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Corporate Reporting
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For exams in 2023
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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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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.
Financial reporting 1
1 Kime 30 63 1 305
2 Billinge 30 63 4 312
3 Longwood 30 63 5 315
Financial reporting 2
11 Kenyon 30 63 27 357
12 Dormro 40 84 31 361
14 Biltmore 40 84 39 374
15 Hillhire 40 84 42 379
16 Maykem 40 84 46 385
17 Tydaway 40 84 50 391
19 Lyght 40 84 57 406
22 Jupiter 30 63 64 425
25 Tawkcom 30 63 74 447
29 KK 30 63 88 468
47 EF 40 84 157 609
50 EC 40 84 169 629
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.
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.
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.
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.
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
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
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
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.
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
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.
Carrying
amount
£m
Property, plant and equipment 18.92
Development asset 0.00
Investments in equity instruments 4.37
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.
(1.09)
Deferred tax liability (1.86)
Deferred tax asset 0.77
(1.09)
Note: On initial recognition of the investments in equity instruments, an irrevocable election had
been made to record gains and losses in other comprehensive income.
The finance director has asked you to produce the following information:
(1) Calculate the adjustment required to the deferred tax figures in the financial statements of
Portobello Alloys solely in respect of the change in enacted tax rates and draft the required
journal.
(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.
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:
Requirement
Respond to Susan Ballion’s email.
Total: 30 marks
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.
Requirement
Prepare the memorandum required by Jane Lewis.
Total: 30 marks
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.
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.
Requirement
Reply to Alex Murphy’s email.
Total: 30 marks
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:
(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.
Exhibit 2: Robicorp – Calculation of basic earnings per share for year ended 30 September 20X4
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.
Requirement
Respond to Antonio’s email.
Total: 30 marks
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
Profits arise evenly throughout the year for all three companies.
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
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
£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
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.
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
Revenue 5,400
Operating costs (3,600)
Operating profit 1,800
Other finance income 240
Finance costs (720)
Profit before tax 1,320
Tax (300)
Profit for the year 1,020
On 1 September 20X2 Aytace bought the remaining 60% of Xema’s ordinary share capital for £12.4
million, at which date its original 40% shareholding was valued at £3.8 million. There were no
material differences between carrying amounts and fair values of the identifiable net assets of Xema
at 1 September 20X2.
I recognised the investment in Xema using the equity method and credited £867,000 to profit or loss
(profit for the year of £1.02m × 3/12 × 40% plus £1.02m × 9/12 × 100%).
(5) Executive and employee incentive schemes
Aytace introduced two incentive schemes on 1 June 20X2. No entries have been made in relation to
either of these schemes in the financial statements for the year ended 31 May 20X3.
The first incentive scheme is for executives. Aytace granted 100,000 share options to each of five
directors. Each option gives the right to buy one ordinary share in Aytace for £6.40 at the vesting
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:
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.
£’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
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
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
Current liabilities
Trade and other payables 95 66
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)
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.
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$4.8 = £1.
H$’000
ASSETS
Non-current assets
Property, plant and equipment 1,940
Current assets
Inventories 2,100
Trade receivables 600
Cash and cash equivalents 40
Total assets 4,680
EQUITY AND LIABILITIES
Equity
Share capital 200
Retained earnings at 1 May 20X1 1,200
Profit for the year 500
Non-current liabilities
Long-term borrowings 1,400
Current liabilities
Trade and other payables 1,380
Total equity and liabilities 4,680
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.
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
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.
Requirement
Prepare a memorandum giving the information required by Annette Douglas.
Total: 40 marks
Put option
Cole plc
£’000 £’000
DEBIT Cash 242
CREDIT Investment 230
CREDIT Profit or loss 12
Routers plc
£’000 £’000
DEBIT Investment 93.28
CREDIT Cash 93.28
SONIA
31 December 20X6 7.0%
30 June 20X7 7.5%
31 December 20X7 7.5%
£’000 £’000
DEBIT Debt investment 1.2
DEBIT Cash 7.0
CREDIT Finance income 8.2
£’000 £’000
DEBIT Cash 83
CREDIT Debt investment 83
£’000 £’000
DEBIT Profit or loss – Interest expense 150
CREDIT Interest accrual 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.
Requirement
Prepare the report required by the audit partner.
Total: 40 marks
Summarised statements of comprehensive income for the year ended 31 December 20X8
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:
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.
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.
Biltmore plc’s head office is a 12-floor office block. The company occupies the bottom
four floors and has left the top eight floors vacant. The directors claim that they intend
to hold these vacant floors for their ‘investment potential’ and are not actively seeking
a tenant or buyer. An architect’s report on the building states that it would be difficult
to remodel the building so as to let or sell the upper floors to a third party.
The upper floors are recognised in the financial statements at £100 million.
The fair value attributed to the upper floors on 1 January 20X8 was £80 million. 100
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.
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 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 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
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 AND LIABILITIES
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
Non-current liabilities
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
Total equity and liabilities 665,450 572,270
1 April 20X7 7%
Exhibit 3: Email from Alison Ritchie, partner responsible for Technology Risk Services in Barber and
Kennedy
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.
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.
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.
£’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
£’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
Exhibit 1: Extracts from Tydaway Ltd management accounts for the 10 months to 31 May 20X1
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
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.
£’000
Raw materials 230
Work in progress 120
Finished goods 159
509
Provision (58)
451
At 31 July 20X1
Spot £1 = $1.5108
At 15 December 20X1
Spot £1 = $1.4108
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.
Requirement
Respond to the manager’s instructions.
Total: 40 marks
£m
Cash paid on 1 January 20X9 675
8% debentures 360
Costs 18
1,053
£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.
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
Draft
RRm
Property, plant and equipment 389
Investment property 1,453
Financial assets 659
Current assets 124
Total assets 2,625
Share capital 300
Retained earnings 1,720
2,020
Non-current liabilities 518
Current liabilities 87
Total liabilities and equity 2,625
• Retained earnings at acquisition were RR1,440 million and the fair value of net assets at
acquisition was RR1,865 million.
• The long-term liabilities of Strobosch include RR444 million in respect of a five-year interest free
loan of £200 million made by Wadi on 1 January 20X9.
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.
The share options have been recorded in the financial statements as an expense in profit or loss and
a credit to non-current liabilities of £700,000 (100 × 500 × 14).
Audit procedures completed
Agreed number of employees in the scheme to details set out in the contract.
The fair value of the share options has been confirmed with management.
The adjustment required has been recalculated and agreed to the client’s calculation.
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
Exhibit 2: Draft management accounts: Statement of profit or loss and other comprehensive
income
All products sold from showrooms make a gross margin of 30% on selling price.
£’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.
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
£’000
Cost
01.01.X8 10,000
Additions 2,000
At 31.12.X8 12,000
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
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.
Requirement
Respond to the email from your audit manager.
Total: 30 marks
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.
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
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.
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).
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
Cost/valuation
Brought forward at 1
October 20X8 32,000 4,160 162,831 19,255 0 218,246
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
Carried forward at 30
September 20X9 381 1,082 41,572 18,499 0 61,534
Carried forward at 30
September 20X9 25,069 6,385 155,650 2,654 3,936 193,694
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:
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
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
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.
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
Summary of staff cost related balances in the statement of financial position at 30 June 20X9
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.
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
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
(financial 500
450 ×
20
18
controller) 400 × × 16
350 14
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
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
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.
£’000 £’000
Revenue (6,720 + (6,240 × 5/12) + 5,280) 14,600
Cost of sales (3,600 + (3,360 × 5/12) + 2,880) (7,880)
Gross profit 6,720
Administrative expenses (760 + (740 × 5/12) + 650 + 119 (W2)) (1,837)
Distribution costs (800 + (700 × 5/12) + 550) (1,642)
Finance costs (360 + (240 × 5/12) + 216) (676)
Profit before tax 2,565
Income tax expense (400 + (360 × 5/12) + 300) (850)
Profit for the year 1,715
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
(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
£’000 £’000
Consideration transferred 980
NCI at proportionate share of fair value (25% × 1,120) 280
Less net assets acquired:
Share capital 100
Reserves 1,020
(1,120)
140
£’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
£’000
NCI at acquisition (W3) 280
NCI share of post acquisition reserves to disposal
(25% × [(1,300 + 709 × 9/12) – 1,020]) 203
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.
£’000
Revenue 56,900
Operating costs (49,893)
Exceptional item (Issue 1) 5,040
Operating profit 12,047
£’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
Non-current liabilities
Loans 20,000
Long-term provision (Issue 4) 8,520
Deferred tax liability 1,000
Total non-current liabilities 29,520
Current liabilities
Trade and other payables (Issue 3) 12,350
Short-term provision (Issue 4) 740
Total current liabilities 13,090
––––––
Total equity and liabilities 60,110
Factory
£’000
Disposal proceeds 8,000
Less carrying amount at 31 March 20X4 (2,960)
Profit recognised as an ‘exceptional item’ 5,040
Requirement
Respond to the audit partner’s email.
Total: 40 marks
£’000
Current service cost for six months (estimated by actuary) 604
Fair value of plan assets at 1 March 20X4 8,062
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:
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.
Requirement
Prepare the report requested by your audit manager.
Total: 34 marks
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
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:
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 –
£’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)
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.
£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.
£’000
Property, plant and equipment 150
Net current assets 50
Net assets 200
Given the nature of these assets and liabilities, their fair values are equal to their carrying amounts.
Disposal of 75% interest in Tabtop
Tabtop has been making losses for a number of years and is also incurring net cash outflows to an
extent that the Congloma group no longer wishes to fund. Its projected loss for the year ending 31
August 20X4 is £3 million. We have received an offer of £6 million for 75% of the Tabtop ordinary
shares which we believe we should accept. In addition, Congloma will retain a holding of 25%
Tabtop’s ordinary share capital, which experts tell us would have a fair value of £1 million. Congloma
would continue to exercise some influence on the business through a seat on the board.
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.
Requirement
Respond to the instructions of the finance director.
Total: 30 marks
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
Property, plant and equipment 113,660 120,400
Development costs 10,380 10,380
Inventories 32,300 23,200
Trade and other receivables 36,100 30,400
(Overdraft) / Cash (8,400) 5,600
184,040 189,980
EQUITY AND LIABILITIES
Share capital 37,000 37,000
Retained earnings 85,220 68,520
Long-term borrowings 22,000 39,000
Trade and other payables 31,600 39,400
Current tax payable 4,420 6,060
Provision for redundancy costs 3,800 –––––––
184,040 189,980
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)
Profit for the year 16,700 24,240
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.
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)
Continuing activities:
(ie, the other three divisions)
Carrying amount at 30 June 20X5 32,200 34,700 28,500 95,400
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.
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
Statement of profit or loss
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
Statement of financial position
Non-current assets
PPE 38.0 10.8 16.0 64.8
Goodwill – HXP – – – 2.6 1 5.6
Goodwill – Softex – – – 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
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
£m
Consideration in cash 22.0
Less: share capital and retained earnings at date of acquisition (19.0)
Goodwill on consolidation 3.0
HXP Softex
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.
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
Additional
information Debit Credit
£’000 £’000
Operating costs 1 11,353 –
Inventories and work-in-progress at 1
September 20X4 1 4,355 –
Sales 2 – 15,680
Selling costs 1,162 –
Administrative expenses 2,340 –
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.
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:
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
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 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.
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
-£
1-
1-
1-
£0
00
00
00
00
£100,000 in any one month (requiring
£1
£2
£3
£4
approval from senior manager)
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
Property, plant and equipment 56,309
Current assets
Inventories 144,380
Trade and other receivables 22,420
Cash and cash equivalents 71,139
Total assets 333,548
Exhibit 2: File note – Transactions noted from review of the minutes of the directors’ quarterly board
meetings – prepared by Greg Troy
I have summarised the key points from the minutes of the board meetings which relate to complex
financial transactions during the year. I have also set out in a separate file note (Exhibit 3) Earthstor’s
draft financial reporting treatment for the year ended 30 June 20X6, for each transaction. I am not
sure that the draft financial reporting treatment is always correct.
Meeting on 10 September 20X5
TraynerCo is an unquoted Malaysian company which supplies Earthstor with footwear, a core product
for Earthstor. An interruption in supply from TraynerCo would affect Earthstor’s ability to trade
successfully in the footwear market.
TraynerCo suffered a serious cash flow problem in June 20X5 and Earthstor’s CEO, Dominic Roberts,
reports that, on 1 July 20X5, he instructed the finance director to provide emergency finance to
TraynerCo. This is an interest-free loan of MYR20 million, repayable at par on 30 June 20X7. (MYR is
the currency of Malaysia.) Loans of equivalent risk in the marketplace have an annual effective
interest rate of 6%. In order to secure footwear supplies, the directors retrospectively approve the
loan.
Dominic proposes a long-term investment in TraynerCo. Henry Min, an entrepreneur, owns 100% of
the share capital in TraynerCo. Dominic states that Henry Min has agreed to sell 10% of his
shareholding in TraynerCo to Earthstor for MYR45 million. The date of the transaction will be 1
October 20X5.
Although the board approves the purchase of the 10% shareholding in TraynerCo, there is a
dissenting vote from the finance director, who believes that the price to be paid for the shares is
above the market price. The finance director states that he will provide further evidence of the
market price valuation.
Meeting on 10 January 20X6
The board records the resignation of the finance director on 1 January 20X6. In his resignation letter
to the board, the finance director states that he can no longer work with Dominic, who is dominating
the board and allowing a close friendship with Henry Min to compromise his judgement.
The HR director presents a short report on the process for recruiting a new finance director. Dominic
joins the meeting via teleconference from Singapore. Dominic tells the board that, in the interim
period, the finance department will have to cope until a replacement finance director is appointed.
Dominic is negotiating the purchase of an office building in Singapore for Earthstor, which will be
rented out entirely to third parties. He asks the board to approve this transaction in advance.
Although details of the purchase are not available, Dominic considers that it is a good investment
opportunity for Earthstor.
After the Singapore office building has been purchased by Earthstor, TraynerCo will relocate its
administration function on 1 August 20X6 to Singapore for tax reasons and has agreed to occupy
one floor of this Singapore office building. Dominic states that no rent will be charged to TraynerCo
as he recently agreed a very low price for Earthstor’s purchases of footwear from TraynerCo.
Exhibit 3: Draft financial reporting treatment for the year ended 30 June 20X6
Set out below are Earthstor’s draft financial reporting treatment and some additional information for
the financial transactions during the year noted from my review of the minutes of the directors’
quarterly board meetings (Exhibit 2).
MYR20 million interest-free loan to TraynerCo
This loan is recognised in trade and other receivables, translated at the exchange rate on 1 July 20X5
of £1 = MYR5. No other entries have been made in respect of this loan. The average exchange rate
for the year ended 30 June 20X6 was £1 = MYR5.5 and the exchange rate at 30 June 20X6 was £1 =
MYR6.
Investment in 10% of TraynerCo’s shares
The investment in TraynerCo is recognised as a financial asset at its cost on 1 October 20X5 of £9.5
million (MYR45 million at £1 = MYR5, plus legal fees of £0.5 million). It is translated at the year-end
exchange rate at 30 June 20X6 of £1 = MYR6. A loss of £1.5 million is presented through other
comprehensive income in a translation reserve in the statement of financial position. On initial
recognition, an irrevocable election was made to recognise valuation gains and losses in other
comprehensive income.
In July 20X6, Henry Min sold a further 10% holding of his shares in TraynerCo to a Malaysian entity for
MYR36 million. This valuation reflects a fall in the value of TraynerCo’s shares since 1 October 20X5
caused by poor trading results since 1 October 20X5. This fall is due to market conditions.
Purchase of Singapore office building
The Singapore office building is held at cost in property, plant and equipment. It is translated at the
date of acquisition. No depreciation has been charged and the accounting policy for investment
properties states that they should be recognised at fair value. The exchange rate at 30 June 20X6 was
£1 = SG$2.7.
New Earthstor website
The following website development costs have been included in non-current assets:
£’000
Planning costs 3,000
Professional fees for photography and other graphic design 1,300
Fee paid to Tanay (Note) 5,000
Internal software development costs 22,000
31,300
Note: £5 million was paid to Tanay, an internationally-famous singer, who is the ‘name behind the
Earthstor brand’.
The above costs have not been amortised in the financial statements.
£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)
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
20X6
£m
Revenue 383.0
Cost of sales (264.2)
Gross profit 118.8
Administrative expenses (102.0)
Profit from operations 16.8
Finance costs (5.5)
Profit before tax 11.3
Income tax (2.3)
Profit for the year 9.0
Other comprehensive income for the year ––––––
Total comprehensive income for the year 9.0
Other information
Depreciation of £28.1 million and lease rentals of £35.5 million are included in cost of sales. The
leases are for less than 12 months, and HiDef has taken advantage of the IFRS 16 recognition
exemptions for short-term leases.
HiDef’s consolidated revenue and costs are expected to remain constant for the foreseeable future.
Revenue for the year ended 30 November 20X5 was £400 million.
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.
Exhibit 1: PPE note from TT management accounts for the 9 months ended 31 May 20X6 –
prepared by TT financial controller
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 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.
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.
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
20X6 20X5
£m £m
ASSETS
Non-current assets
Property, plant and equipment 18.6 15.8
Intangible asset: R&D 14.0 15.4
32.6 31.2
Current assets
Inventories 12.0 7.8
Trade receivables 4.6 5.8
Cash and cash equivalents ––––– 3.6
16.6 17.2
Total assets 49.2 48.4
EQUITY AND LIABILITIES
Ordinary share capital 4.0 4.0
Retained earnings 17.0 16.4
21.0 20.4
Zego Ltd: Statement of cash flows for the year ended 31 October 20X6
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.
Draft statements of comprehensive income for the year ended 30 September 20X6
Non-current liabilities
Deferred tax 19.6 –
Long-term loan owed to Trinkup 5 ––––– 160.0
259.3 345.5
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
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.
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 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.
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.
£’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.
£’000
Property, plant and equipment 7,550
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.
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.
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:
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)
Gross profit 372.5 110.4
Operating expenses (270.8) (91.2)
Finance income 2 3.6 –
Finance costs (9.4) (77.7)
Profit/(loss) before tax 95.9 (58.5)
Income tax (19.1) 12.0
Profit/(loss) for the year 76.8 (46.5)
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
Inventories 243.8 43.2
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
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:
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
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.
Staff costs (4,924) Agreed the total staff costs to payroll schedules
provided by the service company which processes the
payroll for R1-Arca.
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.
Other receivables and 592 No audit procedures carried out as below component
prepayments materiality of A$600,000.
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.
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$6 million
taken out on the same date. The loan is repayable in full after five years and interest is payable
annually in arrears at a fixed rate of 6% per annum. In Elysia, a tax deduction for interest is available
only when the interest is paid.
After buying the property, R1-Elysia converted it into a training facility. The conversion took six
months and was completed on 1 April 20X7 when the property was ready for use.
From 1 April 20X7, R1-Elysia has used the property to run training courses for its clients. Also, training
rooms are rented to third parties on a daily or weekly basis. The rental income includes the use of all
facilities, together with some administrative support. Catering is provided as an optional service. As
the property generates rental and other income, it has been classified as an investment property in
the consolidation reporting pack submitted by R1-Elysia. The property is expected to have a useful
life of 25 years.
Property Loan
E$’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 –––––
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
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.
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.
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.
Requirement
Respond to Gerard Benson’s instructions.
Total: 30 marks
Exhibit 1: Wayte draft information schedule requested by the bank – prepared by Jenny
20X7 20X6
£’000 £’000
Revenue 35,400 34,500
Gross profit 10,020 9,660
Cash generated from operations 6,320 3,990
20X7 20X6
£’000 £’000
Total assets 35,670 33,560
Total liabilities 8,490 8,730
Equity 27,180 24,830
Net debt 450
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%
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
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.
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 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:
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.
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:
Number of GRNs over 2 months old not invoiced at 30 September 20X7 156
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
Number of GRNs over 2 months old not invoiced at 30 September 20X7 122
0
70
40
10
80
50
-£
1,
2,
2,
3,
-£
-£
-£
-£
£0
01
01
01
01
£7
,4
,1
,8
£1
£2
£2
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
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:
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
Profit before tax 1,896
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
Additional information
(1) Income tax expense
The income tax expense includes adjustments for current tax and deferred tax at 20%. Income tax is
calculated for each group company based on 20% of the accounting profit, except for the following
tax rules relating to non-current assets:
• No tax implications arise from a profit or loss on disposal of shares.
£’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
Extracts from statement of comprehensive income for the year ended 30 April 20X8
£’000
Profit before tax 2,300
Other comprehensive income −
Additional information
(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
Equity
Share capital (£1 ordinary shares) 200
Retained earnings 25,920
Revaluation reserve 3 and 4 6,200
Cash flow hedge reserve 1 706
Other reserves 600
33,626
Non-current liabilities
Loans 18,650
Pension – net defined benefit liability 5 136
Suspense account − two 4 10,000
28,786
£ £
DEBIT Suspense account − one (R$50,000,000/5.7) 8,771,930
CREDIT Cash 8,771,930
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)
£ £
DEBIT Cost of sales 12,000
CREDIT Trade payables 12,000
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:
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
30 June 20X8 30 June 20X7
£’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
700
600
500
400
300
200
100
0
Sep Oct Nov Dec Jan Feb Mar Apr May Jun Month
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.
Extracts from financial statements for the year ended 30 September 20X7
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.
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
Additional information
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
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
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
Respond to the audit manager’s instructions.
Total: 28 marks
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.
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.
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
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
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:
JKL: consolidated
(excluding MiTek) MiTek
£m £m
Revenue 200.1 60.9
Cost of sales (128.7) (31.7)
Gross profit 71.4 29.2
Operating expenses (53.0) (20.8)
Finance costs (1.4) (1.2)
Profit before tax 17.0 7.2
Attributable to:
Equity holders of the parent 14.1
Non-controlling interests ––––––
14.1
Exhibit 2: Report from MiTek’s pension scheme actuary, received on 10 July 20X7
On 1 February 20X7, the trustees of the MiTek defined benefit pension scheme made an offer to its
pensioners to exchange future pension increases for a higher current pension which would then
remain constant.
On 1 June 20X7, this offer was accepted by most pensioners and this resulted in a past service gain
of £3.5 million.
The present value of the scheme liabilities at 30 September 20X7 is estimated to be £42.1 million,
which includes the impact of the offer and its acceptance. The fair value of the scheme assets at the
same date is estimated to be £39.5 million.
Relevant projections for the year ending 30 September 20X7 are set out below:
£’000
Current service cost 200
Benefits paid to pensioners 1,200
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.
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 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
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).
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.
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:
Additional information
On 1 January 20X3, YN bought 500,000 of the 10 million issued £1 ordinary shares in BBO for
£500,000. The BBO chief executive owned the remaining shares. YN classifies its investment in BBO
shares as a financial asset at fair value through other comprehensive income (FVOCI).
At 31 December 20X5, the 500,000 shares in BBO had a carrying amount of £800,000 and a
cumulative increase in fair value of £300,000 had been recognised in other comprehensive income
and in equity.
£’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:
The target for 20X7 is 25% and the target for 20X8 is 30%.
% %
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.”
Exhibit 1: Financial information and key ratios for the year ended 30 September 20X3 with
background notes
Financial information
RTone H-Sound
£’000 £’000
Revenue 93,531 49,211
Gross profit 19,640 7,873
Lease rentals – retail properties 1,737 –
Depreciation 100 279
Directors’ salaries 140 550
Finance costs 30 407
Profit before tax 6,250 4,504
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
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:
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.
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.
Exhibit 1: Extracts from financial statements for the year ended 30 September 20X8, with notes
from the engagement manager
Exhibit 2: Review notes raised by the engagement partner, Joe Long, with responses from the
engagement manager
Partner review note 1
Gentri Group audit team’s management of subsidiary audit team
The audit procedures on CarNation were performed by an audit team from Ascott’s Arcadian office.
The only documentation on the Gentri Group audit file at present is:
• extracts from CarNation’s financial statements (Exhibit 1)
• a brief clearance memorandum dated 31 October 20X8, from the subsidiary audit team
This is insufficient for me to evaluate whether the group audit team has adequately considered and
followed up the audit work performed by the CarNation audit team in respect of the group audit.
The clearance memorandum states that all audit procedures are complete and that the subsidiary
audit team has not identified any adjustments above component materiality of £4 million in the
CarNation financial statements.
However, the CarNation audit team has identified two points for the group audit team to consider for
the consolidated financial statements:
• A large shipment of components was made by CarNation to Gentri plc on 29 September 20X8. It
is likely that these components were still in transit at the year end. CarNation recorded revenue of
£15 million in the year ended 30 September 20X8, in respect of this shipment.
• Gentri plc plans to introduce a new range of engines. In the year ended 30 September 20X8,
CarNation recognised an impairment charge of £11.5 million in respect of plant used to
manufacture a part which will no longer be used for the new range of engines. In Arcadia,
impairment charges are deductible for tax purposes when they are recognised in the financial
statements.
I cannot see how you have followed up these two points.
Response from the engagement manager
• We do have some documentation that is not on the group audit file. I sent an email to the
subsidiary audit team on 30 June 20X8. This informed them that component materiality for
CarNation was £4 million, summarised key risks of material misstatement and provided details of
related parties. It asked the subsidiary team to confirm their independence, which they did in an
email response, which also confirmed receipt of my email.
• The members of the subsidiary audit team have all worked on the audit of CarNation for several
years and I have no concerns about their competence.
Partner review note 2
Audit procedures on taxation
I am concerned about the extent of our audit procedures on taxation. Gentri plc’s tax 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.
£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.
Partner review note 3
Consolidated statement of cash flows for the year ended 30 September 20X8
The consolidated statement of cash flows has not yet been audited. I have not looked at it in detail
but from a basic review there seem to be missing figures and it does not seem to reflect my earlier
review points.
Response from the engagement manager
• The figures in the consolidated statement of profit or loss, consolidated statement of financial
position and notes have all been agreed to our audit file, but audit procedures on the
consolidated statement of cash flows are incomplete. The latest draft of the consolidated
statement of cash flows is shown below.
20X8 20X7
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
Extracts from statements of profit or loss for the year ended 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
The investments in shares in Alma plc and VLA plc represent less than 10% of the share capital of
those companies.
£’000
Revenue 14,000
Operating costs (34,000)
Tax 2,000
Loss after tax (18,000)
£’000 £’000
DEBIT Cash 6,000
CREDIT Bonds 6,000
No employees are expected to leave the company in the next three years.
React’s board expects that the share options will vest on 31 July 2022 and therefore there will be no
employee cost to record in the year ending 31 July 2021.
Exhibit 3: Forecast financial information for the year ending 31 July 2021
Forecast summary statement of profit or loss for the year ending 31 July 2021
£’000
Revenue 23,731
Gross profit 20,174
Total depreciation (530)
Other operating costs (6,384)
Operating profit 13,260
Finance costs (125)
Profit before tax 13,135
Tax (to be completed) (x)
Profit for the year 13,135
£’000
Non-current assets
Plant and equipment 21,247
Current assets 26,567
TOTAL ASSETS 47,814
Equity
Share capital (£1 shares) and other reserves 11,810
Retained earnings 17,290
29,100
Non-current liabilities
Borrowings and other financial liabilities 4,264
Deferred tax liability at 1 August 2020 1,741
6,005
Current liabilities
Trade and other payables 12,709
Current tax payable (to be completed) (x)
12,709
TOTAL EQUITY AND LIABILITIES 47,814
Tax information
In the tax jurisdiction where React operates, accounting profit and taxable profit are calculated using
the same rules except for the following:
• Plant and equipment
No tax allowance is available for accounting depreciation. Instead, in the year in which an asset is
capitalised (including assets capitalised under lease contracts), tax depreciation is available for plant
and machinery at the rate of 30% of the asset cost recognised in plant and equipment. Thereafter, an
annual writing down allowance of 18% is available on the brought forward tax base. The current tax
rate is 25% and there are no expected changes to this tax rate in the future.
When the forecast financial statements for the year ending 31 July 2021 were prepared, no additions
to plant and equipment or disposals from plant and equipment were included and accounting
depreciation of £530,000 was recognised.
The deferred tax liability at 1 August 2020 arises from a temporary difference on plant and
equipment as follows:
At 1 August 2020
£’000
Carrying amount of plant and equipment 21,777
Tax base of plant and equipment (14,813)
6,964
Deferred tax liability at 25% 1,741
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
Summary by product:
Exhausts 5,223 1,336
Tyres 11,334 3,615
Head office (2,303)
Total 16,557 2,648
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.
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
£m
Taste database 87
Project Smart 13
Project Textel 79
Total 179
£m
Debit purchased intangible assets 87
Credit operating costs
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.
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).
£m £m
DEBIT Cash 20.15
DEBIT Profit or loss 0.10
CREDIT Non-current liability 20.25
£m £m
DEBIT Cash 40
CREDIT PPE 30
CREDIT Profit or loss 10
£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.
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.
£000
Shares in BW plc 40,000
Cash 70,000
Professional fees for the acquisition 9,000
119,000
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) –––––––
Profit before tax 103,400 88,500
Tax (19,600) (16,000)
Profit for the year 83,800 72,500
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
Profit for the year 83,800 72,500
As at 30 September 2020 264,400 246,300
Ordinary share capital
£1 shares (see Exhibit 1) 140,000
A$1 shares 100,000
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
Other journals
Deferred income
Cash
Credit notes
Sales invoices
1000
0
Mon Tue Wed Thu Fri Sat Sun Days of
the week
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.
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.
Paul Parker
Financial controller
Sunil Bank
Assistant financial
controller
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.
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.
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:
In June 2020:
I cannot find any information about these adjustments because Alain resigned in August 2020 and
no longer works at Panther. Paul has told me that he believes that Alain sometimes posted proforma
invoices to revenue by mistake. The final sales invoices were posted when the goods were received
by the customer. Alain then corrected his mistake by cancelling the proforma invoices with sales
credit notes, debiting the relevant sales account. Paul cannot be certain that all the proforma invoices
posted by Alain in error before he left have been corrected.
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.
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
Operating profit 10,655
Finance costs (6,150)
Profit before tax 4,505
£’000
Assets
Non-current assets
Property, plant and equipment (Exhibit 2, note 1) 83,700
Investment property (Exhibit 2, note 2) 24,200
Current assets 39,500
Total assets 147,400
Industry average
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.
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.
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.
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
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.
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.
Pierre Delvenne
Finance director
Susan Chu
Financial accountant
0010 0011
Leasehold
Leasehold improvements
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 –––––––
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:
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).
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%
£
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 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
Leasehold improvements
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%
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.
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.
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.
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%
£
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
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.
2021 2020
£’000 £’000
Revenue 385,000 376,000
Cost of sales (283,388) (263,200)
Gross profit 101,612 112,800
2021 2020
£’000 £’000
Revenue 76,600 99,416
Cost of sales (52,088) (69,591)
Gross profit 24,512 29,825
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.
Financial reporting issues
(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.
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.
(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 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)
Note £’000
Property, plant and equipment 3 100
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.
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
within the data analytics software.
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.
When the sales invoice is raised and processed, Paula enters a reversing journal entry to remove the
accrued income.
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
Less:
Manual journal transfers to Account code 7003
Core staff salaries 2,033 – 2,033
Paula Elliott
Finance director
Melissa Woodward
Trainee accountant
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
nominal ledger, so the full year nominal ledger data for the year ended 31 December 2021 is now
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.”
4000 Temps – UK
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.
FB’s forecast consolidated statement of profit or loss for the year ending 31 December 2022
£’000 £’000
Revenue 125,000
Operating profit 45,900
Net finance expense (2,000)
Profit before tax 43,900
Current tax expense (7,000)
Deferred tax expense (3,000) ––––––
Total tax expense (10,000)
Profit after tax (33,900)
CC’s forecast statement of profit or loss for the year ending 31 December 2022
€’000 €’000
Revenue 42,200
Operating profit 6,000
Net finance expense (250)
Profit before tax 5,750
Current tax expense (1,505)
Deferred tax expense (45)
Total tax expense (1,550)
Profit after tax 4,200
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
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
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.
Dates
Elephant’s accounting year-end for the data in the software is 31 December 2018.
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.
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
Brian’s notes:
I selected Sample item A due to its size.
Sample item B
Extracted from trade payables. This sample item has more than one transaction, as follows:
Transaction 'PIN029477'
Transaction Id Account Code Amount Effective Date Document Type Journal Description User Id Line Description Created Date
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
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)
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
78 Practice Question 2
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DATA ANALYTICS SOFTWARE
Assume that the current date is 28 February 2019.
You are assigned as audit senior to the audit of the financial statements of Elephant Company Ltd
(Elephant) for the year ended 31 December 2018.
Elephant is a digital marketing company based in the UK. Elephant’s customers sign a contract for a
specific marketing project for the delivery of marketing services. Each project Elephant undertakes is
typically short term, up to six months. In order to monitor and control costs incurred in relation to
each project, the direct costs incurred for each project are recorded in individual memorandum
accounts within the accounting system.
Audit materiality for the financial statements of Elephant has been assessed at £30,000.
At the interim audit, discussions with management identified that Elephant was facing weaker UK
economic conditions and increased competition which were making trading conditions more
challenging for Elephant in 2018. Management informed you prior to the final audit that Elephant is
seeking to raise further private equity funding in 2019 and that the audited 2018 financial statements
will be used by the potential investor for the process of establishing a valuation for the company. As
a consequence, management insist that the audit must be completed and the audit report signed by
31 March 2019.
At the planning meeting for the final audit, the engagement partner identified income as a key audit
risk. She also mentioned the shorter time available for the audit than usual and that Elephant’s
management had made it very clear that it is important that the 2018 audit goes as smoothly as
possible without any unexpected problems.
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.
Rent 72000
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
79 Practice Question 3
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DATA ANALYTICS SOFTWARE
Assume that the current date is 7 March 2019.
Your firm is the external auditor of Elephant Company (Elephant).
Elephant is a digital marketing company based in the UK. Elephant agrees fixed price contracts with
its customers to deliver digital and traditional marketing services related to specific marketing
projects. Each marketing project Elephant undertakes is short term, typically less than three months
in duration. Each project is assigned to a project leader who is responsible for controlling costs and
ensuring that Elephant delivers all marketing services specified in the contract.
Project leaders record costs related to each contract in an electronic job sheet for each contract.
Contract costs include time spent by web developers working in Elephant’s digital design studio. The
standard rate at which web developer time is recorded includes payroll costs (salary and National
Insurance (NI), a related tax cost) and an apportionment of Elephant’s central overheads.
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
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:
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
80 Practice Question 4
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DATA ANALYTICS SOFTWARE
Assume that the current date is 25 February 2019.
Your firm is the auditor for Elephant Company (Elephant).
You are Dougal Skye, the audit senior for the final audit of Elephant for the year ended 31 December
2018.
I am concerned that perhaps there might be a fraud here, so perhaps you should review my work.
Regards,
Brian
81 Practice Question 5
ADVANCE INFORMATION: ELEPHANT LTD
Assume that the current date is 15 February 2019.
This Advance Information relates only to Corporate Reporting Practice Question 5.
The Advance Information comprises:
(1) This document which includes the scenario, notes of a meeting with Frank Wright, Elephant Ltd’s
finance director (Exhibit A) and a working paper prepared by an assistant working for Smith &
Ives, Elephant’s auditor (Exhibit B); and
(2) The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the Data Analytics Software.
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.
Direct payroll
Payroll costs directly attributable to each income stream (direct payroll) are initially recorded in the
following account codes:
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.
Frank Wright
Finance director
Jo Smith
Financial accountant
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.
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
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.
Income stream in Account codes 51010 and 51020 Users making postings
Notes
1 The Advance Information document; and
2 The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the Data Analytics Software.
To access the data analytics software please click below.
DATA ANALYTICS SOFTWARE
Assume that the current date is 15 March 2019
You are an audit senior working for Smith & Ives LLP, a firm of ICAEW Chartered Accountants.
The final audit visit for Elephant started last week and you have joined the audit team today as audit
senior.
Tian Turner, the audit engagement manager, gives you the following briefing:
“You will have reviewed the notes of my introductory meeting with Frank Wright, Elephant’s finance
director, and a working paper prepared by a Smith & Ives audit assistant. You will also have
familiarised yourself with the data for Elephant for the 11 months ended 30 November 2018.
“Data for December 2018 has now been imported into the Data Analytics Software from Elephant’s
nominal ledger, so the full year nominal ledger data for the year ended 31 December 2018 is now
available.
“Last week, I met with Frank Wright. Frank updated me about some changes since our meeting in
August 2018. I have summarised this for you (Exhibit 1).
“An audit assistant has identified an audit matter which I would like you to consider (Exhibit 2).
“I have set out instructions for the tasks I would like you to perform in a separate document (Exhibit
3).”
Requirement
Respond to the audit engagement manager’s instructions (Exhibit 3).
Ignore any adjustments for current and deferred taxation
Total: 45 marks
£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.
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%.
You should identify specific transactions in the data analytics software where they represent items of
significant audit interest.
Name Role
I had a brief meeting with Frank Wright. He told me that the board expects that the profit for the
year ending 31 December 2018 will show a significant improvement on the profit for the year
ended 31 December 2017.
Organisation chart
Set out below are the members of the accounts department at Elephant and their roles.
Frank Wright
Finance director
Jo Smith
Financial accountant
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:
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.
Notes
1 The Advance Information document; and
2 The nominal ledger data for Elephant Ltd (Elephant) for the 11 months ended 30 November
2018, contained within the DAS.
To access the data analytics software please click below:
DATA ANALYTICS SOFTWARE
Assume that the current date is 28 February 2019.
You are part of the PCG audit team that has just commenced the final audit visit for Elephant.
Emily Francis the PCG engagement manager for the Elephant audit gives you the following briefing:
“You will have reviewed the interim audit information prepared by Vijay Shankar after the audit
planning visit. You will also have familiarised yourself with the data for Elephant for the 11 months
ended 30 November 2018.
“Data for December 2018 has now been imported into the data analytics software from Elephant’s
nominal ledger, so the full year nominal ledger data for the year ended 31 December 2018 is now
available. Materiality has been set at £30,000.
“I have had a meeting with Frank Wright, Elephant’s financial director. There are two specific matters
arising from this meeting that we need to focus on (Exhibit 1).
“Also, the Elephant board is concerned about the effect of further weakening of the Chinese yuan on
the outcome of the contract with Rino Ltd. The board has provided an illustrative example of a
currency forward to mitigate this exposure. The example was prepared by Frank Wright before he
went on sick leave (Exhibit 2).
“I am also concerned about the comments made by Tracey Bashir in the note included in her
description of the results of audit procedures on expenses carried out at the interim audit visit.
“I have set out instructions for you in a separate document (Exhibit 3).”
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
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.
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
Draft statement of profit or loss and other comprehensive income for the year ended 30 June 20X2
£m
Revenue (549.8 + 10.2 – 1) 559.0
Cost of sales (322.4 + 18) 340.4
Gross profit 218.6
Distribution costs 60.3
Administrative expenses (80.7 – 21.5 + 8) 67.2
Finance costs (4.8 + 2.0 – 1.3 + 0.2 + 1.3) 7.0
Finance income (1.0)
Profit before tax 85.1
Income tax expense (17.1 + 3.4) (20.5)
Profit for the year 64.6
Cash flow hedge 1.3
Reclassification of cash flow hedge (1.3)
Total comprehensive income for the year 64.6
£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
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.
Also I have reversed the additions to property, plant and equipment as follows:
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:
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:
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:
Discontinued operations
Separate disclosure in the statement of profit or loss as ‘discontinued operations’ may also be
required.
The question of whether the closures are a withdrawal from the market is a question of 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
As the change in cash flow affects profit or loss in the current period, a reclassification adjustment is
required:
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:
Taxation
The following journal is required to adjust for current and deferred tax as noted in the assumptions:
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.
£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
£m
Carrying amount of share-based payment expense 0
Tax base (1,000 × 500 × 75% × £8 × 2/3) (2)
Temporary difference (2)
Deferred tax asset (30%) 0.6
The amount of deferred tax that relates to the excess of the intrinsic value over the fair value at the
grant date should be recognised in equity as there is no corresponding expense to match it to in
profit or loss:
£m
Cumulative tax deduction 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.
£m
Carrying amount in group accounts – inventories [(£5m × 3/4) – £0.75m] 3.000
Tax base – inventories (£5m × ¾) (3.750)
Temporary difference (0.750)
Deferred tax asset (30%) 0.225
The result is a deferred tax credit to profit or loss of £0.225 million in the current period.
There is no deferred tax impact in Ince’s individual accounts because the unrealised profit is not
cancelled.
(4) Unremitted earnings
There is a potential deferred tax liability of £0.4 million on the unremitted earnings of Quando. This is
because the Quando’s profits of 5 million corona have been consolidated in the group accounts, but
the additional tax will not be paid by Billinge until these profits are remitted to owners as dividends,
giving rise to a temporary difference. However, as Billinge controls the timing of the Quando’s
dividends (being a 100% shareholder) and it is probable that the temporary difference will not
reverse in the foreseeable future as Billinge intends to leave the profits within Quando for
reinvestment, IAS 12, Income Taxes dictates that no deferred tax liability should be recognised.
(5) Property, plant and equipment
The carrying amount of property, plant and equipment is its net book value. The grant may either be
deferred and released to profit or loss over the useful life of the asset or deducted from the cost of
the asset.
The tax base is the tax written down value.
Since the depreciation and capital allowances are charged at different rates, this gives rise to a
temporary difference.
The resultant deferred tax liability is calculated as follows (on the assumption that the grant is
recognised as deferred income):
£m £m
Carrying amount:
Property, plant & equipment (£12m – £12m/5) 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.
£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
Temporary difference (0.180)
Deferred tax asset (30%) 0.054
The resultant deferred tax is an asset (and credit in profit or loss) because the tax relief is based on
the rental of £1.5 million yet the expense in the profit or loss is £1.68 million (ie, depreciation of £1.2
million and interest of £0.48 million) which means that part of the future tax saving on rental
deductions is recognised now for accounting purposes, so the tax expense is reduced representing
the tax recoverable in the future.
3 Longwood
Response as follows:
(1) Change of tax rate
Per IAS 12, Income Taxes, the tax rate to be used is that expected to apply when the asset is realised
or the liability settled, based upon laws already enacted or substantively enacted by the year end.
The deferred tax assets and liabilities therefore need to be measured using the enacted rate for 20X7
of 23%, rather than 30%.
The net change in the carrying amount of the deferred tax assets and liabilities (£0.26 million, as
shown in the table below) arising from a change in rates will normally need to be taken to profit or
loss for the year of Portobello Alloys. However, this will not be the case where it relates to a
transaction or event which is recognised in equity (in the same or a different period), when the
resulting deferred tax is also included in ‘other comprehensive income’. This is the case for the
investments.
The schedule below calculates the adjustments to the deferred tax assets and liabilities by reworking
the temporary differences at the new rate.
Debit Credit
£m £m
Deferred tax asset 0.17
Deferred tax liability 0.43
Tax expense – profit or loss 0.19
Equity – in respect of investments 0.07
£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.
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
Debit Credit
£m £m
Deferred tax asset 0.29
Deferred tax liability 1.84
Goodwill adjustment 1.55
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
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
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.
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.
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.
Response as follows:
(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
£‘000
Redundancy costs 300
Retraining –
Lease termination costs 50
Liability 350
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
£’000
30 June 20X4 Equity b/d: 1,000 × 4 × £50 × 1/3 66.67
(3) Consolidated statement of profit or loss for year ended 30 June 20X5
£’000
Revenue (see (W5)) 34,420
Cost of sales (10,640)
Gross profit 23,780
Operating costs (5,358)
Profit from operations 18,422
Finance income 905
Fair value gain on associate 326
Associate income 424
Finance cost (625 + 169 + 78 + 123 + 141) (1,136)
Profit before tax 18,941
Taxation (3,700)
Profit for year 15,241
WORKINGS
(1) Group structure
Upstart
25% 3 months
70% 6 months
80% 3 months
Liddle
(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 £’000
CREDIT Cash 3,500
DEBIT NCI 1,665
DEBIT Group Reserves (balance) 1,835
£’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
210 560
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
£’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
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
Current service cost 90
Net interest on the net defined benefit asset (115 – 110) (5)
Past service cost 100
185
£‘000
Opening defined benefit obligation at 1 October 20X0 2,200
Past service cost 100
Interest on obligation (2,200 × 5%) 110
Current service cost 90
Benefits paid (60)
Remeasurement gain through OCI (balancing figure) (30)
Closing defined benefit obligation at 30 September 20X1 2,410
£‘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
£’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.
6 Robicorp plc
Scenario
Requirement Skills
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.
Recommended adjustments 26
Revised earnings per share and diluted earnings per share 8
Marks Available 34
Maximum 30
Total 30
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).
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.
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.
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.
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.
£‘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
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
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
£’000
Basic totals 30,271 40,000,000
Convertibles (see below) – –
Share options (free shares) –––––– 232,611
Total 30,271 40,232,611
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 treated as issued for nil consideration (free shares) 232,611
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.
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)
Gross profit 20,136
Operating costs (9,489)
Gain on sale of subsidiary 13,340
Profit from operations 23,987
Share of profit of associate 160
Finance income 424
Finance costs (2,998)
Profit before taxation 21,573
Income tax expense (2,974)
Profit for the year 18,599
Other comprehensive income
Exchange differences on translating foreign operations 7,369
(Restatement of goodwill 4,370
Exchange gain in year 2,999) ––––––
Total comprehensive income for the year 25,968
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
On disposal At acquisition
£’000 £’000
Share capital 2,000 2,000
Retained earnings b/f 4,824 2,400
Profits to disposal (6 months) 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
£’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
£’000
At acquisition 1,100
Up to disposal (25% × (4,824 – 2,400)) + 114 (W9) 720
At disposal 1,820
Taricco
35% × PAT × 6/12 160
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
Retained earnings 14,846
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
£’000 £’000
Net assets at acquisition
Kr 35,164 @ closing rate 4Kr : £1 8,791
69
2,999
£’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
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.
(2) Development costs
There is a temporary taxable difference arising in respect of development costs because they have a
carrying amount of CU7 million at 30 April 20X1 in the statement of financial position. However, they
have a zero tax base because they have been treated as an allowable deduction in the company’s tax
computation at that date.
When the development costs are amortised in the statement of profit or loss and other
comprehensive income the timing difference will reverse.
This gives a deferred tax liability of CU1.4 million (20% × CU7m) and a charge to the profit or loss.
CUm
PPE
Carrying amount 64.0
Tax base (36.0)
Temporary taxable difference 28.0
Tax rate 20%
Deferred tax 5.6
Provision at 1 May 20X0 4.4
Increase in provision 1.2
Development costs
Carrying amount 7.0
Tax base 0.0
Temporary taxable difference 7.0
Tax rate 20%
Deferred tax liability 1.4
CUm
20X2 and 20X3 Expected profits 10.0
Tax rate 20%
Deferred tax asset 2.0
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
Non-current assets
Current assets
135.6 133.6
Loss since acquisition (16.0) (1.2) (1.4) 2.0 (2.6) 6.4 (2.0) (14.8)
Non-current liabilities
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.
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
Equity and liabilities
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
£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
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
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
£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.
£’000
Current service cost 1,200
Net interest on net defined benefit liability (732 – (1,080 + 24)) 372
Past service cost 400
Total expense 1,972
IAS 19 is silent on how this expense should be charged, I have therefore charged it all to operating
costs, but some companies separate out the interest costs, and take these to finance costs.
Therefore operating costs should be increased by the difference of £1,072,000 (£1,972,000 –
£900,000) over the contributions paid into the scheme, which was the sum incorrectly charged to the
statement of profit or loss and other comprehensive income.
The net actuarial gain of £572,000 (768,000 – 196,000), should be recognised in other
comprehensive income.
The net pension obligation recognised in the statement of financial position is £6.3 million (£19.8m –
£13.5m).
(3) Holiday pay accrual
IAS 19, Employee Benefits requires that an accrual be made for holiday entitlement carried forward
to next year.
Number of days c/fwd: 900 × 3 × 95% = 2,565 days
Number of working days: 900 × 255 = 229,500
Accrual = (2,565 ÷ 229,500) × £19m = £0.21m
£’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
Holiday Xema 9
Golf/TV Pension accrual Options mnths Total
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
£’000
Xema’s revenue 4,050
Costs (2,700)
Finance income 180
Finance costs (540)
990
Tax for nine months (225)
(765)
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
£’000
Non-current assets
Goodwill 8,826
Property, plant and equipment 10,720
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
Retained earnings 3,031
Non-controlling interests 2,012
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
Retained earnings 2,740 2,540
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
£
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
£
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)
11 Kenyon
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
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.
ROCE = PBIT ÷ (Equity + Debt – Investments (221 – 1 – 7) ÷ (465 + 38 – 56) = 48% (117 – 6) ÷ (432 + 5) = 26%
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
Payable days = Payables/Cost of sales × 365 95/395 × 365 = 88 days 66/315 × 365 = 76 days
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)
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
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 AND LIABILITIES
Equity
Share capital 200
Retained earnings (W4) 5,766
Foreign exchange reserve (W6 and W7) 52
Non-controlling interests 22
Non-current liabilities
Long-term borrowings (6,841 (see above) + 333) 7,174
Current liabilities
Loan 1,000
Trade and other payables (10,252 + 329 + 480) 11,061
*Current tax payable 645
Total equity and liabilities 25,920
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
Consideration transferred 918
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
£’000
Dormro (see below) 5,743
Adjustments
Share of Klip post-acquisition profits
3 months × 90% of Klip H$500,000 = 112.5 @AR 4.8 23
5,766
Retained earnings at 1 May 20X1 5,496
Add profit for the year 568
Add write back of arrangement fee on loan 200
Less finance charge on loan (521)
–––––
Revised retained earnings at 30 April 20X2 5,743
£’000
Closing net assets (37 + 107 + 71) 215,000 × 10% 22
H$’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
£’000
Exchange gain on Goodwill 11
Exchange difference on retranslation of subsidiary 41
52
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
£’000 £’000
DEBIT Investment 12
CREDIT Other comprehensive income 12
£’000 £’000
DEBIT Cash 242
CREDIT Investment 242
£’000 £’000
DEBIT Profit or loss 0.48
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
£’000 £’000
DEBIT Other components of equity 27
CREDIT Investment 27
£’000 £’000
DEBIT Derivative asset 12
CREDIT Profit or loss 12
However, hedge accounting had been applied and the fair value gain recorded in other
comprehensive income/other components of equity:
£’000 £’000
DEBIT Derivative asset 12
CREDIT Other components of equity 12
£’000 £’000
DEBIT Other components of equity 12
CREDIT Profit or loss 12
£’000 £’000
DEBIT Cash 83
CREDIT Profit or loss 10.8
CREDIT Debt investment 72.2
£’000 £’000
DEBIT Debt investment 10.8
CREDIT Profit or loss 10.8
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.
Hedge No. X
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.
Hedged risk Market risk that share price falls below £9.00
Hedged item
Hedging instrument
Put option in 30,000 equity shares in International Energy plc at an exercise price of £9.00
exercisable until 31 December 20X8.
Hedge effectiveness
Monitor on a quarterly basis comparing change in intrinsic value of options to change in share
price where price falls below £9.00.
From an ethical perspective, the preparation of documents for financial reporting purposes on behalf
of the client would constitute a self-review threat. We should explain to the client that due to our
obligation to remain independent, we are unable to prepare supporting documentation for the
financial statements.
Risks from derivatives trading:
Key risks
There are a number of concerns that we should address as auditors.
• Credit risk is the risk that a customer or counterparty will not settle an obligation for full value. This
risk will arise from the potential for a counterparty to default on its contractual obligations and it is
limited to the positive fair value of instruments that are favourable to the company.
• Legal risk relates to losses resulting from a legal or regulatory action that invalidates or otherwise
precludes performance by the end user or its counterparty under the terms of the contract or
related netting agreements.
• Market risk relates to economic losses due to adverse changes in the fair value of the derivative.
These movements could be in the interest rates, the foreign exchange rates or equity prices.
• Settlement risk relates to one side of a transaction settling without value being received from the
counterparty.
• Solvency risk is the risk that the entity would not have the funds to honour cash outflow
commitments as they fall due. It is sometimes referred to as liquidity risk. This risk may be caused
by market disruptions or a credit downgrade which may cause certain sources of funding to dry
up immediately.
Necessary general controls and application controls
Tutorial Note
This answer assumes that a computer system is used in processing trades involving derivatives.
General controls
A number of general controls may be relevant:
• For credit risk, general controls may include ensuring that off-market derivative contracts are only
entered into with counterparties from a specific list and establishing credit limits for all customers.
• For legal risk, a general control may be to ensure that all transactions are reviewed by properly
qualified lawyers and regulation specialists.
• For market risk, a general control may be to set strict investment acceptance criteria and ensure
that these are adhered to.
• For settlement risk, a general control may be to set up a third party through whom settlement
takes place, ensuring that the third party is instructed not to give value until value has been
received.
14 Biltmore
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.
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the
reporting entity can access at the measurement date.
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the
asset or liability, either directly or indirectly eg, quoted prices for similar assets in
active markets or for identical or similar assets in non-active markets or use of quoted
interest rates for valuation purposes.
Level 3 Unobservable inputs for the asset or liability ie, using the entity’s own assumptions
about market exit value.
Harmony Tower may be valued using a Level 2 input, that is, prices that are directly observable for
identical buildings in an active market.
To obtain further evidence that a fair value of £150 million is appropriate, the use of auditor’s experts
may be necessary.
Grove Place
The fair value of the property is £220 million. The £30 million spent during the year should only have
been capitalised in accordance with IAS 16 if it represented an improvement in the asset – ie,
increased the future economic benefits rather than maintaining the asset. Evidence has shown that
the refurbishment work has not created the future economic benefits. Therefore, the £250 million
carrying value must be written down to fair value at the year end, being £220 million, with the
refurbishment expense of £30 million charged to profit or loss for the year.
Head office – upper floors
This is not an investment property. Biltmore plc occupies and uses a significant part of the building
and the vacant part is not capable of being leased or sold separately. The whole building will have to
be treated as normal owner-occupied property.
Northwest development
Biltmore plc’s use of this property is restricted to only a very small proportion, and the complex
cannot be sold separately. It is therefore acceptable, under IAS 40, to treat the whole development as
investment property.
Buy-to-let portfolio – Teesside
The fair value should be decided in terms of market conditions as at the year end. Thus, the
company’s proposed valuation of £150 million is correct providing that the downturn arose after the
year end. There may be an argument for treating this downturn as a non-adjusting event after the
reporting period and disclosing the change in the market value in a note to the accounts.
Essex Mall
IAS 40 states that a property which is being developed for future sale cannot qualify as an investment
property. Thus, the building must be treated in accordance with IAS 2 until such time as it is ready for
disposal. Its initial recognition should be at cost, but it should be written down to its net realisable
value if this falls below cost.
£m £m
DEBIT Gains on investment properties 50
CREDIT Investment properties 50
Grove Place
Treat costs incurred as revenue:
£m £m
DEBIT Repairs 30
CREDIT Investment properties 30
£m £m
DEBIT Gains on investment properties 20
CREDIT Investment properties 20
£m £m
DEBIT Property, plant and equipment 80
CREDIT Investment properties 80
£m £m
DEBIT Depreciation expense 4
CREDIT Property, plant and equipment 4
Northwest development
No adjustment required.
Buy-to-let portfolio – Teesside
No adjustment required.
£m £m
DEBIT Gains on investment properties 80
CREDIT Investment properties 80
£m £m
DEBIT Property under construction 770
CREDIT Investment properties 770
£m £m
DEBIT Property, plant and equipment 150
CREDIT Investment properties 150
£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
DEBIT Gains on investment properties 30
DEBIT Property, plant and equipment 6
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
DEBIT Gains on investment properties 15
CREDIT Investment properties 15
£m £m
DEBIT Inventory 345
CREDIT Investment properties 345
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
15 Hillhire
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%.
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.
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.
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
£ £
DEBIT Profit or loss 15,000
CREDIT Equity 15,000
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.
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:
£’000
Current service cost 360
Net interest on the net defined benefit obligation: (5% × 3,600) – (5% ×
3,420) 9
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)
£’000
Present value of obligation at 1 June 20X7 3,600
Interest cost on obligation (5% × 3,600) 180
Current service cost 360
Benefits paid (342)
Loss on remeasurement through other comprehensive income (residual) 522
Present value of obligation at 31 May 20X8 4,320
£’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.
17 Tydaway
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.
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:
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.
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 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,
being a derivative financial asset) and to recognise the gain on the forward contract in profit or loss.
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).
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).
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.
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.
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).
To recognise the settlement of the forward contract at its fair value by receipt of cash from the
counterparty.
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).
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
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
£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
£m £m
DEBIT Profit or loss for the year 12
DEBIT Non-current liability: Debentures 6
CREDIT Investment in Strobosch 18
£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.
£m
Initial measurement (360 – 6) 354
Interest for 6 months @ 4.42% 16
Coupon paid (8% × 360 × 6/12) (14)
Year end balance 356
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
£m
Opening net assets: RR1,865m @ Closing rate 0.47 877
@ Opening rate 0.45 839
38
Retained earnings:
£’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
accordance with IFRS 5.
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
(1) Financial reporting issues
• 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.
20 Hopper Wholesale
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
21 Button Bathrooms
£
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.
£’000
Present value of plan obligations 249.6
Less fair value of plan assets (240.0)
Plan deficit 9.6
£’000
Current service cost 211.2
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
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.
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.
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.
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
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
£’000
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
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.
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
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
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.
25 Tawkcom
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
26 Expando Ltd
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.
£
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
Share capital 86 86
Share premium 100 100
Revaluation surplus 1,000 –
Retained earnings 1,026 713
2,212 899
27 NetusUK Ltd
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
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
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
£’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
Profit before tax 2,704
Income tax expense (400 + (360 × 5/12) + (300 × 9/12)) (775)
Profit for the year 1,929
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
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
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
Fair value uplift on PPE (W5) 960
(3,210)
Goodwill 232
£’000 £’000
Consideration transferred 980
NCI at proportionate share of fair value (25% × 1,120) 280
Less net assets acquired:
Share capital 100
Reserves 1,020
(1,120)
140
* 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
NCI at acquisition (W4) 280
NCI share of post acquisition reserves to disposal
(25% × [(W6) (1,300 + 532) – 1,020]) 203
Requirement Skills
(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.
Identify audit issue and provide appropriate
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.
(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.
Identify audit issue and provide appropriate
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.
Response as follows:
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.
The right-of-use asset is subsequently depreciated over the lease term of 20 years, therefore in the
year ended 31 March 20X5:
£
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:
£’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
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.
Correcting journals:
£’000 £’000
DEBIT PPE 375
CREDIT Cost of sales 375
£’000 £’000
DEBIT Inventory 2,000
680,000 kg × £15 = £10.2m – Cost £8.2m
CREDIT Income statement – Gain on inventory 2,000
(1,535) (665)
£’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
ASSETS
Non-current assets
Current assets
Equity
Non-current liabilities
Current liabilities
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.
Financial performance 15
Corporate governance 9
The actions to be taken and the potential implications 8
Financial reporting treatment 8
40
Total 40
*Consumption of raw materials and consumables adjusted for inventory change (C$m):
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.
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 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.
* 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.
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
Current service cost 604
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.
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
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).
£ £
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.
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.
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.
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.
£’000 £’000
DEBIT Trade payables 164
CREDIT Exchange gains: profit or loss 164
£’000 £’000
DEBIT Other payables 450
CREDIT Restructuring costs: profit or loss 450
£’000 £’000
DEBIT Impairment loss: profit or loss 807
CREDIT Right-of-use asset 807
£’000 £’000
DEBIT Other payables 1,100
CREDIT Lease costs: profit or loss 1,100
£’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
Examiner’s comments
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.
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.
Response as follows:
(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:
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
£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.
£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.
£’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
Examiner’s comments
Financial reporting treatment
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.
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.
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
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.
20X5 20X4
£’000 £’000
ASSETS
Non-current assets
Property, plant and equipment (113,660 – 18,260) 95,400 120,400
Development costs 10,380 10,380
105,780 130,780
Current assets
Inventories 32,300 23,200
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
Current liabilities
Trade and other payables 31,600 39,400
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
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)
Profit before tax 35,004 23,100
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
Profit for the year 15,710 24,240
Other comprehensive income:
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
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
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.
£’000 £’000
Profit before taxation 21,120
Adjustments for:
Depreciation (120,400 – 113,660) 6,740
Provision 3,800
Increase in inventories (9,100)
Increase in receivables (5,700)
Examiner’s comments
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.
Requirement Skills
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.
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
£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
£m £m
DEBIT Cost of sales (£500,000 + £400,000) 0.9
CREDIT Inventories 0.9
£m £m
DEBIT Trade payables (£1.2m + £1.4m) 2.6
CREDIT Trade receivables 2.6
£m £m
DEBIT Equity: share options (£1m – £200,000) 0.8
CREDIT Administrative expenses 0.8
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
Ref to
First draft Adjustment working Revised draft
£m £m £m
ASSETS
Non-current assets
Property, plant and equipment 64.8 64.8
Intangible assets:
Research asset 2.0 2 2.0
Goodwill 5.6 3.2 1 6.8
(2.0) 2
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:
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.
Examiner’s comments
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
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.
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.
Response as follows:
(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
£’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
£‘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.
£‘000 £‘000
DEBIT Operating costs (depreciation) 9
DEBIT Property, plant and equipment 40
CREDIT Revaluation gain –– 49
49 49
£‘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
£’000 £’000
DEBIT Investment property 155
CREDIT Profit or loss 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
DEBIT Other comprehensive income 10
CREDIT Deferred tax 10
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)
Profit for the year 1,283
£’000
ASSETS
Non-current assets
Investment property 3,500
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
Non-current liabilities
Deferred tax 253
Current liabilities
Trade payables 3,965
Current tax payable 350
4,568
Total equity and liabilities 11,359
Examiner’s comments
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.
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
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.
Clearly set out and explain appropriate
accounting adjustments.
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.
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 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.
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.
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 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.
Examiner’s comments
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
Requirement Skills
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.
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.
£’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
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.
£’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.
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.
£’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
£’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.
£’000 £’000
Operating expenses (£3,000,000 + £1,300,000 + £5,000,000 +
DEBIT £524,000) 9,824
CREDIT Intangible assets 9,824
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.
£’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
Investment property 4,074
Loan to TraynerCo 3,150
Current assets
Inventories 144,380 144,380
Trade and other receivables 22,420 – 4,000 18,420
Cash and cash equivalents 71,139 71,139
Total assets 333,548 320,186
Examiner’s comments
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
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.
Clearly set out and explain appropriate
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
Goodwill calculation 4
Financial reporting issues 12
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.
£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.
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.
£m £m
DEBIT Intangible asset 14
CREDIT Profit or loss 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
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)
Profit before tax 23.8 11.1
Income tax expense (4.8) (4.8)
Profit for the year 19.0 6.3
OCI (Gain) 1.7 1 1.7
£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
Other comprehensive income
for the year 3.7 1.7 × 4/12 0.6 4.3
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
Gross profit 65.4 63.5
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.
WORKING
Predicted group revenue and gross profit for the year ending 30 November 20X7
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.
£m
EBITDAR before consolidation of EyeOP
Profit from operations 16.8
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.
Examiner’s comments
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
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.
Clearly set out and explain appropriate
accounting adjustments.
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.
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.
Examiner’s comments
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.
Requirement Skills
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.
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.
20X6 20X5
Gross profit margin (Gross (9.6/24.8) × 100 = 38.7% (12.6/31.4) × 100 = 40.1%
profit/revenue) × 100
Operating profit margin (Operating (2.4/24.8) × 100 = 9.7% (3.8/31.4) × 100 = 12.1%
profit/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
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
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
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
Examiner’s comments
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.
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.
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.
£m £m
DEBIT Cost of sales 4.2
CREDIT Inventory 4.2
DEBIT Deferred tax asset 0.8
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
CREDIT Cost of sales 61.3
£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.
Km Km
DEBIT Deferred tax asset 5
CREDIT Tax expense 5
Km Km
DEBIT Deferred tax asset 11.3
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
£m
K160 million @ 4.4 (1 April 20X6) 36.4
K160 million @ 4.2 (30 September 20X6) 38.1
Exchange gain 1.7
£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)
Management
charge
Operating income 15.7 15.7 (15.7)
defer’d tax on
unrealised profit
Taxation (9.0) 3.4 (5.6) 0.8 (4.8)
WORKINGS
(1) ZCC – process journal adjustments and translate the profit or loss at average rate and SOFP at
HR/closing rate
(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.
£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
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
Examiner’s comments
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.
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.
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.
Clearly set out and explain appropriate
accounting 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.
Part (1)
Supplier statements
Financial reporting adjustments
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:
Year ending
30 September 20X3 (10 months) £23,438
30 September 20X4 £28,125
30 September 20X5 £28,125
30 September 20X6 £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:
Examiner’s comments
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.
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.
Response as follows:
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.
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
£’000 £’000
Property, plant and equipment 7,550 1,594
Brand name 4,175 881
Goodwill 1,975 1,975
4,450
£’000 £’000
DEBIT Profit or loss 4,450
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.
£’000 £’000
DEBIT Profit or loss 1,000
CREDIT Prepayments 1,000
£’000 £’000
DEBIT Payable 1,000
CREDIT Equity 1,000
£’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)
£’000
DEBIT Profit or loss – administrative expenses service cost 1,400
CREDIT Profit or loss – administrative expenses – contribution paid 900
DEBIT Finance costs 75
CREDIT Net pension benefit obligation 575
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)
Operating profit 14,205
Finance costs (1,280 + 75) (1,355)
Profit before tax 12,850
Taxation (2,000)
Profit for the period 10,850
6 months to
30.6.20X4 6 months to Projected revenue to Year ended
Restated 30.6.20X3 31.12.20X4 31.12.20X3
Other mobile
services 15,700 6,100 157% 39,250 20,500
× 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
Gross profit
An analysis of the gross profit margins also reveals some unusual relationships:
6 months to
30.6.20X4
Gross profit % on
customised devices and 34,986/48,310 × 25,986/33,310 ×
software 100 100
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
Examiner’s comments
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.
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
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.
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.
£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
Debit Credit
£m £m
Investment in associate 350.0
Suspense account 350.0
Investment in associate 50.0
Investments 50.0
Profit or loss 3.9
Investment in associate 3.9
Finance income 1.0
Investment in associate 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
CREDIT Inventories 1.5
Accounting for the group share of unrealised profit arising from trading with associate.
£m £m
DEBIT Provision 5.5
CREDIT Cost of sales 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.
£m £m
DEBIT Cost of sales 0.8
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
Examiner’s comments
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.
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
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.
Response as follows:
(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$540,000 meaning that the
other receivables and prepayments should have been tested. However, changes in exchange rates
across the group and differences in results from those anticipated when materiality was set may have
changed the overall materiality of component materiality for Arca. Group team should therefore look
at this before asking Arcan team to do more work on other receivables and prepayments.
E$ 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$3.6: £1 = £2.874 million as this is translation
arising on the consolidation of a subsidiary which maintains its accounting records in a currency
other than the group functional currency.
Audit procedures: As the amounts capitalised are material to the group results, the group team will
require supporting documentation for a sample of the costs incurred and will also want to see land
Carrying Temporary
amount Tax base difference DT at 35%
E$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
Examiner’s comments
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
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.
Recommend appropriate accounting
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.
Response as follows:
(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.
Examiner’s comments
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 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.
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.
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.
Response as follows:
(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).
£’000 £’000
DEBIT Other components of equity 43
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
CREDIT Profit or loss 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
£’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
20X7 20X6
£’000 £’000
Revenue (£35,400 – £750) 34,650 34,500
Gross profit (£10,020 – £750) 9,270 9,660
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
20X7
£‘000
Land 1,000
Buildings 18,200
Financial assets: fair value through OCI 387
Financial assets: fair value through profit or loss 219
Plant and equipment 8,678
28,484
Key ratios
20X7
£’000
Gearing (Net debt/equity) × 100
20X7 (450/26,208) × 100 1.7%
WORKING
Summary of amendments required in journal entries above:
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%
Examiner’s comments
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.
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
accounting adjustments.
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.
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.
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.
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.
£
MAK GRNI 142 × £2,040 289,680
Other unmatched GRNI 311 – 142 = 169 × £1,900 321,100
610,780
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.
Recommend appropriate accounting
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.
Explain briefly how your adjustments will impact Distinguish between impacts on current tax and
on the income tax expense. deferred tax timing differences.
£’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
£’000 £’000
Proceeds received 7,900
Add: Fair value of 15% retained 1,000 ––––
8,900
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
Recommended financial reporting treatment
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.
£’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
£’000
Cost at 1 June 20X7 4,850
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
£’000
Cost at 1 June 20X7 4,640
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
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
Profit before tax 1,896 (890) 1,400 433 146 – 400 2,585
Profit for the year ––––– –––– –––– ––– ––––––––– 2,232
Examiner’s comments
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.
51 Raven plc
Scenario
Prepare revised financial statement extracts Assimilate information and use own accounting
adjustments to prepare revised extracts from
the financial statements.
£
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.
£ £
DEBIT Financial asset 1,309,243
CREDIT Other comprehensive income 1,216,685
CREDIT Profit or loss 92,558
£ £
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
£ £
DEBIT Profit or loss 1,027,397
CREDIT Depreciation 1,027,397
£ £
DEBIT Trade payables 12,000
CREDIT Equity 12,000
£ £
DEBIT Revaluation reserve 700,000
DEBIT Profit or loss 100,000
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.
£ £
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
Interest at 5% 208,494
Lease payment (540,000)
30 April 20X8 3,838,374
Interest at 5% 191,919
Lease payment (540,000)
3,490,293
£ £
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.
£ £
DEBIT Suspense account 10,000,000
DEBIT Right-of-use asset 2,918,916
CREDIT PPE 7,000,000
CREDIT Lease liability 4,169,880
CREDIT Gain on disposal 1,749,036
£ £
DEBIT Depreciation expense 291,892
CREDIT Right-of-use asset 291,892
£ £
DEBIT Finance costs 208,494
DEBIT Lease liability 331,506
CREDIT Profit or loss (operating costs) 540,000
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
£ £
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
£ £
DEBIT Net pension obligation 575,000
CREDIT Profit or loss (salaries) 575,000
£’000
Profit before tax (working 1) 3,111
Other comprehensive income (working 2) 385
As stated JNL (1) JNL (2) JNL (3) JNL (4) JNL (5) Revised
Non-current assets
(1,923)
(1,028)
Equity
Share capital
(£1 ordinary shares) 200 200
Separate component of
equity 12 12
Working 1 total
adjustments 811
(1,923)
33,626 32,991
Long-term liabilities
obligation (575)
WORKINGS
(1) Revised profit before tax
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
Examiner’s comments
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.
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.
Clearly set out and explain appropriate
accounting adjustments.
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.
Examiner’s comments
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.
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.
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?
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.
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.
£’000
O$21 million @ 6.0 (1 January 20X7) 3,500
O$21 million @ 4.8 (30 September 20X7) 4,375
Exchange gain 875
£’000 £’000
DEBIT Loan to KJL 875
CREDIT Profit or loss 875
DEBIT Income tax - P or L 175
CREDIT Deferred tax liability 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.
The unrealised profit is calculated as follows:
£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.
£’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
£’000 £’000
DEBIT Cost of sales 648
CREDIT Inventory 648
DEBIT Deferred tax asset 130
CREDIT Tax expense 130
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.
(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
Consideration transferred 52,800
Non-controlling interests
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
Examiner’s comments
(1) Financial reporting
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.
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.
Recommend appropriate accounting
adjustments in the form of journal entries.
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.
Adjustments 8
Revised SPL and SOFP 9
Financial analysis 10
Legally distributable reserves calculation 3
30
Total 30
£’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.
£’000 £’000
DEBIT Financial asset 347
CREDIT OCI/OCE 347
£’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
CREDIT Profit or loss 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
Gross profit 7,797 7,797
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)
20X7 20X7
Draft Adjust Revised
£’000 £’000 £’000
Non-current assets
Property, plant and equipment 53,675 53,675
Financial asset 1,503 347 1,850
55,178 347 55,525
Current assets
Inventories 2,770 2,770
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
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)
£’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.
Examiner’s comments
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.
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
accounting adjustments.
• Explain the specific audit objectives of our
audit procedures to provide assurance in
respect of the key audit matter.
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).
The lease liability is amortised, going one year further to determine current versus non-current
liability:
£
1 April 20X7 5,118,000
Interest at 3% 153,540
Lease payment (600,000)
31 March 20X8 4,671,540
Interest at 3% 140,146
Lease payment (600,000)
4,211,686
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
Our audit procedures should do the following:
– 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.
Trade receivables allowance
Relevant financial reporting standard
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
Examiner’s comments
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.
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
required to provide verification evidence for
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
required to provide verification evidence for
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
appropriate recommendations.
• 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.
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.
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.
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
£’000
DEBIT Property 8,182
CREDIT Investment properties 8,182
MYR’000 £’000
40,000 £1 = 5.5 7,273
40,000 £1 = 6.0 6,666
Loss 607
£’000
DEBIT Profit or loss 607
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
DEBIT Finance costs 210
CREDIT Debenture loan 210
DEBIT Debenture loan 210
CREDIT Accrued interest cost 210
£’000
DEBIT Finance costs (20m × 3.7% × 3/12) 185
DEBIT Interest receivable SOFP 15
CREDIT Finance income (20m × 4% × 3/12) 200
£’000
DEBIT Finance costs 302
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
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.
£’000
Decrease in the fair value of the debenture liability (gain) 300
Increase in the fair value of the swap liability (loss) (302)
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
CREDIT Profit or loss 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
DEBIT Profit or loss 321
CREDIT Derivative liability 321
Part (2)
Examiner’s comments
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.
(1) Financial reporting
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.
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.
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).
Part (1)
The additional information received enables adjustments to be made to MiTek’s financial statements
as follows:
£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
WORKINGS
(1) Calculation of goodwill
£m
Cost of investment 50.0
At disposal At acquisition
£m £m
Share capital 20.0 20.0
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
£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)
Attributable to:
*The assumption is made that profits, losses and gains accrue evenly – alternative assumptions could
also be considered valid.
Examiner’s comments
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.
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.
Clearly set out and explain appropriate
accounting adjustments.
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.
Identify potential weakness in controls and the
ability of management to override controls.
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.
Explain the additional procedures required.
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.
Examiner’s comments
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.
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).
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.
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.
£ £
DEBIT Profit or Loss 1,500,000
CREDIT PPE 1,500,000
£ £
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
goodwill calculation.
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.
£ £
DEBIT Goodwill 547,300
CREDIT Liability 547,300
DEBIT P or L 36,943
CREDIT Liability 36,943
£’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
Note: Adjustments for the contingent liability using an estimate of fair value were also
accepted.
Examiner’s comments
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
financial statements.
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
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.
Examiner’s comments
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.
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.
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.
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.
DEBIT P or L £1,300,000
CREDIT PPE £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.
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
£’000
Recommended adjustment:
Fair value of new loan 6,000
Old loan 5,892
Increase the loan by 108
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:
£’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:
Part (2)
Issue 3
Reward Issue 4
Before Issue 1 PPE Issue 2 Loan scheme Revenue After RTone
Net profit before tax 4,504 *(2,061) (408) (1,026) (253) 756 6,250
Revenue per
employee 328,073 319,547 311.77
*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.
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.
Examiner’s comments
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.
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.
Clearly set out and explain appropriate
accounting adjustments.
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.
Use technical knowledge and judgement to
determine appropriate audit procedures or
tests of detail.
Explain the additional procedures required.
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.
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.
£m
Tax base brought forward 43.0
Additions qualifying for capital allowances 21.0
Total 64.0
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.
Examiner’s comments
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.
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.
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.
Demonstrate understanding of the importance
of contributing to the profession & appreciating
the ethos & culture of the accountancy
profession.
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.
£’000 £’000
DEBIT Retained earnings (statement of profit or loss) 3,600
CREDIT OCI – gain recognised immediately before disposal 3,600
£’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
DEBIT Profit or loss 320
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.
£’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
CREDIT Profit or loss 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.
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
CREDIT Profit or loss 570
£’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
Profit before tax 8,500 95,600
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
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.
Examiner’s comments
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.
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
£’000 £’000
DEBIT Distribution costs 5,000
CREDIT Cash 5,000
DEBIT Tax liability 1,250
CREDIT Profit or loss 1,250
£’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
£’000 £’000
DEBIT Profit or Loss – depreciation expense (£27,208 + 80 / 9 years) 3,032
CREDIT Right of use asset – accumulated depreciation 3,032
£’000 £’000
DEBIT Lease liability 4,000
CREDIT Cash 4,000
£’000 £’000
DEBIT Profit or loss – finance cost £27,208 × 6% 1,632
CREDIT Lease liability 1,632
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
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
DEBIT Profit or loss 468
CREDIT Equity 468
£’000 £’000
DEBIT Deferred tax asset 156
CREDIT Tax expense 117
CREDIT Equity 39
£’000
Profit before tax 13,135
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
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
Deferred tax liability at 1 August 2020 1,741
Movement to profit or loss 1,823
£’000
Deferred tax liability at 1 August 2020 1,741
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
£’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
Part (3)
Statement of profit or loss
Right-of-use Share
asset options Tax Profit
Non-current assets
Equity
**5,252
29,100 21,724
Non-current liabilities
6,005 30,002
Current liabilities
12,709 15,264
*old profit
**new profit
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
accounting adjustments.
– 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.
Product*
Revenue
Operating profit
Total assets
Revenue – % of total
Revenue mix
Operating margin %
Assets – % of total
Man.
Retail
– India E 723 291 1,539 20.6 21.2 41.5 40.2 11.0 71.3
– France E 626 234 410 6.5 58.3 13.4 37.4 2.9 86.3
– Other *** E 1,093 208 2,182 27.5 24.0 27.5 19.0 15.6 33.4
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
Revenue
Operating profit
Total assets
Revenue – % of total
Revenue mix
Operating margin %
Assets – % of total
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
HO 0 –2,303 –87.0
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
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.
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.
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
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
Examiner’s comments
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
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.
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
£m £m
DEBIT Operating costs 87
CREDIT Purchased intangible assets 87
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.
£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.
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.
£
DEBIT Profit or loss 605,000
CREDIT Profit or loss 100,000
CREDIT Bond 505,000
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
£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
£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
Examiner’s comments
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.
Examiner’s comments
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.
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.
Part (1)
A subsidiary is defined by IFRS 10 Consolidated Financial Statements as ‘an entity that is controlled
by another entity’.
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.
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
A$000 A$000
DEBIT Payables 26,000,000/2.8 9,286
CREDIT Profit or loss 1,161
CREDIT Cash 8,125
At the year end 30 September 2020, the liability is recalculated using the year end rate. A further
gain of A$ 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
A$000 A$000
DEBIT Payables 1,161 + 1,623 2,784
CREDIT Profit or loss 2,784
A$000 A$000
DEBIT Forward contract – Financial asset 2,000
CREDIT Profit or loss 2,000
To recognise the increase in the fair value of the hedge instrument (which is the forward contract,
being a derivative financial asset) and to recognise the gain on the forward contract in profit or loss.
A$000 A$000
DEBIT Profit or loss 2,000
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.
Note: The exchange gain on the purchase of aircraft of A$2,784,000 occurs post-acquisition.
Part (4)
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
Examiner’s comments
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.
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
accounting adjustments.
Use technical knowledge and judgement to
identify risks.
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.
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
performance obligation.
• 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.
Examiner’s comments
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.
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.
reduce the volatility of future reported profits.
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.
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.
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
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.
£ £
DEBIT 1001 – closing inventory (SOFP) 395,500
CREDIT 5201 – closing inventory (cost of sales) 395,500
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
139239 - 139240 M12(2020) - Transit Inventory from overseas 0 2,265,018 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.
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
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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.
Additional information
(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.”
Individual transactions and key audit risk
Using the Heat Map the following transaction can be identified in Account code 4002:
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
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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.
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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.
Additional information
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.
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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 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
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.
£
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.
Examiner’s comments
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).
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.
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.
Demonstrate understanding of the importance
of contributing to the profession & appreciating
the ethos & culture of the accountancy
profession.
£’000
Carrying amount 32,000
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
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.
£’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.
£’000
The office building was bought on 1 July 2015 27,500
At 30 June 2021 the carrying amount is £24.2 million and £550,000 depreciation was
recognised in the statement of profit or loss.
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.
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
Carrying amount 24,750
Change to reserves 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.
Justify and calculate any differences from Hanna’s proposed adjustments
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.
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.
Other comprehensive
income:
Remeasurement (loss) on net
defined benefit
obligation -3,480 -3,480
Gain on revaluation 5,250 5,250
Examiner’s comments
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.
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.
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.
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.
$’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.
Examiner’s comments
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.
(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.
Examiner’s comments
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.
(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.
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
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.
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.
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.
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.
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
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.
Examiner’s comments
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’
(2) Set out and explain the key audit risks, including inherent risks, arising from transactions and
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
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.
Examiner’s comments
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
(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 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:
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.
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.
Tutorial Note
Calculations amortising Llama Three from November were accepted.
£
DEBIT Right-of-use assets 2,692,125
CREDIT Lease liability 2,692,125
£
DEBIT Right-of-use asset 189,980
CREDIT Rent 007100 9,181
CREDIT 0010 Leasehold improvements 180,799
£
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)
Examiner’s comments
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.
(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.
Recommend appropriate accounting
adjustments in the form of journal entries.
(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.
comprehensive income.
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
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.
(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.
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.
Administrative expenses
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.
£’000
DEBIT: Provisions 800
CREDIT: Closure costs 800
Plant and
Land Buildings equipment
£’000 £’000 £’000
Carrying amount at 30 September 2020 5,000 5,880 8,600
Depreciation charged for the 9 months to 30 June
2021 140 × 9/12 / 1,290 × 9/12 ––––– (105) (968)
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
£’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.
£’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
CREDIT Equity 30,000
£’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
Gross profit 77,100 82,975
Administrative expenses
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 –––––– ––––––
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.
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.
£’000
2021 Revenue 76,600 × 100/80 95,750
2020 Revenue for 12 months 99,416
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
2020 Revenue for 12 months 99,416
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%.”
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.
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
Examiner’s comments
(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.
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.
(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.
(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
Demonstrate understanding of the importance
of contributing to the profession & appreciating
the ethos & culture of the accountancy
profession
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.
(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 the offers in both the separate and consolidated
financial statements.
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.
Examiner’s comments
(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.
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.
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.
% 15% 16%
Europe – Company
temps only
GP 11 43
5% 13%
UK – Employed and
company temps
GP 2,325 2,921
14.7% 16%
GP 2,336 2,964
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?
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:
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.
Additional information
• 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
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.
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.
Appropriate financial reporting treatment
The financial reporting treatment of this appears to be incorrect.
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 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.
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.
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.
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.
£
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.
Key audit procedures
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.
Examiner’s comments
(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.
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.
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
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.
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.
£’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
Original Revised
£’000 £’000 £’000
Profit before interest 45,900 45,900
Net finance income/(expense) -2,000 less finance income 326 -1,674
Profit before tax 43,900 44,226
Current tax expense -7,000 65 -7,065
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
£’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
£’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).
Journals
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
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.
Examiner’s comments
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.
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
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
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.
Examiner’s comments
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.
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.
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).
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.
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.
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.
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
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
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
Adj Q2 Suspense 9,000
Adj Q3 Suspense 11,111
Total 25,111
80 Practice Question 4
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’.
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 costs of issue must be deducted from the amount received on initial recognition
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:
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
81 Practice Question 5
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
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.
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
£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.
£ £
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:
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.
Guidance on preliminary analytical procedures
The relevant account codes for revenue and related costs are:
62105 Studio NI
You should identify specific transactions in the data analytics software where they represent items of
significant audit interest.
Carrying out analytical procedures on the relevant account codes enables the identification of audit
risks.
Income stream in Account codes 51010 and 51020 Users making postings
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
Account code Contract sales sales Other sales Total
£’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
Comparison of revenue by Account 51010 (Domestic Sales) and Account 51020 (Overseas Sales).
Domestic Overseas
% 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.
Domestic sales
Overseas sales
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:
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:
£ £
DEBIT Bad debt – profit or loss 18,655
CREDIT Bad debt allowance – SOFP 18,655
£ £
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
financial statements.
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.
Key audit procedures
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.
Requirement Skills
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.
Recommend appropriate accounting
adjustments in the form of journal entries.
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 accounting
adjustments in the form of journal entries.
Recommend appropriate audit procedures.
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
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 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.
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
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.