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JULY 2019
Mock Exam 1


Copyright © ICAEW 2019. All rights reserved.


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1 Minnex plc
The scenario in this question concerns a listed company, Minnex, which operates
a chain of department stores located throughout the world, but with a
concentration in the UK. The company has been struggling in recent years and, as
a consequence, the board was replaced about a year ago. The new board has
begun to implement a reorganisation including the raising of new finance. The
candidate is placed in the position of an audit senior at the interim audit. A number
of issues have arisen concerning: a reorganisation, management remuneration,
and financing.
Candidates are required to set out and explain the correct financial reporting
treatment for each of these issues and to redraft the financial statements to
include any adjustments arising from the matters raised. Also, with respect to each
of the matters raised, the audit manager has identified specific auditing and
advisory issues that the candidate is required to address.
Marking guide

Requirement Marks Skills

(1) Reorganisation 10 Identification of IFRS 5 criteria.
Audit tests question directors' assertion.
Impact of investment decisions considered,
including those just before the year end.
(2) Remuneration 9 IFRS 2 criteria applied, with clear
supporting calculations.
Auditing considerations should include an
identification of the factors affecting the fair
value of the options in this scenario.
(3) Financing 13 Correct identification of the swap as a fair
value hedge.
Relevant entries correctly set out.
(4) Cyber security 10 Implications of the cyber security breach
Weaknesses in the current arrangements
identified and the required changes
(5) Adjustments 9 Adjustments correctly incorporated into
revised financial statements.
Total marks 51

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Requirement Marks Skills
Maximum marks part (1) 8
Maximum marks part (2) 7
Maximum marks part (3) 10
Maximum marks part (4) 8
Maximum marks part (5) 7
Maximum marks 40

To: Eddie Futch (audit manager)
From: T.I. Senior
Date: 1 December 20X6
Subject: Minnex audit
(1) The reorganisation
Financial reporting
IFRS 5 requires that a non-current asset, such as one of Minnex's retail stores (or
disposal group of assets eg, including the stores' fixtures and fittings), 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 two Scottish
stores identified in the Minnex Strategic Review are therefore potentially in this
To be classified as 'held for sale' the stores 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.
Also, the stores must be actively marketed for sale by Minnex at a price that is
reasonable in relation to its current fair value (which appears to be the case for the
Edinburgh store where the expected sales price is £24 million and the fair value is
£25 million). For a sale to be considered as highly probable there should be a
committed plan and Minnex management should be actively trying to find a buyer.
The commitment by Minnex's management that a sale will take place should be
such that withdrawal from the plan is unlikely.
The conditions for sale should be met before the end of the reporting period if the
stores are to be recognised as 'held for sale' assets in Minnex's statement of
financial position at 31 December 20X6. If the conditions are only met after the
end of the reporting period, there should be full disclosure in the notes to the
financial statements. Depreciation should cease when the held for sale criteria are

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Edinburgh store – It would appear that this store should probably be treated as
'held for sale' if a contract is drawn up with a specific buyer and if completion is
due only three months after the year end. However, if the company did not wish to
have the asset treated as held for sale, it would need to delay signing the contract
until after 31 December 20X6, but even this may not be sufficient, as there would
need to be significant uncertainty regarding the sale and contract completion
before the asset would not be treated as held for sale.
Glasgow store – As the decision has not yet been made it would appear unlikely
that there is currently a committed plan, even though a potential buyer has been
found. On the basis of current evidence therefore, this store is not 'held for sale' in
accordance with IFRS 5. This situation must be reviewed, however, up to
31 December 20X6 in case such conditions are fulfilled before the year end.
Accounting treatment
A non-current asset, or disposal group, that meets the recognition criteria to be
classified as 'held for sale' should be measured at the lower of its carrying amount
and its fair value less costs to sell at the date that they are deemed as held for
sale. The current values will therefore need to be reassessed at this date.
Separate disclosure in the statement of profit or loss and other comprehensive
income as 'discontinued operations' is also required when a company discontinues
a 'component' of its activities, which should have been a cash generating unit
while held for use. The definition of a discontinued operation is when it is classified
as 'held for sale' or when it is sold and according to IFRS 5 para 32:
(a) represents a separate major line of the business or geographical area of
(b) is part of a single co-ordinated plan to dispose of a separate major line of the
business or geographical area of operations; or
(c) is a subsidiary acquired exclusively with a view to resale.
Thus, in this case, IFRS 5 para 32(b) probably applies as the closures are part of
the single co-ordinated plan to withdraw from the Scottish market as part of the
strategic review.
A component of an entity comprises operations and cash flows that can be clearly
distinguished operationally, and for financial reporting purposes, from the rest of
the entity and this seems likely to include each individual Minnex store given their
size and discrete nature. The question of whether the two closures are 'major' is,
however, a question of judgement. However, from the redrafted financial
statements (see below) the profit after tax from continuing operations is
£7.76 million while the profit after tax of discontinued operations is around
£1.54 million (which is just the Edinburgh store). Thus discontinued profit is 20% of
continuing profit, which would normally be judged to be 'major'. As the disposal is
to be made under multiple contracts to different purchasers it does not constitute a
disposal group.

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Edinburgh store – Given that the carrying amount (£2 million) is significantly less
than the fair value and the estimated sales proceeds, no adjustment would be
made to the asset's value upon classification as a 'held for sale' asset. These
values should be re-estimated at their year-end values, but on reclassification as
held for sale there should be no further depreciation.
Assuming classification as 'held for sale' before the year-end, the profit relating to
the Edinburgh store should be disclosed separately as discontinued operations in
the statement of profit or loss. If revenue is £14 million, then cost of sales is 66%
of this amount at approximately £9.2 million. Operating profit is £2 million, leaving
£2.8 million for other operating costs. These figures should be backed out of the
continuing activities net of tax.
Glasgow store – While the Glasgow store should not be classified as 'held for
sale', its fair value (£8 million) is less than the carrying amount (£12 million).
At the year end, there is a requirement to consider whether there is indicative
evidence of impairment in accordance with IAS 36. The difference identified above
is an indicator of impairment. Given that the Glasgow store is to be sold, and does
not appear to be making any profit, its value-in-use does not appear to be
significant. There should therefore be an impairment charge of £4 million in
respect of the Glasgow store. The 31 December values should be used for
impairment so the valuations need to be reviewed at the year end for any major
changes from those existing at 30 November.
The impairment charge may affect the deferred tax charge/balance as it has no
effect on the tax base but it will change the carrying amount. More information will
be required to consider the deferred tax adjustment further.
Specific audit and advisory issues
Establishing fair values
The fair value assertions made by Minnex's management in respect of the two
properties planned for disposal need to be evidenced by third party valuations.
This may be evidence provided by management's experts, independent third
parties used by the client (eg, valuers) or, where there is doubt, it may be
necessary to commission our own expert independent valuations, especially if the
sales of the properties have not been completed by the time we conduct the audit.
Audit tests may include scrutiny of: board minutes; strategic plans; legal contracts
and correspondence; valuations; budgets; performance reports, all to corroborate
the financial details of these two properties and the reported actions of Minnex's
management. If we use evidence provided by management's experts we will need
to perform audit procedures to evaluate the competence, capabilities and
objectivity of that expert, obtain an understanding of the work of that expert by
inspecting their report and the terms of reference agreed with Minnex; and
evaluate the appropriateness of that expert's work as audit evidence.

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(2) Managerial remuneration
Financial reporting
The share option issue is an equity-settled share-based payment transaction in
accordance with IFRS 2.
The three years of service required by the option contract is a non-market vesting
condition which should be taken into account (per IFRS 2: para. 19) when
estimating the number of options which will vest at the end of each period. The
proportion of directors and senior managers retained is therefore relevant in
determining the remuneration charge arising from the options.
The retention rate is not, however, relevant in determining the fair value of the
options which are measured at their fair value at the grant date (per IFRS 2:
para. 11). It is thus the fair value at 1 December 20X6 that is used in determining
the remuneration expense (ie, £3).
The cumulative remuneration expense in respect of the options is thus:
(The number of managers expected to be retained for three years)  (the number
of options granted)  (fair value of options at the grant date)  (the proportion of
the vesting period elapsed).
As there was no brought forward amount in respect of the options, the
remuneration expense for the year ended 31 December 20X6 is:
(120,000  75)  (80%)  £3  1/36 months = £600,000
The expected number of options to be issued will depend on management's
estimates at 31 December 20X6 about retention. In this illustration the expectation
at the date of grant has been used. The change is unlikely to be material in such a
short period of time.
In 20X7, however, there will be a full year's charge of:
(120,000  75)  (80%)  £3  1/3 years = £7.2m
This assumes that there is no change in the estimated retention rate.
This would be a substantial amount in relation to the current profit before tax. (It
would however be moderated by the deferred tax effect in terms of profit after tax
– see below.)
The financial reporting expense charged to profit or loss in respect of equity-
settled share-based payments does not normally correspond to the tax charge. A
tax allowable expense in connection with a share-based scheme is available at the
date of exercise, measured on the basis of the option's intrinsic value at that date.
As a result, there is a deferred tax impact, as a deductible temporary difference
arises between the tax base of the remuneration expense recognised in the profit
or loss and its carrying amount of nil in the statement of financial position (as the
credit is to equity). This generates a deferred tax asset.
A further difficulty in the calculation of the deferred tax asset is that the share price
for tax purposes is determined at the exercise date which is unknown at Minnex's
current year end. It therefore needs to be based on the best available information
which is normally the value at the year end.

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Therefore if the intrinsic value of an option is £3.33 (ie, £6 – £2.67) at
31 December 20X6:
Then the tax deduction per share is £3.33
The total tax deduction is therefore £3.33  (120,000  75)  80% = £24m
The deductible temporary difference relating to the expense recognised to date is:
£24m  1/3  1/12  23% = £153,000
This will be recognised as a deferred tax credit in the statement of profit or loss
and other comprehensive income and a deferred tax asset in the statement of
financial position.
1 IAS 12 requires the use of the liability method, which means that we use the
tax rate in force when the liability reverses. This may not be 23%; however,
given that the tax rate is not expected to change at present, it is reasonable to
assume a rate of 23%.
2 This deferred tax adjustment is rounded to £0.15 million in the adjustments to
the financial statements in the appendix below.
Specific audit and advisory issues
Valuing of options
The fair value of the options depends on a number of variables and these need to
be judged in an option pricing model (eg, Black-Scholes-Merton model, Binomial
Lattice, Monte Carlo simulation). The key date to judge fair value is the proposed
grant date for Minnex which is 1 December 20X6.
The following variables are relevant to the fair value of Minnex's share options:
The underlying share price – as Minnex is a listed company the share price is
observable. While it may change from its current estimated value before granting
this is likely to be insignificant given the short time span.
Exercise price – this is determined by the terms of the arrangement and is thus
known and verifiable.
Dividend – given that the option holders are not normally entitled to a dividend,
the greater the dividend the lower the share price and thus the lower the option
price. Any uncertainty in dividend policy will therefore impact upon the fair value of
the options. The past dividend history of Minnex would indicate future dividends
but a review of board minutes may indicate any change in intended dividend
Volatility – there are a number of different measures of volatility but, in general,
the greater the volatility in the underlying share price the greater the value of the
option. This is because option holders have downside protection from large falls in
share price but have upside potential for increases in share price. The historic
share price of Minnex appears to have been volatile but the key issue is future
volatility, which is difficult to ascertain and verify as it depends upon market

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Time – in conjunction with underlying Minnex share price volatility, the length of
time that the option can be used could vary between three and five years, adding
to the complexity of this estimate.
Interest rates – if interest rates increase then the present value at the exercise
date decreases.
The intrinsic value of the option is used if estimates are unreliable but given that
Minnex is a listed company this is unlikely. The intrinsic value is, however, an
initial lower boundary guide price for the fair value of the option before considering
other variables such as the time to exercising and volatility.
Matters to discuss with the audit committee
The basis upon which the company determines the fair value of the options will
have to be discussed. It is unlikely that any of the instruments has a comparable
financial instrument that is actively traded on the open market. As discussed
above, the values should be based upon one of the recognised valuation models
provided in finance theory, maximising the use of observable inputs as required by
IFRS 13. These are combined with a number of inputs such as whether the
options are 'in the money' or not, the remaining life of the options and the volatility
of the underlying shares.
Provided the company is using an orthodox valuation model and calculated the
estimated fair values using historical observations of the associated parameters, it
should be relatively straightforward for us to check that the resulting figures are
defensible. We might consider obtaining written representations from the directors
that they believe that the model is a realistic means of deciding the fair value, but
that should be sufficient. Any authoritative external advice taken by the directors to
value the options should have been documented, and should be examined for
accuracy and reasonableness given the parameters already agreed.
The number of options granted can be vouched to the associated documentation
and the vesting conditions can be confirmed. We should seek a formal assurance
that there are no undisclosed options or schemes because it would be relatively
easy for management to suppress this information until such time as the options
were exercised.
The assumptions concerning the likelihood of the options vesting ought to be
discussed with the audit committee. There is a risk of material misstatement due to
inappropriate assumptions. The assumption behind the estimate that 80% of the
directors and managers will remain in the company after three years may be
agreed to budgets and plans for managerial staff recruitment. This is, however,
clearly an issue that will require written representation.

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(3) Financing
(a) Bond and swap
Financial reporting
Assuming the IFRS 9 hedge effectiveness criteria have been met:
Assuming that the swap is an effective fair value hedge, and has been
documented as such, then the adjustments are:
The swap should be recognised initially measured at fair value of zero:
DEBIT Derivative asset – hedging instrument £nil
CREDIT Cash £nil
The swap, immediately before the settlement, and the bond are subsequently
remeasured to fair value:
DEBIT Derivative asset – hedging instrument £2m
CREDIT Interest expense £2m
Being the change in the fair value of the swap
DEBIT Interest expense £1.25m
CREDIT Loan stock £1.25m
Being the change in the fair value of the bond
Settlement of the swap in the period:
DEBIT Cash (£3.75m – £3m) £0.75m
CREDIT Derivative – hedging instrument £0.75m
Note: The cash payment of £3.75 million interest on the bond has already
been recorded.
The draft financial statements have been adjusted on the assumption that the
hedge is effective. If the hedging provisions in IFRS 9 did not exist then
movement in the fair value of the swap would impact on the profit or loss and
produce earnings volatility as the bond itself would be recognised at amortised
cost. The alternative hedge accounting enables the movements in the fair
value of the bond to be offset against the fair value of the swap derivative. The
net amount of interest expense is £3 million.
Specific auditing and advisory issues
Risk management
Minnex will, in effect be paying variable rate interest (LIBOR) on the bond
rather than the original fixed rate. As a result, the fair value of the bond will not
be exposed to future interest rate movements.
While fair values are protected by this arrangement the future interest cash
flows are exposed to more risk as they are now variable and thus are subject
to change, as LIBOR changes.
The swap arrangement ties the company into variable interest rates rather
than being exposed to changes in fair values. This arrangement is however
only for three years. While the loan may be refinanced after this period at new

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fixed rates, the new rates will reflect movements in interest rates over the next
three years and may therefore be higher.
While the swap agreement mitigates fair value risk on the bond it does not
mitigate foreign exchange risk. The purpose of the loan is to acquire new
stores. It is suggested, however, that the new stores will be located outside the
UK so there is no matching of the asset and the liability in terms of currency.
If the stores are purpose built then there may be changes in costs arising from
currency movements. Other methods may be used to mitigate currency risk
such as futures, options or merely converting the cash into euros when
received from the lender. Evidence needs to be acquired as to whether
Minnex has taken any of these steps to mitigate currency risk.
The loans also increase financial risk by increasing gearing. At the year end
there are 50 million ordinary shares in issue with an estimated market value of
£6 each. Market capitalisation is therefore £300 million.
The gearing based on market values (including the £102 million relating to the
current proportion of long term borrowing) is therefore:
(£196m + £1.25m + £102m)/£300m = 99.75%
Based on net debt it would be:
(£196m + £1.25m + £102m – £115.75m)/£300m = 61.2%
Where £115.75 million is made up of cash balances of £115 million and net
interest receivable from the swap of £0.75 million.
While net debt is normally a reasonable measure of gearing it is unreliable in
these circumstances as the cash is earmarked to be spent on new stores in
the near future.
Hedging documentation
At the inception of the hedge (ie, before 1 July 20X6) there should be formal
designation and documentation of the hedging relationship and Minnex's risk
management objective and strategy for undertaking the hedge. The audit tests
should substantiate the existence and adequacy of documentation covering
the following matters:
 Risk management objective and strategy (eg, how the swap fits into
Minnex's overall risk management strategy including its target ratio of fixed
debt to floating debt).
 Identification and description of the hedging instrument (the swap
 Details of the related hedged item or transaction (ie, the £100m fixed
interest bond).
 The nature of the risk being hedged (£ sterling interest rate risk).
 Details of how Minnex has assessed the hedging instrument's
effectiveness prospectively.
 Details of how Minnex will assess the hedging instrument's effectiveness

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Specific documentary details should include:
 Background information concerning the parties to the swap arrangement.
 Details of interest rate hedge swap of fixed to floating interest rates.
 Description of prospective and retrospective effectiveness testing. The
hedging relationship must meet all of the hedge effectiveness
requirements of IFRS 9, namely (IFRS 9 para 6.4.1(c)):
– there is an economic relationship between the hedged item and the
hedging instrument;
– the effect of credit risk does not dominate the value changes that
result from that economic relationship; and
– the hedge ratio of the hedging relationship is the same as that actually
used in the economic hedge.
(b) Future financing choices
(1) Financing comparison of loan stock and bank loan
The implicit interest rate on the loan stock is calculated as:
[(131/100)1/4 – 1] = 7% approx.
The implicit interest rate in the bank loan is 6.5%.
While the bank loan appears cheaper there are a number of other factors
to be considered:
 There is a liquidity advantage to the loan stock as interest need not be
paid in cash until redemption. Moreover, because the tax rules follow
the financial reporting rules the loan stock interest is tax deductible
even though no interest is paid. This gives a further cash flow
advantage. Note, however, that special anti-avoidance rules exist
where the two parties to the loan are connected companies.
 Typically there are more covenants on bank loans than loan stock and
this is implied in the requirement for the bank to have restrictive
 The issue costs of the loan stock are likely to be higher than the bank
loan and this will raise the effective interest rate further. Against this is
the cost of the assurance report that the bank requires prior to
approving any loan.
 The loans are not coterminous. The bank loan extends for an extra
year. This has a liquidity advantage from delaying refinancing or
repayment by one year. In evaluating loans of differing fixed periods,
however, the company will need to consider the term structure of
market interest rates. If long-term interest rates are falling then it would
be a disadvantage to be tied into a fixed rate for a longer period (and
vice versa).

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(2) Financial reporting comparison of loan stock and bank loan
The bank loan and the zero coupon bond have no financial statement
entries in the forecast, draft financial statements for 20X6, as further new
finance is not intended to be issued until 20X7.
Bank loan
Financial liabilities are generally accounted for at amortised cost under
IFRS 9. The bank loan would be shown as a liability of £50 million in the
statement of financial position for all relevant periods. The interest would
be £3.25 million per annum (£50m  6.5%). Tax relief would be available
amounting to £747,500 per annum (£3.25m  23%).
Loan stock
In all periods in which the loan stock is in issue, IFRS 9 requires that
interest should be recognised on an amortised cost basis even though no
cash is paid.
For relevant years the interest charges and balances (in £) would be as
Outstanding at Interest Outstanding at
Year 1 January Interest at 7% paid 31 December
£m £m £m £m
20X7 50 3.5 – 53.5
20X8 53.5 3.745 – 57.245
20X9 57.245 4.007 – 61.252
20Y0 61.252 4.288 – 65.5
Note: Rounding difference ignored = £0.04m
The interest charge will be tax deductible, thus the effect on taxation for
instance in 20X7 is £805,000 (£3.5m  23%).
As the tax rules for deductibility of interest follow the financial reporting
rules, there will be no deferred tax implications.
This interest on both forms of debt would normally be expensed in 20X7,
but if the debt is to be used to construct new stores in this year then,
according to IAS 23, these borrowing costs must be capitalised rather than
expensed if the conditions to satisfy interest capitalisation are met in 20X7
on the new building project.
(3) Assurance report issues
The key issues regarding risks for the assurance report include:
The new £50 million bank loan would be the second tranche of debt
finance raised by Minnex in just over a year. The first set of debt financing
generated £100 million in cash and yet, despite this new funding included
in the draft statement of financial position, the forecast cash balance is
only £115 million. The new funds raised are therefore available to
purchase new properties but there is little other financing available. The
new properties, and the other assets required in the new stores, will thus

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be almost entirely debt financed. The liquidity and cash generating
potential needs to be established (eg, examine cash budgets) in order to
estimate Minnex's ability to repay the loan.
The new debt will increase the level of gearing and therefore future
earnings volatility.
The liquidity will improve after the sale of the existing Scottish stores. This
will reduce net debt, but the expenditure on new properties will then
reduce cash and increase net debt.
Most of the carrying value of the existing properties is securing the existing
borrowing, £305 million against £298 million (£196m + £102m) of
borrowing. As the company is using the cost model however the fair
values may be significantly in excess of the carrying amounts and may
therefore, as Minnex management are suggesting, represent reasonable
Profitability of Minnex is low, therefore the ability to sustain loan
repayments from operating cash flows needs to be reviewed and may be
dependent on the success of the new strategy.
The company appears not to have raised much equity, as share premium
is low. This may be a good sign as directors do not want to issue shares
when they are more optimistic for the future than the stock market and
thus believe Minnex shares to be under-priced. However, a share issue in
the near future would reduce gearing and provide additional security for
debt holders. Any plans by directors to issue shares should be seen as an
element in the assessment of financial risk to which the bank will be
The seniority of the bank's debt against existing debt needs to be
considered. In particular, the relative impact of covenants in the bank's
loan compared to that of the bonds should not disadvantage the bank if
there is a breach of covenant in debt that is not owned by the bank.
It needs to be established whether any of the property's carrying amount
arises from stores held under a finance lease. To the extent they are then
they would represent weaker security for loans.
(4) Cyber security breach
Implications for the audit
 Information from the IT manager needs to be
corroborated/investigated further as his comments may simply be
those of a disgruntled employee.
 Assuming that the IT manager's comments are a fair reflection the
attitude of the board to IT issues has historically been poor. This could
have implications for other aspects of the company's systems
increasing the risk of error and/or fraud.
 The publicity surrounding the breach may have resulted in a loss of
customer confidence in the online offering. Whilst this is unlikely to

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raise going concern issues (online sales make up 40% of total sales)
revenue and profits could be affected in the short to medium term until
confidence is restored.
 All costs associated with the breach must be identified and we must
ensure that these are recognised correctly eg, potential claims by
customers for loss of personal details, fines for breaches of data
protection legislation and even further regulatory action that may
require urgent investment in new technology. The adoption of the
General Data Protection Regulation (GDPR) in the UK means that
data breaches can be punished by a fine of up to €20 million or 4% of
global turnover, whichever is higher. For Minnex, 4% of turnover for
the year ended 31 December 20X6 would be £17.7 million, which is
similar to the likely equivalent sterling value of €20 million and would
almost entirely wipe out the company's forecast profit before tax.
Clearly, this would be highly significant for the company and would
require prioritisation under our audit plan, most likely representing a
key audit matter.
 The security breach may have resulted in contagion to other IT
systems resulting in corruption of data or loss of data, including
financial information derived from the accounting system. This may
have implications for the scope of audit work and the availability of
audit evidence.
Weaknesses and expected changes
Weakness: No individual appears to have overall responsibility for cyber-
security. The IT manager appears to be responsible for this in respect of
the online store but there do not appear to be company-wide clear lines of
responsibility at board level.
Change: Minnex should appoint a chief information security officer or
designate an existing member of staff at an appropriate level of seniority to
take on this role.
Weakness: The board does not appear to be taking steps to fulfil its
responsibilities for risk assessment and control in relation to cyber
security. There appears to be a lack of understanding of the issue
amongst board members. Key business data is not identified and the
evaluation of associated risks seems to be trivialised.
Change: Non-executive directors and audit committee members should be
recruited with appropriate skills and/or existing members should receive
adequate training.
The board should evaluate the entity's risk appetite and implement
procedures to indicate instances where risks exceed this level.
There should be effective communication between the IT manager, the
board, the internal audit function and the audit committee.

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Weakness: The IT department appears to be underfunded which means
that security measures have not been able to keep pace with changes in
the nature of the threat.
Change: The audit committee should assess the adequacy of resources. If
necessary additional in-house staff with the relevant expertise should be
recruited (or consultants could be used).
Cyber security measures should be regularly monitored for effectiveness
(by internal audit) and revised as required.
Weakness: There is a lack of transparency regarding the recent breach
and staff are being encouraged to act unethically.
Change: Minnex must create an environment where individuals feel that
they can report concerns without fear of reprisals and are not pressurised
into making statements that are untrue.
Appendix (Part (5) – adjusted financial statements)
Forecast, draft summary statement of profit or loss for the year ending
31 December 20X6
Draft Adj (a) Adj (b) Adj (c) Adj (d) Revised
£m £m £m £m £m £m
Revenue 442 (14.00) 0 0.00 0.00 428.00
Cost of sales (292) 9.20 (4) (0.60) 0.00 (287.40)
Other expenses (111) 2.80 0 0.00 0.00 (108.20)
Financing costs (20) 0.00 0 0.00 0.75 (19.25)
Profit before tax 19 (2.00) (4) (0.60) 0.75 13.15
Tax (6) 0.46 0.15 (5.39)
Profit from continuing
operations 13 (1.54) (4) (0.45) 0.75 7.76
Profit from discontinuing
operations – 1.54 – – 1.54
Profit after tax 13 – (4) (0.45) 0.75 9.30
Note: Adjustments:
(a) Reclassification of the Edinburgh store as 'discontinued', as it is 'held for sale'.
(b) Impairment of Glasgow store.
(c) Share option scheme.
(d) Loan and swap arrangement. The £1.25 million gain on hedge and the
£1.25 million loss on loan stock are a 100% effective hedge and thus cancel
each other out and have not been included in the draft adjustments above.

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Forecast draft summary statement of financial position at 31 December 20X6
Draft Adj Revised
Assets £m £m £m
Non-current assets
Property, plant and equipment (Notes 1 and 2) 305 (2)(4) 299.00

Current assets
Financial assets (Note 4) 1.25 1.25
Inventories 81 81.00
Trade receivables 2 2.00
Cash and cash equivalents (Note 4) 115 0.75 115.75
198 200.00
Non-current assets 'held for sale' (Note 1) 2.00 2.00
Total assets 503 (2.00) 501.00

Equity and liabilities

Share capital 50 50
Share premium 14 14
Retained earnings (Note 5) 80 (3.70) 76.30
Other reserves – share options (Note 3) 0.60 0.60
Total equity 144 (3.10) 140.90

Non-current liabilities
Long-term borrowings (Note 4) 196 1.25 197.25
Deferred tax (Note 3) 20 (0.15) 19.85
Total non-current liabilities 216 1.10 217.10

Current liabilities
Current element of long-term borrowings 102 102
Trade payables 31 31
Current tax 10 10.00
Total current liabilities 143 143.00

Total equity and liabilities 503 (2.00) 501.00

1 Reclassification of Edinburgh store as held for sale
2 Impairment of Glasgow store
3 Share option scheme
4 Loan and swap arrangement
5 Sum of statement of profit or loss adjustments (ie, £13m – £9.30m)

17 of 40
2 Snedd
This question involves adjusting the financial statements of three companies (a
parent and two subsidiaries), and applying the principles of acquisition accounting
to produce consolidated financial statements. The most recently acquired
subsidiary is based overseas, and its results and position (in the form of a trial
balance) require translation. Other issues covered include adjustments within and
outside the measurement period, an adjustment to the overseas financial
statements in order to comply with IFRS, payment of a supplier in ordinary shares
and deferred tax adjustments.
Marking guide

Requirement Marks Skills

Acquisition of Bellte 8 Original calculation of goodwill, including:
Correct treatment of contingent liability
Non-controlling interest
Fair value uplift of specialist plant
Re-calculation of goodwill taking account
of new information
Acquisition of Terald 7 Calculating increase in fair value of the
financial asset
Correct translation of SPLOCI and SOFP
Goodwill on consolidation
Deferred tax 4 Calculation of temporary differences
Recognising deferred tax liability
Share-based payment 3 Explanation and adjusting entries correctly
set out
Preparation of Snedd's 8 Taking account of adjustments
consolidated statement of Setting out workings clearly
profit or loss and other
comprehensive income for
the year ended 31 May
20X4 and a consolidated
statement of financial
position at that date.
Maximum/available marks 30

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Explanation of the correct financial reporting treatment, showing appropriate
(1) Investment in Bellte Ltd
Goodwill on the acquisition date of 1 June 20X3 was originally calculated as
£'000 £'000
Consideration transferred 800.0
Non-controlling interest (25%  £922) 230.5
Net assets acquired
Net assets at carrying amount 932.0
Less contingent liability at fair value (20.0)
Add fair value uplift in specialist plant (£60,000 –
£50,000 (W1)) 10.0
Goodwill on acquisition 108.5
(1) Carrying amount of specialist plant at 1 June 20X3: 5/10  £100,000 =
However, the goodwill amount of £108,500 was based upon provisional values.
IFRS 3, Business Combinations, requires that during the measurement period
following acquisition the acquirer should retrospectively adjust provisional amounts
recognised at the acquisition date to reflect new information obtained about the
facts and circumstances that existed at the acquisition date.
In this case, the settlement of the contingent liability occurred within the
measurement period (which cannot exceed 12 months). The valuation of the
specialist plant, however, did not occur until after the 12 months had elapsed, and
therefore the provisional fair value cannot be retrospectively altered.
The recalculation of goodwill is as follows:
£'000 £'000
Consideration transferred 800.0
Non-controlling interest (25%  £902) 225.5
Net assets acquired
Net assets at carrying amount 932.0
Less contingent liability at fair value (40.0)
Add fair value uplift in specialist plant (£60,000 – £50,000 (W1)) 10.0
Goodwill on acquisition 123.5
Goodwill is increased by the group's share of the additional value of the contingent
liability (£40,000 – £20,000)  75% = £15,000. NCI at acquisition is decreased by

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Tutorial note
Journal entries are required as follows:
£'000 £'000
DEBIT Goodwill 15
DEBIT Non-controlling interests 5
DEBIT Contingent liability recognised 20
CREDIT Bellte operating expenses 40

Treatment of specialist plant:

In the consolidated financial statements this plant was recognised at the date of
acquisition, 1 June 20X3, at its provisional fair value of £60,000. At that date it had
a remaining useful life of five years. Because the valuation of the plant was made
after the end of the maximum measurement period of 12 months, the estimate of
its value at the date of acquisition of 1 June 20X3 was no longer relevant, and
therefore the provisional amount is not adjusted retrospectively.
In Bellte's own financial statements the carrying amount of the specialist plant at
31 May 20X4 was: £50,000 – (£50,000/5) = £40,000 ie, depreciated cost.
The carrying amount of the specialist plant in the consolidated financial statements
at 31 May 20X4 is calculated as follows:
£60,000 – (£60,000/5) = £48,000
The consolidation adjustment required in respect of depreciation is:
(£60,000/5) – (£50,000/5) = £2,000

Tutorial note
A journal entry is required as follows:
£'000 £'000
DEBIT Cost of sales 2
CREDIT Non-current assets 2

(2) Investment in Terald Inc

First, an adjustment must be made in respect of the measurement of the financial
asset. The increase in fair value is D$5,000 which must be recognised as a gain in
profit or loss, and as an increase in the carrying amount of the asset.
Profit for the year in Terald is D$20,000 (Revenue L$150,000 – cost of sales
D$112,000 – operating expenses D$15,000 – tax D$3,000) before accounting for
the fair value increase in respect of the financial asset, all of which is attributable
to the post-acquisition period. Of the D$20,000 profit half is attributable to the pre-
acquisition period (first six months of the year) and half is attributable to the post-
acquisition period. Therefore, equity at the date of acquisition, 1 December 20X3,
was D$160,000 (Share capital D$10,000 + Retained earnings at 1 June 20X3
D$140,000 + Pre-acquisition profit: D$10,000).

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The amounts to be consolidated by Snedd are therefore 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, and financial position
items are translated at closing rate.
Profit or loss
D$'000 Rate £'000
Revenue (150/2) 75.0 2.1 35.7
Cost of sales (112/2) (56.0) 2.1 (26.7)
Gross profit 19.0 2.1 9.0
Operating expenses (15/2) (7.5) 2.1 (3.6)
Other income (fair value increase in financial asset) 5.0 2.1 2.4
Profit before tax 16.5 2.1 7.8
Tax (3/2) (1.5) 2.1 (0.7)
Profit for the six months ended 31 May 20X4 15.0 2.1 7.1
Statement of financial position
D$'000 Rate £'000
Non-current assets (160 + 5) 165 2.2 75.0
Current assets 50 2.2 22.7
Total assets 215 97.7

Current liabilities 40 2.2 18.2

Therefore: equity 175 2.2 79.5
215 97.7
Reconciliation of exchange gain/loss
Opening net assets of £80,000 (D$160/2) plus profit of £7,100 = £87,100. Closing
net assets at closing rate = £79,500. Therefore there has been an exchange loss
of £7,600 (£87,100 – £79,500):
Exchange loss
£'000 £'000
Opening net assets of L$160 at opening rate of 2.0 80.0
Opening net assets of L$160 at closing rate of 2.2 72.7
Profit for the six months ended 31 May 20X4 of D$15.0 at
average rate of 2.1 7.1
Profit for the six months ended 31 May 20X4 of D$15.0 at
closing rate of 2.2 6.8
Exchange loss 7.6
Goodwill on consolidation is calculated as follows:
Consideration transferred: £100,000  2.0 200,000
Less net assets of Terald at date of acquisition (160,000)
Goodwill 40,000
On 1 December 20X3, the sterling equivalent of goodwill was D$40,000/2 =

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This is retranslated on 31 May 20X4 at the closing rate of exchange of 2.2 =
D$40,000/2.2 = £18,200 (to nearest £'000). There has therefore been a loss on
exchange of £20,000 – £18,200 = £1,800.
The overall exchange loss of (£7,600 + £1,800) £9,400 is recognised in other
comprehensive income.
(3) Deferred tax
Temporary differences for Snedd at 31 May 20X4:
In respect of accelerated capital allowances 300
In respect of revaluation surplus 600
Deferred tax liability to be recognised: £900,000  22% 198
At 31 May 20X3 Snedd's deferred tax balance was £92,000. A further £106,000 is
required to increase the deferred tax balance at 31 May 20X4 to £198,000. The
element of deferred tax relating to the revaluation surplus must be calculated and
presented separately in other comprehensive income:
£600,000  22% = £132,000. This leaves a credit of £26,000 (£132,000 –
£106,000) to be credited to income tax expense.
Temporary differences for Bellte at 31 May 20X4 are £180,000. Calculated at
22%, the deferred tax liability to be recognised is £180,000  22% = £39,600. The
deferred tax balance at 31 May 20X3 was £46,000, and therefore the adjustment
required is to debit deferred tax and credit income tax expense in profit or loss with
£46,000 – £39,600 = £6,400.
The debit to other comprehensive income is £132,000
The total credit to consolidated income tax expense is £26,000 + £6,400 =
The total credit to consolidated deferred tax is £106,000 – £6,400 = £99,600
(4) Payment of a supplier in shares
The issue of shares to Whelkin Ltd falls within the scope of IFRS 2, Share-based
Payment. It is an equity-settled transaction because, essentially, Snedd has
received goods in exchange for an issue of shares. This type of transaction, with a
third party, is normally measured at the fair value of goods and services received,
and should be recorded when the goods are received. The fair value of the issue
of 270 shares to Whelkin is therefore measured at £6,000 which is the value of the
goods provided to Snedd. The consultant's estimate of the fair value of Snedd's
shares at 31 May 20X4 is not relevant.
The prescribed accounting treatment is to recognise the fair value of the goods
provided in profit or loss, with a credit to equity. In this case, the fair value of the
goods has already been recognised in profit or loss as part of purchases of goods
for production. The adjusting entry is to derecognise the trade payable of £6,000
from current liabilities, with a corresponding credit to equity.

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Snedd Group – Consolidated statement of profit or loss and other
comprehensive income for the year ended 31 May 20X4
Revenue 10,732.7
Cost of sales (7,170.7)
Gross profit 3,562.0
Operating expenses and finance costs (2,004.2)
Profit before tax 1,557.8
Tax (350.3)
Profit for the year 1,207.5
Other comprehensive income 458.6
Total comprehensive income for the year 1,666.1

Profit attributable to:

Owners of the parent 1,168.4
Non-controlling interests (W1) 39.1

Total comprehensive income attributable to:

Owners of the parent 1,627.0
Non-controlling interests 39.1
Snedd Group – Consolidated statement of financial position at 31 May 20X4
Non-current assets
Goodwill 141.7
Property, plant and equipment 5,058.0

Current assets 2,973.7

Total assets 8,173.4

Equity and liabilities

Equity attributable to owners of the parent
Share capital 306.0
Retained earnings (W2) 4,225.4
Other components of equity 458.6

Non-controlling interests (W1) 264.6

Non-current liabilities
Deferred tax 237.6

Current liabilities 2,681.2

Total equity and liabilities 8,173.4

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(1) Non-controlling interests – Bellte
At 1 June 20X3 (as in revised goodwill calculation) 225.5
NCI share of profit for the year: (£112 + 40 (Contingent liability) – 2
(additional depreciation) + 6.4 (deferred tax – see section 3)  25% 39.1
At 31 May 20X4 264.6
(2) Consolidated retained earnings
£'000 £'000
Snedd: £4,075,000 plus deferred tax £26,000 4,101.0
Bellte: £1,014,000 less pre-acq of £902,000 112.0
Adjustments: (£40,000 operating expenses – £2,000
depreciation + £6,400 deferred tax) 44.4
Group share: 75% 117.3
Terald: post-acquisition (£75,000 – £67,900 see W4) 7.1
At 31 May 20X4 4,225.4
(3) Snedd Group – consolidation schedule at 31 May 20X4
Snedd Bellte Terald Adj 1 Adj 2 Adj 3 Adj 4
£'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000
Revenue 8,511.0 2,186.0 35.7 10,732.7
Cost of
sales (5,598.0) (1,544.0) (26.7) (2.0) (7,170.7)
Gross profit 2,913.0 642.0 9.0 3,562.0
exps (1,541.0) (502.0) (3.6) 40.0 2.4 (2,004.2)
PBT 1,372.0 140.0 5.4 38.0 2.4 1,557.8
Tax (354.0) (28.0) (0.7) 32.4 (350.3)
Profit for the
year 1,018.0 112.0 4.7 38.0 2.4 32.4 1,207.5
OCI 600.0 (9.4) (132.0) 458.6
TCI 1,618.0 112.0 4.7 38.0 (7.0) (99.6) 1,666.1

Goodwill 123.5 18.2 141.7
PPE 3,512.0 1,463.0 75.0 8.0 5,058.0
Investments 900.0 (800.0) (100.0) –
assets 2,365.0 586.0 22.7 2,973.7
Total Assets 6,777.0 2,049.0 97.7 (668.5) (81.8) 8,173.4

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Snedd Bellte Terald Adj 1 Adj 2 Adj 3 Adj 4
£'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000
Equity and
capital 300.0 30.0 *4.5 (30.0) (4.5) 300.0
RE 4,075.0 1,014.0 75.0 (902.0) (67.9) 32.4 4,225.4
Reserves 600.0 (9.4) 6.0 (132.0) 464.6
NCI 225.5 264.6

Deferred tax 92.0 46.0 – 99.6 237.6

liabilities 1,710.0 959.0 18.2 (6.0) 2,681.2
Equity and
liabilities 6,777.0 2,049.0 97.7 (668.5) (81.8) – – 8,173.4
* Share capital in Terald, translated at closing rate of 2.2 (10/2.2)
(4) Elimination of pre-acquisition retained earnings in Terald
Total equity in Terald at 31 May 20X4 (see translation of statement
of financial position in section 2 of answer) 79.5
Less share capital translated at closing rate of 2.2 (4.5)
Retained earnings at 31 May 20X4 75.0
Post-acquisition retained earnings (see translation of statement of
profit or loss in section 2 of answer) (7.1)
Pre-acquisition retained earnings 67.9
Examiners' comments
General comments on candidates' performance
There are examples of overseas subsidiary consolidation in the learning materials.
Therefore this question should not have been unexpected for candidates preparing for
this assessment. The question included a standard consolidation of a UK subsidiary,
which is covered in the financial accounting and reporting paper at professional level.
It was very often this basic knowledge which was missing in the weak candidates.
There were plenty of marks to be gained from dealing logically with the specific
financial reporting issues in advance of preparing the consolidation itself.
Detailed comments
Acquisition of Bellte
Well prepared candidates had little difficulty in setting out the required implications of
the adjustments arising from the remeasurement of the liability and the subsequent
determination outside of the measurement period of the fair value of the machine.
It was pleasing to see that candidates appreciated that these issues would impact on
the measurement of goodwill. Although it was not uncommon for weaker candidates to
make the wrong assumptions about the measurement period or to miscalculate the
dates (30 June 20X4 – is in fact 13 months after the acquisition date – 1 June 20X3).
Plenty of candidates also went on to calculate the extra depreciation charge arising on

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the adjustment to fair value but a significant minority did not appreciate that this
adjustment was for consolidation purposes only. There were also some references to
revaluation reserves which were poorly explained.
Overseas subsidiary
Well prepared candidates were able to produce relevant workings to show how the
financial statements of Terald were to be translated and the calculation of exchange
losses and the appropriate accounting treatment. Goodwill was very often correct and
the appropriate exchange adjustment calculated.
Common errors were:
 taking a full year of results for Terald instead of 6 months
 not adjusting for the fair value adjustment for the financial asset
 using inappropriate rates
 recognising exchange adjustments in profit for the year instead of OCI
Deferred tax
Candidates were aware of deferred tax which was a positive point. There seemed to
be little difficulty in calculating the in-year timing differences and appreciating that
these would impact on the profit or loss (and OCI in respect of the revaluation).
However even the better candidates sometimes failed to spot the brought forward
deferred tax liabilities on the respective balance sheets and therefore processed the
whole timing differences as a movement to profit or loss and OCI instead of calculating
the movement between the closing and opening liabilities. Also worrying to see was
that sometimes all three companies were adjusted on a group basis instead of
identifying deferred tax for the individual companies prior to consolidation. Deferred tax
and current tax are key advanced level topics and the coverage in the learning
materials is extensive. Candidates would be advised to prepare well for
this topic.
Payment of a supplier in shares
Most well prepared candidates scored maximum marks for this and this issue
presented little difficulty. Poorly prepared candidates scored very little.
Preparation of consolidation
If the ground work was done carefully and with clear workings, some candidates
produced consolidated SOFP and statement of profit or loss. Weaker candidates
demonstrated large holes in prior knowledge. For example – it was not uncommon to
see candidates taking a 75% share of Bellte's results and assets? Or fail to cancel cost
of investments with pre-acquisition reserves and share capital. Questions at advanced
level assume basic understanding of technical topics and will continue to progress
from these skills and technical issues acquired in earlier studies.

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3 Wecare
Marking guide

Requirement Marks Skills

For each of the two issues
described in Liz's email
(Exhibit 2), set out:
(1) (a) An explanation of 13 Identify the impairment of Mayfield
the appropriate Road.
financial reporting Advise that the group impairment loss
treatment in both may be higher due to fair value
the consolidated adjustment.
and individual
companies' financial Determine that the goodwill on
statements: consolidation may be impaired.
 Mayfield Rd Distinguish costs which require
 Investment in Gull
Determine that the subsidiary would no
longer be consolidated and determine
profit on disposal of the subsidiary.
(b) The specific audit 8 Recommend relevant audit procedures
procedures we to address financial reporting issues
should carry out identified.
during our audit for
the year ending
31 July 20X4.
(2) (a) Identify and explain 8 Perform financial statement analysis to
any other audit identify audit issues.
issues which you Link information from different sources
have noted from in the scenario.
your review of the
accounts (Exhibit 3)
and the other
(b) For each audit 6 Recommend relevant audit procedures
issue, set out the to address audit issues identified.
key audit
procedures we
should perform.

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Requirement Marks Skills
(3) Explain the matters that 6 Discuss the appropriate level of
the firm needs to assurance that can be given in an
consider in determining engagement to review prospective
whether or not to accept information.
the engagement to Identify the need to understand the
review the Wecare intended use of the prospective
group companies' information, as discussed in ISAE 3400.
forecast financial
statements. Identify the independence threats that
may be posed by accepting the
engagement, and suggest relevant
Total marks 41
Maximum marks 30

(1) (a) An explanation of the appropriate financial reporting treatment in

both the consolidated and individual companies' financial statements
and specific audit procedures we should carry out
Mayfield Road – Points for response to Liz
It is clear from the information provided that there has been an impairment
in the value of the Mayfield Road property. The carrying amount of the
property will need to be reduced to recoverable amount which is the higher
of its fair value less costs to sell and its value in use. As there is no
intention to continue to let the property, fair value less costs to sell is likely
to be the higher. (Alternatively, as the property is to be disposed of it has
no further value in use other than its disposal value.)
The estate agent's valuation would give rise to an impairment loss of
£0.7 million in the financial statements of Twilight, assuming that it is
appropriate to use the estate agent's valuation (will only be so if it is fair
value less costs to sell). However, the recoverable amount should also
take account of the direct costs of sale so the actual impairment loss may
be higher. The loss should be charged as a cost to profit or loss giving rise
to the entry:
DEBIT Impairment loss in profit or loss
CREDIT Carrying value of property
The carrying amount of the property may be higher in the group accounts
as an increase in the value of property was recognised as a fair value
adjustment when the company was acquired a year ago. To the extent
that the fair value adjustment relates to Mayfield Road, a higher
impairment loss should be recognised.

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There is also the question of whether the decision to shut down one of the
apartment buildings gives rise to any impairment of goodwill at the group
level. Each apartment building is a separate cash generating unit but it is
unclear whether the goodwill has been or can be allocated between them.
To the extent that it can be allocated then the element relating to Mayfield
Road will be totally impaired as the decision has been made to cease this
element of the business. This will give rise to an additional charge for
impairment within group profit or loss.
If the goodwill cannot be allocated between the three apartment buildings
(CGUs) then an impairment test will be required across all three CGUs
combined to determine whether the remaining carrying value of the net
assets and goodwill within the consolidated financial statements is
supported by the net present value of the cash flows to be generated from
the remaining two apartment buildings. To the extent that it is not, any
impairment charge will be allocated first to the goodwill balance and then
to the other assets.
Closing the Mayfield Road apartment building will also have other
consequences and give rise to other costs. These are likely to include
costs associated with relocating the remaining tenants who will have rights
under their tenancy agreements which will need to be honoured or
possibly renegotiated. There may also be staff redundancies and security
and other costs associated with the vacant site in the period to disposal.
As the decision is to be communicated to staff prior to year end, the
redundancy costs should be provided under IAS 37 as should contractual
amounts payable to the remaining tenants. Other operating costs will need
careful consideration to determine whether they are part of a future
operating loss (which should not be provided), reorganisation costs (which
should be provided) or costs which should be taken into account in
determining the impairment of the assets.
Where it is appropriate to recognise costs under IAS 37, these will involve
an element of estimation and the correct entry will therefore be:
DEBIT Reorganisation costs (shown separately in the statement of profit
or loss as an exceptional item)
CREDIT Provisions
In terms of classification, the question arises as to whether the Mayfield
Road property should be classified as a 'held for sale' asset at the year
end. In order to qualify it must be available for immediate sale and its sale
must be highly probable, which requires among other things active
marketing. The IFRS 5 conditions are that the carrying amount should be
recovered principally through sale, it must be available for immediate sale
in its present condition subject to such terms as are usual, and its sale
must be highly probable (IFRS 5: paras. 6–7).
(If the asset is classified as held for sale, then the business may be
regarded as a discontinued business as the definition of such a business
is that it is a CGU which has either been disposed of (not the case) or held
for sale (IFRS 5: App A). It will be disclosed as a discontinued business in
both Twilight's accounts and those of the group. However, further
information is required to determine this.)

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(b) Mayfield Road – Audit procedures
 Obtain from the client their assessment of any impairment loss to be
booked both in Twilight and at the group level. Recalculate the loss
and ensure that it is based on the correct carrying values in both
Twilight and at a group level.
 Obtain support for the estimated sale value attributed to the property
and assess whether the basis of the valuation is appropriate.
 Consider the qualification of the valuer used by the estate agent and
whether there is corroborative evidence as to value from any other
sources such as recent similar property transactions or values from
other estate agents/professional valuers.
 Consider the need to involve an auditor's expert in assessment of the
valuation and its reasonableness.
 Consider the estimate of sales costs used in the impairment
calculation and ensure that the costs are both reasonable and
 Consider whether the goodwill on acquisition of Twilight can be
allocated between the CGUs as it would seem likely that this should
be possible. In making this assessment, consider evidence from prior
year files and from client working papers and contractual
documentation at the time of the acquisition.
 If the client has concluded that goodwill cannot be allocated we need
to challenge this as it is a surprising conclusion given that the three
buildings are on separate sites. If we are satisfied that this is the case,
obtain cash flow projections for the continuing business and consider
the extent to which they support the carrying value of the total assets
and goodwill relating to that business within the group statement of
financial position.
 Subject the cash flows used in the client calculations to independent
scrutiny, considering the reasonableness of assumptions made and
the sensitivity of the results to particular assumptions.
 Consider the extent to which the property is both available for sale at
the year end and being actively marketed and conclude as to whether
it should be classified as a held for sale asset. Evidence obtained may
include copies of marketing materials, instructions given to estate
agents and the extent of interest in the property to date. It may also
include legal advice as to the position of the existing tenants and the
extent to which vacant possession of the property can be obtained.
 Determine whether the client has made any provisions for
reorganisation costs at year end. Where provisions have been made,
obtain a detailed analysis and review evidence that decisions were
communicated to staff and residents pre-year end and that the
company could not realistically withdraw from its decision. Review

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Board minutes for evidence of when the Board decision was made.
Assess the reasonableness of any provisions made by reference to
statutory and legal rights; communications and promises made; cost
incurred in the past for similar exercises; estimates obtained; legal
advice provided etc. Consider whether the provisions appear complete
taking into account the plans and decisions made.
 Ensure that only reorganisation costs are provided and that other
costs are either included in the assessment of impairment (if
appropriate) or charged in future years.
 Consider the disclosure made within the financial statements to ensure
that costs are appropriately classified and described.
Investment in Gull – points for Liz
The introduction of a new investor in Gull will result in a reduction in
Wecare's interest in its subsidiary and a part disposal. As the new investor
will have a 60% interest, it seems likely that Gull will no longer be a
subsidiary but an associate (although a review of the detailed agreement
and any control clauses is needed to confirm this). It is also possible that
the arrangement will qualify as a jointly controlled entity.
In either case (JV or associate), Wecare will cease to consolidate Gull's
results in the same way as it has done historically. Instead, using the
equity method, it will include on a single line in the consolidated statement
of profit or loss its share of Gull's profit and, in the consolidated statement
of financial position, the group's interest in Gull will be shown as an
Up to the date of disposal, Wecare should continue to consolidate 100% of
Gull's results in the normal way.
On disposal, the gain to be recorded in the consolidated accounts is
calculated as follows:
Proceeds received 1,200
Add fair value of 40% interest retained 650
Deduct net assets of Gull immediately prior to the disposal (233)
Profit on disposal 1,617
(The net assets at 31 May 20X4 are used in the above calculation of
£233,000 but these may change before year end and when tax and other
year-end adjustments are included.)
Hence a gain of the order of £1.6 million will be recognised and the 40%
investment will be recorded at its fair value of £650,000. Wecare will then
recognise only 40% of any future profit made by Gull.
In Gull's financial statements, it will recognise a share issue, recording
£15,000 as share capital and £1.185 million as share premium, along with
£1.2 million in cash.

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If the transaction completes before the issue of the financial statements for
the year ending 31 July 20X4, it must be disclosed as an event after the
reporting period in the financial statements for both Gull and Wecare.
Investment in Gull – audit procedures
 Consider whether the transaction has been completed before the
financial statements are signed. If so, review contracts and ensure that
the event is disclosed accurately in the financial statements for both
Gull and Wecare.
 To the extent that the transaction has not been completed but is key in
projections used to determine compliance with bank covenants or to
assess going concern (see below), the probability of it being
completed will need to be assessed as it may be so significant that an
uncertainty should be disclosed. To assess this, we will need to gain a
good understanding of the progress of negotiations and due diligence,
any issues raised and, where possible, seek the view of external
advisors as to the likelihood of it completing.
 There is an incentive to manipulate the financial statements in light of
the pending sale. We will need to apply professional scepticism to
management estimates and assertions.
(2) Other audit issues noted from the review and key audit procedures for
each issue
 Mark-up on intra-group recharges
The mark up seems higher than might be expected at 24.4% of operating
costs (although it is possible that some recharge of finance costs can be
justified if financing has been passed on to the subsidiaries who have at
least benefitted from making no payment for recharged costs until after
year end). We need to consider whether this is reasonable and also look
at the way costs are allocated between the two subsidiaries as Twilight's
cost appears disproportionately high. This could be motivated by a desire
to improve Gull's results in advance of the sale transaction.
Audit procedures
We will need to look at how charges compare to prior year and whether
the basis is consistent. We will also need to review transfer pricing
documentation in place.
 Finance costs in Gull
Finance costs in Gull look too low – we would expect £800,000 @ 8%  10
months/12 months = £53,333, whereas charge recorded is only for 4
months at £21,000. This looks like an error and will need to be
investigated. As interest is payable monthly, the company may also be in
default of its loan agreement. If this is the case, it could have much more
significant implications, such as the bank demanding the entire loan to be
repaid immediately. This, in turn, would have going concern implications.

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Audit procedures
Will need to confirm loan agreement terms and ascertain to what extent
discussions have been held with the bank. To the extent that different
terms have been agreed, we will need confirmation of this in writing from
the bank.
 Completeness of consolidation adjustments
There is a consolidation adjustment to increase the carrying amount of
property but no depreciation on this has been booked at present.
Audit procedures
We will need to investigate whether any depreciation charge is necessary
at the year end and also check by reference to prior year and our own
consideration of the adjustments which would be expected that all relevant
consolidation adjustments are made. Although we are told that the
adjustment concerns Twilight's freehold land, some depreciation might still
be required.
 Capitalisation of improvement and renovation works in Gull
Additions to the property value in Gull are significant and there is a risk
that repairs and general maintenance work have been capitalised which
would be incorrect.
Audit procedures
We need to obtain details of the additions recorded and ensure by
reference to the invoices and the physical work done that it is appropriate
to capitalise these amounts.
 Receivables in Gull
Receivables in Gull look unexpectedly high given that residents typically
pay in advance. It may be that they represent advance bills. Two risks
arise: firstly, that Gull is failing to collect fees from residents and potentially
has a bad debt problem; secondly, that income is being recognised too
early, artificially boosting results.
Audit procedures
– Consider age and collectability of year end receivable balances and
the extent to which they have been paid post year end.
– Review the income received to ensure that all and only amounts
relating to pre year end services/periods have been recognised. This
work will focus especially on any income billed in the month/quarter as
some of this could relate to post year end periods.
 Motivation for fraud in Gull
The future of Gull may depend on satisfactorily concluding contracts with
its new investor so there is an incentive for management to make the
company's results as attractive as possible. A number of the points above
could be indicative of deliberate manipulation of results (although error or
the absence of year end journals are also possible explanations).

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Audit procedures
We will need to remain sceptical throughout the audit process and ensure
that we are vigilant for any indications that results are being manipulated
or judgement skewed.
 Classification of loans
All loan balances are classified as long-term in the management accounts.
From terms of loans it is clear that the following elements should be
classified as short-term as at the year-end:
– Wecare – £400,000 due on 31 July 20X5 (assuming 20X4 payment
made on time)
– Twilight – £500,000 due on 31 March 20X5 + 4 months interest on
£5m = £125,000
– Gull – £160,000 due on 30 September 20X4 + interest for 9 months to
July 20X5 unless paid pre-year end + any interest arrears – see above
However, a failure to pay interest on Gull loan (see above) may mean that
further elements become due immediately and this should be taken into
account. In addition, work will be required to ensure that any other
terms/bank covenants are met as any failure to do so might affect the
repayment dates and make the loans repayable immediately.
Audit procedures
Audit procedures on this will need to include a detailed review of the
agreements and compliance with them along with recalculation of the
elements shown as short-term.
 Going concern
Going concern needs to be considered separately for each entity, but the
group position may also be relevant as it would be possible for one entity
to support or fund another.
The group as a whole has net current assets of £733,000 but this is before
taking into account the loan repayment due on 31 July 20X4 of £400,000
and annual interest also due on that date of £170,000, leaving a balance
of £163,000. This will be reduced to a negative net current asset figure
when the loan repayments due within the next year are taken into account.
Audit procedures
As a result it will be necessary to obtain detailed cash flow projections to
ensure that there is evidence that the group and each company within it
will be able to meet their debts as they fall due taking into account
anticipated cash inflows during the year.
Gull has a particular issue as it clearly has insufficient cash at present to
meet the repayment due on 30 September and may have triggered
repayment of the whole loan through its failure to make interest payments.
The cash inflow from the potential deal would be sufficient to resolve this
issue but that is uncertain and there may be commitments associated with

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the deal such that the share issue proceeds are spent not on the
repayment of loans but on future capital development.
Wecare does not have sufficient cash to meet the 31 July 20X4 debt
repayments unless it collects its debt from the group companies (which will
presumably be higher still by year end). Gull's ability to pay its balance due
has to be in doubt.
We will need to include review of support for key cash flows and sensitivity
analysis as it does appear that there may be some uncertainty over the
entities' ability to meet their debts as they fall due for at least one year
from the date of signing.
Even if it is appropriate at group level, it may still be necessary for
commitments of support/funding to be put in place between the entities
such that each can meet their commitments.
If the projections rely on uncertain events such as an incomplete
transaction, then it may be necessary to draw attention to this fundamental
uncertainty in the accounts and potentially as an emphasis of matter
paragraph in the auditor's report. If we conclude that a material uncertainty
exists in relation to the use of the going concern basis of accounting (and
adequate disclosure is made in the financial statements) we will include a
Material Uncertainty Related to Going Concern section in our auditor's
(3) The matters the firm needs to consider in determining whether or not to
accept the engagement to review Wecare Group's forecast financial
statements for the year ending 31 July 20X5
It is important for the firm to consider the following matters before accepting
the engagement:
 the level of assurance that can be given;
 the intended use of the information and the nature of the assumptions
made; and
 ethical and independence issues.
The level of assurance that can be given
Because the forecast financial statements presuppose future events and
actions, which may not occur, making it more difficult for us as auditors to
obtain a satisfactory level of assurance, the firm must consider the level of
assurance that we can give under the circumstances.
As a result of this, ISAE 3400 recommends a moderate level of assurance to
be given when reporting on the reasonableness of management's
assumptions (ISAE 3400.9). In other words, it may be preferable for the review
opinion to be expressed in a negative form.
The level of assurance that we feel can be satisfactorily provided, and the form
of the opinion and report, should be agreed in advance with the client, and
explained in the engagement letter.

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The intended use of the information and the nature of the assumptions
The firm must consider the following matters:
 The intended use of the information: In this case, the information is
provided to the bank to enable it to assess Wecare Group's ability to make
the scheduled loan repayments. If it appears that the information is
inappropriate for this purpose, we should not accept the engagement.
 Whether the information will be for general or limited distribution: By
reviewing and reporting on the forecast financial statements, the firm may
owe a duty of care to those who then rely upon the information. If the
forecast financial statements are to be distributed to other third parties, it
will be important to include wording in the report restricting the firm's
responsibility to the other third parties.
 The nature of the assumptions: that is, whether they are best estimate
or hypothetical assumptions: This will affect the nature of the review
procedures that we undertake.
 The elements to be included in the information: ideally the forecast
information will consist of the same financial statements as the historical
financial information prepared by Wecare, making our review more
straightforward and comparable.
 The period covered by the information: The longer the future period
covered, the more speculative the information and the less assurance we
will be able to provide. In this case, it appears that we are reviewing
information relating to the next 12-month accounting period only. The level
of assurance will need to be reviewed should the bank require any other
information relating to further future periods.
(ISAE 3400.10)
In addition, the firm must also consider practical matters, such as the time
available to them, the experience of the staff member compiling the
information, any limitations on their work, and the degree of secrecy required
beyond the normal duty of confidentiality.
Ethical and independence issues
As in any assurance engagement, we must ensure that we are, and appear to
be, independent. A number of potential independence threats arise here, so
the firm must implement safeguards to reduce them to an acceptable level:
(1) Self-review threat: Because the forecast contains underlying information
and the assumptions that derive from, or will have an impact on, the
statutory audited financial statements, a self-review threat will arise if the
external audit team were to perform the review engagement. To mitigate
this threat, a separate team should be used to carry out the engagement,
reviewed by a separate partner. The firm must evaluate whether we have
sufficient resources to do this.

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(2) Self-interest threat: Although this is likely to be a one-off engagement,
any additional engagement with Wecare increases the amount of revenue
we earn from this client. The firm should review the proportion of revenue
that arises from Wecare Group on a periodic basis. In addition, it is
important to ensure that the fees for this work are fixed and agreed in
advance with the client. Any contingent fee arrangements for an
assurance engagement of this type are prohibited.
(3) Advocacy/management threat: Advocacy threat arises when the auditor
is seen to promote the client's position to the detriment of his/her
objectivity. In reviewing the forecast prepared for the bank, we must
ensure that group management retains full responsibility for the forecast.
We should set out the respective responsibilities of the client and the
auditor in the engagement letter.

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