be in respect of 20% fees invoiced upfront which have not
resulted in the applicant being appointed.
No credit note provision is included as an adjustment in the permanent recruitment revenue
accounts. Given the pattern of credit notes in the final three months of the year this would be
expected.
Also given the increase in the time given to clients to request a refund from three to six months there
is a greater chance that the employee will leave and therefore more likely that refunds will be given.
Further information is required to determine the nature of these credits in particular whether they
relate to the 20% upfront fee and whether this is refundable or from clients requesting refunds due to
the six-month refund period.
In summary additional information required from Gazelle includes:
The contract between Gazelle and its clients – to determine whether separate performance
obligations are established. In particular we should establish whether the 20% is refundable.
Gazelle should quantify the revenue included in respect of 20% of fees invoiced on shortlisting of the
candidate.
Enquire about the reason for the increase in the average invoice value in the months May–July.
£17.3k of credit notes have been posted in December 2021 – enquire about the nature of these
credit notes and any raised after the year end which relate to appointments made before December
2021 and ensure appropriate adjustments are made to the receivables.
Gazelle should be asked to provide correspondence and evidence relating to establishing the level
of refunds.
Note: WIP adjustment
Audit risk: WIP adjustment has been incorrectly recognised leading to overstatement of assets and
understatement of expenses.
Leo has made an adjustment for work in progress in relation to permanent job recruitment services.

The adjustment for £160k is discoverable in the data analytics software as follows:
488386 1104/5000 160,000 31.12.2021 4.7.2022

22:00:12
This is a very late transaction – it has been created on 4/7/2022 and was posted at 10pm. Potentially
therefore an artificial transaction to inflate profits.
The financial reporting treatment of this appears to be incorrect.
performance obligation is satisfied. The performance obligation in this case is satisfied at a point in
time, the service to the customer – triggered by the appointment to the position.
Costs relating to networking events and recruiter’s time on general background research should be
expensed as these are general in nature and not specific to the satisfaction of a future performance
obligation – it may however be a valid adjustment to include the costs of identifying and shortlisting
candidates to a specific job description as WIP and further information would be required about the
nature of these costs and how they have been calculated and determined.
This does not represent a change in accounting policy but a change in accounting estimate and
therefore no prior year adjustment is required.
Further information is required with respect to the nature of the costs and the actual breakdown of
this WIP adjustment as it may result in a material adjustment to the financial statements.
Note: Bonus scheme for recruiting company temps
Audit risk: the bonus could incentivise Gazelle’s recruiters to place company temps in unsuitable
positions – this leads to an audit risk that revenue is overstated and that inadequate provision for
credit notes/ receivable allowances has been made.
Evidence to support these audit risks is as follows:
The bonus accrual is for £75,000 and is transaction ID 488837 – this is credited to Account code 2012
Other creditors and debited to Account code 7012 Staff bonus and reduces profit by £75k. The
bonus is only payable for the recruitment of company temps. In 2021 there were 20 temp recruiters
(although we do not know whether these are all engaged in company or employed temp
recruitment) indicating an average bonus of £3,750 per recruiter for the two-month period from the
implementation of the scheme and the year end.
In December 2021, Paula has posted the following credit note provision for company temps.
487705 – 706 4000/2109 46,720 31.12.2021 4.2.2022 17:06
There are other credit notes relating to 2021 £11,140 and £4,456. It is not clear from the descriptions
whether these credit notes relate to company or employed temps and further information should be
obtained.
Using explore, stacked bar charts, a large number of credit notes are posted in the early part of the
year.
In January 2021 credit notes of 63k and in March 2021 indicating that the recoverability of year end
receivables is a potential audit risk – incentivising staff to place company temps could enhance this
audit risk further.
Further information
More information should be obtained regarding the history of recoverability of receivables.

There is evidence that bad debts have been a problem for Gazelle in the past: Melissa has posted a
bad debt write off on 1 January 2021.
See transactions
461850 £106,253 1/1/2021

461851 £106,253 1/1/2021
These transactions write off £106,253 from trade receivables and then create a loan on the statement
of financial position for the same amount and require further investigation.
Tutorial Note
Employed and company temps sales invoices and costs are posted to Accounts 4000 and 6002
which need to be analysed to identify GP from employed and company temps. This can then be
compared to the previous year figures made available in the AI to identify whether the changes
indicate that there is a risk of misstatement.
Account 4000 – Use the explore stacked bar charts with user for primary and secondary variable
Line Count Net Primary Variable: Secondary Variable:
Stacked Bar Charts Income Selection Users Users
9.00M
8.00M
7.00M
6.00M
5.00M
Net
9.07M 8.97M
4.00M
3.00M
2.00M
Paula Elliott
1.00M
Melissa Woodward
Leo Neom
0.00
Leo Neom Melissa Woodward Paula Elliott
(Diagram for info only – note candidates cannot reproduce this in the exam)
For revenue account 4000 Temps UK, only Melissa posts the sales invoices for employed temps
(£8,967k). Therefore deducting this figure from the total (£18,214) leaves the amount relating to
company temps (£9,247k).
For the temps costs 6002, only Arianna posts payroll costs; these costs include the employed temps
and core staff. To identify the amount posted by Arianna, use stacked bar chart primary variable users
– secondary variable document type (£8,080k).
Line Count Net Primary Variable: Secondary Variable:
Stacked Bar Charts Expense Selection Users Document Type
2.00M
1.00M 2.03M
0.00
445K
1.00M
2.00M
Net
3.00M
4.00M 8.08M
9.00M
5.00M
PI
6.00M
PC
MJ
7.00M
8.00M
9.00M
Arianna Oliver Leo Neom Melissa Woodward Paula Elliott
To find the adjustment for core staff salary (£2066k), see the total on account code 7003.
7003 – Core staff

salaries 2,033,340 2,066,433 33,093 Up 2%
Deducting the core staff figure from the total posted by Arianna leaves the amount of cost
attributable to employed temps (£8,080k – £2,066k) £6,014. The remainder of account 6002
represents the cost of company temps (£15,293 – £6,014) £9,279k.
This is one method of arriving at a breakdown of these accounts. Other reasonable attempts and
figures were accepted in the marking.

(2) Investment in QM
The relevant accounting guidance to consider is that concerning joint arrangements in IFRS 11, Joint
Arrangements.
IFRS 11 classes joint arrangements as either joint operations or joint ventures.
The classification of a joint arrangement as a joint operation or a joint venture depends on the rights
and obligations of the parties to the arrangement.
The existence of a contractual arrangement distinguishes a joint venture from an investment in an
associate.
The terms of the contractual agreement indicate that Gazelle has entered into a joint venture as
follows:
• QM is a separate entity and will have Articles setting out the contractual arrangements between
the parties.
• There are three shareholders and none of the shareholders has overall control.
• QM will have its own assets and liabilities and the arrangement is therefore a joint venture rather
than a joint operation.
The initial capital represents an investment in the JV and is shown in the statement of financial
position as an investment in Account code 0062.
Gazelle should account for its interest in a joint venture in accordance with IAS 27 (2011), Separate
Financial Statements, namely:
• at cost;
• in accordance with IFRS 9, Financial Instruments; or
• using the equity method specified in IAS 28.
Gazelle has an accounting policy choice here about how the investment is recognised and
subsequently measured in its individual financial statements.
The investment should be reviewed for impairment given that QM has made a loss for the year
If Gazelle decides to use equity accounting in its individual financial statements, it will recognise its
share of the loss 30% × £85,500 = £25,650 in the statement of profit or loss and as a deduction from
the cost of the investment.
£
Cost 37,879
Less: Share of loss (25,650)
12,229
A joint venturer may sell or contribute assets to a joint venture so making a profit or loss. Any gain or
loss should, however, only be recognised to the extent that it reflects the substance of the
transaction.
Gazelle recharges the costs of recruiters to QM and charges a markup of 50%; any unrealised profit
should be eliminated and only profits attributable to the interest of the other venturers should be
recognised in the financial statements. Given the nature of these costs this is unlikely to be an issue.
QM is a related party and appropriate disclosure will be required in Gazelle’s financial statements.
Obtain a copy of the contractual agreement, agree terms to substance of the arrangement as a joint
venture to ensure appropriate recognition in the financial statements.
Inspect share documents to confirm existence and ownership of the investment and to ensure no
changes have arisen to the shareholding.
Confirm Gazelle’s accounting policy for the financial reporting treatment of its JV in QM and confirm
that amounts are fairly recognised in accordance with IFRS.

Challenge management regarding the valuation at the year end; whether they have considered
impairment. Confirm that appropriate adjustment is made.
Obtain audit financial statements and confirm Gazelle’s share of loss.
Recalculate recharges and agree to invoices evaluating any adjustment for unrealised profit.
Ensure appropriate disclosures are made regarding the investment and in respect of the related
party disclosures.
(1) Answers to this question were very variable. Those who answered it well analysed the data initially
and identified audit risks supported by audit evidence from the data analytics software (DAS). They
focused their technical analysis on the facts given in the question and Advance Information and
applied relevant technical information to the analysis. In general, it was those who thought more and
wrote less who scored the best.
Some less successful candidates took a ‘scatter-gun’ approach. While they made valid observations,
these were rarely analysed well or linked to other facts in the question.
While it was encouraging that the majority of candidates identified transactions in the DAS (most
commonly the WIP adjustment), some candidates did not produce any analytical procedures. These
candidates struggled to obtain a pass mark for this element of the question.
However there were some amazing answers with candidates producing clear analytical procedures
using the templates provided in the Advance Information and achieving the maximum mark on this
section.
Particular points of note were:
• Candidate must describe transactions in full and provide adequate description of the patterns in
the data.
• Some candidate lost easy marks by not articulating clearly what the audit risk is or presenting
muddled arguments where the reason cited was inconsistent with the risk identified.
• Weaker candidates would discuss the same points eg, refund liabilities and the five steps of IFRS
15 for each risk, without any new data provided to qualify why the new points were relevant.
Repeated points do not score further marks and candidates wasted valuable time by not
structuring their answers.
• A misunderstanding by some candidates was that WIP results in entries to revenue rather than
being the deferral of costs.
• There were references to IAS38 and research and development which were not relevant in this
scenario.
• Weaker candidates presented an unquestioning acceptance that the new contract terms resulted
in two separate performance obligations indicating a lack of judgement and challenge.
• There were references to revenue recognition having changed or a change in accounting policy
when what has changed is the terms of the contracts with the clients which has led to a need to
reconsider the most appropriate approach to revenue recognition.
• Weaker candidates had not used the Advance Information and the 11 months’ DAS to understand
how the accounting operated – for example a journal showing reversals of revenue accrued in
previous months are to be expected and are not unusual – it was the length of time between
accruing the income and reversing which gave rise to the risk.
• No credit was given for the identification of transactions posted to accounts which were not
relevant to the question being asked.
• Many candidates included audit procedures which were not asked for in the question and which
gained no marks unless they reflected additional information which should be requested.
• Some candidates identified a myriad of small and not always concerning transactions, usually
from the first 11 months’ DAS. While some valid points gained marks, the arguments given were
often weak with some questioning transactions such as the posting of pension costs to the payroll
accounts or sales invoices debited to accounts receivable.
• Some candidates relied too heavily on prepared notes and failed to apply themselves to the
impact information in the question and the DAS.

(2) This was generally answered well although surprisingly few spotted that the arrangement was a
joint venture or even explored whether it might be and some candidates who did often missed the
marks for exploring joint operation versus JV. Equity accounting was generally well understood and
explained. Candidates who provided no calculations lost easy marks.
Only the better candidates understood that it was Gazelle’s share of unrealised profit that should be
eliminated. Some provided a calculation of the potential amount and some candidates considered
whether or not the profit they calculated was unrealised at year end.
Surprisingly few candidates discussed whether an associate or joint venture was a related party.
Weaker candidates failed to notice that the acquisition was in the prior year. However, the investment
was bought on the last day of the previous financial year and included at cost, the correct accounting
treatment.
Candidates scored well on audit procedures, where they explained what should be done and why.
There are still a significant minority of candidates who believe audit procedures comprise simply of
‘discussion’ or ‘obtaining representations’. Weaker candidates fail to provide a range of procedures
which cover different audit assertions. Audit procedures need a strong verb, in addition to the reason
for the procedure and many students missed these elements. Too many candidates fail to be specific
in their procedures and rely on ‘check’, ‘ensure’ and ‘review’, without stating specifically the purpose
of the action.
75 FB plc
Scenario
FB plc is a listed company which makes steel structures for the building industry. It owns several
100% subsidiaries. FB group has a 31 December year end and its functional and presentational
currencies are the £.
FB group manufactures its products in the UK and sells to customers in the UK and the rest of
Europe.
FB group’s largest customer, Central Construction (CC), is a company located in the Netherlands. CC
has a 31 December year end and its functional currency is the €. UG Holdings Inc owns 100% of the
shares in CC.
CC has won a large contract to build industrial units on a site near the port of Rotterdam, in the
Netherlands. CC will start preparatory and design work on the Rotterdam contract in October 2022.
CC will correctly recognise revenue relating to the contract, only from January 2023, when work on
the site commences. FB group will sell and deliver the first consignment of steel structures for this
Rotterdam contract to CC in November 2022 and will be paid in December 2022.
CC needs additional finance to fulfil the Rotterdam contract and achieve future ambitious growth
targets. However, its parent company, UG Holdings has told the CC board that it is unwilling to
provide a loan and CC should obtain finance independently. UG Holdings has also indicated that it
wants to sell its investment in CC.
CC has approached the FB board for finance. After initial discussions between the finance directors
and CEOs of both CC and FB, two alternative methods for FB plc to provide financial support to CC
were presented to the FB board on 15 July 2022.
For each of: • Assimilate and demonstrate understanding

Method 1 Zero coupon bond of a large amount of complex information.
Method 2 Purchase of shares in CC and • Evaluate, using judgement and scepticism,

intercompany loan the appropriate accounting treatments for
complex transactions including zero coupon
• Explain the financial reporting implications, bond, acquisition of a subsidiary and
including the current and deferred tax intragroup transactions
implications, for FB’s forecast consolidated
statement of profit or loss for the year • Recommend appropriate accounting
ending 31 December 2022. Set out the adjustments in the form of journal

appropriate journals. • Assimilate information and use own

• Prepare a revised forecast consolidated accounting adjustments to prepare revised
profit or loss for FB for the year ending 31 extracts from the financial statements
December 2022
Evaluate and contrast the impact of Method 1 Explain the impact of consolidation of
and Method 2 on FB’s consolidated profit after subsidiary on the consolidated profit or loss -
tax for the year ending 31 December 2022. demonstrate understanding by explaining that
the profit falls on consolidation because of the
impact of intragroup trading
Marking guide Marks

Compare and contrast impact 4
30
Total 30

Question 2, the financial reporting question, tends to be more narrowly focussed than
Question 1, although sometimes there is an ethical component. The question is for 30 marks,
and therefore while assimilating information is necessary, that skill is not stretched as far as for
Question 1. The other three professional skills are all fully applied.

The main way in which this professional skill is required is quite straightforward – do not leave
anything out. The examiner noted that the second part of the question, requiring an
evaluation of the effect of each method of giving financial support on FB’s forecast profit after
tax, was sometimes left out altogether. Every piece of information is given for a reason.

The structure for your answer is given in the finance director’s briefing, and you should follow
it in the order given, since the second part is dependent on the first. Structuring your time is
also important: there are some easy marks to be gained for consolidation knowledge brought
forward from earlier studies, such as intragroup transactions.
Applying judgement
The professional skill of judgement is needed here in deciding when to move on in your
answer. For example, you may feel that some of your calculations are wrong, but this should
not put you off moving on to the part of the question that requires preparation of a revised
forecast consolidated statement of profit or loss, when in fact the “own figure rule” will be
applied and you will get full credit for using your figures correctly.

This professional skill applies most obviously to the second part. You will gain credit if your
explanations are consistent with the figures you have already calculated, even if those
calculations are wrong. However, you would not get marks for talking generally about the
advantages of debt and equity finance, without relating your conclusion to the specifics of the
scenario. As a professional you would be expected to address the issues directly.
Method 1
With this method, CC is not a subsidiary and therefore the only impact on the consolidated profit or
loss is the interest received from CC and the related tax impact.
The loan is a financial asset to FB. As FB holds the bond to collect contractual cashflows and receive
repayment of the principal, the loan should be initially measured at fair value plus transaction costs
and subsequently measured at amortised cost.
The amount of amortisation should be calculated by applying the effective interest method to spread
the financing cost (that is the difference between the initial amount recognised for the financial asset
and the amount receivable at maturity) over the period to maturity. The amount amortised in respect
of a financial asset should be recognised as income in profit or loss. FB plc will need to consider
whether a credit loss allowance should be set up on initial recognition.
The effective interest rate is 6.9% – this is given in the question.
£’000
Loan at 1.10.2022 18,400
Transaction costs 500
18,900
Finance income at 6.9% × 3/12 326
Balance at 31.12.2022 19,226
The finance income of £326k will increase the current tax payable by £326,000 × 20% = £65,200.
This is because the tax and accounting treatment are the same.
Journals to record the loan in FB
£’000
DEBIT Loan receivable 18,400 + 500 18,900
CREDIT Cash 18,900
DEBIT Loan receivable 326
CREDIT Finance income 326
DEBIT Tax charge 65.2
CREDIT Current tax liability 65.2
A revised forecast of the consolidated profit after tax in Exhibit 2
Original Revised
£’000 £’000 £’000
Profit before interest 45,900 45,900
Net finance income/(expense) -2,000 less finance income 326 -1,674
Current tax expense -7,000 65 -7,065

Original Revised
£’000 £’000 £’000
Deferred tax expense -3,000 -3,000
Total tax expense -10,000 -10,065
Profit after tax 33,900 34,161
Method 2
(1) The loan is a euro loan and is translated at the year end.
(2) CC becomes a subsidiary and is consolidated with FB results for three months; with an
intercompany loan which needs to be dealt on consolidation.
Intercompany loan
FB will pay cash to CC as an intercompany loan of €22.08 million. This is a monetary item and will be
translated at the date that the loan is made.
€22.08 million@ £1 = €1.20 = £18,400,000
FB will record the loan as follows:
£’000
DEBIT Loan receivable 18,400
CREDIT Bank 18,400
The loan is a monetary asset in FB’s separate financial statements and should be translated at the
year end and the movement taken to the statement of profit or loss.
WORKINGS
(1)
£’000
Loan receivable €22.08 million@ £1 = €1.20 18,400
At year end €22.08 million @ £1 = €1.10 20,073
Exchange gain 1,673
The journal to record this in the parent’s financial statements is:
£’000
DEBIT Loan receivable 1,673
CREDIT Finance income 1,673
IAS 21 is silent about where in SPL exchange gains should be recognised so any reasonable
alternative is acceptable.
The loan is a monetary asset in the separate financial statements of FB. Exchange differences cannot
be eliminated against the corresponding intergroup liability in the consolidated financial statements
without showing the currency fluctuation. This is because the monetary item represents a
commitment to convert one currency into another and exposes the reporting entity to a gain or loss
through currency fluctuations.
So, in the consolidated financial statements, the exchange difference is recognised in profit or loss
(IAS 21, para. 44).
Interest on the loan will be charged at 3% by FB plc – the interest will increase the accounting profit
of FB plc and reduce the accounting profit of CC. The interest payable and receivable will cancel on
consolidation.
€22.08 million × 3% × 3/12 = €165,600
€165,600/ 1.15 = £143,913

Tax implications
The exchange gain will not impact on the current tax because it is not taxable in any period.
Because there are no future tax implications of the loan, there is no adjustment to deferred tax and
the carrying amount can be regarded as equal to its tax base.
Tax on the interest will increase FB plc’s current tax payable and reduce the current tax payable for
CC. The current tax impact will also cancel on consolidation subject to a small difference in tax rates.
Journals
£’000
DEBIT interest receivable 144
CREDIT Finance income 144
DEBIT Tax charge 144 × 20% 29
CREDIT Current tax liability 29
Consolidation of CC with FB
FB plc will acquire 100% of the shares in CC and the investment should be treated as a subsidiary
from 1 October 2022.
The figures for the post acquisition profit or loss for CC will be added to FB group’s results and
adjustments made for intragroup trading and unrealised profit on inventory (PURP).
The profit of CC will be translated at the average rate for the three months from acquisition to 31
December 2022.
Intercompany trading from acquisition will be cancelled out and a consolidation adjustment will be
required for the profit held in inventory by CC which it acquired from FB.
Intercompany loans also cancel on consolidation including interest and tax impacts.
(All the net assets will be included in the FB consolidated financial statements at 31 December 2022,
translated at the closing rate.)
To prepare a revised consolidated profit or loss, adjustments will be required for
• Intragroup revenue and profit in inventory and interest will be adjusted (working 2)
• Three months of CC’s results will be consolidated with the group’s results
WORKINGS
(2) Revenue
FB will sell £27 million of goods to CC which will not be sold to third parties outside of the group
until January 2023.
The £27 million revenue from the sale of steel structures would have been included as inventory
in CC – and as revenue in FB. On consolidation therefore the revenue would be cancelled in the
group’s results
DEBIT Consolidated Revenue 27m
CREDIT Consolidated COS 27m
Inventory PURP
In the consolidated statement of profit or loss, as the profit on the intra group sale of £27 million is
not realised, it must be adjusted. The profit on this transaction is:
£27 million × 33.33% = £9 million
This intra-group transaction results in unrealised profits of £9,000,000 which will be eliminated on
consolidation. This is an adjustment to the consolidated financial statements and not the individual
company accounts.
The tax on this £9,000,000 profit will, however, be included within the group tax charge (which is
comprised of the sum of the individual group companies’ tax charges). From the perspective of the
group there is a temporary difference. Deferred tax should be provided on this difference using the
tax rate of CC (the recipient company).

£’000
Carrying amount of inventory in consolidated financial statements £27m – £9m 18,000
Tax base 27,000
Deductible timing difference 9,000
Tax at 10% 900
Journals
DEBIT Cost of sales 9,000

CREDIT Inventory 9,000
CREDIT Tax charge 900
Interest
Finance income/interest payable on intra group loan and the tax effect will also cancel on
consolidation – a deferred tax adjustment will be required for the difference in the tax rates between
the tax deduction claimed by CC and the tax payable by FB.
Revised Forecast profit or loss – method 2
The amounts for CC’s profit or loss to be consolidated by FB are as shown in the table below. In
compliance with IAS 21, The Effects of Changes in Foreign Exchange Rates, profit or loss items are
translated at average rate. Only three months of the profit for the year is consolidated with the results
of FB.
Note: The impact of interest receivable and interest payable have not been adjusted in the individual
financial statements of FB and CC because these will cancel on consolidation. Credit given to
candidates who do show these adjustments.
WORKINGS
(3)
Three Average
€’000 months rate £’000
Revenue 42,200 10,550 1.15 9,174
Operating profit 6,000 1,500 1.15 1,304
Net finance income/(expense) -250 -63 1.15 -54
Profit before tax 5,750 1,438 1.15 1,250
Current tax expense -1,505 -376 1.15 -327
Deferred tax expense -45 -11 1.15 -10
Total tax expense -1,550 -388 1.15 -337
Profit after tax 4,200 1,050 1.15 913

A revised forecast of the consolidated profit after tax in Exhibit 2
*CC W3 Intra group/

Add 3 revenue
FB months profit
£’000 £’000 £’000 £’000

Revenue 125,000 9,174 134,174 (27,000) 107,174
Operating profit 45,900 1,304 47,204 -9,000 W2 38,204
Net finance income/ (expense)
(2,000 + 1,673 W1 -327 -54 -381 –––––––– -381
Profit before tax 45,573 1,250 46,823 37,823
Current tax expense -7,000 -327 -7,327 -7,327
Deferred tax expense -3,000 -10 -3,010 900 W3 -2,110
Total tax expense -10,000 -337 -10,337 –––––––– -9,437
Profit after tax 35,573 913 36,486 –––––––– 28,386
Evaluate and compare the impact of Method 1 and Method 2 on the consolidated profit after tax
for the year ending 31 December 2022
For Method 1, there is little impact on profit after tax caused by recognition of interest and its tax
effect because CC is not a subsidiary of FB. Profit after tax increases from 33.9 to 34.1and FB
continues to recognise the £9 million on the sale of steel structures to CC in November 2022.
With Method 2, on consolidation, FB’s revenue will fall by £27,000 which will cancel with a fall in
consolidated costs of sales.
However, because the goods have not left the group, the profit element is removed.
The profit after tax falls because although three months of CC’s profit is consolidated (£913,000), the
intra group profit on FB’s sale of steel structures in November 2022 of £9 million cancels on
consolidation and after the deferred tax effect results in profit after tax falling from 33.9 to 26.7 – this
is below the shareholders expectation of profit for the year.
This was the best-answered question on the paper with many candidates scoring well.
This question included the explanation of two proposed financial support packages from FB to CC.
These were via:
• a zero-coupon bond
• purchase of 100% of the shares in CC and an intercompany loan
Method 1
Method 1 was regularly well answered with maximum marks awarded. The common (and worrying)
mistake made by weaker candidates was to designate the loan from FB as a financial liability.
Some candidates, having stated the right basis for initial recognition then applied an alternative
basis, involving further discounting calculations which were not required.
Some candidates failed to present the restated financial statements for Method 1 and lost out on
some very straightforward marks.
Some candidates recalculated the current tax overall as 20% of profit, taking no account of deferred
tax and failing to recognise that there may be items not deductible for tax purposes or income which
is not taxable.
Method 2
This element was also answered well by many candidates with a significant proportion gaining full
marks.
Some wasted time on detailed calculations of FX movements which did not affect the consolidated
statement of profit or loss.

Some candidates discussed the loan in the context of a net investment in a foreign operation and
credit was given for valid comments.
Fairly common points:
• Including deferred tax on the exchange gain – the question stated that this was never taxable and
therefore could have been assumed to be a permanent difference
• Debiting the PURP adjustment to revenue rather than COS
• Including the revenue adjustment to operating profit
• As in Method 1, discounting calculations having failed to understand the information presented in
respect of the loan
• Not being sufficiently explicit about the fact that FB has acquired a subsidiary because it has
control and that it therefore needs to consolidate CC’s results for three months. A failure to state
this clearly lost candidates easy marks
• Not including adjustments in sub-totals for profit, often leading to answers which were not
credible but were not questioned or revisited. Candidates should use the spreadsheet provided
in the exam software appropriately
• Not time apportioning the results of the subsidiary for three months or not including the
subsidiary results at all in the consolidated statement of profit or loss
• Using the wrong FX rate or multiplying rather than dividing by the correct rate
• Including adjustments in round millions as if they were in £ or £’000
• Presentation was sometimes poor, with candidates just allowing formulae to calculate numbers to
5 or 6 decimal places.
Candidates who did well on part 1 often scored well on part 2 too. However, many candidates left
this out completely, passing up on any of the marks available for discussing anything relevant to the
figures they had already prepared.
Those who made a serious attempt at this element of the question generally scored well. Credit was
given for those who calculated effects on KPIs such as operating margin or interest cover.
Some candidates focused entirely on tax rather than on profit after tax as the question required. By
doing so they missed a number of the key points.
Weaker candidates continued to use their incorrect revised profits in their evaluation despite the
figures being not credible. Others gave answers that would have been better suited to an SBM
question on the benefits of raising finance using these two methods. Others focused on the impact
on the effort required from the accounting staff rather than the impact on the financial statements.
76 Spycit Ltd
Scenario
The scenario is set in the final audit phase for a company owned by a private equity firm. The
company imports spices and makes its own spice mixes for catering and retail customers. It was until
recently a family company and has largely new management who are incentivised to increase profit
under the terms of a generous bonus scheme.
The candidate is an audit senior asked to supervise and guide an audit assistant in their work on
prepayments and other receivables. They are asked in particular to identify financial reporting issues
and set out the correct financial accounting treatment and to explain the additional audit procedures
required. The issues to be identified include hedge accounting; accounting for an interest free loan;
related party transactions; and accounting for supplier rebates. A successful candidate needs to use
all of the information in the question to ensure the full picture is taken into account both for the
financial accounting and when determining the audit procedures required.
Ethics
The ethical requirement focuses on the behaviour of one of the new directors who has a personal
connection with a new supplier which was not disclosed to the board. The director was responsible
for the preparation of financial information used as a basis for a decision both to lend to the supplier
and accept its trading terms. In addition, there are indications that the new supplier may have a bad

reputation and that its business may be declining as a consequence. The director is a member of the
ICAEW and so bound by its code. A successful candidate will consider in particular concepts of
integrity; objectivity; professional competence; and self-interest. As well as the considerations
relating to the new supplier, there are also more general indications that the financial results may
have been mis-stated.
In addition to setting out ethical implications for the director, the candidate is also asked to identify
actions for the audit firm.
Review all the information provided and draft a • Use technical & professional knowledge to
briefing paper for Jo which, for each element of analyse the data
prepayments and other receivables set out in • Use technical knowledge and judgement to
Exhibit 2: determine appropriate audit approach
• identifies any financial reporting issues and • Explain the additional audit procedures
sets out and explains the correct financial required
reporting treatment in Spycit’s financial
statements for the year ended 30 June 2022; • Relate different parts of the question to
and identify critical factors
• describes and explains the additional audit
procedures that Jo should perform.
Explain the ethical issues arising for the finance • Explain the scenario from different
director, Cary Komo, from the matters disclosed perspectives
in Murray Evans’s email (Exhibit 3) and set out • Identify the self-interest threats and threats
any actions that Vallis LLP should take. to objectivity arising from the scenario and
Murray’s email.
• Explain the actions for Vallis including
consult with ethics partner and potential
need to report ICAEW member for breach of
ethical code
• Demonstrate understanding of the
importance of contributing to the profession
& appreciating the ethos & culture of the
accountancy profession
Marking guide Marks

Ethical issues 8
30
Total 30

This is the most wide-ranging question on the paper, covering financial reporting, auditing
and ethics, so all four professional skills apply. Judgement was the most important skill for the
ethics element, but also applied in the audit part. Assimilating and using information was key
to the financial reporting section, and structure to the audit section. (Examiners have
commented that weaker candidates sometimes list random audit procedures, rather than
giving a logical explanation for their use.)

The financial reporting issues require application of IAS 37, IFRS 9 and IAS 24, and there is a
lot of information to assimilate, particularly as regards the treatment of the hedge. It is
important to use the information in the question, for example the hedge is designated a fair
value hedge, so it would be incorrect, and time-wasting to argue that it was a cash flow
hedge.

Again, the structure of your answer is given in Cary Como’s email, but also, when answering
the ethical requirement, in the application of the ICAEW’s Code of Ethics. Audit issues also
arise when considering whether the information on which the auditor has relied are reliable. It
is also important to structure your answer such that financial reporting aspects and ethical
aspects are dealt with separately. IAS 24 on related parties needs to be applied but related
party transactions are not necessarily unethical.
Applying judgement
The ethics section is an opportunity to provide the professional skill of judgement. This is
achieved by systematically applying the ethical code and not making assumptions, but being
clear and incisive about what cannot be taken at face value. To this extent, ethics and audit
overlap. Ethical breaches may require the auditor to conduct further investigations, or cast
doubt on those already conducted. Professional scepticism is at the heart of applying
judgement.

The question does not ask directly for a conclusion, but in stating the actions recommended
for the auditor, communicating and recommending skills certainly come into play. Any
recommendations should be specific, not generic. In the exam as in working practice, it is not
helpful to give boilerplate statements about what needs to be done.
(1) Insurance claim of £200,000 – financial reporting

The fact that Spycit has made a claim against the insurance company does not necessarily mean that
the claim will be honoured or that Spycit will receive the full amount claimed. Whether or not the
claim is honoured will depend on the decision of the insurance company, a factor which is outside
Spycit’s control.
The claim is possibly a contingent asset in which case the disclosure should be made, but no amount
recognised. The prepayment should therefore be reversed.
If it is highly likely that the claim will be received (eg, if the insurance company has formally agreed)
then the £200,000 can be recognised, but as a receivable rather than a prepayment, as it is not really
a prepayment.
Prepaid insurance – what Jo needs to do
Insurance claim
• Obtain and review any correspondence with the insurance company and/or insurance advisors or
loss adjusters to enable judgement on its recoverability to be applied.
• Obtain further details concerning the circumstances of the loss and review insurance policy
documents to ascertain whether it appears to be claimable under the policy, whether there is an
excess to deduct etc.
• Ascertain whether claim has been paid since year end to confirm the amount recognised.

• Discuss with management whether they are concerned about the time it is taking the insurance
company to agree the claim and investigate whether this has been the case for previous similar
claims
• Challenge management to provide evidence to support their view (inherent in recognising the
claim) that it is virtually certain to be repaid.
• Form an independent assessment based on all the evidence available of the probability that the
claim will be paid.
Remaining balance
• Remaining balance is material at £283k and has increased from prior year (£231k). Need to gain
an understanding of why it has increased.
• Obtain a breakdown and perform substantive procedures on a sample of prepayments.
Other prepayments – financial reporting
Unless they relate to transactions associated with the same deferred expense (such as a proportion
of a total prepayment recognised as an expense pre year end), or with a legal right of set-off, credit
balances should not be offset against debit prepayments and they should be classified in an
appropriate account caption.
Other prepayments – what Jo needs to do
• Obtain an analysis of the account balance and a better understanding of what the debit and
credit balances relate to.
• Raise an audit adjustment to reclassify credit entries which are not part of an overall debit
balance.
• Once debit and credit balances understood, compare balances to prior year and investigate any
significant differences.
• Consider whether the final debit balance is material and, if it is, select a sample of items for
detailed substantive testing – agreeing to invoice and pre year end payment/creditor and
ensuring that the expense is recognised in the correct period.
Financial asset from hedging contracts
The forward currency contracts (Hedging instrument) have been designated as fair value hedges of
foreign currency firm commitments (Hedged item – the monthly supplier agreements from January
2022 for purchase of items to be delivered in six months from the agreement dates).
The gain or loss on each forward currency contract has been recognised in the statement of profit or
loss in line with the guidance in IFRS 9. However, that guidance also requires the gain or loss on the
hedged item to be recorded in profit or loss. At the year end, most of the contracts relate to future
firm commitments and the change in those commitments from the point at which they arose and
were designated as hedged items should be recognised as an asset or liability with the
corresponding amount in profit or loss.
In net terms overall for six months, there is a gain on the hedged instruments as it is an asset of
£192,000. Therefore, overall, there will be a liability and a loss on the hedged items of about this
amount if the hedge is effective.
It is not clear from the working paper whether those entries relating to firm commitments have been
made. They are likely in all cases to offset the gains / losses recognised on the hedging contracts and
thus to result in an additional charge to profit or loss and a financial liability.
The net gain is shown within other receivables – this appears to be incorrectly presented.
Assets and liabilities should not be offset but disclosed separately.
Financial asset from hedging contracts – what Jo needs to do
• Audit work done on the valuation of contracts is sensible, but Jo needs to document in much
more detail what has been tested so the audit procedure should be re-performed so that the
reviewer can ensure that the sample is adequate. Also, Jo should provide information on how the
sample was selected. Insufficient detail is documented at present. Adequate sampling from both
debit and credit balances should be included.
• Obtain a schedule of contracts and ensure that values are classified correctly as relating to assets
or liabilities, raising an adjustment as needed.

• Consider what gains and losses should be recognised in respect of the firm commitments and
ensure appropriate entries are made to recognise these either as separate assets or liabilities or
within inventory valuation where consignments have already been received.
• Review the documentation put in place at the inception of the hedge and ensure that it is
adequate to support hedge accounting.
Jarman loan – financial reporting
Jarman is an associate of Dragon, an entity which holds a controlling interest in Spycit – hence
Jarman and Spycit are related parties. Therefore, the loan will need to be disclosed as a related party
transaction with disclosure required under IAS24 of the nature of the transaction, the amount, the
year-end balance, terms and conditions and any provisions or write-offs made. The fact Cary’s wife is
the sales manager at Jarman is unlikely in itself to mean that Jarman and Spycit are related.
The loan to Jarman does not appear to be on arms-length terms. This is not a problem, but we need
to make sure that Spycit have not stated that transactions were at arms-length in their related party
disclosures.
It is interest free when the market rate quoted for a similar loan was 9%. In addition, the bank was not
prepared to lend without director guarantees. Jo is not clear whether any guarantees or security
have been given for the loan from Spycit but the implication of the comments is that no such security
exists. The loan is currently recognised at an amount equal to the funds advanced but its fair value
will be lower given it is non-interest bearing. Need to consider what the cost of providing an interest
free loan represents and how it can be justified as an appropriate transaction for Spycit. Argument is
presumably that arrangement as a whole is beneficial.
Fair value of loan at inception discounted at 9% is £448,600 (£448,592 with manual calculation – both
figures accepted). Interest earned to year end based on this amount is (6 months) is £20,186.
Difference between £600k advanced and fair value of £448,600 = £151,400 and should be taken as
a charge to P&L. Interest earned will offset this to a small extent, giving a net P&L charge of £131,214.
The balance should be classified as a financial asset rather than within receivables.
The loan is a financial asset and on initial recognition, an impairment allowance should be
recognised based on 12 months credit losses. It is apparent that no allowance has been made but
not clear whether this is reasonable given the high risk attributed to loan by a potential third-party
lender. If there is a significant increase in credit risk after initial recognition, then the impairment
provision should be made to cover lifetime losses. The rumoured financial difficulties being
experienced by Jarman may be an indicator or increased credit risk, thus changing the basis for any
provision which should be made.
Jarman loan – what Jo needs to do
• Obtain a copy of the loan agreement and ensure we understand key terms and that these have
been used to inform both the calculation of fair value and the disclosures made, including related
party disclosures.
• Make enquiries as to why the Spycit Board are satisfied that it was appropriate to lend to Jarman
on the terms which have been agreed. There is a potential benefit to Spycit from funding the
investment in machinery but the arrangement does look questionable. It was evaluated at a Board
meeting so Jo should ask for the supporting papers as these will frame the disclosures to be
made.
• Ensure that appropriate disclosures have been made and that the loan is classified appropriately.
• Obtain evidence of the recoverability of the loan, including up to date financial information for
Jarman and consideration of monitoring processes put in place by the Board. Investigate further
both concerns about environmental and employment practices and any information can gain
about the effect on Jarman’s financial position.
Jarman rebates – financial reporting
• The rebates should only be recognised if they have been earned and are virtually certain to be
received. To date, purchases have been at an average monthly rate of £360,000/3 = £120,000 per
month rather than at the average monthly rate of £810,000/6 = £135,000 needed to earn the 20%
rebate. Hence it is questionable whether the receivable should be recognised although further
information on expected/actual purchases for July to September is needed to conclude on this.
• If there is sufficient certainly to recognise the rebates, then any inventory purchased from Jarman
needs to be recorded at the cost net of the rebate.

• If there is not, then inventory should be at the full cost but consideration will need to be given to
whether this is in excess of NRV.
• Given the financial position of Jarman, consideration should also be given to the recoverability of
this financial asset in the same way as for the loan.
• Purchases are from a related party as determined above and should be disclosed.
Jarman rebates – what Jo needs to do
• Review the contract with Jarman and note all key terms. Ensure these are reflected in both how
the contract is accounted for and how it is disclosed.
• Obtain invoices to corroborate purchases from Jarman up to the year end.
• Review post year end purchases from Jarman and orders for future purchases and assess whether
there is sufficient certainty that the threshold for earning the 20% discount will be met.
• Identify at what cost any inventory purchased from Jarman has been recorded and whether there
is evidence that provision has been made to the extent this exceeds NRV.
• Ask client to consider whether any impairment allowance is required and review both the
calculation and the support for their rationale.
• Ensure appropriate disclosures made.
(2) Issues for Cary Komo
As an ICAEW Chartered Accountant, Cary should act in accordance with the ICAEW Code for
Professional Accountants. Most relevant to the situation outlined in the email, this code requires that
he act with:
• Integrity, being open and honest in what he does. It seems that may not have been the case here
if he did not disclose to the board that his wife worked at Jarman (and may indeed have
benefitted from commission on the deal as the sales manager). The email from Murray also
alleges that the financial information used was incorrect although that needs to be investigated
further.
• Objectivity and lack of bias – he may have been biased towards using Jarman because of his
wife’s job there or pressure from Dragon, rather than looking objectively at the options. The fact
that the initial price is higher than the price paid to the current supplier even considering the full
rebate (price is 25% higher and rebate 20%) for the first six months and that a beneficial loan had
to be given suggests that other options may have been better. Cary needs to be able to show that
he considered such options objectively. The views of a majority shareholder such as Dragon are
always going to carry weight but the directors should act for the benefit of the company and also
consider minority shareholders.
• Professional competence and due care – Again the terms of the deal with Jarman and an apparent
failure to identify the bad publicity (Murray was the one who raised that with the board) or
possible financial difficulties could indicate a lack of competence or care in making and
supporting the proposal for a change in supplier.
• Professional behaviour – Likewise, these failings would also amount to conduct that would
discredit the profession.
• In addition, adjustments identified in the course of the audit suggest that costs have been
deferred when they should not be, finance charges not recognised and errors made in
accounting, many of which have inflated profits which could suggest a lack of competence or
deliberate manipulation.
Cary should have recognised that there are self-interest threats he faces in dealing with Jarman and
more generally and these need to be mitigated with appropriate safeguards put in place:
• In terms of the deal with Jarman, the threat arises both from Cary’s wife’s position at Jarman – she
may have benefitted from the contract through commission or bonus payments or indeed job
security. To mitigate this, he should have disclosed the self-interest and absented himself from the
vote on the contract.
• Cary and Kit Beard also have a “generous bonus arrangement” in place which may have
incentivised Cary to maximise profits. While the higher costs of the new purchase agreement
appear to contradict this, other audit adjustments identified are suggestive of deliberate
manipulation.

Actions for Vallis
• The engagement partner and firm’s ethics partner should be informed of this issue.
• Murray has already raised the issues with fellow board members who have indicated that they are
satisfied with the decision made to use Jarman. Vallis should engage in discussions with them to
understand further the Board’s decisions and whether other directors share the concerns.
• The statements that Murray Evans has made with regard to Cary Komo, and his wife’s connection
to Jarman, will need to be investigated.
• If there is evidence that Cary has breached the Code in not dealing appropriately with self-interest
or conflicts, consideration should be given to reporting him to ICAEW as he is an ICAEW
Chartered Accountant
• To the extent possible, Murray’s allegations about Jarman’s business practices and financial
position need to be corroborated. Press accounts are not conclusive evidence but they are
publicly available evidence which can be used in discussion with the board to challenge the
position taken.
• The audit team need to reconsider the extent to which they have relied on information or
representations provided by Cary (and possibly Kit) and to seek alternative independent
corroboration wherever possible.
• The assessment of audit risk and extent of audit testing need to be revisited to ensure that the
self-interest threat of manipulation of the results is considered.
• The assessment of the recoverability of all debt owed by Jarman should be revisited.
Hedging
There were many long answers full of technical guidance cut and pasted from the LM, with no
application to the fact pattern presented. Marks are not awarded for technical information which is
not applied to the scenario.
Some stated incorrectly that the hedge had to be a cashflow hedge, rather than accepting the choice
made by the client for a FV hedge.
Those who focused on the fact pattern presented, easily scored the maximum marks available for
spotting that only one of the two required entries had been made. However, many candidates
overcomplicated the scenario.
A minority noted that a derivative asset was not a prepayment and that individual contracts might be
financial assets or liabilities which should not be netted off.
Some candidates did not seem to understand that the asset recognised is in respect of the hedging
instrument and suggested that an adjustment needed to be made to recognise this.
Audit procedures were often weak for this element and failed to take any account of the work Jo had
already done or express the additional procedures arising from the shortcomings of her
documentation and audit procedures.
Loan
Candidates who recognised the need to calculate a fair value and showed their calculations scored
well. Those who simply set out the theory or missed the point completely did less well. Some
candidates who did calculate a fair value failed to recognise that the loan was payable in instalments
rather than all at the end of the term.
Those who identified that the transactions with Jarmon were related party transactions often did so
because of the role of Cary’s wife rather than the far clearer reason that they share a common
shareholder in Dragon.
Audit procedures were generally covered better than the FR.
Many candidates did identify the link between the financial difficulties with information about Jarmon
from elsewhere in the question.
While it was entirely appropriate to question the motivation for the loan and potential links with other
transactions, candidates often focused on the difference between the cost of the plant and the loan
(failing to read on that the loan was also for working capital) or stated incorrectly that the loan was in
fact a lease.

Rebates
This element of the question was generally less well answered. The successful candidates were those
who questioned whether the minimum level of purchases would be achieved and used the facts in
the question to assess that. Those who jumped immediately to the conclusion that the entire target
had not yet been achieved gained some credit but scored less well as they had failed to recognise
that the period for making purchases was only half complete at the year end.
Few, if any, considered whether the inventory value would be affected
The best candidates recognised that the arrangement was unnecessarily complex and questioned
the underlying motivation.
Ethics
There was some good use of ethical language although objectivity was often replaced with self-
interest and transparency replaced integrity.
Points to note
• Candidates failed to focus on the ethical position of Cary and the actions of Vallis and included
issues for various other parties which were not asked for. Candidates should identify the parties
involved in the scenario and limit their answer to those parties.
• There was often considerable focus on the environmental and other issues allegedly facing
Jarman rather than what Cary should have done about them and Vallis’s response to Cary’s
actions.
• Many jumped to conclusions about Cary’s motivation rather than exploring the issues of conflict
of interest etc, which arose. Candidates stated that Cary was acting fraudulently or illegally which
was not necessarily true.
• Too much emphasis was placed on self-interest rather than a conflict of interest.
• Many referred to a familiarity issue, a matter which relates to audit independence not the
relationship between an individual and a close family member.
• The actions proposed were often generic with no explanation of what advice should be sought or
why a report to the ICAEW might be necessary.
• Candidates muddled accounting issues with ethical issues – while some credit was given for
additional points Vallis might want to follow up from an accounting/auditing perspective, some
candidates included no other actions.

77.1 Sample item A
This is the recognition of a quarterly rental in respect of a property in Newcastle. It was entered
on 23 May 2018 in respect of the period 24 June to 28 September.
Audit procedures:
• Compare rental amount with other quarters and the same quarter last year and obtain
explanations from management of any changes.
• Agree the due amounts and timings of rental payments to the lease contract.
• The transaction states 24/6/2015 to 28/09/2015. The 2015 dates could be a clerical error,
but this needs to be checked to documentation available from the lessor (rental contract,
invoice, other correspondence).
• Enquire of management why the entry has been created on 23 May when the quarterly
period begins on 24 June.
• Trace transaction to cash book for evidence of payment of the rental.
• Inspect lease contract for any other terms that may create additional obligations.
• Consider whether lease payments need to be capitalised rather than expensed (see Tutorial
note below).
• Ensure transaction has been authorised for F. Wright to process.
• Search for other rental payments for the same property in the year to ensure rents are fully
recorded.
• Enquire about recognition of prepayments at the year end.
Tutorial Note
Credit will be awarded for demonstrating awareness of audit risks from the need for lease
recognition in the statement of financial positions.
Sample item B
Transaction PIN029477 is a purchase transaction on credit with input VAT.
Transaction PPY013791 is the credit card transaction on the following day.
Audit procedures:
• Obtain documents authorising the order.
• Inspect order form for details.
• Match order form to GRN. Elephant has no inventories, but materials are ordered for
projects.
• Match GRN to purchase invoice.
• Verify which credit card was used to make the purchase and who had authorised use of this
credit card.
• Trace goods to relevant marketing project and trace costs to job costing account for the
project.
• Ascertain the purpose of the transaction from the project leader.
• Inspect bank statement for payment of credit card balance containing the transaction
(account 20040).
• Inspect signature or other evidence authorising the payment of the credit card balance.
Note: The approach to this answer adopts a two-column format, but other approaches are
acceptable.

Cost of sales
Risk justification Audit procedures
Using the ‘Financial Statement view’ in the • Enquire of management about any price
question. or cost changes.
This shows a 9% increase in ‘Cost of Sales • Enquire of management about changes
(COS)’ compared with the prior year (2018: in operations or in the business model.
£881,464; 2017: £809,659). • Check cut-off for possible omissions of
The 9% increase is significant and above costs in COS eg, review post year end
materiality which may suggest a risk of transactions for evidence that they may
overstatement. relate to the current year.
However, this is lower than the 14% increase • Obtain a breakdown of COS from the
in income and may suggest an Data Analytics Software (‘Account view’).
understatement of COS. • Reconcile the total of COS in the
‘Financial Statement view’ to the total in
the ‘Account view’ (Reconciles at
£881,464).
Using the ‘Account view’ in the Data Analytics • Enquire of management for explanations
Software to review all the accounts of increases in each of the accounts
comprising COS (ie, accounts beginning with identified as high risk.
a 6). • Obtain supporting evidence for
There is a potential risk of overstatement of management’s explanations.
COS from significant increases (% and • Review the selected high-risk accounts
absolute) in a number of accounts: and obtain supporting evidence for a
- 61017 Deliveries: 23% up (£5,244) sample of significant transactions.
- 61050 Mock-Ups: 49% up (£24,681) • Review high-risk accounts for evidence of
- 61085 Travel and subs on jobs: 19% up transactions being allocated to an
(£13,840) incorrect account that should not be
included in COS.
- 61097 New Media - External: 39% up
(£25,997)
- 62405 Equipment Rental: 29% up (£6,491)
Using the ‘Account view’ in the Data Analytics • Review for expenses being
Software to review COS accounts where inappropriately capitalised
there has been a significant decrease: • Review for cut-off errors
61060 Photography: down 17% (£12,380) • Review other expense accounts (ie, not
Understatement risk. COS) for evidence of transactions being
allocated to an incorrect account that
should be included in COS (thereby
understating COS).
Elevated risk transactions in Heat Map in • Obtain explanations of the transactions

COS ‘Account view’: from management.
There is one transaction in the red area • Enquire of management regarding the
which represents the highest level of methodology used to identify costs for
elevated risk, which is the capitalisation of website capitalisation.
website development costs. • Obtain supporting evidence (invoices
and documentation) as to the nature of
the transaction and the breakdown of
costs capitalised.
• Inspect a sample of photography
invoices to verify that they are related to
website development.

• Obtain advice on the financial reporting

treatment as to whether it is appropriate
to capitalise these costs.
The Bar Chart for COS in ‘Account view’ • Obtain explanations from management
indicates a number of transactions: about the reasons for transactions being
Outside (or significantly outside) normal outside the normal working hours/week.
working hours of 9am to 5pm. • From reviewing the Bar Chart ascertain
On Saturday or Sunday. which users are mainly responsible for
posting entries on Saturdays (F Wright,
and J Smith) and make enquiries of these
individuals for the reasons for the timing
of data processing.
• From reviewing Bar Chart ascertain which
users are mainly responsible for working
outside normal hours (A Bloggs, and F
Wright) and make enquiries of these
individuals of the reasons for the timing
of data processing.
• Trace users entering transactions out of
normal working hours to overtime
payment payroll records to evidence
authorised access to software at specified
times.
The manual job costing system may lead to • Verify how project managers monitor
errors in transfers which may result in an project costs (are they monitored on a
incorrect allocation of costs between regular basis?).
marketing projects. • Inspect a variance analysis to explain cost
Cost overruns on projects may not be overruns or errors (if one exists).
identified • Vouch a sample of costs recorded
in a timely manner and therefore losses on manually in the job costing system to
marketing contracts that span year ends may purchase invoices/payroll records.
not be appropriately recognised. • Trace invoices/payroll records for
material/labour costs to the manual job
costing system.
• Reconcile total of job costing sheets to
cost of sales.
Trade payables (Account 31010)
Using the ‘Financial Statement view’ in the • Enquire of management about the
Data Analytics Software: reasons for the change.
This shows a 3% increase in ‘trade payables’ • Enquire of management about any
compared with the prior year (2018: change in credit terms or supplier
£151,941; 2017: £148,109). relationships.
The 3% increase is low relative to the 9% • Check cut-off for possible omissions of
increase in COS and may suggest an purchases or payments affecting
understatement. payables. For example, inspect post year
end invoices/payments for transactions
relating to the current year.

Using the ‘Account view’ in the Data Analytics • Review selected high-risk transactions
Software to review transactions comprising and sample significant transactions
trade payables: (purchases and payments) obtaining
There is a potential risk of overstatement of supporting evidence for validity.
trade payables from invalid/inappropriate • Review for evidence of transactions being
purchases and of understatement from allocated to an incorrect account that
invalid/inappropriate payments. would not be included in trade payables.
Elevated risk transactions in Heat Map for • Obtain explanations from management
trade payables’ ‘Account view’: for both transactions.
There are two transaction types in the • Obtain supporting evidence (invoices
second highest level of elevated risk. Both and documentation) as to the nature of
transactions have a negative monetary the transactions.
impact (although individually each is below • Take a sub-sample from the transactions
the materiality level). They potentially making up the £18,127 and obtain
represent a high risk. supporting evidence (invoices and
The two transactions are: documentation).
A posting run control amount totalling • Obtain documentary evidence of the
£18,127 (matched by 9 smaller transactions). larger transaction of £15,653 relating to
Two transactions of £15,653 and £1,367. The business rates.
larger transaction relates to business rates. • Substantiate the dates of the rates period
and question the validity of the stated
period of 01/04/15 to 31/03/16 as this
falls outside the current accounting
period.
The Bar Chart for Trade payables in ‘Account • Obtain explanations from management
view’ (Variables: Effective period and Users) about the reasons for so many payment
indicates a significant number of payments transactions being in these months.
transactions in May, September and • Obtain supporting evidence for
October: management’s explanations.
The risk of overstatement of payments • Sample the payments and check to
creates a risk of understatement of the trade supporting evidence (suppliers’
payables balance. statements, invoices being settled, bank
records).
The Bar Chart for Trade payables in ‘Account • Enquire of this individual the reasons for
view’ (Variables: Created hour and Users) the timing of data processing.
indicates a significant number of transactions • Trace A Bloggs’ transactions out of
being input outside normal working hours of normal working hours to overtime
9am to 5pm: payment payroll records to evidence
Primarily these are by A Bloggs and are after authorised access to software at specified
5pm. times.
The Bar Chart for Trade payables in ‘Account • Enquire of management what internal
view’ (Variables: Document type and Users) controls are in place (eg, effective
indicates that F Wright, A Bloggs and J Smith management authorisation of all
have processed a significant number of both purchases and payments) which would
purchases and payments transactions: prevent the one user processing both the
There is potentially a risk of misstatement purchase and payment sides of an invalid
due to an internal control deficiency where transaction.
(in the absence of strong authorisation • Review a sample of payments and check
control procedures) one user can input a whether the same user is entering
false purchase and also the subsequent payment transactions as entered the
payment. matching purchase transaction.

• Obtain a list of known suppliers from

management and review a sample of
payments to ensure payments are only
being made to these known suppliers.
Supplier statement reconciliations are not • Inspect a sample of supplier statements

carried out: and reconcile with the trade payables
There is a risk of unresolved errors and ledger.
cumulative material misstatement given that • Make enquiries of management for
reconciliations do not take place. evidence and explanations of any
differences in the supplier statement
reconciliations.
77.2 Internal control recommendations

No suppliers’ statement reconciliations
Reconciliations between supplier statements and the trade payables ledger should be
undertaken on a regular basis (at least monthly) by competent employees who are
independent of the purchase and payment processing functions.
Any discrepancies identified should be investigated and resolved.
Reconciliations should be reviewed by a manager and signed as evidence of having been
reviewed.
There is no authorised supplier list maintained.
• Prepare a list of authorised suppliers.
• Ascertain criteria for authorisation of suppliers.
• Set up an internal control which permits purchase orders to be made only from the
authorised list unless there is management approval.
• Staff approving orders to check against the list of authorised suppliers.
• Monitor supplier performance.
Periodically review the list to add and remove suppliers as appropriate and as business needs
change.
Lack of segregation of duties
There should be effective management authorisation of all purchases and payments,
particularly where one person has posted both sides of a transaction.
Ideally there should be segregation of duties between users posting the purchase transaction
and users posting the payments transaction. A small number of accounts staff may however
mitigate against this being feasible.
Related party
Philippa Wright is the daughter of Frank Wright, the senior accounts manager and they are
therefore related parties.
Frank Wright should not be permitted to post or approve any transaction (eg, claiming
expenses) where Philippa Wright has been involved.
A member of management should periodically review all expenses processed on behalf of
Philippa Wright.
An appendix to this answer can be found on icaew.com/corporatereportingdas which explains
the audit software screens and the navigation methods used to derive the answer points from
the data analytics software. Please note, the appendix is for guidance purposes only and does
not form part of the answer.

78.1 As the audited 2018 financial statements are to be used by the potential investor for the
valuation of Elephant there is an incentive for management to overstate income and profit in
order to increase its valuation.
This creates a risk of window dressing transactions.
Total income has increased by 14%, despite more challenging trading conditions. This is
considerably in excess of the 9% increase in the cost of sales. This suggests possible
overstatement of income (and/or understatement of cost of sales).
Overstatement of income may be due to the inclusion of income not related to the financial
year through premature recognition of income or cut-off errors.
Due to the fact that projects undertaken by Elephant have a duration of up to six months, there
is a need to estimate the amount of income recognised in the current year. This involves
management judgment, increasing risk of misstatement.
Using the Data Analytics Software to analyse the accounts making up Income, we can identify
that there has been a material increase in three of the underlying accounts
Account number Account name £ increase % increase
51010 Domestic Sales 172,158 9
51020 Overseas Sales 141,516 18
54800 Other Income 59,117 84
The risk of overstatement of Income is increased by the fact there is a substantial 84% increase
in Other Income which is not the main source of revenue for the business.
There has also been a large 18% increase in Overseas Sales which has exchange rate risk and
may not have the same internal controls as Domestic Sales.
78.2 Using the Heat Map visualisation in the Explore module we can identify the following high
value transactions.
Item description (a) Reasons for risk of material Procedures (c)

misstatement (b)
Three similar transactions • High value relative to • Inquire of management

with the narrative ‘Correct’ or materiality. as to the reason for the
‘Adjust’ quarterly sales. • No evident logic for a entries.
These total £75,333, need to adjust/correct • Request that
credited to 51010 Domestic sales. management provide any
Sales with the debit entries supporting
in 990 Suspense Account. • Use of suspense account
may suggest a lack of documentation.
clear rationale for
transactions.
51020 Overseas income has • High value relative to • Obtain copy of contract
been credited with £100,000 materiality. with Spooks, determine
described as ‘Overseas • Very significant amount length of contract and
receivable’ with the debit to relative to total overseas establish basis for
21020 Overseas sales (11%). deposit.
Receivables. Examining the • Examine Spooks job card
transaction details a • Deposit may be in
advance of work to verify extent of
narrative of ‘Deposit on marketing services
brand management contract provided and transaction
posted in December provided in 2018.
with Spooks’ is visible.
2018. • Confirm when cash
• Due to nature of received in respect of
marketing contracts the deposit.
deposit may not relate in

Item description (a) Reasons for risk of material Procedures (c)
misstatement (b)
full services provided

in 2018 (even if work
on contract
commenced).
There are two large entries • High value relative to • Inquire of management
to 54800 Other Income, a materiality. for reasons behind large
debit of £170,294 being a • 2018 accrued income increase in amount
reversal of income accrued 76% higher than prior accrued.
in 2017 and a credit of year, despite only 14% • Request a breakdown of
£300,000 described as ‘Sales increase in total income. amounts included in
accrued reverse in January accrued income.
2019’. • Round number suggests
high degree of estimation • Confirm invoices/cash
rather than calculation received post year end
from individual contracts. related to accrued
amount.
• Establish basis for any
estimation and assess
whether reasonable.
78.3 Reversal – Quarter 4 sales

It is unclear why a transaction with the narrative ‘Reversal – Dec18 sales’ should occur after the
year end.
It may suggest that £38,000 of sales recorded in December 2018 were not valid for some
reason.
It is possible that these were window dressing transactions designed to boost reported 2018
income.
This suggests that both income and trade receivables at 31 December 2018 may be materially
overstated.
Hilditch Mobile refund for October inv error
The transaction ‘Hilditch Mobile refund for October inv error’ suggests that this entry was to
correct an error in sales invoicing in October 2018.
Any correction of such an error should be adjusted in the 2018 financial statements. The
effective date for the transaction of 31/1/2019 indicates that this is not the case.
By recording the correction of an error in 2019 that relates to 2018 Elephant would be
overstating both income and receivables.
Rent – Newcastle
The narrative clearly suggests that this rent expense is related to the final quarter of 2018.
As such this amount should be recorded as an accrual in 2018.
Examining 34030 Accruals Control A/C using the Data Analytics Software reveals that no
accrual appears to be made for this amount. (In fact, no accruals in relation to expenses appear
to have been made at all for 2018).
This suggests that profit may be overstated by a significant amount.
Invoice 23910 – Executive Search Ltd
This payment of an invoice was posted on 13 January 2019. Given that this is so close to the
year end it suggests that this invoice relates to services provided prior to the 2018 year end.
The narrative is consistent with payment for the executive search performed in relation to the
recruitment of the new marketing director in November 2018 described by Navan.
Examining account 71080 within the Data Analytics Software, the account can be identified as
Recruitment and Selection which has no transactions recorded for 2018. This supports the

supposition that the amount related to recruiting the marketing director in November 2018
has been recorded in 2019.
This amount should be accrued in 2018. However, 34030 Accruals Control A/C further
indicates that no such accrual has been made for this amount.
The failure to accrue this amount further increases the extent which expenses may be
understated and therefore profit overstated.
78.4 Request for assistance with appointment of finance director and advice on remuneration
Threats
A familiarity threat arises as the audit team may be reluctant to criticise the information or
explanations provided by the finance director.
A management threat arises if the directors expect the firm to be involved in the appointment
of the finance director and providing advice on structuring an appropriate remuneration
package. The firm may become too closely aligned with the views and interests of
management.
Response
Appointment of finance director
The firm should not provide recruitment services to an audit client that would involve taking
responsibility for the appointment of any director.
Remuneration package
FRC ES section 5 prohibits the provision of services to an audit client that would involve the
audit firm advising on the quantum of remuneration package or the measurement criteria
because the familiarity threat is too high. Consequently, this request should be refused.
Tight audit deadline and requirement for audit to ‘go smoothly’
Threats
The fact that the audit deadline is very short, combined with the client’s stated desire for the
audit to go smoothly, represent a potential self-interest threat to the auditor’s objectivity. The
auditor may feel pressured to avoid raising issues that may extend the audit beyond this
timetable and feel pressure to concur with management judgments.
In addition, these pressures may undermine the auditor’s exercise of appropriate professional
scepticism.
A demand for ‘no unexpected problems’ could also give rise to an intimidation threat,
depending on how forcefully the management of Elephant have expressed this.
In this context the engagement partner’s decision to inform the audit team about
management’s desire for the audit to go ‘as smoothly as possible without any unexpected
problems’ may be ill-advised. By doing so she is potentially applying undue influence to the
members of the audit team, thus threatening their objectivity.
Response
The firm should ensure that the audit is properly planned and adequately resourced in order
to be able to complete all necessary audit work within the required accelerated timetable.
At the planning meeting the engagement partner could have asserted the need to maintain
rigour and professional scepticism despite the timetable, rather than simply passing on
management’s expectations.

Marking guide Marks
79.1 Explain why land, buildings and improvement are a key audit risk 6
6
79.2 Identify and explain key audit risk transactions 6
6
79.3 Procedures to address key audit risks 6
6
79.4 (a) Financial reporting issues 8
(b) Appropriate audit procedures 6

12
Total 30
79.1 There is a risk that the accounts making up land, buildings & improvement are overstated.
The increase in land, buildings & improvement in the year of £129,126 is nearly four times
materiality of £30,000.
Fixtures and fittings have increased by 109% and Office equipment by 56%.
The Heat Map for land, buildings and improvement indicates three transactions with significant
elevated risk based on magnitude relative to materiality and frequency.
Risk of overstatement of land, buildings & improvement is exacerbated by management’s
incentive to capitalise expenditure in order to boost reported profit. This arises from the
impact of higher profits on directors’ bonuses. In addition, higher profit increases the
probability of a successful flotation from which the directors stand to directly benefit.
The capitalisation of internally generated assets already identified presents high risk of
misstatement due to the need for an estimate by management of the costs to be capitalised.
The use of management judgements in arriving at an estimate leads to a high level of risk of
misstatement. The round sum nature of the £95,000 debited to Office Equipment 13020 also
suggests estimation rather than a precise record of the amounts incurred to develop the
website.
The incentives to overstate profit referred to above may lead to management bias in the use of
judgement to arrive at an estimate of website development costs for capitalisation. The
challenging business environment faced by Elephant may add further incentives for
management to capitalise rather than expense costs in order to support reported profit.
79.2 An examination of the higher risk transactions for land, buildings and improvement, using the
Heat Map visualisation reveals amounts debited from Suspense Account 990 as follows:
Description £
Adj Q1 Suspense 5,000
Total 25,111
Together the total of these entries approaches materiality.

An examination of account 990 Suspense indicates that these entries are, in effect, the other
side of a credit entry to sales. Each amount appears to be an apportionment of an amount
credited to sales and debited to suspense with the narrative description ‘Correct Q1 sales’,
‘Correct Q2 sales’ and ‘Adjust Q3 sales’. It can be seen from an analysis of 990 Suspense that
the credit entries to 51010 Domestic Sales appear to be matched through the suspense

account to three debit entries of equal size to the Fixtures and Fittings account within Land,
buildings & improvement and two other non-current asset accounts (13025 Office Equipment
Depreciation and 11010 Motor vehicles).
The effect of these entries passing through the suspense account is to increase both reported
sales revenue and non-current assets. As above, management has an incentive to overstate
profit.
It is difficult to construct a valid justification for these entries. One would anticipate that the
debit entry related to a credit to domestic sales would be to either cash or receivables
dependent on the nature of the sale.
An analysis of the posting details using the Stacked Bar Charts reveals that these entries (and
those related to the capitalisation of website development) were posted by Frank Wright on a
Saturday. Journals posted on non-business days can indicate a risk of fraud and Frank Wright
may be under pressure from the directors to overstate profit for the reasons discussed above.
The round number nature of the amounts and the equal apportionment across three non-
current asset accounts are also indicators of higher risk.
Thus, these entries increase the risk that land, buildings & improvement (and revenue) is
overstated.
79.3 Entries from Suspense Account 990
Procedures include:
• Obtain explanation from management as to the substance of the underlying transactions
that these entries reflect.
• Inquire as to the rationale and basis on which the amount credited to sales is apportioned
equally across the three asset accounts.
• Inquire as to why there are entries for each quarter, yet no similar set of entries for Quarter
4.
• Identify and verify the non-current assets to which the debit entries to 13010 Fixtures &
Fittings relate.
• Verify the amounts debited to 13010 Fixtures and Fittings against invoices confirming asset
purchases.
• Identify whether the journal entries were correctly authorised.
79.4 (a) Amounts still recorded in revenue
The entries of Transaction SRC006972 related to website development include a credit of
£75,000 to 21010 Receivables Control A/c with the debit to 13020 office equipment. This
has reversed the incorrect entry to receivables, but sales are still overstated by this
amount.
In addition, it is probable that the expense accounts are also overstated as the costs
incurred were likely to have been posted to expenses and payables/cash also.
Frank’s correcting journal simply transfers the capitalised amount from Office Equipment
to Intangible Assets. It does not address overstatement of sales and expenses.
Absorption of central overheads
Since employee time is recorded in job sheets at a rate including an allocation of
overheads the amount initially recorded in receivables as related to Digital Dreams Ltd
would have included absorbed central overheads. This amount has been capitalised in
transaction SRC006972.
IAS 38.65 stipulates that general overheads, not directly related to preparing an asset for
use, are not a valid component of the cost of an internally generated intangible asset.
Therefore, only the direct costs related to web development can be capitalised, ie, the
web developers’ payroll costs. As a result, there is a risk that the amount capitalised as
web development is overstated with corresponding understatement of expenses.

Costs not directly related to the generation of future economic benefits
IAS 38.21 only permits recognition of an intangible asset (whether purchased or self-
created) where the entity can demonstrate that:
• it is probable that the future economic benefits that are attributable to the asset will
flow to the entity; and
• the cost of the asset can be measured reliably.
IAS 38.57 also requires that development costs can only be recognised as an intangible
asset where the entity can demonstrate that the intangible asset will generate probable
future economic benefits.
SIC-32 – Intangible Assets – Website Costs clarifies that in the context of website costs
economic benefit is demonstrated where the website is capable of generating revenues,
including those from enabling orders to be placed. Whereas a website developed solely
or primarily for promoting and advertising its own products and services does not meet
this requirement.
Elephant’s website development costs relate to the creation of a website both for
promotion of its services and taking and managing customer orders. Consideration needs
to be given to whether the extent of the intended e-commerce functionality is sufficient to
prevent the website being considered primarily for promotion and advertising and thus
ineligible for recognition as an intangible asset.
E-commerce functionality of website not yet in operation
If it is determined that Elephant’s website is not intended to be solely or primarily for
promotion and advertising, IAS 38.57 other criteria must still be met for development
costs related to an intangible asset to be capitalised. Since Frank’s email makes clear that
the e-commerce side of Elephant’s website is not yet in operation, the most relevant
criteria of IAS 38.57 are the need to demonstrate the technical feasibility of completing
the intangible asset, and the availability of resources to complete it. This creates a further
risk of overstatement of intangible assets and understatement of expenses.
Photography costs
SIC-32 sets out the activities an entity undertakes in development and operation of a
website. It states that only costs related to application and infrastructure development,
graphical design and content development stages can be recognised as an intangible
asset. Costs incurred in relation to time spent by Elephant’s web developers would be
considered within this definition and thus eligible for capitalisation. However, SIC-32 states
that costs incurred in content development to advertise and promote an enterprise’s own
products and services should be recognised as an expense as incurred. SIC-32 gives
digital photography of an entity’s own products as an example of such costs. The
information provided suggests that the photography expenditure by Elephant would not
be eligible for recognition as an intangible asset. This creates a further risk of
overstatement of assets and understatement of expenses.
Intention to capitalise cost of web administrator
The web administrator’s salary and National Insurance (NI) relate to running the website.
These costs would be classified by SIC-32 as related operating activities since they relate
to the period after the website went live. SIC-32 specifies that website costs related to
operating activities should be expensed as incurred. Therefore, Frank’s proposed journal
would lead to overstatement of intangible assets and understatement of expenses.
Appropriate period for amortisation
Elephant intends to apply the cost model for measurement after initial recognition in
accordance with IAS 38.74. This requires a carrying amount for intangible assets of cost
less accumulated amortisation and impairment losses, if any. Although SIC-32 does not
prescribe a maximum period over which website development costs should be amortised,
it stipulates that the best estimate of a website’s useful life should be short. A period of
seven years is unlikely to be considered short and seems unlikely to represent the useful
life of the current website given the pace of technological development.

(b) Appropriate audit procedures include:
• Request a listing/schedule of web developer time and costs that have been capitalised
and verify time spent against developers’ time sheets or similar evidence.
• Identify the amount of central overhead absorption in rate applied to time spent and
calculate total amount of absorbed overhead that has been capitalised.
• Examine the detailed specifications of the website to determine whether it could be
considered to be primarily for promotion and advertising.
• Inquire of management as to the expected date that e-commerce functionality will
come into operation.
• Consider use of IT specialist as an auditor’s expert in accordance with ISA 620 Using
the work of an expert for the purpose of determining the feasibility of the e-commerce
functionality and the availability of resources to complete work outstanding before
revenue generated.
• Examine a sample of photography invoices making up the £25,000 capitalised to
confirm whether or not the nature of photography makes it eligible for capitalisation.
• Request explanation for why management had selected a period of 7 years for
amortisation.
An appendix to this answer can be found on icaew.com/corporatereportingdas which
explains the audit software screens and the navigation methods used to derive the answer
points from the data analytics software. Please note, the appendix is for guidance
purposes only and does not form part of the answer.
Marking guide Marks
80.1 Identify and explain audit risks 8

8
80.2 Audit procedures and additional information 5
5
80.3 Audit quality management issues 8
8
80.4 Financial reporting treatment 9
9
Total 30
80.1 Using the DAS, it can be identified that the only transaction in 22200 Accrued Income is a
credit of £170,294 with the narrative ‘reversal of un-invoiced sales in December 2017 now
invoiced in Sept 2018’ with the debit to 54800 Other Income. As such this transaction
represents the reversal of accrued income for the prior year.
The fact that there are no equivalent entries relating to un-invoiced sales for 2018 could
suggest that this entry has been omitted leading to understated sales and non-current assets.
Given the magnitude of last year’s accrual, it is probable that this understatement would
exceed audit materiality of £30,000.
It is also notable that although these sales are described as invoiced in ‘sept 18’, the entries
were not effective until 17 December. The fact that these sales could be invoiced in
September, yet only be recorded in December suggests possible weakness in internal controls
over completeness of sales.
However, using the Heat Map to identify reasons for the movement in 23040 we can identify
two transactions: A debit for £51,066 with the narrative ‘2017 Prepay Reversal – Prepayments’
and an amount for £300,000 with the narrative ‘Sales invoice’.

Tutorial Note
Given the small number of items in these two accounts you may have chosen to directly
show all of the transactions in these accounts directly from Account View rather than using
the heat map. The DAS often offers more than one route to identify required information.
A reversal of prior year prepayments is to be expected, but the larger entry required further
investigation. However, the fact there is not an entry for 2018 prepayment requires
investigation.
Using the Data Analytics Software, we can identify a debit entry for £300,000 to 23040
Prepayments Control A/C with the credit to 54800 Other Income with the narrative ‘Sales
accrued reverse in January 2019’. This would appear to be accrued income for 2018.
Therefore, it would appear that an entry for accrued income in the current year has, in fact,
been made, albeit with the debit to a different account.
The accrual for uninvoiced sales for 2018 is larger than that for 2017 by an amount
considerably in excess of audit materiality. The amount accrued is also a round figure of
£300,000, suggesting that it is an estimate. These factors lead to an increased risk that Income
and Accrued income are overstated.
In addition, although posting the sales accrual to prepayments control a/c will not have an
impact on the classification of this amount in the statement of financial position it could raise
questions over the accuracy of other postings by ABLOGGS and the effectiveness of controls
over the posting of journal entries.
80.2 Appropriate audit procedures related to accrued income for Elephant include:
• Inquire of management as to the methodology used to identify and calculate accrued
income
• Request a breakdown/justification of the amount of income accrued by Elephant for 2018
• Reperform any calculations for accrued income
• Examine the basis of any estimates included within accrued income for reasonableness
• Agree a sample of amounts included within accrued income to subsequent invoicing and
receipts post year end
• Inspect contract to which accrued income relates and review timing and amounts for
consistency with contract
• Inspect a sample of invoices post-year end to identify whether they relate to work
undertaken in 2018 and whether included within accrued income
• Inspect signature, or other method of authorising, accrued income journals
80.3 Brian’s email indicates he is uncertain and struggling with the task he has been assigned and
appears to be somewhat out of his depth. Given the fact he has only just begun working as an
accountant, it is very unlikely that he has sufficient experience or technical competence to
perform the task that has been requested of him.
ISQM (UK) 1 Quality Management for Firms that Perform Audits or Reviews of Financial
Statements, or other Assurance or Related Services Engagements lists human resources as an
element of a firm’s system of quality management. The fact that Brian appears to have been
allocated a task for which he lacks adequate experience and knowledge suggests a human
resources failure.
Ultimately, it is the engagement partner’s responsibility to ensure that appropriate staff are
allocated to each engagement team. However, as in this case, allocation of tasks to audit staff is
typically delegated to the audit senior or other individual responsible for the day-to-day
management of the onsite audit visit.
Characteristics that should be considered in determining the appropriate staff for a task should
encompass:
• An understanding of/practical experience with similar engagements
• Appropriate technical knowledge
• Knowledge of the relevant industry
• Ability to apply professional judgement

The fact that Brian has only very recently started work, and therefore has received very limited
training, suggests that he lacks these features, which to a degree is confirmed by his email.
Given his very limited experience and technical competence it can be argued Brian should
have been more closely supervised and given more specific instructions for any work he was
asked to do. It could also be argued that there has been a failure to adequately supervise
Brian.
ISA (UK) 220 (Revised) Quality Management for an Audit of Financial Statements identifies the
need to consider the competence and capabilities of individual members of the audit team as
a component of supervision. It could be argued that this has not been done effectively when
allocating the task of looking at accrued income to Brian.
Fortunately, in this instance, Brian has raised his concerns with a more experienced member of
the audit team enabling a review by them, thereby reducing the potential adverse impact on
audit quality.
80.4 Debenture loan
The debenture loan creates a financial liability. It is not held for trading, nor does it satisfy the
requirements to be designated as fair value through profit or loss. Therefore, it should be
classified as amortised cost in accordance with IFRS 9.
As such it should be initially recognised at fair value of £75,000 less transaction costs of £1,375
(IFRS 9: para 5.1.1).
Therefore, the costs of issue need to be recorded in the 2018 financial statements.
Subsequent measurement will be at amortised cost (IFRS 9: para 5.2.1).
Amortised cost is the initial amount recognised adjusted for any repayment of principal and
any amortisation. Amortisation is the difference between interest on the liability calculated at
the effective rate and at the coupon rate. In this case Elephant has issued the debenture loan at
a deep discount and no coupon is payable. Therefore, interest at the effective rate is added to
the liability as amortisation on subsequent measurement.
The effective interest rate must take into account fees directly related to the issue of the loan.
Thus 4.1% must be used.
Journals:
From the Data Analytics Software it can be identified that the other side of the debit to 20010 –
Bank, current account was a credit to 20021 – Invoice finance account. This first needs to be
transferred to a separate debenture loan account
DEBIT Invoice finance account (SOFP) £75,000

CREDIT Debenture loan (SOFP) £75,000
The costs of issue must be deducted from the amount received on initial recognition
DEBIT Debenture loan (SOFP) £1,375

CREDIT Accruals (SOFP) £1,375
Thus, the liability is initially recognised at FV less transaction cost of £73,625 = £75,000 –
£1,375
To reflect interest for the year to 31 December 2018:
DEBIT Finance cost (SOPL) £251.55 (EIR 4.1%/12 × (75,000 – 1,375))

CREDIT Debenture loan (SOFP) £251.55
On subsequent measurement 31 December 2018 the amount initially recognised has been
adjusted for amortisation (reflecting the fact that the debenture will be redeemed at a
premium to issue proceeds received).
£73,876.55 = £73,625 + £251.55

UK government bond purchase
For transactions in financial markets there is normally a delay between the trade date, when the
terms of the contract are agreed, and the settlement date, when consideration is exchanged.
Such transactions are referred to by IFRS 9 as ‘regular way’ transactions (IFRS 9: para 3.1.2).
IFRS 9 permits two accounting methods for regular way transactions: trade date accounting
and settlement date accounting. It is permissible for Elephant to account for regular way
transactions using settlement date accounting provided that it is its accounting policy and it is
used for all such transactions.
Under settlement date accounting a purchased financial asset is only recognised when
settlement occurs and the asset is transferred to the buyer. In this case, that occurs on 2
January 2019. So, it is correct that the value of UK government bonds would not be recognised
in the 2018 financial statements. However, under settlement date accounting the change in fair
value from trade date, 30 December 2018, to the year end, 31 December 2018 must be
recognised in the same way as the financial asset will be.
Therefore, we need to determine the classification of this investment under IFRS 9. This
depends on the nature of the contractual cashflows and the objectives of the business model
within which the financial asset is held. In this case, the contractual cashflow test is met as all
cashflows from a UK government bond represent interest or principal. The point in time when
liquidity requirement will lead to bonds being sold is uncertain. We are told that in holding
assets to meet future liquidity Elephant expects to both hold to collect contractual cash flows
and sell to realise their value. Thus, the business model within which the bonds are held is best
described as collecting contractual cash flows and selling (IFRS 9: para. 4.1.2A). This means
that the bond holding will be classified as fair value through other comprehensive income.
Journals:
The journals related to this transaction for the year to 31 December 2018 must reflect the fall in
fair value of £750 (75,000 – 74,250) as a loss. To record this the following journal is required:
DEBIT Loss on FVOCI investment (SOCI) £750

CREDIT Payables (SOFP) £750

Scenario
Requirement Skills
For the new contract (Exhibit 1) set out and Identify the three financial reporting issues
explain the appropriate financial reporting where the treatment is incorrect and/or
treatment. incomplete: misposting and potential omission
of VAT, recognition of revenue too early and
failing to take account of financing element of a
receivable.
Ability to correct the treatment using journals,
setting out the adjustments in a suitable form.
For the new internal control (Exhibit 1), Assimilate information using the Data Analytics
• use the Data Analytics Software to evaluate Software.
whether the control has been applied Use judgement to identify risks and
effectively in December 2018 weaknesses.
• identify any evidence where the new internal Make appropriate recommendations for
control has not been appropriately applied; additional audit procedures.
and

Requirement Skills
• set out relevant audit procedures relating to

this internal control deficiency.
Using preliminary analytical procedures (see Appreciate that carrying out analytical
guidance below) and other information, identify procedures on relevant account codes enables
and explain the key audit risks for revenue, the identification of audit risks.
direct payroll and gross profit. For each audit Identify key transactions.
risk identified, set out any information and
explanations you require from management. Identify the need for further information.
For the audit matter identified by the audit Apply technical knowledge to show the correct
assistant (Exhibit 2): treatment of the receivables loss allowance and
• Set out and explain the financial reporting the provision.
treatment in Elephant’s financial statements Recommend appropriate accounting
for the year ended 31 December 2018. adjustments in the form of journal entries.
Include relevant journal entries. Make appropriate recommendations for key
• Set out key audit procedures that Smith & audit procedures.
Ives should perform.
Marking guide Marks
Financial reporting treatment of new contract 6

New internal control deficiencies 8
New internal control - audit procedures 3
Using analytical procedures for key audit risks 16
Financial reporting treatments 8
Key audit procedures 4
45
Total 45
Part (1)
New contract entered into from 1 December 2018
Appropriate financial reporting treatment.
The following entry has been recorded in Elephant’s nominal ledger
Account £ Effective date User Created date
23040 – prepayments 300,000 18/12/2018 ABlogg 24/12/2018

control s
SRC006975 54800 other income 300,000 18/12/2018 ABlogg 24/12/2018

s
The description is “Sales accrued reverse in January 2019”.

There are three issues:
(1) Incorrect recording of the sales invoice raised by Andrea
The entire amount of £300,000 has been recorded as a sales invoice in the Data Analytics Software
and recognised as revenue in the year ended 31 December 2018 and this is incorrect (see below).
Also prepayments is not the appropriate account.

This posting is therefore incorrect and should be reversed.
We should question the client about the VAT for this sales invoice. It appears that Andrea has not
recorded any VAT on this amount.
(2) Recognition of revenue and receivables
performance obligation is satisfied.
Contract terms £ Payment terms
£3,000 monthly fee for ongoing support for brand development 72,000 Monthly 35 days
for 24 months period after invoice
One-off fee in exchange for 18% discount on services and goods 228,000 Payable on 1
supplied in the two financial years ending 31 December 2019 and January 2021
2020
Total 300,000
The £3,000 monthly fee should be recognised over time – as the contract commenced on 1
December 2018 – only £3,000 should be recognised in respect of this element of the contract. The
remaining amount should not be recognised as revenue as performance obligations have not been
satisfied.
The issue arises of whether to recognise the second element of the contract relating to the 18%
discount. IFRS 15 paras 105 & 108 (and IFRS 15 BC 323) state a receivable can be recognised if there
is the right to receive consideration that is unconditional (ie, only the passage of time is needed). It
could be argued that the amount of £228,000 would be due under the contract even if no sales were
made under the discount scheme and, in this sense, it is unconditional. Also, if Elephant still makes a
profit on these sales, despite the discount, then it can be argued there is no future cost to be
incurred by Elephant to receive the consideration of £228,000. Taking this view, a receivable would
be recognised as an enforceable contract is in place. It would not be appropriate however to
recognise revenue as no performance obligation (or passage of time) has taken place at 31
December 2018.
Tutorial Note
An alternative acceptable view is that the right to receive the consideration is not unconditional
and no further entries should be made in 2018 in respect of the £228,000, beyond reversing
Andrea’s postings.
(3) Measurement of the receivable

As the receivable is only due to be received in two years’ time, there is an element of financing
included within the figure. Therefore, the receivable should be recorded at the present value using
the discount rate of 8% = £195,473 [ie, £228,000/(1.08)2]
Each year the receivable is ‘grown’ by 8% as the discounting unwinds and the amount is recognised
as finance income. Therefore, in the year ending 31.12.2019, Elephant would recognise:
£195,473 × 8% = £15,638 as finance income which would be debited to the receivable and credited
to the statement of profit or loss.
As the receivable entitles the customer to a discount over time, again it would be incorrect to
recognise the entire £195,473 for this element of the contract in the year ended 31.12.2018.

I would recommend that this amount is taken to deferred income. The correcting journal is:
Correcting journal required:
£ £
DEBIT ‘Other revenue’ – Account code 54800 300,000
CREDIT Prepayment control – Account code 23040 300,000
Being reversal of accrued income incorrectly recognised
DEBIT Accrued income – Account code 22200 3,000
CREDIT Domestic sales – Account code 51010 3,000
Being recognition of one month revenue
DEBIT Receivables 195,473
CREDIT Deferred income 195,473
Being recognition of receivable at 31.12.2018 for the second element of the contract.
In the year ending 31 December 2019, the finance income would be released to the statement of
profit or loss:
£ £
DEBIT Receivable 15,638
CREDIT Finance income 15,638
Also, for 2019 about half of the £195,473 (depending on expected sales value pattern over the two
years) would be released to profit or loss in 2019 to match against the reduced revenue from the
discounts given. So:
£ £
DEBIT Deferred income 97,500
CREDIT Revenue 97,500
Part (2)
New internal control
Use the Detect module with the ‘Large Value’ routine and the Visualise function. Click on December
2018 transactions, using the Effective period visualisation.
This enables a search for transactions over £100,000 posted by the three accounts assistants (Tanya,
Andrea, Emma).
This investigation reveals three transactions equal to, or in excess of, £100,000, posted by accounts
assistants in December 2018.
These are as follows:
Account Account Transact’n ID Descript’n £ Dates Posted by Docum’t

number
(Effective)
(Created)
Invoice 20021 NOM059201 TRN 100,000 30/12/2018 ABLOGGS NOM

finance
account
5/01/2019
Other 54800 SCN006975 Sales accrued 300,000 18/12/2018 ABLOGGS SIN

income reversed Jan
2019
24/12/2018

Account Account Transact’n ID Descript’n £ Dates Posted by Docum’t
number
(Effective)
(Created)
Other 54800 SRC006974 Reversal of un- 170,294 17/12/2018 TPOTTS SIN

income invoiced sales
in Dec 2017,
now invoiced 23/09/2018
Sept 2018
Of the three transactions equal to, or in excess of, £100,000, posted by accounts assistants in
December 2018, two were posted by Andrea Bloggs and one was posted by Tanya Potts.
Frank Wright the FD informed Tian in their meeting, that he had asked Andrea Bloggs to record the
above transaction for £300,000 in Elephant’s nominal ledger. This appears to be senior authorisation
to over-ride the new internal control. However, Frank has not reviewed the posting to ensure it had
been made correctly, which would be appropriate, given the size of the transaction.
Given that the transaction appears to be incorrect, it can be regarded as high risk. This also seems to
justify having the new internal control, despite the apparent failures in its implementation.
Audit procedures:
• Document the three exceptions identified which have breached the new internal control.
• Inquire whether specific authorisation was given to accounts assistant Users to post any of these
transactions (see above) or whether they have been posted on the Users’ own initiative.
• Investigate why the new internal control has not been implemented in each of the three cases
identified. Inquire of management and inquire of individual users. For example, is management
aware that these transactions have been posted in breach of the new internal control? Are there
controls in place to highlight to management that large postings have taken place by accounts
assistant Users?
• Investigate whether the transactions have been reviewed by management after postings have
taken place.
• Assess whether transactions are high risk.
• Review the transactions for accuracy and appropriateness (for example the £300,000 transaction
posted by A Bloggs appears to be incorrect).
Part (3)
For each audit risk identified, set out any information and explanations you require from
management.
The relevant account codes for revenue and related costs are:
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
Carrying out analytical procedures on the relevant account codes enables the identification of audit
risks.

Preliminary analytical procedures
Revenue
From Financial Statement view – taking the whole year, there is an increase in Income of 14% overall
compared with the prior year (2017: £2.707m 2018: £3.076m).
Split of Domestic and overseas – and between revenue streams and calculation of gross profit
Revenue
Using Account view to drill down into the detailed revenue accounts, the revenue by income stream
can be identified for the year ended 31 December 2018. The AI explains that certain users are
exclusively responsible for posting transactions relating to specific income streams 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
By setting the Primary and Secondary variables to Users in the Stacked Bar Chart in the Explore
module, it is possible to determine the amount of revenue posted to each income stream by reading
the figures off the columns for each user.
Gross profit
The gross profit is calculated by deducting the direct payroll costs and where appropriate
reallocating the relevant studio wages to Exhibition sales and Other sales. The same proportions
have been used as 2017 – ie 4 members of 20 studio staff (20%) allocated to Exhibition sales and 3
out of 20 staff (15%) to Other sales. Information and explanations from management will be required
regarding whether these ratios are still appropriate for the year ended 31 December 2018.
Key transactions in December 2018
There are two key transactions which have been posted in December 2018 in Account code 54800
(Other Income) which require further consideration.
These transactions are:
• A reversal of sales invoices posted by Tanya Potts in this account for £170,294 – transaction SRC
006974. I would need to confirm with management, but it would appear that this transaction
should be debited to ‘Other sales’ as it has been posted by Tanya who only posts sales
transactions for Other sales; and
• Sales accrued reversed in January 2019 for £300,000 posted by Andrea Bloggs SRC 006975
The accrued income in this account for £300,000 has not been included in the analysis below
because the financial reporting appears to be incorrect and this amount incorrectly recognised in
DAS – see comments above for part (1).
A spreadsheet has been used to assimilate the information and set out below the calculation of gross
profit per income stream for the year ended 31 December 2018 (rounded to the nearest £1,000)
Exhibition
£’000 £’000 £’000 £’000
51010 – Domestic sales 987 423 602 2,012
Less SRC 0006974 (170) (170)
432
1,842
51020 – Overseas sales 474 148 309 931
Total revenue 1,461 571 741 2,773

Exhibition
£’000 £’000 £’000 £’000
Less:
62100 – Studio salaries 600
62105 – Studio NI 56
Total studio salary cost 656 656
62130 – Fitting salaries 27
62135 – Fitting NI 4
Total fitting salary cost 31 31
62120 – Sales salaries 331
62125 – Sales NI 33
Total sales salary cost 364 364
Allocate studio salary costs from Contract sales to:
Total salary costs 656 31 364 1,051
Exhibition salary costs (131) 131 -
Other sales salary costs (98) - 98 -
427 162 462 1,051
Gross profit for management
accounts 1,034 409 279 1,722
Gross profit % 71% 72% 38% 62%
Compared to 2017 per advance
information 55% 69% 61% 60%
Analysis and information and explanations

Overall, the gross profit percentage has increased from 60% to 62%, however there are variations
between the income streams. Other sales gross profit has fallen from 61% to 38%. It is necessary to
ask management to confirm the following:
• Confirm with management that the users are still posting the same income streams as 2017.
• Confirm that the allocation of studio salaries remains the same as 2017.
• Confirm with management that SCR 006974 £170,294 related to Other sales.
The key transaction identified above for £170,294, related to the release of a debit balance on
account code 22200 accrued income which had a brought forward balance of the same amount. The
release then to sales is correct as the journal description indicates that sales invoices have now been
raised and posted in September 2018 therefore crediting revenue. Without releasing this brought
forward balance, revenue would have been overstated. However, it is necessary to confirm with
management that the entire amount of £170,294 relates to ‘Other sales’. It has been posted by Tanya
Potts who posts only invoices for ‘Other sales’.
Although the brought forward accrued income receivable appears to have been correctly reversed,
apart from the specific contract identified by the audit assistant in relation to Contract sales, there is
no other entry for accrued income for other sales or exhibition sales in the year ended 31.12.2018 -
the balance on account code 22200 (Accrued income) is zero – it is unusual that there would not be
accrued income for Other sales and Exhibition sales for 2018 and this should be confirmed with
Elephant’s management. (There is a small sales accrual included in the accruals for £5,987
SRC006968 – I would need to confirm whether this is in the correct account code and whether it
should be included in 22200 Accrued income.)

Key audit risk
Revenue may be understated due to invoices being recorded in a different period from the
performance obligation being satisfied (cut off risk).
Intra year (month by month) comparisons of Income (Domestic and Overseas) and direct payroll
accounts
Intra year comparisons can be made for Income (Domestic and Overseas) and direct payroll
accounts using Explore module, Account view, to highlight movements between months in the
relevant accounts.
Comparisons between income and payroll are however weak. This is because income is largely
recognised on contract completion, but payroll is recognised as incurred.
Nevertheless, some peaks in income, such as September 2018, can be identified and highlighted to
make inquiries of management. Similarly, January 2018 is a low month for income, which requires
explanation from management.
Key audit risk
Revenue may be over or understated due to invoices being recorded in a different period from the
performance obligation being satisfied (cut off risk).
Comparison of revenue by Account 51010 (Domestic Sales) and Account 51020 (Overseas Sales).
Domestic Overseas
2018 1,842 931
2017 1,840 789
% increase 0% 18%
Domestic sales have not changed significantly compared with 2017 (2017: £1840k; 2018: £1842k
after taking the above £170k into account). However, Overseas sales have increased by 18% (see
DAS also calculated as ((£931k – £789k)/ £789k) × 100%.
Examining the DAS for large transactions in Account code 51020 shows a large sale recorded by
Frank Wright in December 2018:
• SRC 006973 deposit on brand management contract with Spooks £100,000.
This can be identified either by using the Stacked Bar Chart with the primary variable as Effective
period, and secondary variable as Users or by using the Detect module in DAS – (using Large Value).
Key audit risk
There is an audit risk that revenue relating to this contract may be overstated as recognising a
deposit is unlikely to satisfy the performance obligations under IFRS 15 – more information should be
obtained from management.
Sales mix – Comparison by revenue stream and geographical regions
Contract sales Exhibition sales Other sales Total
Domestic sales
2018 54% 23% 23% 100%
2017 27% 22% 51% 100%
Overseas sales
2018 51% 16% 33% 100%
2017 52% 9% 39% 100%
2018 Total 53% 20% 27% 100%
2017 Total 35% 18% 47% 100%

Analysis and other information
Contract sales
53% of revenue for 2018 is derived from contract sales compared with 35% for 2017. During the year
a new manager, Jenny Hines, was recruited. The audit assistant has identified an issue with an
adjustment for accrued income for £300,000 which is recorded in account code 54800 other income
and 23404 prepayments control.
This adjustment has not been included in the above analysis as it appears to be incorrect – see
discussion below. However, the new manager may have negotiated other similar contracts and
therefore there may be other contracts which have been incorrectly recognised. This should be
confirmed by making inquiries of Elephant’s management and performing audit procedures on
specific contracts.
Key audit risks
There is an audit risk that revenue may be incorrectly recognised for Contract sales as other
transactions may be incorrectly recorded.
There is a key risk of lack of internal control over the authorising of the recognition of large
transactions (see section 2 above).
Direct payroll costs % of Contract sales Exhibition Other sales Total

revenue sales
2018 29% 28% 62% 38%
2017 45% 31% 39% 40%
Analysis and information

Overall direct payroll cost as a percentage of revenue has fallen to 38% from 40% for 2017. There are
some variations between the income streams - Contract sales % have fallen to 29% and Other sales
have increased to 62% which suggests that the method of allocating studio salaries based on the
same method as 2017 may not be applicable to 2018. Further information is needed to determine
whether this gives rise to any further audit risks.
Using the Metrics module in DAS (‘Salaries and Employees’ routine), which calculates Financial
Information based on the total payroll costs (‘Salary as a % of income’) – the decrease in direct payroll
is in line with the overall fall for the ratio payroll/ income, which has fallen from 47.5% to 43.3%.
22200 – Accrued income 170,294 0 -170,294 100%
23040 – Pre-Payments Control A/C 51,066 300,000 248,934 487%
Average salary (including NI) compared with 2017
Average salary Average salary

2018 2017 2018 2017
No. No. £’000 £’000
Studio 20 20 33 31
Fitting 2 1 15 19
Sales 12 10 30 39
34 31 31 30
Revenue per employee £81.56k £84.81k
Key audit risk

The average salary for sales staff has decreased – this could be because a more experienced
member of staff has left and been replaced by a more junior member – this would substantiate also
why the average revenue per employee has fallen. More information should be obtained from
management about changes in employees (leavers and joiners) and salary increases during the year.

Specific transactions in the data analytics software where they represent items of significant audit
interest.
The specific transactions SCR 006974 £170,294 and SRC 006975 £300,000 and SRC 006973 deposit
on brand management contract with Spooks £100,000 are discussed. These are key transactions
because they are clearly above materiality and are discussed in detail above.
Other transactions of audit interest which would also be given credit could include:
Transaction ID Description Credit Account codes Effective date User ids
61348 Correct Q1 15,000 51010 – 990 31.3.2018 FWright

sales (suspense)

sales (suspense)

sales (suspense)
The debit entry to these credits to 51010 are taken to the suspense account. For each amount there
are three journals which debit 13025 – office depreciation and credit 990 suspense – These
transactions are of audit interest because they appear to inflate revenue by a debit to office
equipment depreciation. Frank Wright should be challenged about the validity of these transactions
and whether they should be reversed. This would reduce revenue and profit by £75,000 which is in
excess of materiality.
Part (4)
Financial reporting treatment of the receivables loss allowance
The total amount outstanding on this contract comprises of the following three invoices which I have
identified in the DAS:
Amount in Amount in Effective Description Due date

receivables revenue date
SIN 18405 37,200 31,000 28/1/2018 To produce switched back 28/2/2018

video part 1
SIN 19262 39,127 32,606 21/9/2018 To design build and 19/10/2018

deliver exhibition stand
SIN 19347 26,304 21,920 30/9/2018 2000 boxed kits 28/10/2018
The invoices are now overdue and there is clear evidence that there is a need for an impairment
allowance for this receivable as MonaHomes has informed Elephant of its financial difficulties.
Using Elephant’s predetermined matrix this would suggest the following impairment loss allowance
is required:
Expected impairment loss

Days overdue allowance Impairment loss
£ £
SIN 18405 31,000 90+ 25% 7,750
SIN 19262 32,606 61 to 90 20% 6,521
SIN 19347 21,920 61 to 90 20% 4,384
18,655
£ £
DEBIT Bad debt – profit or loss 18,655
CREDIT Bad debt allowance – SOFP 18,655

However, there may be a need for a specific allowance against the entire balance once the extent of
MonaHomes financial difficulties is established.
Financial reporting implications of the court case
IAS 37 states that a provision should be recognised in the accounts if:
• an entity has a present obligation (legal or constructive) as a result of a past event;
• a transfer of economic benefits will probably be required to settle the obligation; and
• a reliable estimate can be made of the amount of the obligation.
Elephant has also been informed that the injured visitors have appointed a legal team and a court
case has commenced against Elephant. The commencement of the court case creates a present
obligation from a past event.
The claim for damages of £100,000 has been estimated by Elephant’s legal team at 31 December
2018, and given that there is an 80% probability that Elephant will be found negligent, this
represents a probable outflow of economic benefits.
The provision that should be established should be the most likely outcome which the legal team
estimates is the highest amount it would reasonably be expected to pay as settlement – £60,000. As
the court case is expected to be settled by January 2021 – the provision should be discounted using
an annual discount rate of 8% = £51,440.
Journal required:
£ £
DEBIT Expenses – profit or loss 51,440
CREDIT Provisions – SOFP 51,440
This is a significant transaction and exceeds materiality and therefore should be adjusted in the
Other provisions may also be required – for example for legal costs.
Also, the potential for Elephant to recover the costs from insurance cover – it would seem unlikely
that Elephant would not have commercial insurance to cover potential claims of this nature.
Receivables allowance
• Agree the invoices to source documentation and confirm that ageing is appropriately calculated.
• Confirm that no cash has been received after the year end relating to year-end balance.
• Review historical data for write-offs and whether any are relevant to MonaHomes.
• Document and understand client’s procedures for identifying any other allowances required
against receivables.
• Obtain confirmation of the outstanding balance from MonaHomes.
• Review minutes of board meetings and other correspondence to obtain understanding of the
recoverability of the balance.
• Inspect any correspondence with MonaHomes directly regarding the legal claims made against it
and the ability of MonaHomes to pay any claim (eg, whether they have insurance cover).
An appendix to this answer can be found on icaew.com/corporatereportingdas which explains the
audit software screens and the navigation methods used to derive the answer points from the data
analytics software. Please note, the appendix is for guidance purposes only and does not form part
of the answer.

82 Practice question 6
Scenario
Requirement Skills
In respect of the three issues identified by Assimilate and demonstrate understanding of a

Tracey Bashir (Advance Information, Exhibit B) large amount of complex information.
from substantive testing of expenses at the Use judgement and professional scepticism to
interim audit visit: Identify and explain the key recognise the key issues: inadequate
audit risks for the audit of Elephant for the year supporting documentation, expenses included
ended 31 December 2018. Use the Data in loan balances and the large item posted by a
Analytics Software to identify further specific trainee.
transactions in relation to these issues which
require investigation. Include any additional Use the Data Analytics Software to identify
information that you require from Elephant’s specific significant transactions.
management. Apply technical knowledge to identify incorrect
capitalisation of expenses.
Use judgement to identify the audit risk of a
weak control environment with inadequate
supervision.
Identify additional information needed from
management.
Identify and explain any weaknesses in the Use technical knowledge and judgement to
substantive audit procedures on expenses determine appropriate approach to substantive
carried out by Tracey Bashir at the interim audit audit procedures and therefore identify
(Advance Information, Exhibit B). Include an weaknesses in Tracey Bashir’s approach.
evaluation of the audit implications of Tracey’s Appreciate the concept of materiality and
comment on materiality (Issue 1) and her evaluate the audit implications of Tracey’s
conclusion. comment about materiality.
In respect of the contract with Rino discussed Identify appropriate accounting treatments for
with Frank Wright (Matter 1): complex transactions, specifically recognise that
Set out and explain the appropriate financial the receivable represents a monetary item and
reporting treatment for the year ending 31 as such, must be retranslated at the closing rate
December 2018 for the overseas receivable on subsequent measurement at the year-end
arising from the deposit on the Rino Ltd and that an exchange loss is recognised in
contract. Provide appropriate journals. profit or loss.
Explain the financial reporting implications Apply technical knowledge to recognise that
arising from the information provided by Frank IAS 37 requires that a provision be established
regarding the expected cost for the contract for an onerous contract.
with Rino Ltd. Set out the audit procedures that Recommend appropriate audit procedures.
you would undertake in relation to this matter.
Set out and explain the appropriate financial Apply technical knowledge to identify that the
reporting treatment for the year ending 31 spot element of forward is the hedging
December 2019 for the illustrative example of a instrument, the hedge conditions must be
currency forward prepared by Frank Wright. satisfied and that this is a firm commitment,
Include journal entries. therefore either fair value hedge or cash flow
hedge.
Recommend appropriate audit procedures.

Marking guide Marks
Key audit risks – issue 1 7

Weaknesses in audit requirements 6
FR treatment of overseas receivable 4
FR implications of cost of contract 4
Audit procedures 3
FR implications of currency forward 8
40
Total 40
Part (1a)
Issue 1: Inadequate supporting documentation
The description for two of the expense items identified includes the phrase ‘private travel’. This
suggests that these may not be valid business expense. This risk is increased by the lack of
supporting documentation.
The other transaction is described as a ‘three-night holiday’. It is difficult to see how expenditure of
this nature would be related to Elephant’s business. Therefore, this is also likely to not be a valid
business expense. The written request for payment from Jerry Holmes, a director, does not provide
any justification for payment. More information should be sought from management to clarify the
nature of this expenditure and management asked for the rationale for its recognition as an expense.
All three of the items identified by Tracey may be examples of a staff member claiming expenses for
personal expenditure and would result in an overstatement of expenses.
If such a claim for personal expenditure as a business expense is determined as having been made
with intention to deceive it is likely to constitute a fraud by the individual concerned, one of
Elephant’s directors, involved to misappropriate company funds.
The three items can be identified in the nominal ledger using the data analytics software. From the
information available in the data analytics software, it can be determined that all three transactions
were posted by Andrea Bloggs. Two of the three transactions refer to ‘JH’ as the individual incurring
the ‘private’ expenditure. JH appears to stand for Jerry Holmes to whom Andrea Bloggs is married.
The fact that a member of the accounts team is posting expenses incurred by their spouse is a risk
factor for fraud unless adequately mitigated by appropriate internal controls such as authorisation.
Frank’s dismissive response to the inadequate documentation in relation to the sample items and
attitude to items claimed by directors is indicative of a key audit risk of management override of
internal controls over expenses and represents another fraud risk factor.
A review, using the Data Analytics Software of transactions posted by Andrea in the four expense
accounts sampled by Tracey reveals a large number of entries with a description including ‘JH’.
Although none of these transactions has a narrative description suggesting that these are not valid
business expenses it does indicate that Andrea frequently posts transactions for her husband.
The Detect module can be used to search for transactions containing the word ‘private’. Performing
this search reveals three further transactions in addition to those identified by Tracey. Two of these
have the description ‘Virgin train – JH/private travel’ and are for very low values. The other is
described as ‘Archduke Restaurant – JH/Private food’ with a transaction value of £160 and posted by
Andrea to account 26530 – Car Loan 7. An explanation for this transaction and why it is posted to this
account should be sought.
Issue 2: Expenses included in loan balances
The debiting of vehicle related expenses such as fuel and servicing to various Car loan accounts
rather than appropriate expense accounts may result in understatement of expenses and
overstatement of profit. Debiting these amounts to Car loan accounts would only be appropriate if
the amounts are ultimately repayable to Elephant by the employee that incurred them. If this not the

case, then there is a key audit risk that assets are overstated and possibly that expenses are
understated.
Frank stated that the board expects that the results for 2018 will exceed those for the year ended 31
December 2017 and this may represent an incentive to overstate profit.
Reviewing the three Car loan accounts highlighted by Tracey in the Data Analytics Software shows a
large number of transactions of this nature can be identified. For example:
Transaction Id Description Amount Account Effective date Posted by
NOM059315 Shell 53 26524 10/12/2018 FWRIGHT

Chesterfield –
GMJan/Fuel
NOM059316 Shell Preston – 34 26524 11/12/2018 FWRIGHT

GMJan/Fuel
NOM053982 North Road – 68 26524 26/12/2018 TPOTTS

GMJan/Fuel
Note: In the examination it is not possible to cut and paste extracts from the Data Analytics Software.
So, if providing example transactions enough information should be included in your answer to
identify these transactions. Simply giving the amount or a transaction number is not sufficient.
These transactions have narrative descriptions that suggest that the amounts recorded relate to items
that should be either be expensed to profit or loss or are personal expenditure by the individual
employees.
Although the individual amounts are typically low value there are a large number of them and may
be collectively an amount in excess of materiality given the size of the Car loan balances.
Issue 3: Large item posted by trainee
A limit of £30,000 has been put in place for transactions that Emma Davids, the accounts trainee is
permitted to post. Tracey has identified that this internal control has been broken.
Using the Detect module (Large Value) it is possible to identify the transactions posted by Emma that
exceeded £30,000. It can be seen that Emma posted 11 transactions in excess of the £30,000 limit
during 2018. The total of these transactions was £451,310.
All but one of these transactions is described as a transfer, with the transaction posted in November
being a tax refund from HMRC.
The reasons why these transactions have been posted by Emma should be sought.
The fact that transactions have been posted by Emma in excess of the limit indicates a weak internal
control environment with inadequate supervision and ineffective operations of controls. This is a key
audit risk because a weak internal control environment increases the risk of misstatement in the
financial statements. The identification of a weak control environment may require that decisions
related to risk assessment and the determination of materiality are revisited.
Part (1b)
Tracey’s conclusion to her work indicates that she was uncertain and struggled with the audit
procedures she had been assigned. The audit senior was apparently unavailable to supervise the
work she carried out. Given the recent commencement of her apprenticeship with PCG, it is very
unlikely that Tracey had sufficient experience or technical competence to carry out the procedures
without supervision.
This lack of supervision has led Tracey to seek assistance from John Smith, a member of the client’s
accounts staff.
Whilst making enquiries and seeking information from client staff is a normal and acceptable
practice, it appears that in this case the assistance provided may have led to the involvement of a
member of the client’s staff in conducting audit procedures.
The involvement of John Smith in the work assigned to Tracey is problematic. The auditor is
responsible for designing and carrying out audit procedures and Tracey’s note suggests John’s
assistance has led to his involvement in carrying out audit procedures. This is most evident from his
involvement in the selection of samples.

This is a serious weakness in the procedures carried out by Tracey. Client involvement in sample
selection creates a risk that sample items are cherry picked or problematic items avoided. Samples
should be selected by the auditor, with no possibility of interference from the client.
It is also unclear as to the basis on which Tracey selected specific accounts to sample and omitted
others. This may have been at random, or at least not on a systematic basis and is thus a serious
weakness in the procedures carried out and may undermine the conclusion drawn by Tracey that
expenses are not misstated. There is also a risk that her choice of account selection was influenced
by John Smith.
ISQM (UK) 1 Quality Management for Firms that Perform Audits or Reviews of Financial Statements, or
other Assurance and Related Services Engagements lists human resources as an element of a firm’s
system of quality management. The fact that Tracey appears to have been left to perform a task
without supervision for which she lacks sufficient experience and knowledge suggests a human
resources failure.
Ultimately, it is the engagement partner’s responsibility to ensure that appropriate staff are allocated
to each engagement team. However, allocation of tasks to audit staff is typically delegated to the
audit senior or other individual responsible for the day-to-day management of the onsite audit visit.
Characteristics that should have been considered in assigning Tracey to this task should have
encompassed:
• an understanding of practical experience with similar engagements
• appropriate technical knowledge
• knowledge of the relevant industry
• ability to apply professional judgement
Since Tracey has only very recently started work and has received very limited training, this implies
that she is unlikely to have satisfied these criteria.
Given her very limited experience Tracey should have been more closely supervised and given more
specific instructions for any work she was asked to do. The fact that the audit senior was occupied on
another client has resulted in a failure to adequately supervise her.
ISA (UK) 220 (Revised) Quality Management for an Audit of Financial Statements identifies that
supervision includes the need to consider the competence and capabilities of individual members of
the audit team and ensure that individuals understand instructions given. It could be argued that this
requirement has not been satisfied in respect of Tracey.
If the work carried out is not adequately reviewed by a more experienced member of the audit team
there may be an adverse impact on audit quality.
Regarding the comment on materiality, the items identified by Tracey are not material and would
likely be beneath the threshold to be considered trivial. As such, based on their value the auditor
would not need to include these within the total of aggregate misstatements to determine its
materiality.
However, these amounts may suggest fraud has occurred and despite the low value of the amounts
concerned under ISA 240 the auditor has a duty to respond appropriately to fraud or suspected
fraud identified during the audit. Furthermore, ISA 240 states that if the auditor has identified that a
fraud may exist, this must be communicated as soon as practicable to those charged with
governance. This is particularly difficult in this circumstance because many of the transactions relate
to transactions with directors.
Also, as directors, they are key management personnel and in accordance with IAS 24 these are
Related Party Transactions which are material by nature, even where they are small.
Despite the small size of the items identified, consideration should still be given as to whether these
are indicative of significant deficiencies in the design or implementation of controls. If this is
determined to be the case it may be necessary to revisit decisions made by the auditor in relation to
materiality and risk assessment. In addition, the auditor should make relevant parties such as
Elephant’s management aware of these deficiencies.

Part (2a)
The amount of £100,000 recorded in relation to the deposit on the Rino contract represents the right
to receive CNY900,000 expressed in Elephant’s functional currency, British pounds. Initial recognition
has taken place at the spot rate of 9 yuan to the pound prevailing on 1 December.
This transaction with Id number SRC006973, posted by Frank, can be identified within the Data
Analytics Software indicating the following entries occurred on 1 December 2018:
DEBIT £100,000 51020 Overseas sales
CREDIT £100,000 21020 Overseas receivable
This receivable represents a monetary item and as such, must be retranslated at the closing rate on
subsequent measurement at the year-end in accordance with IAS 21. The prevailing spot rate for the
yuan against the pound at the year-end is 10.2 giving a retranslated value for the receivable of
£88,235.
The change in the carrying amount of the receivable of £11,765 represents a foreign exchange loss
and is recorded in SOPL.
DEBIT SOPL Foreign exchange loss
CREDIT SOFP Overseas receivable
There may also be an issue related to whether the amount of the deposit should all be recognised in
revenue for the year ending 31 December 2018. To determine this further information would be
required from management regarding the performance obligations of the contract and the extent to
which services had been provided to Rino prior to the year end.
Part (2b)
Account 21020 Overseas Receivable indicates a single transaction related to the recognition of the
receivable related to the Rino deposit. This indicates that this amount is outstanding at the year end.
Therefore, using the prevailing exchange rate at 31 December 2018 the total expected sterling value
of the total transaction price of the Rino contract is £2.7million/10.2 = £264,706.
This amount can be compared to the total expected costs for the contract. This is stated by Frank in
the meeting with Emily to be £270,000. This indicates that at the 31 December 2018 the Rino
contract is expected to generate a loss of £5,294.
IAS 37 defines an onerous contract as a contract where the unavoidable costs of meeting the
contract obligations exceed the expected economic benefits to be received.
On this basis the contract with Rino would be onerous.
IAS 37 requires that a provision be established for an onerous contract. The provision should be
equal to the amount by which unavoidable costs are expected to exceed economic benefits. The
amount of excess unavoidable costs is included in profit or loss for the year.
Therefore, Elephant should recognise a provision for the Rino contract of £5,294. This amount is not
material but is clearly non-trivial.
Audit procedures in relation to this matter include:
• Obtain a copy of the contract with Rino and confirm total transaction price
• Confirm exchange rate at 31 December 2018 to reliable external information source (eg, FT or
Bloomberg)
• Request a listing of costs incurred on the contract to date
• Request a calculation of how the figure of £270,000 for total costs has been arrived at
• Examine supporting documentation for sample of costs incurred recorded to confirm related to
Rino contract
• Obtain original cost budget for the Rino contract and identify cost variances against costs to date
to identify possible cost overruns
• Review forecasts for future costs to identify whether all expected categories of cost are included
• Enquire of management as to whether Rino contract is progressing in line with schedule

• Identify any key milestones to date and enquire as to whether they were achieved on time
• Determine whether projected total costs include an allocation of overheads attributable to
fulfilling the contract
• Review correspondence with Rino for indication of disputes or other matters that could lead to
further cost escalation
Part (3)
Elephant intends to designate the spot element of the forward contract as the hedging instrument.
The sterling value of the yuan cash flow related to the payment of the remainder of the transaction
price of the Rino contract will be the hedged item. These represent an eligible hedging instrument
and eligible hedged item under IFRS 9.
In order to adopt hedge accounting, further conditions must be satisfied in addition to the hedging
relationship consisting of eligible hedging instrument and hedged item.
Elephant must demonstrate that the hedging relationship between the currency forward and the
expected yuan receipt from Rino meets hedge effectiveness requirements of IFRS 9. These require
that an economic relationship exists between the hedged item and the hedging instrument.
Therefore, the currency forward must be expected to generate offsetting changes in value to those
related to the yuan receipt from Rino.
Also, credit risk must not dominate the value changes in either hedging instrument or hedged item.
This is likely to be satisfied by the proposed hedge in this case.
The final requirement for hedge effectiveness is that the hedge put in place must reflect the hedge
ratio of the hedging relationship. Since changes in value of both hedged item and hedging
instrument reflect the effect of the exchange rate for yuan against the pound on same yuan amount
this condition is satisfied.
Elephant must also formally designate and document the hedging relationship at the inception of
the hedge and the entity’s risk management objective and strategy for undertaking the hedge. The
documentation must identify both hedged item and hedging instrument, the nature of the hedged
risk and state how the hedge effectiveness will be assessed against the requirements.
Elephant’s expected receipt of 1,800,000 yuan on 1 September 2019 following Rino’s acceptance of
the contract is a firm commitment. This could be treated as a cash flow or a fair value hedge.
Elephant has elected to treat it as a cash flow hedge. The currency forward protects the sterling value
of the yuan receipt.
No entries are required on entering the currency forward on 1 March 2019 as a currency forward will
be conducted at the market forward exchange rate. A forward or futures contract at market price
always has a fair value of zero on inception.
On 1 September 2019, the loss from settling the currency forward will be £17,576 (1.8m/10.35 –
1.8m/9.4). Of this amount a loss of £4,304 relates to the forward points (financing cost) and the
remainder of £13,272 (17,576 – 4,304) is attributable to the change in the spot exchange rate.
As this is a cash flow hedge the change in the hedging instrument (the element of the forward
related to the spot value) is debited to OCI. The financing cost related to the forward points is
debited to profit or loss.
Journals:
DEBIT OCI – cash flow hedge reserve 13,272

DEBIT SOPL financing cost 4,304
CREDIT Cash 17,576*
*cost to settle forward

The hedged item is received in the same year and when this occurs the amount in OCI is transferred
to SOPL.
CREDIT OCI – cash flow hedge reserve 13,272

DEBIT SOPL 13,272
If we assume that Rino pays 1.8 million yuan on the 1 September, the sterling value net of the hedge
would be 1,800,000/9.4 – 13,272 = £178,217. This is an effective exchange rate of
1,800,000/178,217 = 10.1 – the same as the spot rate at the inception of the hedge – indicating 100%
hedge effectiveness.
An appendix to this answer can be found on icaew.com/corporatereportingdas which explains the
audit software screens and the navigation methods used to derive the answer points from the data
analytics software. Please note, the appendix is for guidance purposes only and does not form part
of the answer.

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The Institute of Chartered Accountants in England and Wales

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Audit and integrated 2

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iv Corporate Reporting ICAEW 2023

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