TI BR Advanced Stage July 2010

MARK PLAN AND EXAMINERS COMMENTARY TI Business Reporting July 2010 This report includes: A summary of the scenario and requirements for each question the technical and skills marks available for each part of the requirement a description of how skills should be demonstrated detailed points for a full answer examiners commentary on candidates performance

The information set out below was that used to mark the questions. Markers were encouraged to use discretion and to award partial marks where a point was either not explained fully or made by implication.. BR Question 1 Flynt Scenario The candidate is in the role of a newly appointed financial controller who is asked to adjust a consolidated statement of comprehensive income in respect of three technical issues. Share options, defined benefit scheme and lease of surplus machinery. The candidate is also asked to calculate the EPS and diluted EPS taking into account the adjustments to the consolidated statement of comprehensive income.

Available Marks

Requirement 1. Redraft consolidated statement of comprehensive income

Technical marks 15

Skills marks 6

Skills Identify the treatment of share options is incorrect Evaluate the lease to determine correct accounting treatment Appreciate impact on different elements of the statement of comprehensive income Explain the difference between defined contribution and benefit schemes Produce revised statement of comprehensive income in an appropriate format

2. Calculate EPS and diluted EPS

Summarise the impact of adjustments on EPS and diluted EPS Identify the impact of adjustments on EPS

Total marks Maximum marks

18 25

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1. Flynt To: From: Andrea.Ward@flynt.co.uk miles.goodwin@flynt.co.uk

Re: Finalisation of financial statements for year ended 31 May 2010. I would respond to your email as follows: Share Option Scheme Shane Pontings treatment of the option scheme is incorrect. IFRS2, Share Based Payment, should have been applied as follows: The fair value of the options at the grant date should be treated as an expense in the income statement and spread over the vesting period, which is from the grant date until the date the scheme conditions vest. The scheme conditions are both market and non-market based, as they are impacted by both the share price and continuing employment. The fact that the share price has increased since the grant date is ignored when determining the charge to the income statement. This is because market based conditions are embedded in the fair value calculations. The continuing employment condition should be based on the best estimates at the statement of financial position date, which in this case is for 16 executives to be employed at the vesting date. The charge to the income statement is therefore 378,000 (10,000 x 16 x 12.60 x x 9/12). This will reduce profit after tax and therefore EPS. In addition this sum is also credited in the statement of financial position to equity. IFRS2 does not state where in equity this entry should arise, and many companies add it to retained earnings. When calculating diluted EPS it will be necessary to take into consideration the number of free shares being allocated to executives assuming the whole scheme will vest. (see appendix for calculations) Lease of machinery Shane Pontings analysis of the agreement as an operating lease is incorrect. This would appear to be a finance lease because: (a) the lease term and useful life of the asset are the same (b) the present value of the lease payments received, plus the residual value guaranteed by Prior plc come to 606,381, which is almost all of the fair value of the machinery. The asset should therefore be derecognised and a receivable created. This is called the net investment in the lease. The direct costs incurred should be included in the initial measurement of the finance lease receivable and will therefore be recognised in the income statement over the lease term as part of interest receivable. The rental income of 150,000 is removed from the income statement. Interest receivable of 61,000 is credited to the income statement (appendix 3) Because the machinery is being derecognised the depreciation charge should be added back to profit. Overall the reclassification of the lease to a finance lease will increase EPS. In the statement of financial position at 31 May 2010 there will be a receivable of 524,000 (appendix 3) which should be analysed between amounts due in less than and more than one year.

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Dipper Pension Scheme The accounting treatment for a defined benefit scheme is considerably different to that of a defined contribution scheme. It is therefore necessary to remove the charge of 480,000 made by Shane Ponting and replace it with the following. The income statement charge is split into three elements: (a) Service cost, this is the pension earned by the employees of Dipper in the year, and is an operating cost. This means that operating costs will rise by a net 80,000 after deducting the contributions paid into the scheme that have been incorrectly charged by Shane Ponting. (b) Return on assets: This is the expected investment income on the equities, bonds and other investments owned by the pension fund. This works out as 55,000 (5% x 2.2 million x 6/12). IAS19 does not specify where this should appear in the income statement. I have treated it as investment income but it would not be incorrect to offset it against operating costs. (c) Discount rate for obligations: This is the unwinding of the present value of the pension liability due to employees who are one year closer to retirement at the end of the accounting period. A charge of 52,000 (4% x 2.6 million x 6/12) should therefore be made in the income statement. Because it relates to a present value, I have added this to finance costs, but once again IAS19 is silent on the issue. The actuarial difference reflects that some of the above figures are estimates, and also the increase in the net liability in the pension fund to 670,000. (2.75m - 2.08m). This figure will appear in the statement of financial position as a liability. Per appendix 5 there is a net actuarial difference of 193,000. IAS 19 allows a number of methods of dealing with gains and losses. Dippers accounting policy in relation to pensions is to recognise immediately gains and losses. IAS 19 permits immediate recognition in both profit or loss and as other comprehensive income. Goodwill impairment The goodwill impairment should be charged to the income statement rather than other comprehensive income. This will impact on EPS Summary of adjustments As a result of these adjustments EPS has increased from 1.21 to 1.41 per share from the previous year. The diluted earnings per share is 1.38, and therefore should be disclosed as lower than basic. EPS.

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Appendices Appendix 1 Flynt plc: Revised statement of comprehensive income for year ended 31 May 2010 2010 Options Lease Pension Goodwill '000 '000 '000 '000 '000 Revenue Cost of sales Gross Profit Operating costs Goodwill impairment Other operating income Operating profit Investment income Finance Costs Profit before tax Taxation Profit after tax Other comprehensive income Actuarial loss on pension Goodwill impairment 14,725 (7,450) 7,275 (3,296) 150 4,129 39 (452) 3,716 (1,003) 2,713

Total '000 14,725 (7,450) 7,275 (3,631) (400) 0 3,244 155 (504) 2,895 (810) 2,085

(378)

122+1 (150) 61

(80) (400)

55 (52)

(193) (400) (400) 2,313 400

(193) 0 (193) 1,892

Appendix 2: PV of lease agreement at 10% Cash Flow 000 150 150 150 150 211 9 PV 000 136 124 113 103 131 6 613

Unguaranteed

Year 1 2 3 4 5 5 Total

Fair value plus the direct costs is equal to the net investment in the lease 612,100 + 1,000 = 613,100 Appendix 3: Net investment in lease Interest Income 000 61 52

Bal b/f 000 1 June 2009 1 June 2010 613 524

Installment 000 (150) (150)

At 31 May 000 524 426

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Appendix 4: Pension Calculations Asset '000 2,200 55 Obligation '000 2,600

Balance at Acquisition Return on asset Unwinding of discount (interest cost) Service cost Contributions Pension Paid Expected closing bal Actual closing balance Actuarial difference Net actuarial difference

52 560 480 (450) 2,285 2,080 (205) (193) (450) 2,762 2,750 12

Appendix 5: Basic EPS 2010 '000 2,085 *1,475 1.41 2009 '000 1,699 1,400 1.21

Profit after tax Shares at start and end of year Basic EPS

*6/12 x 1,400,000 = 700,000 6/12 x 1,550,000 = 775,000 1,475,000

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TI BR Advanced Stage July 2010

Appendix 6: Diluted EPS Diluted EPS Basic Share Options (see below) Total Diluted EPS Share Options Maximum cash raised from shares (19 x 10,000 x 39) Shares issued at average price in year (7.41m/48) Maximum shares issued (7.41/39) Free' shares Earnings '000 2,085 2,085 '000 7,410 000 154 190 36 Shares 1475 36 1511 1.38

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

Examiners comments This question was generally well answered with the majority of candidates displaying a sound technical knowledge. Answers were, in the majority of cases, well structured and clearly laid out following the structure of the question. It was rare that candidates omitted complete sections of the question and most candidates achieved a pass on this question. A majority of candidates were able to give correct explanations for the treatment of the three issues. In addition the calculations for the share option and pension schemes were mostly accurate with most mistakes being due to carelessness rather than errors of principle The standard of the revised statements of comprehensive income was more mixed with many candidates not correctly adjusting against the appropriate headings, although at least in most cases they did make some attempt to do so. Almost all candidates correctly identified the goodwill adjustment. A surprising number of candidates were unable to calculate the correct number of shares required in the basic EPS computation. Hardly any students correctly calculated the number of free shares for the diluted EPS, although quite a few made a reasonable attempt. Many students did not attempt this part. A weak aspect of the candidates performance in respect of this question was in summarising and concluding the impact of the adjustments on the EPS.

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BR Question 2 - Pepper Art Scenario The candidate is in the role of a member of a tax department advising a client Pepper Art. The key skills in this question required of the candidate are reviewing, assimilation and judgement in providing advice to the client regarding the clients tax liabilities. In terms of skills the candidate needs to identify errors in a tax computation provided by the client and identify potential VAT liabilities arising from the application of capital goods scheme to the potential acquisition of a building. The question includes two ethical issues, an incorrect repayment issued by HMRC and an unsupported payment for software support of 50,000. A good answer to the ethics section should include considerations of the implications for the firm and also the consequences of making hasty accusations of inappropriate behaviour.

Available Marks Requirement 1. A revised calculation of the corporation tax liability correcting any errors you identify 2. Brief notes to explain any errors made by the internal tax department and your adjustments Technical marks 2 Skills marks 1 Skills Identify that errors have been made and provide a corrected computation

Identify that impairment provides a larger tax deduction and conclude that this is potentially a preferred option Evaluate the use of group losses and conclude that further information needed to assess optimum use Link the add back for legal fees to the chargeable gain computation Identify the opportunity for rollover relief against the purchase of plant and machinery by DeliverUK

3. A note of any additional information you require to complete your review 4. VAT implications of acquisition of Star House by Spaceway 5. Ethical implications of Jims email

Adopt sceptical attitude in respect of software costs and identify that further information required Assimilate information from past transaction to identify current tax liability and impact on acquisition price Appreciate ethical implication for the firm with respect to need for professional sceptism and extent of reporting requirements Identify and explain the consequences of reacting inappropriately to accusations Appreciate money laundering requirements Provide clear advice on what steps the firm must take in respect of each issue

Total marks Maximum

14 25

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Draft email reply to: Jim Jones Date: 27 July 2010 Subject: revised adjustment of Profit Computation year ended 30 June 2010 Please find attached a revised corporation tax calculation, together with notes identifying the errors I have found, explanation of my adjustments and detail of any further information to complete the review. (Attachment 1) I also attach a note setting out the VAT implications of the acquisition of Star House by Spaceway (Attachment 2) Attachment 1 Pepper Art - Revised corporation tax calculation Profit before taxation per the accounts Add back Software support Legal fees Depreciation and other disallowable 000 000 802

50 35 75 160 962

Less Profit on sale of Prospect House Dividend from Spaceway Tax repayment Less capital allowances Trading profit Chargeable gain (Note 3)

585 55 207 (847) (52) 63 400 463 (200) 263

Group relief from Spaceway Taxable profits 3 associated companies Therefore marginal company PCTCT @ 28% Less 7/400 (500,000 263,000) Revised corporation Tax liability

73,640 (4,148) 69,492

Brief notes explaining errors and adjustments Identification of errors 1. 2. 3. 4. 5. Legal fees have been correctly disallowed. However they could potentially be allowed against the disposal of the building for chargeable gains calculation. The chargeable gain has been calculated incorrectly. Foreign exchange losses have been incorrectly disallowed. Foreign exchange losses on settled transactions are deducted for tax purposes. The calculation of corporation tax must take into account associated companies. Pepper Art now has three associated companies. Goodwill 4% WDA claimed (see below)

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Explanation of adjustments Impairment charge on goodwill Goodwill represents a new intangible asset. Since 2002 the tax and accounting treatments of intellectual property are aligned. This means that the accounting entries for intellectual property such as goodwill are given tax relief or are taxable. Therefore it would appear to be more beneficial in this instance to follow the accounting treatment as this results in a larger tax deduction in the current financial year. The 4% per annum deduction is given only if an election (which is irrevocable is made). It is unlikely an election had been made by July 2010. Therefore the tax computation has incorrectly added back the impairment charge and allowed the 4% deduction. However this is a matter which would need to be confirmed. (see later additional information) Software Support Charges For an expense to be allowable for tax purposes it should be wholly and exclusively for the purposes of the trade. Provided there is evidence of this in terms of work performed and payment made the expense could be allowed. Clearly this is a substantial potential deduction and therefore the supplier should be requested again to produce an invoice. However, at the moment this expense has been disallowed until further evidence is supplied. Chargeable gain - Sale of Prospect House The chargeable gain has been incorrectly calculated by the client. A deduction for allowable cost, legal fees and indexation is permitted. The acquisition of Spaceway by Pepper Art means that Pepper Art now forms a capital gains tax group with Spaceway and its 100% subsidiary DeliverUK. DeliverUK plans to invest 900,000 in fixed plant and machinery which will enable Pepper Art to rollover the gain on the disposal of Prospect House against the purchase by DeliverUK of plant and machinery. As only part of the proceeds is being reinvested some of the gain will become chargeable in the current period. 000 Disposal Proceeds Less Cost Legal fees Indexation allowance 215-166.6 /166.6 = 0.291 x 500,000 Indexed gain Rollover relief Proceeds not reinvested = Chargeable gain 1,335 (500) (35) (145.5) 654.5 254.5 400

Spaceway potential group relief claim Group relief available 240,000 x (1.8.09 31.5.10) 10/12

200

Group relief could be claimed in respect of the period from 1 August 2009 (the date of acquisition of Spaceway by Pepper Art. However as the accounting periods are different only the period matching to the accounting period of Pepper Art can be used as group relief. Spaceway could carry the unused surplus management expenses forward against future profits.

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Given no further information a group claim would appear to be effective since Pepper Art is paying at the marginal rate of tax. Additional information required to complete the review Confirmation that claim for 4% WDA on goodwill has not been made There may be acquisition costs in respect of Prospect House which would be allowed as a deduction in calculating the chargeable gain. More detail on the future profits of Spaceway to assess whether claim for group relief is more or less effective than a carry forward of the loss. Software support charges need to obtain evidence of this expense. We will need to review the capital allowances computation and review tax sensitive accounts such as repairs and renewals, legal expenses etc.

Attachment 2 VAT implications of purchase of Star House by Spaceway It is important to examine the tax history of this building to appreciate whether there are any future liabilities for Spaceway. Star House was a newly constructed property and CartoonGo would have suffered input VAT of 210,000. The recoverability of this input VAT would have been determined by the initial use of the building which was exclusively business. Therefore CartoonGo would have recovered 210,000 input VAT. However, as the building cost more than 250,000, it will be subject to the capital goods scheme. No capital goods scheme adjustments would be required for the year ended 31 May 2007 or 2008 since the use remained business. However an adjustment, i.e. repayment of input tax to HMRC, would be required for the year ended 31 May 2009 of 210,000/10 x (33 - 100%) = 14,000. The same adjustment will be made for the year ended 31 May 2010 and a further 14,000 would be payable to HMRC by CartoonGo. If Spaceway buys the property with tenants occupying the property, it will constitute a transfer of a going concern (TOGC). The property is commercial (not residential) and more than three years old and no option to tax was made by CartoonGo Therefore there is no requirement for Spaceway to opt to tax for the property to be included in the TOGC (i.e. the transfer is not subject to VAT). Spaceway is not occupying the premises for its own business purposes. The rental charges to CartoonGo and the Insurance company will be exempt supplies. Therefore the adjustment for each of the remaining 6 intervals will be: 210,000/10 x (0% x 100%) = 21,000 Therefore a total payment to HMRC of 21,000 x 6 = 126,000 will be made by Spaceway over the remaining 6 years. Spaceway needs to consider this potential liability in negotiating the price for Star House.

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Briefing note to Tax Partner Subject: Ethical implications for the firm arising from Jim Joness email Over repayment by HMRC of tax of 207,000 As the engagement letter has been revised in the current year, there appears to be no authority to advise HMRC of the error without the clients consent. Professional accountants are advised to include the right to communicate with HMRC in their engagement letters with clients. It is important to establish the facts of this apparent error as making unsubstantiated accusations could have consequences both for our firm and for the employee who has informed us of the managing directors attitude towards the repayment. This may be an attempt to discredit the managing director and we should therefore not rely on this account by the employee in the internal tax department but establish his claim for ourselves The first step is to examine the correspondence regarding the repayment and to establish that HMRC was in full possession of the facts and has made an error. If this is the case, as the error is clearly substantial, we should: ask the client to give us authority to advise HMRC of the error warn the client of the possible legal consequences a deliberate attempt to benefit from an error made by HMRC may constitute a criminal offence under the Theft Act 1968. advise the client that we will cease to act if consent to disclose is not given.

This advice must be recorded in writing and a copy of the meeting notes given to the client. If a crime is committed, (i.e. non-disclosure of the error) there are additional responsibilities for the firm under anti money laundering legislation. A suspicious activity report will be required to SOCA and care should be taken that the firm is not responsible for tipping off the client as this is itself a criminal offence under the POCA. Advising the client to stop breaking the law does not constitute tipping off. Software support payment of 50,000 In order to determine whether there is an ethical issue for our firm with respect to this payment, more information is required regarding the nature of the work performed. The amount appears unusually large for the services provided. It is extremely unusual for no invoice to be supplied for such a large amount. This has implications for both direct taxes and VAT. We need to confirm that no claim for VAT has been made without an invoice displaying the VAT number of the registered trader. The client may inadvertently be party to a money laundering transaction and this may require a suspicious activity report by our firm. However, again care should be taken to establish the facts without tipping off the client. The firms money laundering officer must be informed of both transactions and legal advice and advice from ICAEW should be obtained. Further points If we conclude that the managing directors attitude to tax compliance appears to be very cavalier. Professional skepticism should be adopted in respect of any information provided to us by the client and it may therefore be inappropriate for our firm to be associated with this client in future.

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Examiner comments This question was again generally well answered with candidates adopting a structured approach to answering the question. Although this was the question where candidates were most likely not to attempt a part of the question. For example, the provision of additional information was often omitted. The VAT subsection was sometimes well answered with many candidates going beyond the requirements of the question to consider future tax planning in relation to the potential option to tax. Even if the numbers were not always correct if was pleasing to see that the issues were understood. Certain aspects of the computation were done well for example foreign currency and goodwill. The weaker candidates demonstrated poor assimilation skills in terms of not identifying opportunities for rollover relief and loss relief. Candidates were reasonably good at describing errors and saying how these should be corrected but actually redrafting the computation was sometimes beyond the weaker candidates. Performance on ethics elements of this question: A common weakness was to identify only one of the two ethical issues. Also very few candidates applied judgement to the source of the information to question the accuracy of Jims assertions regarding the managing director. Many candidates proposed very radical approaches to the ethical implications for the firm on the basis of unsubstantiated information.

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BR Question 3 Ed Holdings Scenario The candidate has recently assumed responsibility for the audit of Ed Holdings and its consolidated financial statements. Ed Holdings heads a group of companies which supply IT goods and services to the education sector. It has a tight deadline for completion of the group accounts. The audit work on the subsidiaries is largely complete and an assistant has completed work on the parent company and consolidation. The candidate is asked to brief the audit manager on the status of the audit work, issues arising and additional information required either from the client or from subsidiary auditors. This scenario tests the application of practical auditing skills to a complex scenario and includes a number of financial reporting issues, including issues associated with acquisition accounting, pensions and consolidation entries. A successful candidate will understand fully the principles and mechanics of a consolidation and be able to identify issues from the information provided. The scenario also tests the candidates ability to determine what is significant to a group (as opposed to an individual subsidiary) audit and to consider wider implications across the group of issues identified at a particular subsidiary. In addition, the requirement to assess the adequacy of a report from a subsidiary auditor tests the candidates knowledge of reporting and their ability to assess whether it is appropriate to rely on another firm.

Available Marks Requirement Identify and explain any known and potential issues which you believe may give rise to material audit adjustments or significant audit risk in the group accounts. Technical marks 6 Skills marks 10 Skills assessed Linking issues with audit risk e.g. no fair value review, growing business leads to potential undervalue of other intangibles Appreciate potential difference between Ruritanian accounting standards and IFRS and impact on group accounts Identify potential risk from use of overseas auditors Identify potential non compliance with IFRS impacts on group accounts (e.g. IAS 19) Identify lack of fair value adjustment and implications for accounts Identify that goodwill adjustments will be material Outline for each issue the additional audit procedures, if any, required to enable us to sign our audit opinion on the group accounts. 4 5 Ascertain gaps in work performed and recommend appropriate audit work Identify the need for tax expert to determine adjustment to the group accounts Identify need for expert advice in respect of fair value adjustments and IAS 19 Appreciate inadequate work simply to agree to bank statement Identify appropriate audit tests Total marks Maximum marks 10 25 15

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BR3 Ed Holdings Issues identified which may give rise to an adjustment or an indication of a significant audit risk in the group accounts and additional audit procedures to enable sign off of group accounts Bhagats results are very significant to the group and reliance has been placed on other auditors to audit this entity. Need to assess their competence by reviewing size, reputation, experience, client base etc of the firm.

Additional audit procedure A formal confirmation of their independence will be required and this is not covered in the clearance supplied. The audit of Bhagat has been conducted under Ruritanian Standards of Auditing which may not be equivalent to IAS. Need to assess adequacy of work performed,

Additional audit procedure This could be achieved by asking them to complete a questionnaire based on IAS or by asking for a clearance under IAS if they have the experience and training to supply this. Bhagat has prepared financial statements under group accounting policies supplied by group financial controller. There is a risk that these are not compliant with IFRS or that they are incomplete local policies have been used where group policies silent and this appears to included potentially material areas such as pension fund accounting.

Additional audit procedures Need to obtain either opinion based on IFRS (assuming local audit firm has the training and competence to supply this) or to conduct a very detailed review of completeness and appropriateness of policies supplied. As Bhagat is in a different business to UK entities, there may well be omissions, such as the treatment of software development costs (not clear where these are classified at present). Comment in clearance from Bhagat implies that the company has a defined benefit pension plan and that this has not been accounted for under IAS-19. It also implies that the plan may have a significant deficit which should be reflected on the group balance sheet. This could be a very significant adjustment.

Additional audit procedures Need to determine the nature of the scheme and how accounted for at present. If it is a defined benefit scheme then will need an actuary to assess the liability to be recognised under IAS-19. Will also need to perform work on the existence and valuation of pension scheme assets. Knowledge of both IFRS and the local Ruritanian employment and investment markets is likely to be required. Bhagat appears to have an investment which has not been considered further. Amount is immaterial but need to determine whether this is a trade investment or an investment in a subsidiary or associate whose results should be included in the group accounts.

Additional audit procedures Further information on the nature of this investment and the results of any subsidiary / associate are required so that the need for and materiality of any adjustment can be fully assessed. UK subsidiaries Aducit comment on obsolescence provision is potentially concerning as this is a policy which has presumably been applied across the group. If a similar error rate applied to the provision in the other group companies, then the total error would be 225,000 which is material. Need to consider the nature of inventories in each entity and to evaluate further any potential error which may arise. Bhagat auditors have not raised this as an issue but that may be because their audit work has not gone beyond ensuring compliance with group policies. Could however be because Bhagat is not facing the same issues.

Additional audit procedures Need to discuss with management and other audit teams and determine extent to which additional analysis is required based on actual post year end sales and sales forecasts rather than historic data. Adjustment identified in Aducit is not material but should be considered along with any other unbooked adjustments at subsidiary or group level. An overall group adjustment schedule should be maintained.

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Confirmations of all intercompany balances are not required, providing the balances eliminate on consolidation there is in fact a difference and this is discussed below Warranty provision - Although the balance is not material, the key audit consideration here will be whether it is complete and understatement could potentially be material.

Additional audit procedure Need to assess provision based on the number of months warranty given, historic experience of warranty claims and any known issues or problems with IT equipment supplied. Going concern sign off is not required on each individual company for the sign off of group accounts. However the overall cash position of the group is relevant and this looks poor, especially given that first installment of 1 million on long term debt is due in 4 months time on 1 November 2010 and Aducit has very high trade payables. Although companies are profitable, there are also signs (comment on inventory provision) that trading is difficult. In addition, significant proportion of profit is generated abroad and there may be issues in repatriating the cash to the UK to repay the loan.

Additional audit procedures Need to consider carefully cashflow forecasts and ability of company to repay its debts as they fall due. In addition, terms of the loan agreement need to be reviewed and covenant compliance assessed both now and over the next year as any breach of covenant might render the entire debt repayable immediately. Should also chase bank letter in Aducit even though bank balance is not in itself material. Bank letter also provides details of any loan accounts and other arrangements and is an important piece of audit evidence. Tax position on Aducit looks incorrect as no tax credit recognised at present. Would expect there to be group relief and company has also clearly been profitable in the past so there may be the opportunity to carry back losses. Need to investigate but would expect credit of around 28% - ie 243,000 which is potentially material.

Additional audit procedures Need to enquire further as to tax position, obtain draft computations and determine to involve a tax expert as necessary. Ed Holdings Agreeing investment of this size to bank statement alone is clearly inadequate

Additional audit procedures Need to review sale and purchase agreement for Bhagat to ensure no additional consideration payable, adjustments to consideration, warranties etc which need to be considered. Also need convincing evidence of ownership of shares through share certificates etc. Important to check that ownership is 100% as has been assumed in consolidation entries. Need to enquire as to how any costs related to the acquisition of Bhagat have been treated as these do not appear to have been included within the investment value. Need to ensure that Ed Holdings has not issued any shares in year through review of minutes and of documents filed at Companies House. Review of Board minutes and legal correspondence for the holding company are important tests which do not appear to have been performed / documented. Installment of long term debt repayable in November 2010 should be reclassified to current liabilities. Amount to be reclassified is 1million (959,000 after adjustment below for loan issue costs). No documentation of work on Ed Holdings to ensure completeness of liabilities.

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Additional audit procedures Would expect at least a review of post year end bank statements for items which relate to pre year end. No loan interest has been accrued on the long term loan and the loan arrangement fee of 200,000 appears to have been treated incorrectly as an administrative expense. Under IAS39, it should instead have been deducted from the loan balance outstanding and charged over the loan period in proportion to the outstanding balance on the loan. Correct income statement charge would be interest and finance charges of 262,000 (8million @ 6% for 6 months = 240,000 + (on straight-line basis) 0.5 x 200,000/8 = 12,500. Tutorial note other possible answers would include a sum of digit calculation for the allocation of the loan arrangement fee.

Consolidation entries Need to investigate further the difference on intercompany balances as current treatment may be incorrect. Given that all group companies operate in similar sectors, seems unlikely that only intercompany trading is management recharges so consolidation entries may well be incomplete. Need to enquire further into this. Consolidation entries for acquisition of Bhagat seem very simplistic and may not comply with IFRS. No fair value exercise appears to have been carried out at the date of acquisition and the difference between the net assets in Bhagat and the acquisition price has all been posted to goodwill. May well be elements which should be allocated to intangibles which should then be amortised through the income statement.

In addition, costs and revenues for Bhagat have been assumed to occur evenly throughout the year which may well not be the case, especially as Bhagat is clearly a growing company. Given materiality of Bhagat results and goodwill balance, adjustments here could clearly be material. Additional audit procedures An expert valuer may be required to assess this unless an exercise was carried out at the time of the acquisition May well also be fair value adjustments to values of non current assets. Need to determine nature of these assets and whether any independent valuation was carried out. Also need to consider whether adjustments should be made at the acquisition date for the application of group policies (clearance indicated that this effect has been posted to the income statement at present). Need to obtain management accounts or other evidence which give a more precise analysis of the split between pre and post acquisition results. Likely to be significant additional work to do in auditing this once company has prepared it Consolidation schedules are at summarised level. Will also need to complete work on detailed disclosures within group accounts. Work done on consolidation adjustments comprises largely a description of the adjustment. Need to ensure that the amounts of the adjustments and the financial statement captions to which they have been posted has been substantiated by agreement to individual company results or other supporting documentation. Also need to ensure that completeness of the consolidation entries has been considered by comparison to prior year and our knowledge of the way the companies trade and interact.

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Examiners comments Certain subsections of this question were answered well. The issues relating to Bhagat, and the going concern problems with Aducit demonstrated judgment and assimilation skills. Relatively fewer candidates spotted the pensions aspect of Bhagat, but many got the point about the differences between Ruritanian and international standards and the points relating to reliance on other auditors' work and Ruritanian auditing standards. Aspects of the question, which were done less well, were relating to consolidation. Few candidates made the substantive point that the audit work done on the consolidation schedules was completely inadequate. Very few appreciated that the calculation of goodwill involved the identification of fair values on acquisition. Most candidates betrayed a scanty knowledge of accounting for groups. Overall it was disappointing to see that students in most cases were focussed solely on the implications of the issues at the individual company level rather than considering the wider implications for the group accounts. This was particularly the case in respect of the going concern and the obsolescence issue. Many candidates demonstrated a familiar obsession with foreign currency translation, and this was quite often the only contentious issue identified in relation to the consolidation schedule. The quality of the audit work suggested varied but overall candidates were probably more specific in the nature of the work suggested than in past sittings.

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TI BR Advanced Stage July 2010

BR Question 4 - Precision Garage Access plc

Scenario The scenario is a listed company, PGA, which manufactures and installs garage doors for private residences. There are two types of garage door produced which have different prices and margins. The candidate is a senior working for PGAs auditors and is currently supervising the planning and interim audit work. As part of the planning process, an audit junior has completed some initial analytical procedures on the interim 9 months management accounts. The analysis by the audit junior is inadequate and the candidate is required to carry out more detailed analytical procedures with supporting calculations. The candidate is also required to outline the audit risks that arise from the patterns and trends identified in the analytical procedures and set out the audit procedures. Finally the candidate is asked to identify the financial reporting issues that arise from the audit issues identified in respect of both the 9 month interim financial statements and the full year financial statements.

Available Marks Requirement 1. Carry out revised analytical procedures identifying any unusual patterns and trends in the data which may require further investigation. Technical marks 7 Skills marks 6 Skills assessed Comparison of actual and imputed figures based on data provided. Use of judgement in interpreting data and offering potential reasons for variances Correct analysis and treatment of staff bonus Appropriate calculation and interpretation of working capital ratios.

2. 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 3. Set out the financial reporting issues that arise from the above audit work

Structuring of presentation of audit work to link into each analysis for each audit area Use of data to identify risks and identification of appropriate audit tests Identification of key financial reporting issues. Specify correct financial reporting treatment

Total marks Maximum marks

13 25

12

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To: From: Date: Subject:

Gary Megg, Audit Manager A. Senior 26 July 2010 PGA audit

1. Analytical procedures 1.1 Income statement 9m to 30/6/2010 Revenue: Monty Gold Cost of sales: Monty Gold Gross (loss)/profit Fixed administrative and distribution costs Exceptional items Staff bonus scheme (Loss)/Profit before tax Income tax expense (Loss)/profit for the year 7,500 14,000 (6,700) (15,500) (700) (1,200) 9m to 30/6/2009 9,600 28,800 Note 2 (7,800) (23,400) 7,200 (1,200) Note Note 1

(450) (2,350) 0 (2,350)

6,000 (1,680) 4,320

Note 3

Note 1 Revenues Revenue of the Monty has declined by 21%. Revenue of the Gold has declined by 51%. The predicted values of revenue for each of the products are as calculated below. These are based on actual volumes sold (from the inventory records) x list prices. Monty 9,000 units x 840 = 7.56 m The actual revenue for sales of Monty is 7.5m which is extremely close to the predicted level and therefore provides some assurance. Gold 6,000 units x 2,520 = 15.12m The actual revenue for sales of Gold is 14m which is a difference of 8% and may represent a risk of material understatement of sales (eg through significant and inappropriate discounting of sales, or errors in recording of sales.) Audit work Verify the data provided by Claire which was used to make the predictions in the analytical procedures Agree standard prices to price lists and time of price change. Test standard prices against sample of invoices Review inventory records against inventory count information or continuous inventory records

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Enquire whether significant discounts have been made which may explain the shortfall. Determine conditions for discounting and relevant authorization enquiries from invoice sample. 70% of sales are overseas and denominated in euro. The standard price is fixed in euro at the beginning of the year as equivalent to the , but exchange rate movements during the year may have caused a change. As a consequence, the actual revenue may have moved out of line with the predicted revenue based in s. Review exchange rate movements and examine whether the translation is at the actual or average /euro exchange rate. (This test also applies to each category of cost.)

Note 2 - Cost of Sales Cost of sales of the Monty declined by 14%. Cost of sales of the Gold declined by 34%. Using the quantity data provided by Claire, a significant fall in cost of sales would have been anticipated due to reductions in total variable costs. The reduction in cost of sales would however be expected to be smaller in percentage terms than the reduction in revenues as this is a manufacturing company and hence some costs are fixed. This fixed element of costs therefore does not change despite the fall in volumes. The predicted values of cost of sales are: Monty (4m x 9/12) + (9,000 units x 840 x 50%) = 6.78m The actual cost of sales of Monty is 6.7m which is extremely close to the predicted level and therefore provides some assurance. Gold (12m x 9/12) + (6,000 units x 2,520 x 50%) = 16.56m The actual cost of sales of Gold is 15.5m which is a difference of 6.8% and may represent a risk of material understatement of cost of sales if the understatement is due to errors and omissions. It is not clear from the data whether the cost saving arises from lower variable cost per unit or fixed costs savings but this requires further investigation. Audit work While the percentage difference is smaller for cost of sales than for revenue it may be more concerning as exchange rates do not appear to an explanatory factor as manufacturing is in the UK. However installation costs and the sales network are incurred in euro so the exchange rate effect is not entirely to be ignored. As cost of sales and revenues are both lower than anticipated this may be a consistent explanation. Agree the total fixed costs being incurred against budget assumptions Review the method of allocation of fixed production costs as given the seasonal nature of the businesses then if the allocation is on a time basis, rather than a normal usage basis, this may distort the costs allocated to cost of sales and inventory. Similarly, the large fall in volumes compared to previous years may not represent a normal usage basis in allocating fixed production costs to units of output An alternative explanation for the increase may be that there are fewer economies of scale arising from the smaller production runs from the lower volumes. Variable cost per unit may therefore have risen. As we are relying on budget data, review of the budgeting process and its historic accuracy

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

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Gold based on results for 9 months to 30.6.09 Actual gross loss Revenue difference COS difference Imputed loss from analysis (1,500) 1,120 (1,060) (1,440)

Overall the possible indicated misstatement 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 is sales volumes of Monty and a 50% reduction in sales volumes of Gold compared to the 9m period last year. Given the high fixed costs, then cost of sales has not fallen in line with revenues and a gross loss has been made. As the business is seasonal then further losses are anticipated in the fourth quarter as revenues will be low and fixed costs will be high, being recognised on a time basis. Note 3 Staff Bonus The full year bonus is potentially 600,000. An accrual of 9/12 of this amount (i.e. 450,000) appears to 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 2010 are expected to be the same as the final quarter of the year ending 30 September 2009. On this basis revenue will be: 9 months to 30 June 2009 Y/e 30 Sept 2009 Final quarter y/e 30 Sept 2009 Price increase 5% 9 months to 30 June 2010 Projected revenue y/e 30.9.2010 38,400 41,600 3,200 3,360 21,500 24,860

This is lower than 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 assess 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 of the interim final statements a combination of the latest actuals and the budget would be needed. Examine the terms of the bonus agreement and of any announcement or other undertakings with staff regarding the possible payment of the bonus. 1.2 Statement of financial position 1,2,1 Receivables 9 months to 30 June 2010 Receivables days = = (2,400/21,500) x 270 days 30 days

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9 months to 30 June 2009 Receivables days = = Y/e 30 Sept 2009 Receivables days = = (1,000/41,600) x 360 days 8.7 days (4,300/38,400) x 270 days 30 days

Alternatively use last quarter: Receivables days = = (1,000/3,200) x 90 days 28 days

Superficially it may seem that receivables have fallen substantially from 4.3m to 2.4m. On closer inspection however the reduction is in line with the fall in sales and the receivables days are more or less the same. Conversely, it may seem the receivables at 30 September 2009 are very low using the first calculation of 8.7 days. However receivables reflect sales in the most recent month(s) before the statement of financial position is drawn up, rather than the average for the year. Given the seasonality of PGA then the final quarter sales are low and therefore the year end receivables are expected to be low. This is reflected in the alternative calculation of 28 days. 1.2.2 Inventories Superficially it may seem there has been little movement in inventories and thus it is low risk. However the inventory days shows significant movement: 9 months to 30 June 2010 Inventories days = = 9 months to 30 June 2009 Inventories days = = (3,500/31,200) x 270 days 30 days (3,500/22,200) x 270 days 43 days

The significant increase in inventory days shows that inventory remained constant but the expectation was that it should have fallen as the cost of sales has reduced through a lower level of commercial activity. Audit work Analytical procedures shows a low level of risk for receivables as the receivables days (30 days) is consistent both with the previous period and with the credit terms extended. Inventories are more concerning as we would have expected them to fall and they have not. The key tests are to look at older inventory to see if there is a problem with quality, settlement or ability to sell. It may also be worth looking at whether there has been a large increase in finished goods (eg cancelled orders in a recession). If this is the case, then an impairment of such inventories should be considered.

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Financial reporting issues Revenue There is a risk from revenue recognition policy as it may not be appropriate to record the sale of garage doors until the installation complete unless two elements are separable. Foreign currency translation According to IAS21 sales should be translated at the date of the transaction (or the average rate as an approximation). Given that sales are seasonal in the full year then there is a risk that the average rate may not be at an appropriate rate Staff bonus The bonus should only be recognised according to IAS19 when there is a constructive or legal obligation to make a payment. In this case, the full years revenue on which the bonus is based is expected to fall below 26m in the full year (see note 3 above) thus no bonus should be recognised in the interim or the final full year financial statements. Impairments of PPE The Gold product looks to be performing poorly in making losses and the estimate is that Sales of Gold doors are not expected to increase in the foreseeable future. Gold doors production seems likely to be a cash generating unit as the asset to make the Gold doors are separately identifiable from the Monty assets. Similarly, the revenue streams are also separately identifiable. As a consequence the value in use of the PPE used on the Gold production line (and other PPE specifically associated with the Gold product) seems likely to be low. Also the fair value less costs to sell also seem to be low as the Production equipment is specialised and highly specific to each of the separate production processes. In such circumstances the sharp downturn in Gold sales could represent an impairment event and therefore an impairment review of the Gold assets should be carried out. Receivables The amount for receivables is a monetary asset and so should be translated at the year end exchange rate. If in the recession bad debts are increasing then an impairment change should be considered.

Examiners comments There were some excellent answers which really used the information given in the question to produce expected revenue and cost of sales figures and receivable and inventory ratios. Having produced the figures the audit issues were then relatively easy to identify and these candidates were able to score high marks. The weaker answers were those which made little attempt to use the figures given in the question, or only in a very basic way and answered the question using very basic presumptions. For example there is a staff bonus scheme therefore revenue must be overstated; or revenue has declined therefore there is a cut off error; or cost of sales is understated therefore there is a foreign exchange error. Very few candidates appreciated the significance of the fact that we were only 3/4 of the way through the year, so the inventory and receivables calculations were often incorrect.

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It was not uncommon for students to ignore the financial reporting requirements of the question. Where candidates tackled the financial reporting properly, they often did well in identifying appropriate issues, although less well in describing the accounting. There were also some excellent answers to this question, but those candidates who were not prepared to get into the numbers in the question and use them to identify audit issues did not achieve a pass on this question

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