ICAEW Advanced Level Corporate Reporting Question Bank Sixth Edition 2019

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The Institute of Chartered Accountants in England and Wales
CORPORATE
REPORTING
For exams in 2019
Question Bank
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Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-50971-979-2
Previous ISBN: 978-1-78363-795-9
First edition 2014

Sixth edition 2019
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© ICAEW 2019
ii ICAEW 2019
Contents
The following questions are exam-standard. Unless told otherwise, these questions are the style,
content and format that you can expect in your exam.
Time Page
allocation
Title Marks Mins Question Answer
Financial reporting questions

1 Kime 30 63 3 209
2 Mervyn plc 30 63 6 216
3 Billinge 30 63 8 220
4 Longwood 30 63 9 224
5 Upstart Records 30 63 12 227
6 MaxiMart plc 30 63 15 234
7 Robicorp plc 30 63 17 237
8 Flynt plc 30 63 20 242
9 Gustavo plc 30 63 22 247
10 Inca Ltd 30 63 24 252
11 Aytace plc 30 63 27 259
12 Razak plc 30 63 29 263
13 Finney plc 30 63 32 269
14 Melton plc 30 63 35 277
15 Fly-Ayres 30 63 37 281
16 Aroma 30 63 41 289
17 Kenyon 30 63 42 293
Audit and integrated questions

18 Dormro 40 84 45 297
19 Johnson Telecom 40 84 48 304
20 Biltmore 40 84 53 311
21 Button Bathrooms 40 84 56 316
22 Hillhire 40 84 59 324
23 Hopper Wholesale 40 84 63 332
24 Lyght plc 40 84 65 338
25 Maykem 40 84 67 348
26 Sunnidaze 40 84 71 354
27 Tydaway 40 84 74 360
28 Wadi Investments 40 84 79 371
29 Jupiter 30 63 81 377
30 Poe, Whitman and Co 30 63 84 384
31 Precision Garage Access 30 63 87 393
32 Tawkcom 30 63 91 400
ICAEW 2019 Contents iii

Time Page
allocation
33 Expando Ltd 30 63 94 405
34 NetusUK Ltd 30 63 97 411
35 Verloc Group 30 63 100 414
36 KK 30 63 105 424
37 UHN (July 2014) (amended) 45 95 107 432
38 Couvert (November 2014) 40 84 111 439
39 ERE (November 2014) 34 71 115 448
July 2015 exam questions

40 Congloma 40 84 119 458
41 Heston 30 63 122 466
42 Homehand 30 63 126 473
November 2015 exam questions

43 Larousse 40 84 130 483
44 Telo 30 63 134 493
45 Newpenny (amended) 40 84 137 499

46 Earthstor 40 84 142 509
47 EyeOP 30 63 145 519
48 Topclass Teach 30 63 149 526

49 Zego 40 84 153 536
50 Trinkup 32 68 157 545
51 Key4Link 28 58 159 552

52 Konext 40 84 163 560
53 Elac 30 63 167 570
54 Recruit1 30 63 170 575

55 EF 40 84 174 584
56 Wayte 30 68 178 593
57 SettleBlue 30 58 181 599
iv Corporate Reporting ICAEW 2019

Time Page
allocation

58 EC 40 84 185 608
59 Raven plc 30 63 188 616
60 MRL 30 63 192 624

61 Zmant plc 42 84 196 633
62 Chelle plc 30 63 199 643
63 Solvit plc 28 63 202 651
ICAEW 2019 Contents v

Exam
Your exam will consist of:
Three written test questions 100 marks
Pass mark 50
Time available 3.5 hours
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vi Corporate Reporting ICAEW 2019

Question Bank
2 Corporate Reporting: Question Bank ICAEW 2019
Financial reporting questions
1 Kime
Kime plc is in the property industry, operating in both the commercial and private housing
sectors. Kime uses the cost model for measuring its property portfolio in its financial statements
and has a 30 June year end.
You are Jo Ng, Kime's recently appointed financial controller. Your role is to prepare the
financial statements for the year ended 30 June 20X2 before the auditors start work next week.
The finance director has supplied you with some work papers containing a trial balance and
outstanding issues (Exhibit) which have been prepared by a junior assistant. The finance director
gives you the following instructions:
"The auditors are due to start their audit work on Monday and I would like to be aware of any
contentious financial reporting issues before they arrive.
"Review the outstanding issues identified by the junior assistant (Exhibit) and explain the
potentially contentious financial reporting issues. Determine any adjustments you consider
necessary and explain the impact of your adjustments on the financial statements, identifying
any alternative accounting treatments. The board of directors has indicated that accounting
policies should be selected which maximise the profit in the current year.
"Using the trial balance and after making adjustments for matters arising from your review of the
outstanding issues (Exhibit) prepare a draft statement of financial position and statement of
comprehensive income."
Requirement
Respond to the finance director's instructions. Total: 30 marks
Exhibit: Work papers prepared by the junior assistant
Trial balance at 30 June 20X2
Debit Credit
Notes £m £m
Land 1 30.5
Buildings – cost 132.7
Buildings – accumulated depreciation 82.5
Plant and equipment – cost 120.0
Plant and equipment – accumulated depreciation 22.8
Trade receivables 2 174.5
Cash and cash equivalents 183.1
Ordinary share capital (£1 shares) 100.0
Share premium 84.0
Retained earnings at 1 July 20X1 102.0
Long-term borrowings 80.0
Deferred tax liability at 1 July 20X1 3 33.0
Trade and other payables 54.9
Sales 549.8
Operating costs 322.4
Distribution costs 60.3
Administrative expenses 80.7
Finance costs 4.8
1,109.0 1,109.0
ICAEW 2019 Financial reporting questions 3

Notes and outstanding issues
(1) Freehold land and buildings – at 30 June 20X2
Land Buildings Total
£m £m £m
Cost:
At 1 July 20X1 34.0 118.4 152.4
Additions – 26.8 26.8
Disposals (3.5) (12.5) (16.0)
At 30 June 20X2 30.5 132.7 163.2
Accumulated depreciation:
At 1 July 20X1 – 84.8 84.8
Charge for the year – 5.9 5.9
Disposals – (8.2) (8.2)
At 30 June 20X2 – 82.5 82.5
Carrying amount:
At 30 June 20X2 30.5 50.2 80.7
At 30 June 20X1 34.0 33.6 67.6
The accounting policy states that land is not depreciated and all buildings are depreciated
over their expected useful life of 50 years with no residual value.
Additions – total £26.8 million
The additions comprise two major commercial property projects (these are the first
construction projects undertaken by Kime for a number of years):
 Renovation of Ferris Street property (£8.8 million)
Kime commenced this renovation during the year ended 30 June 20X2. The budgeted
cost of this project is £15 million, of which £12 million (80%) has been designated as
capital expenditure by the project manager. The remaining £3 million is charged in the
budget as repairs and maintenance cost.
In the year ended 30 June 20X2, the company incurred costs of £11 million on the
project. Therefore I have capitalised 80% of the cost incurred in line with the original
budget.
 Construction of a sports stadium in London (£18 million)
On 1 July 20X1, Kime began constructing a sports stadium for a local authority, which
was expected to take 20 months to complete. Kime agreed a total contract price of
£34 million. The contract specifies that control of the sports stadium is transferred to
the local authority as it is constructed and that Kime has an enforceable right to
payment. Total contract costs were expected to be £16 million, however costs incurred
at 30 June 20X2 are £18 million and these have been capitalised in the year ended
30 June 20X2. Reliable estimates of costs to complete the project have been certified
by the company's own surveyor to be £4.5 million. He has also provided a value of
work completed to date of £23.8 million.
In the year ended 30 June 20X2, Kime raised invoices totalling £17 million to the local
authority and recognised this amount in revenue for the year. The local authority had
paid all outstanding invoices by 30 June 20X2.

Disposals
Kime disposed of two properties during the year:
Accumulated
Cost of Cost of depreciation at
Property land buildings disposal date
£m £m £m
FX House 2.0 8.0 4.2
Estate agency buildings 1.5 4.5 4.0
Total 3.5 12.5 8.2
FX House
This property was leased to a third party under an agreement signed on 1 January 20X2.
This is a 40-year lease and the title to both the land and buildings transfers to the lessee at
zero cost at the end of the lease term. The annual rental is £2 million payable in advance.
The present value on 1 January 20X2 of the future lease payments discounted at the
interest rate of 10% implicit in the lease was £21.5 million, which clearly exceeds the
carrying amount at the date of disposal and the lease is therefore a finance lease.
I have derecognised the property and recognised a loss on disposal equal to the carrying
amount of £5.8 million in administrative expenses for the year ended 30 June 20X2. The
first annual lease payment received on 1 January 20X2 has been credited to finance costs
for the year ended 30 June 20X2.
Estate agency buildings
Due to the recession Kime has reconsidered its business model and closed down its high
street estate agencies buildings from which it operated its private housing business. The
estate agencies business is now operated entirely online.
In May 20X2 a contract for the sale of these buildings, including land was agreed for a price
of £10 million, with the sale to be completed in September 20X2. A gain has been
recognised in administrative expenses in profit or loss of £8 million and a receivable of
£10 million in trade receivables.
(2) Trade receivables and forward contract
Included in trade receivables is an amount due from a customer located abroad in
Ruritania. The amount (R$60.48 million) was initially recognised on 1 April 20X2 when the
spot exchange rate was £1= R$5.6.
At 30 June 20X2, the exchange rate was £1 = R$5.0. No adjustment has been made to the
trade receivable since it was initially recognised.
Given the size of the exposure, the company entered into a forward contract, at the same
time as the receivable was initially recognised on 1 April 20X2, in order to protect cash
flows from fluctuations in the exchange rate. The forward contract is to sell R$60.48 million
and the arrangement satisfies the necessary criteria to be accounted for as a hedge, under
IFRS 9, Financial Instruments.
At 30 June 20X2, the loss in fair value of the forward contract was £1.5 million. The
company elected to designate the spot element of the hedge as the hedging relationship.
The difference between the change in fair value of the receivable and the change in fair
value of the forward contract since inception is the interest element of the forward contract.
(3) Property management services
On 1 June 20X2, Kime entered into a contract to provide management services for 50
residential properties owned by a local authority. The services are to be provided for three
years at £8 million per year starting on 1 July 20X2, and the local authority has paid a
deposit of £1 million on 1 June 20X2. Kime has recorded this deposit as revenue.

(4) Current and deferred taxation
I have not yet made any adjustments for deferred or current taxation, but have been told to
make the following assumptions:
 The tax rate is 24%.
 Taxable profits are calculated on the same basis as IFRS profits except for temporary
differences arising on plant and equipment.
 The deferred tax temporary taxable differences have risen by £14 million over the year
to 30 June 20X2 after the effects of accounting for depreciation on plant and
equipment only. No tax relief is available on freehold buildings and land.
2 Mervyn plc
Mervyn plc manufactures electrical components for the motor trade. Mervyn is in the process of
finalising its financial statements for the year ended 30 September 20X7. Due to cash flow
problems Mervyn sold two pieces of its freehold land during the current financial year. The land
was held in the financial statements at cost. The finance director, reviewing the draft financial
statements, has asked for your advice on these sales as well as on some unusual features
identified.
An extract from the statement of changes in equity in the draft financial statements shows:
Retained earnings
£'000
At 1 October 20X6 2,190
Profit for the year 1,471
Dividends paid (515)
At 30 September 20X7 3,146
There is a note explaining that there is no 'other comprehensive income' in the statement of
profit or loss and other comprehensive income as there are no gains and losses other than those
recognised in profit or loss for the year.
The statement of profit or loss and other comprehensive income shows an 'exceptional' gain
relating to gains on the two land bank sales:
£'000
The Ridings 100
Hanger Hill Estate 250
350
A contract for the sale of land at The Ridings was entered into in June 20X7 conditional upon
obtaining a detailed planning consent, but only outline consent had been obtained by
30 September 20X7. Planning consent was received in October and the land sale was
completed in November 20X7. Tax of £27,000 has been provided on the sale.
The sale of land at Hanger Hill to the Beauford Corp on 1 October 20X6 took place under a sale
and leaseback arrangement. The terms of the lease arrangement were:
Lease term Five years
Rentals first payable on 30 September 20X7 £80,000 per annum
On 1 October 20X6 the carrying amount of the Hanger Hill land was £900,000 and its fair value
was £950,000. The first rental was paid on its due date and charged to operating expenses.
Beauford Corp is expected to take possession of this land at the conclusion of the lease.
The cumulative discount factor for a five-year annuity at 10% (the appropriate interest rate for
this transaction) is 3.791.

Operating expenses include £405,000 relating to the company's defined benefit pension
scheme. This figure represents the contributions paid into the scheme in the year. No other
entries have been made relating to this scheme. The figures included in the draft statement of
financial position represent opening balances as at 1 October 20X6:
£'000
Pension scheme assets 2,160
Pension scheme liabilities (2,530)
(370)
Deferred tax asset 85
(285)
After the year end, a report was obtained from an independent actuary. This gave valuations as
at 30 September 20X7 of:
£'000
Pension scheme assets 2,090
Pension scheme liabilities (2,625)
Other information in the report included:
Current service cost 374
Payment out of scheme relating to employees transferring out 400
Reduction in liability relating to transfers 350
Pensions paid 220
Interest rate on high quality corporate bonds at 1 September 20X7 10%
All receipts and payments into and out of the scheme can be assumed to have occurred on
30 September 20X7.
Mervyn's accounting policy is to recognise any gains and losses on remeasurement of the
defined benefit asset or liability (actuarial gains and losses) in accordance with IAS 19, Employee
Benefits (revised 2011).
In the tax regime in which Mervyn operates, a tax deduction is allowed on payment of pension
contributions. No tax deduction is allowed for benefits paid. The rate of tax applicable to 20X6,
20X7 and announced for 20X8 is 23%.
In March 20X7, a customer of Mervyn brought legal proceedings against Mervyn for alleged
injury to employees and loss of business through a fault in one of Mervyn's products. In
September 20X7, the case came to court but Mervyn's lawyers think that it could be a very
lengthy case and believe that Mervyn will lose the case. The actual cost of damages and timing
of the case are far from clear but management have made a number of estimates. They believe
that the best outcome for Mervyn will be damages of £200,000 payable in one year's time. The
worst possible outcome would be for the case to continue for three more years in which case the
estimate of damages and costs is £1,500,000 payable in three years' time. A further estimate,
between these two extremes, is that damages of £800,000 will be payable in two years' time.
Management's estimates of probabilities are best outcome 25%, worst case outcome 15% and
middle ground outcome 60%. No provision nor any disclosure has been made for this court
case in the financial statements.
At the request of one particular customer, Mervyn has a new arrangement that it will hold the
goods that it sells until such time as the customer needs them, and they are kept in a separate
storage area exclusive to that customer. The customer is invoiced for the goods when they are
ready for delivery, but they are set aside until the customer needs them, ready for delivery. This
particular component is made exclusively for that customer. The accountant of Mervyn has not
been recognising the revenue on these sales until the delivery has taken place to the customer.
At 30 September 20X7, there were goods with a selling price of £138,000 and cost of £99,000
which had not yet been delivered to the customer. These goods had been included at cost when
the inventory count took place.

The company granted share appreciation rights (SARs) to its employees on 1 October 20X5
based on 10,000 shares. The SARs provide employees at the date the rights are exercised with
the right to receive cash equal to the appreciation in the company's share price since the grant
date. The rights vested on 30 September 20X7 and payment was made on schedule on
1 November 20X7. The fair value of the SARs per share at 30 September 20X6 was £6, at
30 September 20X7 was £8 and at 1 November 20X7 was £9. The company has recognised a
liability for the SARs as at 30 September 20X6 based upon IFRS 2, Share-based Payment but the
liability was stated at the same amount at 30 September 20X7.
If any figures are to be discounted, a rate of 10% per annum should be used.
Requirement
Explain how each of the above transactions should be treated in the financial statements for the
year ended 30 September 20X7, briefly explaining how treatment of the sale and leaseback
would change under IFRS 16, Leases and prepare a statement of amended profit for the year
ended 30 September 20X7. Total: 30 marks
3 Billinge
You are Anna Wotton, an ICAEW Chartered Accountant, and have recently been appointed as
the financial controller at Billinge, a manufacturer of electrical components for vehicles. Billinge
is a public limited company with a number of subsidiaries located throughout the country and
one foreign subsidiary, Quando.
Peter McLaughlin, Finance Director of Billinge, is in the process of finalising the financial
statements for the year ended 31 October 20X3. However, he is unsure about the impact of
deferred taxation on various transactions of the company, because the previous financial
controller, Jen da Rosa, always dealt with this side of the financial statements preparation.
Peter has provided you with a file (Exhibit) prepared by Jen before she left, which contains a
number of transactions that have deferred tax implications. He has asked you to prepare a
briefing note which provides explanations and calculations of the deferred tax implications for
each of the transactions in the file (Exhibit) on the consolidated financial statements of Billinge for
the year ended 31 October 20X3.
In the country in which Billinge operates, the applicable tax rate is 30%. Peter has asked you to
use the working assumption that Billinge will continue to pay tax at the current rate of 30%.
Requirement
Prepare the briefing note requested by Peter McLaughlin. Total: 30 marks
Exhibit: Deferred tax issues identified by Jen da Rosa
(1) Fair value adjustment
On 1 November 20X2, Billinge acquired a 100% subsidiary, Hindley for £10 million. On that
date, the fair value of Hindley's net assets was £8 million and the carrying amount was
£7 million, which is also the tax base under local tax law. The difference between the fair
value and book value of net assets relates to an item of property, plant and equipment
which Hindley currently has no plans to sell.
(2) Share options
On 1 November 20X1, Billinge granted 1,000 share options each to its 500 employees
providing they remained in employment until 31 October 20X4. The fair value of each
option was £5 on 1 November 20X1, £6 on 31 October 20X2 and £7 on 31 October 20X3.
Local tax law allows a tax deduction at the exercise date of the intrinsic value of the options.
The intrinsic value of each option was £3 at 31 October 20X2 and £8 at 31 October 20X3.
The percentage of employees expected to leave over the vesting period was 20% as at

31 October 20X2 and has been revised upwards to 25% as at 31 October 20X3. The
deferred taxation on this transaction was correctly accounted for in the year ended
31 October 20X2 but the finance director is unsure how to account for the deferred taxation
in the current year.
(3) Goods purchased from subsidiary
A wholly owned subsidiary, Ince, sold goods for £5 million to Billinge on 20 September
20X3 at a mark-up of 25%. At 31 October 20X3, Billinge has sold a quarter of these goods
to third parties. The financial director does not understand how this transaction should be
dealt with in the financial statements of the subsidiary and the group for taxation purposes.
(4) Profits from foreign subsidiary
Quando, the 100% owned foreign subsidiary of Billinge, has undistributed post-acquisition
profits of 5 million Corona which would give rise to additional tax payable of £0.4 million if
remitted to Billinge's tax regime. As Quando is a relatively new and rapidly expanding
company, Billinge intends to leave the earnings within Quando for reinvestment.
(5) Property, plant and equipment
On 1 November 20X2, Billinge purchased an item of property, plant and equipment for
£12 million which qualified for a government capital grant of £2 million. The asset has a
useful life of five years and is depreciated on a straight line basis. Capital allowances are
restricted by the amount of the grant. Local tax law specifies a tax writing down allowance of
25% per annum.
(6) Lease
Due to the age of its assets, Billinge has recently begun a programme of capital
expenditure. Until now, Billinge has always purchased its assets outright for cash. However,
due to liquidity problems, Billinge had to lease an item of machinery on 1 November 20X2.
The asset has an expected economic life of five years and the lease term is also for five
years. Both the present value of minimum lease payments and fair value of the asset are
£6 million. The annual lease payments are £1.5 million payable in arrears on 31 October
and the effective interest rate is 8% per annum. Under local tax law the company can claim a
tax deduction for the annual rental payment as the asset does not qualify for capital
allowances.
4 Longwood
The Longwood Group is a listed European entity specialising in high grade alloy production for
civil aviation, military and specialist engineering applications. On 1 January 20X7, Longwood
completed the acquisition of a private company, Portobello Alloys, to strengthen its product
offering in high performance electro-magnetic alloys.
The total price paid to acquire the entire share capital of Portobello Alloys was £57 million in
cash paid on the deal date, along with a further £10 million in deferred cash and 5 million shares
in The Longwood Group, both to be paid or issued in three years' time. The share price of The
Longwood Group was £1.88 at 1 January 20X7, but rose to £2.04 shortly after the acquisition
was completed. The best estimate of the share price on the transfer date in three years is £2.25.
The appropriate discount rate for deferred consideration is 10%.
Longwood paid its bankers and lawyers fees of £0.8 million in connection with the deal.
Longwood estimates that £0.2 million of the finance department costs relate to time spent on
the acquisition by the Finance Director and his team.
Below is the draft 'deal-date' statement of financial position of Portobello Alloys. You may
assume the carrying amounts of assets and liabilities are equal to their fair values, except as
indicated in the information that follows.

Portobello Alloys – Statement of financial position at 1 January 20X7
Carrying
amount
£m
Property, plant and equipment 18.92
Development asset 0.00
Investments in equity instruments 4.37
Deferred tax asset 0.77
Non-current assets 24.06
Inventory 7.33
Accounts receivable and prepayments 4.17
Cash and equivalents 4.22
Current assets 15.72
Total assets 39.78
Long-term debt 16.34

Post-retirement liability 0.37
Deferred tax liability 1.86
Non-current liabilities 18.57
Accounts payable and accruals 7.91

Current portion of long-term debt 3.40
Current liabilities 11.31
Share capital 2.50

Share premium 1.20
Retained earnings 6.20
Equity 9.90
Total liabilities and equity 39.78
Both Longwood and Portobello report to 31 December each year. The Board has asked your
firm to examine the deferred tax implications of various areas relating to the acquisition.
Research and development
Portobello Alloys applied a policy of expensing all development expenditure as incurred.
Longwood's policy is to capitalise development cost as an intangible asset under IAS 38. The
carrying amount of the development asset in the deal-date statement of financial position was
£0 million. The fair value of the development asset was actually £5.26 million at the deal date.
None of this development asset will be amortised over the next year.
Property, plant and equipment
Portobello's premises are located on a prime piece of commercial real-estate. The surveyors
have indicated that the land is worth £2.73 million in excess of its carrying amount in the
financial statements of the company. The Longwood Group has no intention of selling the
property as, if it changed location, they could lose some of the key staff. Longwood's policy is to
carry assets at depreciated cost, and it does not revalue any assets on a regular basis.
Retirement benefit obligation
Portobello operates a defined benefit plan for its key research and production employees. The
plan asset manager has made some bad equity investments over the years, and the plan is in
deficit by £1.65 million. Portobello only recognised a liability of £0.37 million in its financial
statements. The local tax authorities grant tax relief on the cash contribution into the plan.

Tax losses
Portobello made a disastrous foray into supplying specialist alloys to a now defunct electronics
business, Electrotech. It set up a special division, took on new premises and staff, and spent a lot
of money on joint development with its client. Electrotech promptly went into liquidation.
Portobello incurred total tax losses of £7.40 million over the two years that it was involved with
Electrotech – it has now paid all the redundancy costs, sold all the assets and closed the division.
To date, Portobello Alloys has only relieved £1.20 million of the losses. The revised forecast
numbers for Portobello's performance post-acquisition suggest it will be able to relieve the
balance of losses in the next couple of years (see below). Up to the date of the deal, the
management forecasts used to calculate the deferred tax in the financial statements had only
anticipated relieving £2.20 million of the losses, as indicated in the schedule below.
Profit forecasts for tax loss utilisation
20X7 20X8 Total
£m £m £m
Forecast taxable profit – original 0.98 1.22 2.20
Forecast taxable profit – revised 1.90 4.74 6.64
Enacted tax rates
Deferred taxes in the deal-date statement of financial position extracted above were calculated
using a tax rate of 30%. However, the corporate tax rate for Portobello has been enacted to fall
to 23% for the period after 1 January 20X7. A schedule of the composition of the deferred tax
assets and liabilities included in the deal-date statement of financial position is shown below.
Deferred tax schedule
Carrying Tax Temporary Deferred
amount base difference tax 30%
Property, plant £m £m £m £m
and equipment 18.92 13.78 (5.14) (1.54)
Investments in equity
instruments* 4.37 3.30 (1.07) (0.32)
Post-retirement liability (0.37) 0.00 0.37 0.11
Unrelieved tax losses –
recognised 0.00 2.20 2.20 0.66
(1.09)
Deferred tax liability (1.86)
(1.09)
*Note: On initial recognition of the investments in equity instruments, an irrevocable election

had been made to record gains and losses in other comprehensive income.
The finance director has asked you to produce the following information:
(a) Calculate the adjustment required to the deferred tax figures in the financial statements of
Portobello Alloys solely in respect of the change in enacted tax rates and draft the required
journal.
(b) Calculate the adjustment required to the deferred tax asset relating to unrecognised tax
losses in Portobello's financial statements resulting from the revised estimates of
profitability over the next two years. You should provide a draft correcting journal.
(c) Calculate the deferred tax effect of the consolidation adjustments in respect of:
 fair value adjustments to property, plant and equipment
 fair value adjustments to the development asset
 fair value adjustments to the post-retirement liability

(d) Calculate the goodwill arising in the consolidated financial statements in respect of this
acquisition.
(e) Explain the deferred tax treatment of goodwill under two possible deal structures for the
acquisition of Portobello Alloys:
 As the acquisition actually took place, with the purchase of the shares of Portobello
Alloys.
 Under an alternative structure, with the purchase of the assets and liabilities of
Portobello Alloys instead, which would have granted tax relief charged over 15 years
on the straight-line basis on purchased goodwill.
Requirement
Prepare the information required by the finance director. Total: 30 marks
5 Upstart Records
Upstart Records plc (Upstart) is a listed company and the parent company for a group that
operates in the music equipment industry. You are Thomas Mensforth, an ICAEW Chartered
Accountant, and you joined Upstart six months ago.
You have received the following email from Susan Ballion, the Group Finance Director of Upstart:
EMAIL
To: Thomas Mensforth
From: Susan Ballion
Date: 17 July 20X5
Subject: Upstart
I have been called away to an urgent meeting, so I need your assistance to finalise some aspects
of the Upstart consolidated financial statements for the year ended 30 June 20X5. I attach details
of transactions involving Liddle Music Ltd (Liddle) that occurred during the year ended 30 June
20X5 (Exhibit 1).
I also attach the draft statements of profit or loss for the Upstart Group and for Liddle for the year
ended 30 June 20X5. The draft group statement of profit or loss consolidates all group
companies except Liddle (Exhibit 2).
Finally, there are two financial reporting issues concerning the parent company that I have not
had time to deal with (Exhibit 3). These will need to be resolved before the consolidated
financial statements can be prepared.
I would like you to:
(a) show and explain, with supporting calculations, the appropriate financial reporting
treatment of goodwill and non-controlling interests for Liddle in Upstart's consolidated
statement of financial position at 30 June 20X5. Use the proportion of net assets method to
determine non-controlling interests;
(b) explain, with calculations, the appropriate accounting treatment in respect of the issues in
Exhibit 3;
(c) prepare Upstart's revised consolidated statement of profit or loss for the year ended
30 June 20X5 to include Liddle. This should take account of any adjustments arising from
the calculations above; and
(d) explain (without calculations) the impact on Upstart's consolidated financial statements if
the fair value method for measuring non-controlling interests were to be used instead of the
proportion of net assets method.

Requirement
Respond to Susan Ballion's email. Total: 30 marks
Exhibit 1: Transactions in respect of Liddle
Original investment
Upstart purchased 250,000 ordinary shares in Liddle on 1 January 20X3 for £23 each, when
Liddle had in issue 1,000,000 £1 ordinary shares and retained earnings of £6.6 million. There are
no other reserves and there has been no change to Liddle's ordinary share capital since that
date. Upstart appointed two of the six directors on the Liddle board and recognised the
investment as an associate in its group financial statements for the years ended 30 June 20X3
and 30 June 20X4.
Shares purchased on 1 October 20X4
On 1 October 20X4, Upstart purchased a further 450,000 shares in Liddle from existing
shareholders. At this date, the fair value of Upstart's original 250,000 shares in Liddle had risen
to £30 each. The consideration was as follows:
 800,000 new ordinary £1 shares in Upstart issued on 1 October 20X4; the market price of
one share in Upstart at this date was £11.50.
 Cash of £2 million payable on 1 October 20X4.
 Cash of £3 million payable on 1 October 20X6.
 Cash of £3 million payable on 1 October 20X7, subject to Liddle increasing profits for the
year ending 30 June 20X7 by 35% compared with its profits for the year ended 30 June
20X4. The board of Upstart believes there is a 50% probability of this profit increase being
achieved.
Upstart paid professional fees of £250,000 in respect of this share purchase. These fees have
been debited to the cost of the investment in Liddle in Upstart's individual company statement
of financial position.
Upstart has an annual cost of capital of 9%.
On 1 October 20X4, the fair value of Liddle's assets and liabilities was equal to their carrying
amount, with the exception of buildings which had a carrying amount of £1.4 million and a fair
value of £3 million. These buildings had a remaining useful life of 20 years at 1 October 20X4.
Depreciation is included in cost of sales. Liddle has not made any adjustment for the increase in
the fair value of the buildings in its financial statements.
Shares purchased on 1 April 20X5
On 1 April 20X5, Upstart purchased 100,000 shares in Liddle from other shareholders at a price
of £35 each.
Financing
On 1 October 20X4, to assist in funding the share purchases, Upstart borrowed €4 million from a
German bank when £1 = €1.30, taking advantage of a lower interest rate than offered by UK
banks. Interest on the loan, at 6% per annum, is payable annually in arrears on 30 September.
No accounting entries in relation to the loan have been made in Upstart's financial statements
except to recognise the loan at 1 October 20X4 at £3.077 million in non-current liabilities. The
average exchange rate from 1 October 20X4 to 30 June 20X5 was £1 = €1.28 and the rate on
30 June 20X5 was £1 = €1.25.

Loan to Liddle
Upstart made a loan to Liddle of £2 million on 1 October 20X4 at an interest rate of 8% per
annum. The loan is repayable on 1 October 20X7. Loan interest has been correctly accounted
for in the individual statements of profit or loss for both Upstart and Liddle.
Trading with Liddle
Upstart made monthly sales of £120,000 to Liddle in the year ended 30 June 20X5. These sales
were at a mark-up on cost of 60%. At 30 June 20X5, Liddle had £560,000 of the purchases from
Upstart in inventories.
Exhibit 2: Draft statements of profit or loss for the Upstart Group (excluding Liddle) and for
Liddle for the year ended 30 June 20X5
Upstart
Group Liddle
£'000 £'000
Revenue 23,800 15,600
Cost of sales (7,400) (5,400)
Gross profit 16,400 10,200
Operating costs (3,500) (1,500)
Profit from operations 12,900 8,700
Investment income 890 180
Interest paid (520) (300)
Profit before tax 13,270 8,580
Taxation (2,350) (1,800)
Profit for the year 10,920 6,780
Note:
Retained earnings at 1 July 20X4 15,840 9,000
Exhibit 3: Outstanding financial reporting issues

Restructuring
Upstart has announced two major restructuring plans. The first plan is to reduce its capacity by
the closure of two of its retail outlets, which have already been identified. This will lead to the
redundancy of 20 employees, who have all individually been selected and communicated with.
The costs of this plan are £300,000 in redundancy costs, £200,000 in retraining costs and
£50,000 in lease termination costs. The second plan is to re-organise the finance and
information technology department over a one-year period but this will not be implemented for
two years. The plan results in 20% of finance staff losing their jobs during the restructuring. The
costs of this plan are £250,000 in redundancy costs, £300,000 in retraining costs and £200,000
in equipment lease termination costs. No entries have been made in the financial statements for
the above plans.
Share options
On 1 July 20X3, Upstart made an award of 1,000 share options to each of its seven directors.
The condition attached to the award is that the directors must remain employed by Upstart for
three years. The fair value of each option at the grant date was £50 and the fair value of each
option at 30 June 20X5 was £55. At 30 June 20X4, it was estimated that three directors would
leave before the end of three years. Due to an economic downturn, the estimate of directors
who were going to leave was revised to one director at 30 June 20X5. The expense for the year
as regards the share options had not been included in profit or loss for the current year and no
directors had left by 30 June 20X5.

6 MaxiMart plc
MaxiMart plc operates a national chain of supermarkets. You are Vimal Subramanian, the
Assistant Financial Controller, and the accounting year-end is 30 September 20X1.
It is now 15 November 20X1 and the company's auditors are currently engaged in their work.
Jane Lewis, the Financial Controller, is shortly to go into a meeting with the audit engagement
partner, Roger MacIntyre, to discuss some unresolved issues relating to employee
remuneration, hedging and the customer reward card. To save her time, she wants you to
prepare a memorandum detailing the correct financial reporting treatment. She has sent you the
following email, in which she explains the issues.
From: jlewis@maximart.com
To: vsubramanian@maximart.com
Date: 15 November 20X1
Subject: Financial statements of MaxiMart
I am pleased you can help me out with the information for my forthcoming meeting with Roger
MacIntyre – as you know, I have been tied up with other work, and have not had time to look into
these outstanding issues.
As you will see (Exhibit 1) the principal issues concern remuneration:
Historically we have had a problem with high staff turnover due to low salaries and having to
work evenings and weekends. To encourage better staff retention, we introduced a share option
scheme. Details of the scheme are given in Exhibit 1. I need you to show how the share option
scheme should be dealt with in the financial statements of MaxiMart for the year ended
30 September 20X1.
Exhibit 1 also has details of the company pension scheme, which was introduced a few years
ago to encourage management trainees to stay with us. Since many of our rivals no longer
provide defined benefit schemes, this gives MaxiMart an edge. It would help in the meeting if I
could show Roger MacIntyre the relevant extracts from the financial statements. You will need to
show the amounts to be recognised in the statement of profit or loss and other comprehensive
income of MaxiMart for the year ended 30 September 20X1 and in the statement of financial
position at that date so far as the information permits, in accordance with IAS 19, Employee
Benefits (revised 2011). You should also include the notes, breaking down the defined benefit
pension charge to profit or loss, other comprehensive income, net pension asset/liability at the
year end and changes in the present value of pension obligation and the fair value of plan
assets.
There will be a deferred tax effect arising from the pension plan, but we will deal with that on a
later occasion, as there isn't time before the meeting.
I also attach details of three further issues (Exhibit 2). The first relates to our Reward Card. I
believe there is a recent IFRS relevant to the treatment of these schemes, but I can't remember
exactly what it says. The second issue is a futures contract. It would be good if you could explain
how we should treat this and show the double entry. The third issue is a proposed dividend – we
need to know if the proposed treatment is correct.
Please draft a memorandum showing the appropriate treatment of these transactions together
with explanations and any necessary workings.
Requirement
Prepare the memorandum required by Jane Lewis. Total: 30 marks

Exhibit 1: Staff remuneration
Share options
On 1 October 20X0, the board decided to award share options to all 1,000 employees provided
they remained in employment for five years. At 1 October 20X0, 20% of employees were
expected to leave over the vesting period to 30 September 20X5 and as at 30 September 20X1,
this expectation had risen to 25%. The fair value of these options at 1 October 20X0 was £2 and
this had risen to £3 by 30 September 20X1. The number of options per employee is conditional
on the average profit before any expense for share options over the five years commencing
1 October 20X0 as follows:
Average profit Number of options per employee
From £1m up to £1.2m 100
Above £1.2m up to £1.4m 120
Above £1.8m 180
Profit before share option expense for the year ended 30 September 20X1 was £0.9 million and
profit for the following four years was forecast to rise by £0.2 million a year. The awarding of the
options was also conditional on the share price reaching at least £8 per share by 30 September
20X5. The share price at 30 September 20X1 was £6.
Pension scheme
MaxiMart set up a funded defined benefit pension plan for management-track employees three
years ago. The plan provides a pension based on 1/80th of the final salary for each year worked
for the company, subject to a minimum employment period of eight years.
The following information has been provided by the actuary for the year ended
30 September 20X1:
(a) The present value in terms of future pensions from employee service during the year is
£90,000. This has been determined using the projected unit credit method.
(b) The present value of the obligation to provide benefits to current and former employees
has been calculated as £2.41 million at 30 September 20X1 and the fair value of plan assets
was £2.37 million at the same date.
(c) The interest rate on high quality corporate bonds relevant to the year was 5%.
The following has been extracted from the financial records:
(a) The present value of the defined benefit obligation was £2.2 million at 30 September 20X0
and the fair value of the plan assets was £2.3 million at the same date.
(b) Pensions paid to former employees during the year amounted to £60,000.
(c) Contributions paid into the plan during the year as decided by the actuary were £68,000.
With effect from 1 October 20X0, the company amended the plan to increase pension
entitlement for employees. The present value of the improvement in benefits was
calculated by the actuary to be approximately £100,000 at 1 October 20X0. The present
value of the plan liability at 30 September 20X1 correctly reflects the impact of this increase.
(d) The company recognises gains and losses on remeasurement of the defined benefit asset
or liability (actuarial gains and losses) in accordance with IAS 19, Employee Benefits (revised
2011).
(e) Pension payments and the contributions into the plan were paid on 30 September 20X1.

Exhibit 2: Other transactions
Reward card
MaxiMart offers its customers a reward card which awards customers points based on money
spent. These points may be redeemed as money off future purchases from MaxiMart or as
free/discounted goods from other retailers. Revenue from food sales for the year ended
30 September 20X1 amounted to £100 million. At the year end, it is estimated that there are
reward points worth £5 million arising from this revenue which are eligible for redemption.
Based on past experience, it is estimated that only about two in five customers are likely to
redeem their points.
Futures contract
MaxiMart entered into a futures contract during the year to hedge a forecast sale in the year
ended 30 September 20X2. The futures contract was designated and documented as a cash
flow hedge. At 30 September 20X1, had the forecast sale occurred, the company would have
suffered a loss of £1.9 million and the futures contract was standing at a gain of £2 million. No
accounting entries have been made to record the futures contract, because the Financial
Controller is not sure whether or not it is effective, and would like some advice on how to test for
this.
Proposed dividend
The company has a good relationship with its shareholders and employees. It has adopted a
strategy of gradually increasing its dividend payments over the years. On 1 November 20X1, the
board proposed a dividend of 5p per share for the year ended 30 September 20X1. The
shareholders will approve the dividend along with the financial statements at the general
meeting on 1 December 20X1 and the dividend will be paid on 14 December 20X1. The
directors feel that the dividend should be accrued in the financial statements for the year ended
30 September 20X1 as a 'valid expectation' has been created.
7 Robicorp plc
Robicorp plc is a listed company that develops robotic products for the defence industry. You
are Marina Nelitova, an ICAEW Chartered Accountant working within the finance team at
Robicorp. You receive the following email from Alex Murphy, who was appointed finance
director of Robicorp in October 20X4.
To: Marina Nelitova

From: Alex Murphy
Subject: Review of financial statements for year ended 30 September 20X4
I am attending a board meeting next week, and have concerns over the way my predecessor has
treated some transactions in the financial statements (Exhibit 1).
I would like you to review these transactions and:
 recommend any adjustments, with accompanying journal entries, that are required to make
the accounting treatment comply with IFRS, explaining the reasons for your proposed
changes; and
 revise the draft basic earnings per share figure (Exhibit 2), taking into account your
adjustments, and calculate the diluted earnings per share.
Ignore any tax consequences for now.
Requirement
Reply to Alex Murphy's email. Total: 30 marks

Exhibit 1: Transactions requiring further review
(a) On 1 October 20X3 Robicorp started work on the development of a new robotic device, the
XL5. Monthly development costs of £2 million were incurred from that date until
1 January 20X4, when Robicorp made a breakthrough in relation to this project. On that
date the XL5 was deemed financially and commercially viable and thereafter development
costs increased to £2.5 million per month until development work was completed on
30 June 20X4.
The XL5 went on sale on 1 August 20X4. By 30 September 20X4, Robicorp had received
orders for 3,000 units priced at £25,000 per unit, of which it had manufactured and
delivered 1,200 units to customers. The terms of trade required a non-refundable payment
in full on receipt of the order.
Robicorp anticipates the XL5 having a commercial life of four to five years, with total sales of
36,000 units over that period. Variable production costs are £11,000 per unit.
In the draft financial statements for the year ended 30 September 20X4, all XL5
development costs have been capitalised. Cash received in respect of the 3,000 units
ordered has been recognised as revenue because the orders are non-cancellable.
Entries made to reflect the above are:
DEBIT Intangible assets £21m
CREDIT Cash £21m
DEBIT Cash £75m

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

CREDIT Cash £13.2m
CREDIT Accrued variable production costs £19.8m
On 1 January 20X4, to help fund the XL5 development and production, Robicorp issued a
£40 million, 3% convertible bond at par. The bond is redeemable on 1 January 20X7 at par.
Interest is paid annually in arrears on 31 December. Bondholders have the choice on
1 January 20X7 of: either converting the bonds into equity shares at the rate of 10 £1 shares
for every £100 of bonds; or redeeming the bonds at par. Similar non-convertible bonds for
a company such as Robicorp pay interest at 10% per year. Robicorp anticipates that all
bondholders will choose to convert the bonds into shares. Therefore in the draft financial
statements the bonds have been treated as equity shares.
In the draft financial statements the following accounting entries have been made in respect
of the bond and interest:
DEBIT Cash £40m
CREDIT Share capital £4m
CREDIT Share premium £36m
DEBIT Finance costs £0.9m

CREDIT Accruals £0.9m
(b) On 1 October 20X3, Robicorp introduced a share option scheme for 30 senior executives.
Each executive was granted 48,000 share options on that date. Each option gives the right
to acquire one share in Robicorp, for an exercise price of £4 per share, if the executive is still
in employment with the company at 1 October 20X6, and the share price at that date is at
least 30% higher than the price at 1 October 20X3. The executives will be able to exercise
these options from 1 October 20X7.
The fair value of an option was £3.50 at 1 October 20X3 and £5.30 at 30 September 20X4.
By 30 September 20X4, one executive had left her job. Robicorp expects one more
executive to leave by 1 October 20X6.

The Robicorp share price at 30 September 20X4 was 32% higher than at the grant date. The
average share price of Robicorp for the year ended 30 September 20X4 was £7.60.
No accounting entries have been made in respect of the share option scheme.
(c) On 1 April 20X3, Robicorp bought 400,000 shares in Lopex Ltd for £6 each. This represents
3% of the ordinary share capital of Lopex. An irrevocable election was made by Robicorp to
treat this as an equity investment at fair value through other comprehensive income.
At 30 September 20X3, Lopex's shares had a fair value of £9.20 each and Robicorp
measured its investment at £3.68 million in its financial statements at that date.
A gain of £1.28 million was recognised in other comprehensive income with a
corresponding other component of equity being created at 30 September 20X3.
On 1 August 20X4 Saltor plc, an unrelated company, acquired all the shares in Lopex in a
share-for-share exchange. The terms were 2.5 shares in Saltor for each share in Lopex. At
1 August 20X4, immediately before the takeover by Saltor, the fair value of a Lopex share
was £11.20. Saltor's shares at 1 August 20X4 were trading at £5.50 each.
No entries have been made in Robicorp's financial statements for the year to 30 September
20X4 to reflect the share-for-share exchange. Its investment continues to be recognised at
£3.68 million.
Robicorp intends to sell its shareholding in Saltor and to classify the investment as at fair
value through profit or loss. At 30 September 20X4, Saltor's shares had a bid-offer spread
of 480–485 pence. A sales commission of 4 pence per share would be incurred upon
disposal.
(d) Robicorp granted interest-free loans to its employees on 1 October 20X3 of £8 million. The
loans will be paid back on 30 September 20X5 as a single payment by the employees. The
market rate of interest for a two-year loan on both of the above dates is 6% per annum.
The loans have been classified as financial assets at amortised cost under IFRS 9, Financial
Instruments. No accounting entries have been made to date in respect of these loans.
Exhibit 2: Robicorp – Calculation of basic earnings per share for year ended
30 September 20X4
Profit after taxation £66.27m
Share capital Number of £1 ordinary shares
At 1 October 20X3 40m

Convertible bond issue 1 January 20X4 4m
At 30 September 20X4 44m
Basic earnings per share = 150.6 pence (£66.27m/44m shares).

8 Flynt plc
You are Miles Goodwin, the newly-appointed financial controller of Flynt plc, a company that
manufactures electronic components for the computer industry. You receive the following email
from Andrea Ward, the CEO of Flynt.
To: Miles.Goodwin@flynt.co.uk
From: Andrea.Ward@flynt.co.uk
Subject: Finalisation of consolidated financial statements for year ended 31 May 20X6
Miles, I know you have just joined us, but I would be grateful if you could look at the impact of
some issues that were left unresolved by your predecessor, Shane Ponting (Exhibit 1). I have
been very busy recently and have not had the chance to look at these issues myself. I would also
appreciate your opinion on whether the accounting for the lease will change when IFRS 16,
Leases comes into force – I don't know anything about this but Shane mentioned it on a number
of occasions.
I would like you to redraft the consolidated statement of profit or loss and other comprehensive
income. I attach a draft for you to work from (Exhibit 2). Please explain the reasoning for any
adjustments you make, as I would like a greater understanding of the impact of these issues on
our post-tax profits. You should also give journal entries.
I have a meeting with the board shortly, and we are concerned about earnings per share (EPS).
I would therefore be grateful if you would also calculate the basic and diluted EPS for the year
ended 31 May 20X6 and the diluted EPS if applicable.
At this stage do not worry about any adjustments to the current or deferred tax charge; just
assume an effective rate of 23%.
Requirement
Draft a reply to the email from Andrea Ward. Total: 30 marks
Exhibit 1: Consolidated financial statements for year ended 31 May 20X6: Unresolved issues –
arising from notes prepared by Shane Ponting
Share option scheme
On 1 September 20X5 the board approved a share option scheme for 20 senior executives. On
that date each executive was granted options over 10,000 shares at an exercise price of £39 per
share, which was the market price at 1 September 20X5. Each option gives the rights to one
share. The options vest on 1 September 20X9 subject to the following conditions:
(a) Each executive remains in the employment of Flynt until 1 September 20X9.
(b) The share price of Flynt has increased by at least 50% at 1 September 20X9.
The fair value of an option was estimated to be £12.60 at 1 September 20X5 and £19.40 at
31 May 20X6.
This is the first time that Flynt has operated such a scheme. As there is no cash cost to the
company, I have not made any adjustments to the financial statements. The share price of Flynt
at 31 May 20X6 was £52 and the average share price for the nine months to 31 May 20X6 was
£48.
At 31 May 20X6 there were still 19 executives in the scheme, but I anticipate there will only be
16 still employed by 1 September 20X9.

Lease of surplus machinery
On 1 June 20X5 Flynt leased some surplus machinery to Prior plc, an unrelated company, on the
following terms:
Lease term and remaining useful life of machinery 5 years
Carrying amount and fair value of machinery at 31 May 20X5 £612,100
Annual instalment payable in arrears £150,000
Interest rate implicit in lease 10% per annum
Residual value guaranteed by Prior plc £61,000
Expected residual value at 31 May 20Y0 £70,000
Initial direct costs incurred by Flynt £1,000
I have treated the agreement as an operating lease and recognised lease rental income of
£150,000. I have also charged depreciation of £122,420 and written off the direct costs incurred
to profit or loss.
Acquisition of Dipper plc
On 1 December 20X5 Flynt purchased 100% of the ordinary shares of Dipper plc for a
consideration of £6.4 million when Dipper had net assets with a fair value of £4.9 million
including a deficit on a defined benefit pension scheme of £0.4 million. Goodwill of £1.5 million
therefore arose on acquisition. The consideration given was 150,000 ordinary shares in Flynt.
This was the first equity issue for a number of years. There were 1.4 million ordinary shares in
issue on 31 May 20X5.
Flynt operates a defined contribution scheme, and I am unfamiliar with how to deal with
Dipper's defined benefit scheme.
We obtained the following figures from Dipper's actuaries at the acquisition date:
Fair value of scheme assets £2.2m
Present value of pension obligations £2.6m
Estimated service cost from 1 December 20X5 to 31 May 20X6 £560,000
Interest rate on high quality corporate bonds 5% per annum
Discount rate for scheme obligations 4% per annum
The total contributions paid into the scheme by Dipper from the acquisition date to 31 May
20X6 were £480,000, and I have charged this sum to operating costs. I have had a letter from
Dipper's pension fund advising me that they have paid out £450,000 to pensioners in the same
period. I have not adjusted the deficit in the statement of financial position.
Dipper recognises remeasurement (actuarial) gains and losses immediately in accordance with
IAS 19, Employee Benefits (revised 2011). I intend to continue to apply IAS 19 in the group
financial statements but I do not know how to calculate the remeasurement gain or loss.
I have been advised by the scheme actuary that at 31 May 20X6 the fair value of the pension
assets was £2.08 million and the present value of pension obligations was £2.75 million at that
date.
We conducted an impairment review of goodwill at the end of our accounting period and
estimated that goodwill arising on the acquisition of Dipper was worth £1.1 million. I have
therefore debited £400,000 to other comprehensive income. No other adjustments were
required to goodwill.

Exhibit 2: Draft consolidated statement of profit or loss and other comprehensive income for
year ended 31 May 20X6
20X6 20X5
£'000 £'000
Revenue 14,725 13,330
Cost of sales (7,450) (7,560)
Other operating income 150 –
Operating profit 4,129 2,763
Finance costs (452) (468)
Income tax expense (1,003) (628)
Profit after tax 2,713 1,699
Other comprehensive income
Goodwill impairment (400) –
Total comprehensive income for the year 2,313 1,699
Note: All calculations should be to the nearest £'000.
9 Gustavo plc
You are Anita Hadjivassili, the recently appointed financial controller at Gustavo plc, a
manufacturer of sports equipment. During the year ended 30 September 20X6, Gustavo has
sold and purchased shares respectively in two companies, Taricco Ltd and Arismendi Inc.
You have just received the following email from the CEO, Antonio Bloom.
To: Anita Hadjivassili

From: Antonio Bloom
Subject: Draft Financial Statements for the Gustavo group
I attach extracts from the draft financial statements for the year ended 30 September 20X6
(Exhibit 1). I know you are still unfamiliar with Gustavo's business, so I have also attached some
file notes prepared by your predecessor (Exhibit 2).
I would like you to prepare the draft consolidated statement of profit or loss and other
comprehensive income for the year ended 30 September 20X6 including other comprehensive
income, as I need to present it at the next board meeting. Please provide briefing notes to
explain the impact of the share transactions (Exhibit 2) on the consolidated statement of profit or
loss and other comprehensive income. Please show separately the profit attributable to the
non-controlling interest.
I would also like you to advise on the impact that any future changes in exchange rates will have
on the consolidated statement of financial position.
In addition, we have a potential problem with one of our credit customers defaulting on
payment (Exhibit 3). I have heard that the rules on revenue recognition are about to change to
allow us to take account of credit risk. I would like some advice on the rules relating to credit
risk.
Ignore any further income tax or deferred tax adjustments.
Requirement
Respond to Antonio's email. Total: 30 marks

Exhibit 1: Extracts from the draft financial statements for year ended 30 September 20X6
Gustavo Taricco Arismendi
£'000 £'000 Kr'000
Revenue 35,660 28,944 48,166
Cost of sales (21,230) (22,164) (30,924)
Gross profit 14,430 6,780 17,242
Operating costs (5,130) (4,956) (9,876)
Profit from operations 9,300 1,824 7,366
Investment income 580 108 –
Finance costs (2,450) (660) (1,456)
Profit before taxation 7,430 1,272 5,910
Income tax expense (2,458) (360) (2,240)
Profit for the year 4,972 912 3,670
Retained earnings
At 1 October 20X5 11,720 4,824 14,846
Profit for the year 4,972 912 3,670
Dividends paid (1 July) (3,000) (600) –
At 30 September 20X6 13,692 5,136 18,516
Other financial information

£'000 £'000 Kr000
Ordinary share capital (shares of £1/Kr1) 10,000 2,000 5,000
Profits arise evenly throughout the year for all three companies.
Exhibit 2: File notes for key issues in year
Taricco
Gustavo bought 1.5 million ordinary shares in Taricco Ltd on 1 January 20X2 for £15 million
when Taricco had retained earnings of £2.4 million. The proportion of net assets method was
used to value the non-controlling interest as the acquisition occurred before IFRS 3 was revised.
At the acquisition date the fair value of Taricco's net assets was equal to the carrying amount.
Prior to 1 October 20X5 there had been goodwill impairments in relation to Taricco of
£2.5 million. There have been no changes in share capital or other reserves since acquisition.
On 1 April 20X6 Gustavo sold 800,000 shares in Taricco for £19.8 million. Gustavo continues to
be represented by two directors on Taricco's board to oversee its remaining interest in the
company. (Taricco's board consists of eight directors.) The only entry in Gustavo's financial
statements regarding the sale has been to credit a suspense account with the sale proceeds.
It was estimated at 1 April 20X6 that Gustavo's remaining shares in Taricco had a fair value of
£8.2 million.
Arismendi
On 1 January 20X6 Gustavo bought 4 million shares in Arismendi Inc, a company located
overseas, (where the local currency is the Kr) for Kr75.6 million (£12.6 million). Professional fees
relating to the acquisition were £400,000, and these have been added to the cost of the
investment.
At 1 January 20X6 Arismendi owned property which had a fair value of Kr14.4 million
(£2.4 million) in excess of its carrying amount. This property had a remaining life of eight years at
this date.

Gustavo would like to adopt the fair value method to measure the non-controlling interest. At
1 January 20X6 the market price of Arismendi's shares was Kr12 each.
An impairment review of goodwill took place at 30 September 20X6, and no impairment was
deemed necessary.
Exchange rates which may be relevant are:
1 January 20X6 £1:Kr6
Average Jan-Sep £1:Kr5
30 September 20X6 £1:Kr4
Exhibit 3: Impaired receivable
Gustavo has entered into a contract with Bravo Ltd, a retail chain, to provide sports equipment at
a value of £200,000. The terms are that payment is due one month after the sale of the goods.
On the basis of experience with other contractors with similar characteristics, Gustavo considers
that there is a 5% risk that the customer will not pay the amount due after the goods have been
delivered. Gustavo subsequently felt that the financial condition of the customer has
deteriorated and that the trade receivable is further impaired by £20,000.
We would like to know how the above transaction would be treated in subsequent financial
statements under IFRS 9.
An annual discount rate of 4% should be used in any calculations.
10 Inca Ltd
Inca Ltd supplies specialist plant and machinery to the oil drilling industry. On 1 May 20X0 Inca
acquired 80% of Excelsior Inc, a company based in Ruritania, where the currency is the CU.
You are Frank Painter, a chartered accountant employed on a temporary contract following the
retirement of the Inca finance director. You have been asked to assist the managing director in
finalising the financial statements of Excelsior and the Inca group for the year ended 30 April
20X1.
Both Inca and Excelsior prepare their financial statements using IFRS. You receive the following
email from the managing director of Inca.
From: Inca MD
Subject: Finalising Financial Statements
To: Frank Painter
Date: 25 July 20X1
Acquisition of Excelsior
Excelsior is the first subsidiary that Inca has acquired, and so I would be grateful for some advice
in relation to the consolidated financial statements and also in finalising the financial statements
of Excelsior.
The cost of the investment in Excelsior was CU120 million, and at 1 May 20X0 Excelsior had
retained earnings of CU64 million. There were no fair value adjustments to the net assets of
Excelsior. Inca uses the proportion of net assets method to value non-controlling interest.
Assistance needed
I wish to show your findings to my fellow board members, as they are concerned about
Excelsior's effect on the consolidated financial statements. I have not told them that I have asked
for your input as I would like to make a favourable impression in terms of my accounting
knowledge.

I have provided you with the draft statements of financial position for both companies (Exhibit 1).
I have also provided some exchange rates (Exhibit 2). The accountant at Excelsior is unqualified.
He has identified a number of outstanding financial reporting issues (Exhibit 3).
I have heard that there is an option of valuing non-controlling interests at fair value, rather than
using the proportion of net assets method, as we do. The fair value of the non-controlling
interest in Excelsior is CU20 million. I understand that using this method would change the
figures for goodwill and perhaps the exchange difference relating to goodwill.
Please prepare a working paper for me which comprises:
 an explanation of the appropriate financial reporting treatment for each of the issues
identified by the Excelsior accountant (Exhibit 3);
 the consolidated statement of financial position of Inca at 30 April 20X1, assuming there are
no adjustments to the individual company financial statements other than those you have
proposed; and
 a calculation of goodwill assuming that Inca values the non-controlling interest in Excelsior
at its fair value of CU20 million.
Do not tell anyone else that you are preparing this working paper for me. In return I will ensure
that you are given a permanent contract in the Inca group. In order to save costs I am not
intending to replace the Inca finance director as I can do this role myself with your help.
Requirements
Prepare the working paper requested by the managing director.
In addition to the working paper, explain any ethical concerns that you have, as Frank Painter, in
relation to the managing director's email, and set out the actions you intend to take.
Total: 30 marks
Note: Ignore any UK current tax implications.
Exhibit 1: Draft statements of financial position at 30 April 20X1
Inca Excelsior
Non-current assets £m CUm
Investment in Excelsior 24.0 –
Property, plant and equipment 32.4 64.0
Intangible assets 12.4 7.0
Total non-current assets 68.8 71.0
Current assets
Inventories 9.8 16.6
Trade receivables 17.4 35.2
Cash 1.6 12.8
Total current assets 28.8 64.6
Total assets 97.6 135.6
Equity and liabilities
Share capital £1/CU1 4.0 10.0
Share premium account 12.0 16.0
Retained earnings 41.6 48.0
Non-current liabilities
Deferred tax 12.0 4.4
Loans 5.8 48.0
Current liabilities 22.2 9.2
Total equity and liabilities 97.6 135.6

Exhibit 2: Exchange rates
£1 = CU
1 May 20X0 5.0
Average for year 4.8
30 April 20X1 4.5
US$1 = CU
1 May 20X0 3.2
Average for year 3.0
30 April 20X1 2.8
Exhibit 3: Excelsior – Outstanding financial reporting issues prepared by Excelsior accountant
Excelsior's draft statement of profit or loss and other comprehensive income shows an after-tax
loss of CU16 million for the year ended 30 April 20X1. The current tax has been correctly
calculated by our tax advisers. However, I am not familiar with deferred tax and some of the more
complex financial reporting rules and the following matters are outstanding:
(1) At 1 May 20X0 there was a deferred tax liability of CU4.4 million in the statement of financial
position and no adjustments have been made to this figure in the draft financial statements
at 30 April 20X1. This deferred tax provision was solely in relation to the differences between
the carrying amount of property, plant and equipment and the tax base.
The carrying amount of property, plant and equipment on 1 May 20X0 was CU60 million,
compared with its tax base of CU38 million. At 30 April 20X1 these figures were
CU64 million and CU36 million respectively.
Companies in Ruritania pay tax at a flat rate of 20%. This rate is not expected to change in
future years.
(2) In the year ended 30 April 20X1 Excelsior capitalised development costs of CU7 million.
These costs are likely to be amortised over four years from 1 May 20X2.
Under Ruritanian tax law such costs are deductible when incurred.
(3) The tax trading loss carried forward in respect of the year ended 30 April 20X1 is
CU16 million. Excelsior has reliable budgets for a taxable profit of CU5 million for each of
the next two financial years, but it has no accurate budgets beyond that date. Tax losses can
be carried forward indefinitely under Ruritanian tax law.
(4) On 1 May 20X0 Excelsior issued a 5% bond to American financial institutions. The bond had
a nominal value of US$16 million and is repayable on 30 April 20X3. The bond was issued at
a discount of US$1 million, and is redeemable at a premium over nominal value of
US$1.79 million.
Interest of US$800,000 is paid every 12 months commencing 30 April 20X1. The implicit
interest rate on the bond is approximately 10.91%.
The loan has been translated on 1 May 20X0 and the interest paid in relation to the bond has
been charged to profit or loss. This sum was CU2.24 million (US$800,000 × 2.8) but no other
adjustments have been made.
According to Ruritanian tax law, the only tax deduction in respect of the bond is for nominal
interest which is tax deductible when paid. Debits and credits relating to discounts and
premiums are not tax deductible.
(5) On 1 April 20X1 Excelsior made a loan of CU2 million to one of the directors of the
company, who also happens to be a prominent politician. I do not expect any of this sum to
be recoverable, but it would be politically embarrassing to disclose this in the financial
statements. The loan has been included in trade receivables and no adjustments have been
made. On the grounds of materiality, the board is very keen to exclude any reference to the
loan.

11 Aytace plc
Aytace plc is the parent company of a group that operates golf courses in Europe. It has had
investments in a number of 100% owned subsidiaries for many years, as well as owning 40% of
the share capital in Xema Limited since 20X0.
You are Frank Brown, a Chartered Accountant. You have recently taken up temporary
employment with Aytace while the financial controller, Meg Blake, is on maternity leave.
You receive the following email from the finance director, Willem Zhang.
To: Frank Brown

From: Willem Zhang
Subject: Draft consolidated statement of profit or loss and other comprehensive income for the
Prior to maternity leave, Meg prepared a first draft consolidated statement of profit or loss and
other comprehensive income and has noted some outstanding matters relating to transactions
in the year (Exhibit).
Please prepare a working paper which comprises:
 Advice, with explanations and relevant calculations, on the appropriate financial reporting
treatment of the outstanding matters highlighted by Meg in the Exhibit.
 A revised consolidated statement of profit or loss and other comprehensive income,
showing clearly the financial reporting adjustments you have proposed.
Ignore any tax consequences arising from the outstanding matters, as these will be finalised by
our tax advisers.
Requirement
Prepare the working paper requested by the finance director. Total: 30 marks
Exhibit: Briefing notes prepared by Meg Blake for year ended 31 May 20X3
Aytace Group – Draft consolidated statement of profit or loss and other comprehensive income
for the year ended 31 May 20X3
£'000 Notes
Revenue 14,450 1
Operating costs (9,830) 1, 2
Operating profit 4,620
Income from associate 867 4
Other investment income 310
Finance costs (1,320)
Profit before tax 4,477
Tax (1,220)
Notes on outstanding matters

I have not had sufficient time to look into the following matters because of my personal
circumstances.
(1) Golf tournament
On 1 December 20X2 Aytace won the tender to host an annual international golf
tournament for each of the next four years. The first golf tournament will take place in
September 20X3.

The tender process commenced on 5 August 20X2 and the tender was submitted on
8 November 20X2. Internal management time costs of £1.2 million were incurred in relation
to the tender submission. These costs were capitalised and are being amortised from
1 December 20X2 over a four-year period. Therefore £150,000 (6/48 × £1.2 million) has
been recognised in profit or loss as an operating cost for the year ended 31 May 20X3.
A separate contract was subsequently signed on 1 February 20X3 with a satellite television
company for the exclusive rights to broadcast the tournament. The contract fee is
£4.8 million for the whole four years of the tournament. The broadcaster made an advance
payment of £1.0 million to Aytace on 1 May 20X3. This amount was initially credited to a
contract liability. I then decided to recognise revenue on the satellite television contract
evenly over a four-year period from 1 February 20X3. An amount of £400,000 (£4.8m ×
4/48) is therefore recognised as revenue in profit or loss for the year ended 31 May 20X3.
(2) Defined benefit pension scheme
Aytace operates a defined benefit pension scheme. Employees are not required to make
any contributions into the scheme. Aytace recognises remeasurement (actuarial) gains and
losses immediately through other comprehensive income in accordance with IAS 19,
Employee Benefits (revised 2011).
The scheme assets had a fair value of £12.2 million and £13.5 million at 31 May 20X2 and
31 May 20X3 respectively. Scheme obligations had a present value of £18 million and
£19.8 million at 31 May 20X2 and 31 May 20X3 respectively.
At 1 June 20X2 the interest rate on high quality corporate bonds was 6%.
In the year ended 31 May 20X3, employer contributions paid into the scheme were
£0.9 million, and pensions paid by the scheme during the year amounted to £1.1 million.
These payments took place on 31 May 20X3. The service cost for the year ended 31 May
20X3 was £1.2 million.
Aytace decided to improve the pension benefit at 1 June 20X2 for staff who will have
worked at least five years for the company at the date the benefit is claimed. The scheme
actuary calculated the additional benefit obligation in present value terms to be £400,000.
The only entry in the financial statements in respect of the year ended 31 May 20X3 was to
recognise in profit or loss the contributions paid to the scheme by Aytace, with no
adjustment to the scheme obligations in the statement of financial position.
(3) Holiday pay
The salaried employees of Aytace are entitled to 25 days paid leave each year. The
entitlement accrues evenly over the year and unused leave may be carried forward for one
year. The holiday year is the same as the financial year. At 31 May 20X3, Aytace has 900
salaried employees and the average unused holiday entitlement is three days per
employee. 5% of employees leave without taking their entitlement and there is no cash
payment when an employee leaves in respect of holiday entitlement. There are 255
working days in the year and the total annual salary cost is £19 million. No adjustment has
been made in the financial statements for the above and there was no opening accrual
required for holiday entitlement.
(4) Investment in Xema
On 1 January 20X0, Aytace bought 40% of the issued ordinary share capital of Xema Ltd, a
sportswear company, for £2.3 million. Aytace has had significant influence over Xema since
this date and has used the equity method to account for the investment.
At 1 January 20X0, Xema had an issued ordinary share capital of 1 million £1 ordinary
shares and retained earnings of £3.4 million. There has been no change to Xema's issued
share capital since 1 January 20X0. At 31 May 20X2 retained earnings were £4.8 million.
Xema's statement of profit or loss for the year ended 31 May 20X3 was as follows:

£'000
Revenue 5,400
Operating costs (3,600)
Other investment income 240
Finance costs (720)
Tax (300)
On 1 September 20X2 Aytace bought the remaining 60% of Xema's ordinary share capital
for £12.4 million, at which date its original 40% shareholding was valued at £3.8 million.
There were no material differences between carrying amounts and fair values of the
identifiable net assets of Xema at 1 September 20X2.
I recognised the investment in Xema using the equity method and credited £867,000 to
profit or loss (profit for the year of £1.02m  3/12  40% plus £1.02m  9/12  100%).
(5) Executive and employee incentive schemes
Aytace introduced two incentive schemes on 1 June 20X2. No entries have been made in
relation to either of these schemes in the financial statements for the year ended 31 May
20X3.
The first incentive scheme is for executives. Aytace granted 100,000 share options to each
of five directors. Each option gives the right to buy one ordinary share in Aytace for £6.40 at
the vesting date of 31 May 20X5. In order for the options to vest, Aytace's share price must
rise by a minimum of 35% from the market price on 1 June 20X2 of £6.40 per share. In
addition, for a director's options to vest, he/she must still hold office at 31 May 20X5.
Aytace's share price was only £5.80 at 31 May 20X3, and I am not confident that we will
achieve the required price increase of 35% by the vesting date. The fair value of a share
option at 1 June 20X2 was estimated to be £2.70, but this had fallen to £1.90 by 31 May
20X3.
Most of the board has been with Aytace for a number of years, and none has left in the last
12 months. I would anticipate only one director leaving prior to the vesting date.
The second incentive scheme is an employee scheme in the form of share appreciation
rights for senior managers. The vesting date is 31 May 20X5, and managers must be still in
employment at that date.
There are 60 managers eligible for the scheme, each of whom has appreciation rights over
4,000 shares. Under the scheme each manager will receive a cash amount equal to the fair
value of the rights over each share. I anticipate 50 of the managers being in the scheme at
31 May 20X5. The fair value of the rights was £2.85 per share at 1 June 20X2 and £2.28 per
share at 31 May 20X3.
12 Razak plc
Razak plc is a listed parent company. During the year ended 30 September 20X2 Razak plc
increased its shareholding in its only equity investment, Assulin Ltd.
Razak publishes magazines in the UK. You are Kay Norton, a chartered accountant and a
member of the Razak financial reporting team. You report to the Razak group finance director,
Andrew Nezranah, who is also a chartered accountant.

You receive the following email:
To: Kay Norton

From: Andrew Nezranah
Date: 29 October 20X2
I have recently joined the board and I am preparing for our annual update presentation to our
bank.
As part of this update, I have been asked to present the bank with draft consolidated financial
statements for the year ended 30 September 20X2. I appreciate that there will be tax issues to
finalise at a later stage, but the bank has said that it is not interested in these at present.
For a number of years Razak plc held 15% of the ordinary share capital of Assulin, a paper pulp
manufacturer. On 31 March 20X2 this shareholding was increased to 80%, as we wanted to secure
continuity of supply in relation to paper pulp. Further details of this transaction can be found in
Exhibit 1.
Razak plc's draft financial statements at 30 September 20X2 are summarised in Exhibit 2.
In addition I have some concerns about Razak plc's purchase of a bond in Imposter plc
(Exhibit 3).
The directors are proposing to introduce a pension plan for next year (Exhibit 4) and are
perhaps unclear on how to account for it.
Please would you:
 provide explanations of how the increase in the stake in Assulin will be treated in Razak's
consolidated financial statements;
 explain any adjustments needed to account for the purchase of the Imposter bond in
Razak's consolidated financial statements and evaluate any ethical issues arising from this
matter;
 prepare Razak's consolidated statement of financial position at 30 September 20X2 after
making all relevant adjustments; and
 explain how the proposed pension plan would be accounted for in the financial statements.
Requirement
Reply to Andrew's email. Total: 30 marks
Exhibit 1: Shareholding in Assulin
In 20W4 (eight years ago), Razak plc bought 75,000 shares in Assulin for £6 each. An irrevocable
election was made on purchase to classify this investment as being at fair value through other
comprehensive income. At 30 September 20X1, the shares had a fair value of £16 each, and a
cumulative increase in fair value of £750,000 had been recognised in other comprehensive
income and was held in equity. In Razak plc's draft statement of financial position, the increase in
the share valuation has also been included in the investment in Assulin.
On 31 March 20X2 a further 325,000 shares in Assulin were purchased for £25 each. This sum
has been added to the investment in Assulin.
In addition to the cash consideration of £25 per share, Razak plc agreed to pay a further £6 per
share on 31 March 20X4, subject to a condition that Assulin's management team, each of whom
owned shares in Assulin, remain with the company to that date. It is considered to be highly
probable that this condition will be met. No adjustments for a contingent payment have been
included in Razak's financial statements. Razak has a cost of capital of 9%.
On 31 March 20X2, the fair value of an Assulin share was estimated to be £20. Razak has
decided to use the fair value (full goodwill) method to measure non-controlling interest.

The statements of financial position of Assulin at 30 September 20X2 and 31 March 20X2 were
as follows:
30 September 31 March
20X2 20X2
£'000 £'000
Non-current assets
Property, plant and equipment 3,460 3,210
Current assets
Inventories 610 580
Receivables 400 280
Cash at bank 70 90
Total assets 4,540 4,160
Equity
£1 ordinary shares 500 500
Retained earnings 2,740 2,540
Loan from Razak plc 800 800
Current liabilities
Trade payables 290 240
Tax payable 210 80
Total equity and liabilities 4,540 4,160
Included in Assulin's non-current assets is a property which had a carrying amount of

£1.2 million at 31 March 20X2. This property was estimated to have a fair value of £2.6 million at
this date, and a remaining useful life of five years.
Exhibit 2: Draft statement of financial position for Razak plc at 30 September 20X2
£'000
Non-current assets
Property, plant and equipment 6,000
Investment in Assulin 9,325
Loan to Assulin 800
Other financial assets 1,193
17,318
Current assets
Inventories 1,255
Receivables 960
2,215
Total assets 19,533
Equity
£1 ordinary shares 2,800
Share premium account 7,400
Retained earnings 2,510
Other components of equity 750
13,460
Non-current liabilities 2,788
Current liabilities
Bank overdraft 1,220
Trade payables 865
Tax payable 1,200
3,285
Total equity and liabilities 19,533

Exhibit 3: Imposter bond
Razak plc purchased a 6% bond in Imposter plc on 1 October 20X1 (the issue date) at par for
£1.2 million. On recognition, Razak created a separate allowance of £7,000 for 12-month
expected credit losses (present value of lifetime expected credit losses of £100,000  7% chance
of default within 12 months). The bond has an effective annual rate of interest of 7.5%. No
repayments were made in the year ended 30 September 20X2.
At 30 September 20X2, the credit quality of the bond was considered to have significantly
deteriorated. The present value of lifetime expected credit losses was revised to £600,000.
The discount rate used to calculate the present value of lifetime expected credit losses is 6%.
It is currently recognised in 'other financial assets' in the draft statement of financial position at
£1,193,000, which is the value on initial recognition net of the 12-month expected credit losses.
The chief executive of Razak plc is also a director of Imposter and has a 5% shareholding in
Imposter. The chief executive authorised the purchase of the bond. There is no record of this
matter in the board minutes.
Exhibit 4: Proposed pension plan
The directors of Razak are considering setting up a pension plan in the next accounting period
with the following characteristics:
(1) The pension liabilities would be fully insured and indexation of future liabilities will be
limited up to and including the funds available in a special trust account set up for the plan,
which is not at the disposal of Razak.
(2) The trust account will be built up by the insurance company from the surplus yield on
investments.
(3) The pension plan will be an average pay plan in respect of which the entity pays insurance
premiums to a third party insurance company to fund the plan.
(4) Every year 1% of the pension fund will be built up and employees will pay a contribution of
4% of their salary, with the employer paying the balance of the contribution.
(5) If an employee leaves Razak and transfers the pension to another fund, Razak will be liable
for, or is refunded the difference between the benefits the employee is entitled to and the
insurance premiums paid.
In the light of the above, the directors believe that the plan will qualify as a defined contribution
plan under IAS 19, Employee Benefits rather than a defined benefit plan, and will be accounted
for accordingly.
13 Finney plc
Finney plc is a UK-based company that produces engineering equipment for the mining
industry. Finney has a number of investments both in the UK and overseas, as well as an active
treasury function that trades in commodities.
You are Marina Bujnowicz, and you recently joined Finney as an ICAEW Chartered Accountant to
help finalise the financial statements for the year ended 30 September 20X2.

You receive the following email from a director of Finney, Simone Hammond.
From: Simone Hammond

To: Marina Bujnowicz
Re: Financial Statements for year ended 30 September 20X2
Dear Marina,
Finney's treasury department has gathered together information relating to outstanding issues
for inclusion in the financial statements (Exhibit 1). The Financial Controller, who is on holiday at
the moment, has left a note about share appreciation rights (Exhibit 2). Draft financial
statements are shown in Exhibit 3.
Please review this information and prepare for me a briefing note, including any relevant
calculations and journals, that sets out the financial reporting consequences for the year ended
30 September 20X2 of the issues contained in Exhibits 1 and 2. Please could you also re-draft
the financial statements in Exhibit 3 in the light of your conclusions regarding the financial
reporting issues identified.
Regards
Simone
Requirement
Draft the briefing note requested by Simone. Total: 30 marks
Exhibit 1: Outstanding issues from the treasury department
(a) Investment in loan stock
On 1 October 20X1 Finney acquired an investment in £3,000,000 8% loan stock at par. The
investment meets the business model and contractual cash flows test and is therefore
measured at amortised cost. The loan stock has an effective annual rate of interest of 10%.
No repayments were made in the year ended 30 September 20X2.
Finney made the following estimates:
(1) At 1 October 20X1 there was a 5% probability that the borrower would default on the
loan during the year resulting in a 100% loss.
(2) At 30 September 20X2 there is a 2% probability that the borrower will default on the
loan before 30 September 20X3 resulting in a 100% loss.
The Treasury Department have provided a note that an impairment allowance of £150,000
had been recognised under IFRS 9 when the bond was first acquired, but has not explained
how this was calculated, or made any further entries for the accounting treatment of the
asset during the year. It would be helpful if you could provide both.
(b) Financial liability
Finney provides loans to customers and funds the loans by selling bonds in the market. The
liability is designated as at fair value through profit or loss. The bonds have a fair value
decrease of £10 million in the year to 30 September 20X2 of which £2 million relates to the
reduction in Finney’s creditworthiness. Simone Hammond would like advice on how to
account for this movement.
(c) Copper inventories contract
At 1 July 20X2 Finney had inventories of 1,000 tonnes of copper. The average historic cost
of the copper was £9,200 per tonne.
To protect against a decline in copper prices, on 1 July 20X2 Finney entered into a futures
contract, using a recognised commodities exchange, to sell 1,000 tonnes of copper for

£9,200 a tonne. (The fair value of the futures contract at that date was zero.) The contract
matures on 31 December 20X2. Our compliance department designated the futures contract
as a fair value hedge of the copper inventory, and has determined that the IFRS 9, Financial
Instruments hedging criteria have been met.
At 30 September 20X2, the fair value of the copper inventory had fallen to £8,200 a tonne
and, at this date, the fair value of the original futures contract (written on 1 July 20X2) for
31 December 20X2 delivery was £950 per tonne. At 30 September 20X2, a new futures
contract could be written for delivery of copper on 31 December 20X2 at £8,250 a tonne.
(d) Investment in Coppery
On 1 October 20X0 Finney bought two million shares at £1.60 each, representing a 0.9%
shareholding, in Coppery plc. The shares were held for trading. Finney had recognised a
gain of £300,000 for the year ended 30 September 20X1 in profit or loss.
On 1 April 20X2 Coppery was acquired by Zoomla plc, a large mining corporation. The
terms of the deal were that shareholders in Coppery would receive, for each share they
owned:
(1) on 1 April 20X2, two shares in Zoomla, worth £1.10 each; and
(2) on 1 April 20X3, cash of £0.15.
Finney has a weighted average cost of capital of 10%.
At 30 September 20X2, the market price of a Zoomla share was £1.20.
Exhibit 2: Share appreciation rights

On 1 October 20W9, Finney granted 300 share appreciation rights to each of its 200 managers.
All of the rights vest after two years' service and they can be exercised during the following two
years up to 30 September 20X3. The fair value of the right at the grant date was £20. It was
thought that 30 managers would leave over the initial two-year period and they did so. The fair
value of each right was as follows.
Year Fair value at the year-end (£)
30 September 20X0 23
On 30 September 20X2, 40 managers exercised their rights when the intrinsic value of the right
was £21.
The director wishes to know what the liability and expense will be at 30 September 20X2.
Exhibit 3: Draft financial statements as at 30 September 20X2

Draft statement of profit or loss and other comprehensive income of Finney plc for year ended
30 September 20X2
£m
Revenue 194
Cost of sales (111)
Gross profit 83
Operating costs (31)
Operating profit 52
Finance income 3
Interest payable (16)
Profit before taxation 39
Taxation (8)
Profit for the year 31
Other comprehensive income 7

Total comprehensive income for the year 38

Draft statement of financial position as at 30 September 20X2
£m
Non-current assets
Property, plant and equipment 84
Investment in equity instruments 36
Other financial assets 10
Inventories 66
Receivables 56
Total assets 252
Share capital: £1 shares 75

Retained earnings 97
Other components of equity 24
Non-current liabilities 27
Current liabilities
Trade payables 18
Overdraft 11
Total equity and liabilities 252
14 Melton plc
Melton plc ('Melton') owns a number of subsidiaries that operate high quality coffee bars.
You are a recently appointed investment analyst for a major investment bank that owns 6% of
the issued equity of Melton. You have been asked to analyse the profitability, cash flows and
investor ratios of Melton. You need to prepare notes for a meeting with the investment team to
determine whether the investment bank should consider disposing of its investment.
One of your colleagues has left you a note of background information concerning Melton
(Exhibit 1) and some financial information (Exhibit 2).
Your meeting notes should do the following:
(a) Evaluate the investment team member's comment (Exhibit 1 point (8)), explaining the
usefulness and limitations of diluted earnings per share information to investors.
(b) Analyse the profitability, cash flow and investor ratios of Melton plc, calculating additional
relevant ratios to assist in your analysis. Your notes should identify and justify matters that
you consider require further investigation.
(c) Explain the validity or otherwise of your colleague's statement that Melton plc is unable to
pay a dividend because of the debit balance on consolidated retained earnings (Exhibit 1,
point (7)).
(d) Discuss the reporting implications of the issue raised in the director's comment in Exhibit 1,
point (9).
Requirement
Prepare the meeting notes for the investment team. Total: 30 marks
Exhibit 1: Notes on background information for Melton
(1) Melton has a reputation for depreciating its assets more slowly than others in the sector.
(2) The strategy of the group is to fund new outlet capital expenditure from existing operating
cash flows without the need to raise new debt.
(3) Like for like revenue growth in the sector is estimated at 4.1% pa.
(4) Grow 'outlet profits' (gross profits) as a percentage of outlet revenue year on year.
(5) Increase promotional and advertising spend on new outlets to encourage strong initial
sales.

(6) Management are accused of concentrating on new outlet openings to the detriment of
existing outlets.
(7) Melton is unable to pay dividends as the company has a debit balance on its consolidated
retained earnings.
(8) One member of the investment team has questioned the usefulness of diluted earnings per
share, which, he believes, 'adds in unnecessary complications that may never happen'.
(9) Melton acquired 8,000 out of the 10,000 shares of R.T. Café Ltd, which operates a chain of
cafés offering simple food and a good but limited range of coffees. Mr Bean, one of the
directors of Melton, has stated the following:
"While R.T. Café Ltd is profitable, long-term it is not a good fit with the image we are trying
to portray. I suggest we dispose 2,000 of our shares in this subsidiary in January 20X8.
Preliminary enquiries suggest that we could make a profit of £500,000, which would be a
nice boost to earnings per share for next year."
Exhibit 2: Financial information
Melton plc: Consolidated statement of profit or loss for the year ended 30 September
20X7 20X6
£'000 £'000
Revenue 37,780 29,170
Cost of sales (28,340) (22,080)
Administrative expenses (6,240) (4,480)
Profit before taxation 2,790 2,190
Tax (610) (460)
Earnings per share – basic 26.8p 21.3p

Earnings per share – diluted 21.2p 19.2p
No dividends have been paid or proposed in 20X6 and 20X7.

Melton plc: Consolidated statement of cash flows for the year ended 30 September
20X7 20X6
£'000 £'000 £'000 £'000
Cash flows from operating activities
Cash generated from operations (Note) 6,450 4,950
Interest paid (410) (440)
Tax paid (320) (260)
Net cash from operating activities 5,720 4,250
Cash flows from investing activities
Purchase of non-current assets (5,970) (5,790)
Proceeds on sale of non-current assets 20 30
Net cash used in investing activities (5,950) (5,760)
Cash flows from financing activities
Proceeds of share issue 240 20
Borrowings 650 2,000
Net cash from financing activities 890 2,020
Net increase in cash and cash equivalents 660 510

Cash and cash equivalents brought forward 2,480 1,970
Cash and cash equivalents carried forward 3,140 2,480

Note: Reconciliation of profit before tax to cash generated from operations for the year ended
30 September
20X7 20X6
£'000 £'000
Finance cost 410 420
Depreciation and amortisation 3,060 2,210
Loss on disposal of non-current assets 30 10
(Increase)/decrease in inventories (40) 10
(Increase) in receivables (250) (20)
Increase in trade payables 450 130
Cash generated from operations 6,450 4,950
Analysis of revenue, outlet profits and new outlet openings for the years ended 30 September
20X6 and 20X7
30 new outlets were opened during the year ended 30 September 20X7 to bring the total to
115.
20X7 20X6
£'000 £'000
Revenue per outlet
Outlets open at 30 September 20X6 354 343
Outlets opened in current financial year 258 –
Gross profit per outlet

Outlets open at 30 September 20X6 87 83
Outlets opened in current financial year 69 –
Additional information
20X7 20X6
Gross margin 25.0% 24.3%
Gearing (net debt/equity) 35.2% 44.4%
Current ratio 0.56:1 0.48:1
Trade payables payment period 86 days 103 days
Return on capital employed (ROCE) 20.0% 19.1%
Cash return on capital employed (CROCE) 40.2% 36.3%
Revenue per employee (£'000) 41.1 37.9
Earnings before interest, tax, depreciation and
amortisation (EBITDA) (£'000) 6,260 4,820
Non-current asset turnover 1.68 times 1.49 times
Share price (at 30 September) 302p 290p
15 Fly-Ayres
Fly-Ayres plc (Fly-Ayres), an unlisted company, was established in 20X5 by Bill Ayres, a
successful entrepreneur, as a budget airline business. The business has grown rapidly since start
up. Bill Ayres currently owns 75% of the ordinary share capital, but in a recent press interview he
announced that he planned to seek a stock exchange listing for the company during 20X9. This
would help to raise new capital for Fly-Ayres' planned expansion of services over the next two or
three years.
It is now 20 November 20X8. Fly-Ayres's finance director, Tom Briar, is an ICAEW Chartered
Accountant. He qualified many years ago and until 20X5 worked as an insurance salesman. In
20X5, Bill Ayres invited Tom, an old school friend, to be Fly-Ayres' finance director.
The company has just appointed George, a recently-qualified ICAEW Chartered Accountant, as
Tom's assistant. George replaced Sally, also ICAEW qualified, who moved to another company.
Tom has prepared Fly-Ayres's financial statements for the year ended 31 October 20X8, in

accordance with IFRS, as set out in Exhibit 1, and included some additional information in
Exhibit 2, including information from Sally on the share options scheme and the disposal of a
financial asset.
Requirements
15.1 Draft the requested report for the non-executive director. Your report should:
(a) Address the usefulness of 'industry average' ratios.
(b) Provide additional comment on whether the finance director, Tom Briar, is correct in
his comments about the financial reporting treatment of employee share options, and
if not, what the correct treatment should be.
(c) Redraft the 20X8 financial statements, making appropriate adjustments for the share
options and the disposal of the investment in equity instrument to comply with IFRS.
You should make adjustments, if needed, to ratios as calculated, in order to facilitate
interpretation. (26 marks)
15.2 Draft a note of any ethical implications of the scenario for both Tom Briar and his assistant
George. Your answer should refer to the background information above and also to the
ethical issue raised in the last paragraph of Tom's email to George (Exhibit 3). (4 marks)
Total: 30 marks
Exhibit 1: Financial statements
Fly-Ayres: Statement of profit or loss and other comprehensive income for the year ended
31 October
20X8 20X7
£m £m
Revenue 158.4 138.3
Cost of sales (see below) (137.3) (103.8)
Gross profit 21.1 34.5
Other income 0.5
Other costs (7.6) (5.2)
Profit from operations 14.0 29.3
Finance costs (10.4) (10.0)
Profit before taxation 3.6 19.3
Taxation (1.4) (5.2)
Profit for the year 2.2 14.1
Other comprehensive income 30.0 1.0

Total comprehensive income for the year 32.2 15.1
No dividends have been paid or proposed.

Extract from the financial statements: Analysis of cost of sales
Cost as a Cost as a
percentage percentage
20X8 of revenue 20X7 of revenue
£m £m
Fuel 57.7 36.4% 36.4 26.3%
Airport charges 25.2 15.9% 20.2 14.6%
Crew costs 21.7 13.7% 21.2 15.3%
Depreciation and leasing costs 14.3 9.0% 10.6 7.7%
Other costs 18.4 11.6% 15.4 11.1%
137.3 103.8

Fly-Ayres: Statement of financial position as at 31 October
20X8 20X7
£m £m £m £m
ASSETS
Non-current assets
Property, plant & equipment 272.9 222.1
Financial asset 2.0 2.0
Current assets
Trade and other receivables 9.3 8.2
Cash and cash equivalents 11.2 7.4
20.5 15.6
EQUITY AND LIABILITIES
Issued capital: £1 ordinary shares 25.0 25.0
Revaluation surplus 30.0 –
Retained earnings and other reserves 54.3 52.0
Equity 109.3 77.0
Borrowings and obligations under finance leases 150.2 123.7
Maintenance provisions 5.2 4.8
Deferred tax liability 2.1 2.0
157.5 130.5
Current liabilities
Trade and other payables 18.4 17.3
Taxation 1.6 5.7
Borrowings and obligations under finance leases 8.6 9.2
28.6 32.2
Exhibit 2: Additional information

(1) In August 20X8, Bill Ayres made a £20 million interest-free loan to the business. It is
included in non-current borrowings and obligations under finance leases.
(2) On 1 November 20X6, Fly-Ayres granted 200 share options to each of its 500 employees.
Each option gives the right to acquire one £1 ordinary share. Vesting is conditional upon
each employee working for the entity over the next three years. The fair value of each share
option as at 1 November 20X6 was £18.
On the basis of a weighted average probability, the company estimated on 1 November
20X6 that 20% of employees would leave during the three-year period and therefore forfeit
their rights to share options.
20 employees left during the year ended 31 October 20X7 and on that date, the estimate of
total employee departures over the three-year period was revised to 15% (75 employees).
22 employees left during the year ended 31 October 20X8 and on that date, the estimate of
total employee departures over the three-year period was revised to 12% (60 employees).
Sally, George's predecessor, correctly accounted for the share option scheme in the
financial statements for the year ended 31 October 20X7, but left before making any
adjustments for the year ended 31 October 20X8.
(3) During the year ended 31 October 20X8 Fly-Ayres sold an investment in an equity
instrument which had a carrying value of £2 million at 1 November 20X7 for £3 million in
cash. As at 1 November 20X7, £500,000 of cumulative revaluation gains had been
recognised in profit or loss, on which deferred tax was provided at 20%. Sally correctly
recorded the proceeds of the sale in the bank account and correctly included the current
tax at 20% payable on sale of the investment on the selling price less cost in the current tax

charge in income tax expense, but she left before making any other accounting entries in
respect of this sale.
(4) Accounting ratios are shown below. The industry comparatives are averages based on the
published financial statements of six listed budget airline companies for years ended
between 31 December 20X7 and 31 May 20X8.
Fly-Ayres Fly-Ayres Industry
20X8 20X7
Return on shareholders' funds (ROSF) 2.0% 18.3% 13.8%
Non-current asset turnover 0.58 0.62 0.89
Gearing (net debt/equity) 135.0% 163.0% 46.4%
Passenger numbers (in thousands) 3,722 3,163 –
Revenue per passenger (£) 42.56 43.72 42.70
Operating profit margin 8.8% 21.2% 12.7%
Exhibit 3: Tom's email

Tom has sent the following email to his new assistant:
George,
The non-executive director needs you to draft a report giving a critical analysis of the financial
statements before the board meets next week to assess the figures. He's a marketing expert, not
an accountant, so keep it understandable.
I've collected some 'industry average' ratios, which might come in useful, although you may
have to spell out why, as the non-executive director probably won't know.
Your report should comment on the performance and financial position of Fly-Ayres, and you
should calculate any further ratios that may assist you in your analysis. You should also identify
and justify any additional information that you would find useful and briefly point to ways in
which the analysis may be lacking.
As you see, a couple of years ago we brought in an employee share option scheme for
employees who stay with us for three years. Not only does this motivate staff, but last I heard
there isn't a charge to profit or loss because they're only share options. (Correct me if I'm wrong,
though, as I was out of the accountancy sector for a long time and may have missed some finer
points of the more recent standards.) Sally put a charge through last year, but I don't know why,
or why the information on the scheme is relevant. I don't think we need a charge this year, but if
I'm wrong, please make the appropriate adjustments.
Sally has also made some notes concerning the financial asset that Fly-Ayres sold during the
year. I do not understand how this should be treated, so please make the appropriate
adjustments.
Despite the downturn in profits, Bill says it is important to project an optimistic message. Even if
we don't seek a stock exchange listing next year, we need a strong statement of financial
position to permit future borrowings. If we do seek a stock exchange listing, as planned, Bill
intends that all staff, including recent appointees, will be rewarded with a substantial holding of
shares. I hope there isn't a problem with this – I know accountants study ethics these days, but I
can't understand why rewarding people for their hard work is unethical.

16 Aroma
Jo West owned a highly successful technology business which she sold five years ago for
£20 million. She then set up an investment entity that invests primarily in smaller private
businesses in need of short to medium term funding. Jo sits on the board as a non-executive
director of a number of the entities that her business has invested in and is often able to offer
valuable business advice to these entities, especially in the area of research and development
activities. You are Lois Mortimer, a member of Jo's investment management team.
Jo has been approached by the managing director of Aroma, a small private entity looking for
investment; she has asked you, as a member of her investment management team, to produce a
report analysing the financial performance of Aroma for the year ended 30 June 20X1 and its
financial position at that date. Your report should contain a recommendation as to whether she
should consider this investment further.
Jo has sent you the following email:
From: jowest@westinvestments.com
To: loismortimer@westinvestments.com
Date: 31 August 20X1
Subject: Financial performance of Aroma
Thank you for agreeing to do this report for me. I've got hold of some extracts from Aroma's
financial statements (Exhibit).
Some background detail for you:
Aroma has been trading for more than 10 years manufacturing and selling its own branded
perfumes, lotions and candles to the public in its 15 retail stores and to other larger retailing
entities. Revenue and profits have been steady over the last 10 years. However, 18 months ago,
the newly appointed sales director saw an opportunity to sell the products online. Using
long-term funding, she set up an online shop. The online shop has been operating successfully
for the last 14 months. The sales director also used her prior contacts to secure a lucrative deal
with a boutique hotel chain for Aroma to manufacture products for the hotel, which carry the
hotel chain name and logo. The contract was set up on 1 January 20X1.
The managing director of Aroma now believes that the business could take advantage of further
sales opportunities and does not wish to lose the momentum created by the sales director. The
bank that currently provides both the long-term loan and an overdraft facility has rejected
Aroma's request for additional funds on the basis that there are insufficient assets to offer as
security (the existing funding is secured on Aroma's property, plant and equipment).
Exhibit: Financial statements extracts

Statement of profit or loss for the year ended 30 June
20X1 20X0
£'000 £'000
Revenue 6,000 3,700
Cost of sales (4,083) (2,590)
Administrative expenses (870) (413)
Distribution costs (464) (356)
Profit before tax 540 307
Income tax expense (135) (80)
Profit for the year 405 227

The revenues and profits of the three business segments for the year ended 30 June 20X1 were:
Retail operations Online store Hotel contract
£'000 £'000 £'000
Revenues 4,004 1,096 900
Gross profit 1,200 330 387
Profit before tax 320 138 82
The online store earned a negligible amount of revenue and profit in the year ended
30 June 20X0.
Statement of financial position as at 30 June
20X1 20X0
£'000 £'000
ASSETS
Non-current assets
Property, plant and equipment 380 400
Intangible assets – development costs 20 10
400 410
Current assets
Inventories 1,260 1,180
Receivables 455 310
Cash and cash equivalents – 42
1,715 1,532
Equity
Share capital (£1 equity shares) 550 550
Retained earnings 722 610
Total equity 1,272 1,160
Long-term borrowings 412 404
Current liabilities
Payables 363 378
Short-term borrowings (overdraft) 68 –
431 378
Total liabilities 843 782
Requirement
Prepare the report required by Jo West. Total: 30 marks
17 Kenyon
You work for a team of investment analysts at Inver Bank.
Kenyon plc, a listed entity, operates a number of bottling plants. The entity's business consists
primarily of contract work for regular customers. Revenue from existing contracts has increased
in the year and in November 20X0 Kenyon plc secured a new contract with a high profile drinks
company. Kenyon plc paid a dividend of £100 million during the year ended 31 October 20X1.
Gary, a client, recently received the latest published financial statements of Kenyon plc and was
impressed by the level of profitability and the dividend paid. He was also impressed with the fact
that the share price had increased from £2.80 per share on 31 October 20X0 to £4.90 on
31 October 20X1. Gary is now considering acquiring some of Kenyon plc's shares and has asked
for your advice in an email:

"I am interested in your views on whether it is worth investing in Kenyon plc. It would be useful in
making my decision if you could produce a report which:
(a) analyses the financial performance of Kenyon plc for the year to 31 October 20X1 and its
financial position at that date and discusses whether or not it is a good investment at this
time.
(b)  shows the best and worst case potential impact of the contingent liability on Kenyon
plc's profitability and investment potential.
 discusses any further information I may need to access regarding the contingent
liability in advance of making a final investment decision."
You have obtained the financial statements of Kenyon plc (Exhibit 1), together with some further
information (Exhibit 2).
Requirement
Prepare the report required by Gary Watson. Total: 30 marks
Exhibit 1 – Financial statements

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

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

Total equity and liabilities 598 494

Kenyon plc
Statements of profit or loss and other comprehensive income for the year ended 31 October
20X1 20X0
£m £m
Revenue 663 463
Cost of sales (395) (315)
Gross profit 268 148
Distribution costs (27) (20)
Administrative expenses (28) (17)
Share of profit of associate (Note 1) 7 –
Income tax expense (45) (24)
Other comprehensive income (not re-classified to P/L):
Remeasurement loss on pension assets and liabilities (Note 2) (48) (10)
Tax effect of other comprehensive income 14 2
Other comprehensive income for the year, net of tax (34) (8)
Total comprehensive income 142 85
Exhibit 2 – Additional information

(a) Investment in associate
Kenyon plc acquired 40% of AB, its associate on 1 April 20X1 for £49 million.
(b) Pension liability
The actuary has provided the valuations of pension assets and liabilities as at 31 October
20X1 in the financial statements. However, as yet the actuary has not informed Kenyon plc
of the contribution level required for the year to 31 October 20X2.
(c) Contingent liability
The notes to the financial statements include details of a contingent liability of £10 million.
On 5 October 20X1, Kenyon plc suffered a chemical leak at one of the bottling plants and
there is currently an investigation into the potential damage this caused to a nearby river
and surrounding area. The investigation is at an early stage and it is not yet clear whether
Kenyon plc was negligent. As stated in the notes to the financial statements Kenyon plc's
lawyers have intimated that, in their opinion, Kenyon plc is likely to lose the case. No
obligation has been recorded because the amount of potential damages could not be
measured with sufficient reliability at the year-end. However, the lawyers have given a range
of possible estimates of between £7 million and £13 million. The case is due to be decided
by 31 October 20X2.

Audit and integrated questions
18 Dormro
Note: For formatting reasons it is recommended that this question is done as home study/in a
paper-based context.
You are Bernie Eters, an audit assistant manager working for FG, ICAEW Chartered Accountants.
The audit engagement manager in charge of the Dormro Ltd and Dormro group audit gives you
the following briefing:
"This audit is turning into a nightmare and I need your assistance today. The Dormro finance
director has just informed me that Dormro acquired an investment in Klip Inc., an overseas
company resident in Harwan, on 31 January 20X2, which is not included in the consolidation
schedules. Klip is audited by a local Harwanian auditor.
"I am also unhappy about the level of detailed testing carried out by our audit senior. I have
provided you with the following relevant work papers:
Exhibit 1 Extract from Dormro audit planning memorandum.

Exhibit 2 Consolidation schedule, notes and outstanding audit procedures.
Exhibit 3 Information concerning the acquisition of Klip provided by Dormro finance
director; statement of financial position for Klip; and audit clearance from Klip
auditors in Harwan.
"I have a meeting with the audit partner tomorrow and I need to inform her of any issues relating
to the group financial statements and to provide a detailed summary of the progress of our
work. Please review all the information provided and prepare a work paper which:
(a) identifies and explains any known and potential issues which you believe may give rise to
material audit adjustments or significant audit risks in the group financial statements; and
(b) outlines, for each issue, the additional audit procedures, if any, required to enable us to sign
our audit opinion on the group financial statements.
"Also, please include in your work paper a revised consolidated statement of financial position
as at 30 April 20X2, which includes the overseas subsidiary, Klip."
Requirement
Prepare the work paper requested by the audit engagement manager. Total: 40 marks
Exhibit 1: Extract from Dormro audit planning memorandum for year ended 30 April 20X2
Group planning materiality has been set at £250,000.
Dormro has two wholly-owned UK subsidiaries; Secure Ltd and CAM Ltd.
Secure was set up several years ago and supplies security surveillance systems.
CAM is a specialist supplier of security cameras and was acquired by Dormro on
31 October 20X1. CAM is a growing business with profitable public sector contracts.
The UK companies have a 30 April year end and FG audits all the UK companies.
ICAEW 2019 Audit and integrated questions 45

Exhibit 2: Dormro: consolidation schedules for the year ended 30 April 20X2
Statement of financial position
Dormro Secure CAM Adjustments Notes Group
ASSETS £'000 £'000 £'000 £'000 £'000
Non-current assets
Property, plant and equipment 45 2,181 788 3,014
Goodwill – – – 9,490 1 6,251
(3,239) 2
Investments 10,180 – 15 (10,010) 1 185
Current assets
Inventories – 3,380 2,947 6,327
Trade receivables 4,292 4,849 9,141
Intercompany receivables 2,045 – 1,474 (3,519) 3 –
Cash and cash equivalents 567 (706) 382 243
Total assets 12,837 9,147 10,455 (7,278) 25,161
Equity
Share capital 200 10 510 (520) 1 200
Retained earnings at 1 May
20X1 4,523 973 1,758 (1,758) 2 5,496
Profit/(loss) for the year 54 (867) 2,962 (100) 3 568

(1,481) 2
Long-term borrowings 8,000 – – 4 8,000
Current liabilities
Trade and other payables 37 5,702 4,513 10,252
Intercompany payables – 3,329 90 (3,419) 3 –
Current tax payable 23 – 622 645
Total equity and liabilities 12,837 9,147 10,455 (7,278) 25,161

Statement of profit or loss
Revenue 767 23,407 28,097 (14,049) 2 37,455
(767) 3
Cost of sales – (19,703) (19,455) 9,727 2 (29,431)

767 3
Administrative expenses (740) (4,532) (4,688) (100) 3 (6,949)
2,344 2
Finance income/(cost) 50 (39) 31 (15) 2 27

Profit/(loss) before tax 77 (867) 3,985 (2,093) 1,102
Income tax expense (23) – (1,023) 512 2 (534)
Profit/(loss) for the year 54 (867) 2,962 (1,581) 568
Notes on adjustments
1 This adjustment eliminates investments in the subsidiary companies Secure and CAM. The
equivalent adjustment in the prior year was £10,000 and related to the elimination of share
capital in Secure. The increase in the current year is due to the acquisition of CAM for
£10 million which I have agreed to the bank statement. In addition, £170,000 was paid to
acquire the shares in Klip and there is an investment of £15,000 held by CAM both of which
are below the materiality level.

2 This adjustment removes from the statement of profit or loss half of CAM's results as the
subsidiary was acquired on 31 October 20X1. In addition, all pre-acquisition retained
earnings have been eliminated and treated as part of the goodwill calculation.
3 These adjustments eliminate intragroup balances and management charges from Dormro to
its subsidiaries. The difference of £100,000 between the receivables and payables has been
written off to profit or loss and is concerning a dispute between Secure and CAM.
4 This loan was taken out by Dormro on 1 May 20X1. I have agreed the balance to the loan
agreement, noting capital repayable over 8 years in equal annual instalments commencing
1 May 20X2 and an effective interest rate of 6.68%. An arrangement fee of £200,000 has
been expensed to profit or loss and interest is payable at 6% annually in arrears. An
adjustment is required to accrue for interest of £480,000.
Outstanding audit procedures
I have reconciled all balances from the consolidation schedules to the audit work papers for
each company, noting no exceptions. The following procedures are outstanding:
Secure
Review of the directors' assessment of the company's ability to continue as a going concern
given the loss for the year, the overdraft balance and the company's reliance on loans from
other group companies.
CAM
Final conclusion on the adequacy of the inventory obsolescence provision. CAM has applied the
group accounting policy in determining its provision, but this is based on historical sales. Given
the technical issues with the product range, I am concerned that the calculated provision may be
understated by around £220,000.
Audit procedures on the provision for warranty costs of £205,000 (20X1: £275,000).
Management have failed to supply any supporting documentation for this provision.
Secure and CAM
Receipt of bank confirmation letters and confirmation of balances due to other group
companies.
Exhibit 3: Information concerning the acquisition of Klip provided by Dormro finance director
On 31 January 20X2, Dormro paid H$918,000 (£170,000) to acquire 90% of the issued ordinary
share capital of Klip which trades in Harwan where the currency is the Harwan ($H). Klip makes
security cameras and is a supplier company to CAM. There were no adjustments to the fair value
of the net assets acquired except that inventory required a write down of H$1,000,000. None of
this inventory had been sold at the year end.
Dormro measures non-controlling interest using the proportion of net assets method. The rate
of exchange at 30 April 20X2 was H$4.2 = £1 and the average rate for the three months to
30 April 20X2 was H$4.8 = £1.
Klip – Statement of financial position as at 30 April 20X2
H$'000
ASSETS
Non-current assets
Current assets
Inventories 2,100
Trade receivables 600
Cash and cash equivalents 40
Total assets 4,680

H$'000
Equity
Share capital 200
Retained earnings at 1 May 20X1 1,200
Long-term borrowings 1,400
Current liabilities
Trade and other payables 1,380
Clearance from Harwanian auditors of Klip

From: Mersander Partners, Harwan
Date: 26 July 20X2
Subject: Audit of Klip for the year ended 30 April 20X2
To: Finance director, Dormro, United Kingdom
We have performed an audit of the accompanying reporting package of Klip for the year ended
30 April 20X2 in accordance with Harwanian Standards on Auditing and using materiality
specified by you of £250,000. The reporting package has been prepared in accordance with
group accounting policies as notified by Dormro. Where no group policy has been notified, the
reporting package has been prepared using accounting policies consistent with those adopted
in previous years.
The net profit for the year increased by 10% compared to the previous year. This is due to a
decrease in inventory obsolescence provisions when the group accounting policy was applied.
There is no outstanding audit work which would affect our opinion and there are no uncorrected
audit adjustments.
In our opinion, the reporting package of the entity has been prepared in all material respects in
accordance with group accounting policies and presents fairly the results of Klip for the year
ended 30 April 20X2 and its financial position as at that date.
Mersander Partners
19 Johnson Telecom
Johnson Telecom plc (Johnson) is a telecommunications consultancy company delivering
telecoms support to businesses across Europe. Johnson's treasury department uses financial
instruments for both speculative and hedging purposes. The company has an accounting year
end of 31 December. The company's financial statements show the following financial
instruments:
Extracts from financial statements at 31 December
Draft
20X6 20X7
Financial assets £'000 £'000
Investments in equity 485 321
Derivatives 98 102
Debt investments 143 143
726 566
Financial liabilities
Loan note 2,000 2,000
2,000 2,000

You are Poppy Posgen, a newly qualified audit senior at Beckett & Co, Chartered Accountants,
and you are assigned to the statutory audit of Johnson for the year ended 31 December 20X7.
You have received the following email from your manager, Annette Douglas.
Date: 7 February 20X8
From: Annette Douglas <a.douglas@beckett.co.uk>
To: Poppy Posgen <p.posgen@beckett.co.uk>
Subject: 20X7 Financial Statements
Attachments: Market information
Poppy,
Following our meeting yesterday, I would like you to review the way Johnson have accounted
for a number of financial instruments. As you know, the Finance Director, who has prepared the
supporting documentation, is on sick leave at the moment and is not expected to return to work
until after the financial statements are published. The Financial Controller has provided all the
information she can find, but lacks the background knowledge on these financial instruments.
I have attached below the notes that the audit junior has taken in relation to the financial
instruments. Bear in mind that planning materiality for the financial statements as a whole is
£80,000, and we have set a lower performance materiality level for investments at 20% of
planning materiality.
Investments in equity
The £485,000 balance at 31 December 20X6 represents two small investments in UK equity
shares. Johnson has held the investment in Cole for a number of years, and sold it on
14 August 20X7 for £242,000. The investment in International Energy plc was acquired on
1 November 20X6. Both Cole plc and International Energy plc are listed companies.
Valuation at Draft at
31 December 31 December
Historical cost 20X6 20X7
£'000 £'000 £'000
Cole plc (50,000 shares) 163 230 –
Routers plc (16,000 shares) – – 93
International Energy plc (30,000 shares) 270 255 228
433 485 321
On initial recognition of the investments in both Cole plc and International Energy plc an
irrevocable election was made to measure them at fair value through other comprehensive
income, with any fair value gains or losses accumulated in other components of equity.
A new investment of 16,000 shares (out of a total of 50,000 shares) in Routers plc was made on
8 November 20X7. In the Finance Director's absence, the Financial Controller could not find
supporting documents for the investment.
According to the Financial Times on that date, the bid-offer spread was £5.80–£5.83 at
acquisition. The Directors explained to me that this investment is a short-term investment and is
held for trading, with the aim of generating a profit if the price changes. As a result, it was
designated as at fair value through profit or loss.
The journal entries in respect of the disposal of Cole plc and the acquisition of the new
investment in Routers plc are shown in Attachment 2.

Derivatives
The balance comprises two derivatives:
(1) Put option
There is a put option to hedge against a fall in the share price of the 30,000 shares in
International Energy. The put was purchased on 1 January 20X7 at £2 per option and is
exercisable at £9.00 until 31 December 20X8.
In the absence of the Finance Director, who prepared the documentation to support this
hedge, the documentation cannot be found. The option is accounted for using hedge
accounting.
The Directors are unfamiliar with the hedge accounting rules and have asked us to outline
the hedging principles, and explain how fair value hedge accounting changes the way the
investment and option are accounted for.
They have also asked us to provide suitable documentation to support the fair value hedge.
As the original documentation has been lost, the Directors have suggested they may
backdate the documentation as 1 January 20X7.
(2) Interest rate swap
The interest rate swap is a five-year variable-to-fixed interest rate swap to hedge the interest
rate risk of the loan note liability. The swap was entered into on 30 November 20X6. In the
financial statements for the year ended 31 December 20X6, the swap was recorded at a fair
value of £38,000. The swap was designated as a hedge at inception and the hedging
documentation was reviewed by the audit team as part of last year's statutory audit.
The company applies cash flow hedge accounting to this swap. The Finance Director has
prepared a note on the accounting treatment of the interest rate swap (see Attachment 5).
The terms of the swap:
 £2 million notional amount
 Pay 7% fixed, receive variable at LIBOR
 Semi annual payments
The fair value of the swap at 31 December 20X7, based on current LIBOR rates, is £30,000.
Debt investments
The debt investment is a four-year quoted bond in Spence and May plc acquired on
1 January 20X6 and meets the IFRS 9 conditions to be measured at amortised cost (the business
model test and cash flow characteristics test). Half of the holding was sold on the last day of this
year for £83,000.
Terms:
 Acquired at nominal value of £140,000
 Redemption at premium of £10,000 on 31 December 20X9
 Coupon 10% pa, payable six-monthly in arrears (5% per six-month period)
 Effective interest rate is 11.79% per annum (5.73% per six-month period)
Loan note
The loan note was issued at nominal value on 31 December 20X6 and is a five-year note at
LIBOR with semi annual payments. Issue and redemption of the loan is at the nominal value of
£2 million. The variable interest rate payments are hedged by the interest rate swap referred to
in the Derivatives section above.

Actions
I need you to:
(a) evaluate the accounting treatment adopted in the draft financial statements for the above
financial instruments, showing any journal entries where relevant. Explain any audit
adjustments required;
(b) draft a summary of the hedge accounting rules and hedging principles as requested by the
Directors, along with a sample hedging documentation. Explain separately how we should
approach the Directors' proposal to use hedging documentation prepared by us to support
the put option;
(c) identify and explain five key risks that arise from the derivatives trading activities, and the
internal controls that should be in place to mitigate these risks; and
(d) identify and explain any additional audit evidence the audit team will need to obtain with
regards to the financial instruments.
Requirement
Prepare a memorandum giving the information required by Annette Douglas. Total: 40 marks
Attachment 1: Market information as at 31 December 20X7
Share prices
Day's close Mid market Bid Offer
£ £ £ £
International Energy plc 7.70 7.62 7.60 7.64
Routers plc 5.84 5.86 5.85 5.88
Put option
Fair value of option (per share)
31 December 20X6 £2
31 December 20X7 £2.40
Attachment 2: Journal entries in respect of investments
Cole plc
£'000 £'000
DEBIT Cash 242
CREDIT Investment 230
CREDIT Profit or loss 12
Being the disposal of the investment in Cole plc

Routers plc
£'000 £'000
DEBIT Investment 93.28
CREDIT Cash 93.28
Being acquisition of investment in Routers plc
Attachment 3: Bloomberg market data

LIBOR
31 December 20X6 7.0%
30 June 20X7 7.5%
31 December 20X7 7.5%

Attachment 4: Supporting workings for Spence and May bonds
The amortised cost is calculated every 6 months in line with the frequency of the coupon
payments.
Opening Interest at Cash flow Closing
Period ended balance 5.73% (5% × 140,000) balance
£ £ £ £
30 Jun 20X6 140,000 8,022 (7,000) 141,022
31 Dec 20X6 141,022 8,081 (7,000) 142,103
30 Jun 20X7 142,103 8,143 (7,000) 143,246
31 Dec 20X7 143,246 8,208 (7,000) 144,454
Journal entries in respect of the bonds
£'000 £'000
DEBIT Debt investment 1.2
DEBIT Cash 7.0
CREDIT Interest income 8.2
Being re-measurement of amortised cost at 31 December 20X7
 De-recognise 50% of the amortised cost of the investment holding.
 Resulting gain of £10,773 (83,000 – (144,454/2) is recognised in profit or loss.
£'000 £'000
DEBIT Cash 83
CREDIT Debt investment 83
Being year-end disposal of 50% of holding
Attachment 5: Accounting note on the loan and interest rate swap
Loan note and interest rate swap
 The interest rate swap (IRS) provides a cash flow hedge against the interest payments on the
loan note.
 Hedge accounting is permitted as:
– the hedge is a perfect hedge as all terms match (currency, maturity, nominal amount)
– documentation has been in place since inception
 The amortised cost of the loan will remain at £2 million as the loan issue and redemption are
both at par.
 The entries through the year are as follows:
– The £150,000 variable rate interest for 12 months to 31 Dec 20X7 is charged to profit
or loss and accrued until payment is made (£2m × 7.5%).
– The net settlement on the interest rate swap is £10,000 ((7.5% – 7%) × £2m). This is
received from the swap bank as a cash settlement and reduces the £150,000 variable
rate interest expense on the loan note to £140,000, being the fixed rate cost.
– The £8,000 change in the fair value of the swap is released from equity (other
components of equity). This represents the settlement of £10,000 less the unwinding of
the discounting in the future swap settlements.

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

CREDIT Cash 150
DEBIT Cash 10
CREDIT Profit or loss – Interest expense 10
DEBIT Equity 8
CREDIT Derivative asset 8
20 Biltmore
The Biltmore group, a property business which came into being on 1 January 20X8, owns a
number of investment properties. The parent company, Biltmore plc, and the other members of
the group, had no connection before that date.
The directors of Biltmore plc have a reputation for adopting aggressive accounting practices. At
the audit planning meeting, the need for professional scepticism was highlighted. Materiality for
the financial statements as a whole is set at 1% of the group's total assets. Total group assets at
the year end are £2,423 million.
You are Jane Smith, a senior in James & Co, an accounting firm. David Williams, the audit
partner, has sent you the following email.
To: Jane Smith

From: David Williams, Audit Partner
Subject: Investment properties owned by Biltmore group
Following our earlier discussion, I would like you to prepare a report on the investment
properties owned by the various members of the Biltmore Group at 31 December 20X8. Details
of the investments are in an Appendix. As you know, this is a complex area of the audit. The
valuation of investment properties was identified as an area where there is a particular risk of
material misstatement.
All the detailed audit fieldwork has been completed, but the financial statements have yet to be
finalised and agreed by the board of directors, and the auditor's report is still under
consideration.
One thing I'm particularly concerned about is the misclassification of assets. As we have seen
throughout this audit, the directors are very reluctant to make adjustments to reclassify such
assets, arguing that "you'd end up with the same total assets figure anyway".
Your report should cover the following:
(a) The appropriate treatment of each investment property in the consolidated financial
statements of the Biltmore Group as at 31 December 20X8, with justifications in each case.
(b) A calculation of the adjustments that would have to be made to the figures in the draft
financial statements in order to show the corrected figures relating to investment properties
in the consolidated financial statements.
(c) A summary and explanation of the impact on our auditor's report if the directors refuse to
put through the reclassification adjustments, setting out the reasons for your conclusion.

Appendix: Details of Biltmore investments
The draft financial statements are as follows:
Summarised statements of comprehensive income for the year ended 31 December 20X8
Biltmore plc Subone plc Subtoo plc
£m £m £m
Revenues
Rental income 500 – 300
Gains on investment properties 100 80 50
Operating costs
Depreciation of property (2) – (1)
Administration (12) (8) (9)
Finance costs (140) (50) (25)
Net profit 446 22 315
Summarised statements of financial position as at 31 December 20X8

Biltmore plc Subone plc Subtoo plc
£m £m £m
Property, plant and equipment (excluding
investment properties) 38 – 19
Investment properties 1,000 850 510
Investments 2,000 – –
3,038 850 529
Current assets 3 2 1
3,041 852 530
Equity 1,539 351 279
Non-current liabilities 1,500 500 250

Current liabilities 2 1 1
3,041 852 530
All of the property, plant and equipment is in the form of land and buildings. All of these were
professionally revalued as at the date of Biltmore plc's investment in the group members.
Biltmore plc owns 100% of the share capital of Subone plc and 80% of Subtoo plc.
All companies show all of their investment properties at fair value, unless otherwise stated.
All properties have an estimated useful life of 20 years.
The following information relates to the properties classed as investment properties in the draft
statement of financial position of the group members:
Present
carrying
Biltmore plc
amount
£m
Harmony Tower 3 – a medium-sized office block in London's Docklands
This property was purchased in February 20X8 for £200 million. The directors have
decided to leave this property valued at cost because they do not believe that they
can measure its fair value reliably.
Harmony Tower 3 is flanked by two identical buildings, neither of which is owned by
any member of the Biltmore Group. The owner of neighbouring Harmony Tower 2
sold the property on the open market in December 20X8 for £150 million. The
owner of Harmony Tower 1 has put the property on the market for £160 million. 200

Present
carrying
Biltmore plc
amount
£m
Grove Place – an office block in Birmingham City Centre
This property had a fair value of £220 million on 1 January 20X8. During the year
Biltmore plc spent £30 million on a major programme of improvement and
refurbishment and capitalised these costs.
The latest valuation report, dated December 20X8, suggests that the property's fair
value remains at £220 million. 250
Head office – upper floors
Biltmore plc's head office is a 12-floor office block. The company occupies the
bottom four floors and has left the top eight floors vacant. The directors claim that
they intend to hold these vacant floors for their 'investment potential' and are not
actively seeking a tenant or buyer. An architect's report on the building states that it
would be difficult to remodel the building so as to let or sell the upper floors to a
third party.
The upper floors are recognised in the financial statements at £100 million.
The fair value attributed to the upper floors on 1 January 20X8 was £80 million. 100
Northwest Forward – a mixed retail and office complex in Lancaster
This complex had a fair value of £240 million on 1 January 20X8.
Biltmore plc rents out 99% of the floor space in this development, but occupies a
small suite of management offices on the site. The complex cannot be sold
separately. 300
Buy-to-let portfolio – Teesside
Biltmore plc owns a large number of flats and houses in the Northeast of England.
These had a fair value of £150 million as at 1 January 20X8.
There was a downturn in house market prices in that region at the end of January
20X9. The portfolio's value was estimated at £120 million at that time. 150
Essex Mall
Subone plc's principal asset is the site of Essex Mall, which is presently under
construction. This will be a major shopping development and all of the units in the
mall are under contract to retail chains, with leases commencing from the estimated
completion date of 1 September 20X9. Subone plc intends to sell the development
once it is completed.
The cost of the site and building work as at 1 January 20X8 was £600 million.
A further £170 million was spent on the work done during the year ended
31 December 20X8.
The directors of Subone plc believe that the property has a fair value of £850 million
in its present state. 850
Subone plc's head office
Subone plc occupies a prestigious London office block which is leased from Subtoo
plc on a 20-year lease.
The property had a fair value of £120 million on 1 January 20X8. 150

Present
carrying
Biltmore plc
amount
£m
Coventry building
Subtoo plc owns a building in Coventry.
Subtoo plc commenced development of the Coventry building in March 20X8 with a
view to resale. At that time its fair value was £345 million. The property remains on
the market as at the present date. There have been several expressions of interest,
but no formal offers. 360
Requirement
Prepare the report required by the audit partner. Total: 40 marks
21 Button Bathrooms
Button Bathrooms Ltd (BB) is a retailer of bathroom fittings and accessories. You are a senior in
Rudd & Radcliffe LLP, the auditors of BB.
The meeting
You have been called to a meeting with the engagement partner, Carol Ying, in respect of the
audit of BB's financial statements for the year ended 30 June 20X1. Carol opened the meeting.
"I would like you to act as senior on the BB audit. In the past year there have been some
significant changes in BB's business model and in its accounting and internal control systems. As
a consequence, I believe there is greater control risk than in previous years. In addition, the
company is seeking an AIM listing in 20X2 and the board is very keen to present the company's
performance as favourably as possible.
"I realise that you are new to this client, so I have provided some background notes about the
company and the changes that have occurred this year (Exhibit 1). Especially note BB's new, and
very successful, e-commerce activity and the defined benefit pension scheme. I have also
provided you with the draft management accounts (Exhibit 2).
"I have some particular concerns about the revenue recognition procedures that BB has adopted
since installing its new information systems. An audit junior has provided some notes from a
preliminary audit visit (Exhibit 3), but he did not have time to follow up on these matters.
"I am due to meet the finance director of BB next week and I would like you to provide briefing
notes for me which:
(a) With respect to each of the matters raised by the audit junior (Exhibit 3):
(1) Explain the financial reporting issues that arise and show any adjustments that will be
required to the draft management accounts.
(2) Describe the key audit risks and the related audit procedures that we should carry out.
(b) Other than the issues raised by the audit junior, set out the audit risks which arise in respect
of the new e-commerce activities of BB, including those relating to SupportTech, and explain
how we should address these in our audit procedures.
(c) Outline the audit issues we will need to consider regarding the outsourcing of the payables
ledger function. Details are provided below. You do not need to refer to any general issues
relating to SupportTech that you have already referred to in (b).

"This morning I received an email from the finance director of BB (Exhibit 4) relating to a
cyber-security breach at SupportTech. Fortunately as the breach occurred two days ago it does
not have any direct impact on the current year's audit. However, I do need to respond to his
email and therefore I would like your briefing notes to include a summary of points that can form
the basis of my response.
"Please ignore any tax issues."
Requirement
Respond to the instructions of Carol Ying. Total: 40 marks
Exhibit 1: Background details and recent changes
History
BB was established 23 years ago as an upmarket retailer of bathroom fittings and accessories. By
20W9 (two years ago) it was operating from 30 showrooms. Of these, 20 large showrooms sold
BB's full product range and it offered a service to design, supply and install bathrooms in
customers' houses. Products sold included baths, showers, toilets, taps, washbasins and
bathroom accessories. The other 10 smaller showrooms sold only bathroom accessories, a
distinctive BB product range including towels, bathrobes, lighting and decorative items.
Competition and reorganisation
By 20W9 competition from comparable retailers, combined with the recession, forced BB to
reconsider its business model. The board believed that the company's overheads were too high.
As a consequence, between 1 July 20X0 and 31 December 20X0, BB closed the 10 smaller
showrooms and ceased selling its bathroom accessories range from the other 20 showrooms.
New e-commerce activity
BB decided to adopt an e-commerce business model for sales of all products in its range,
including bathroom accessories, and it commenced the development of a website on 1 July
20X0. The website was completed and ready for use by 31 December 20X0. It enables customers
to design their own bathrooms online, select the required products and pay in advance, also
online. The total cost of website development in the year ended 30 June 20X1 was £1 million.
This was capitalised and is to be written off over five years.
After initial development, the operation of the website, including collection of payments from
customers, was outsourced to an external service provider, SupportTech plc. BB receives the cash
from SupportTech each month after deduction of a service charge fee.
The selling prices of products have been reduced by approximately 10% for online sales,
compared with the showroom prices.
Inventories of a wide range of products were previously stored in four regional warehouses.
Customer orders for less popular items, not in inventory, needed to be ordered by BB, which
sometimes caused delays of up to four weeks. From 1 January 20X1 the range and the value of
inventories held were significantly reduced.
Goods sold via the website are all ordered from the manufacturer automatically after the
information is input by the customer. Distribution of goods to the customer is outsourced by BB
to a third party courier.
Costs of reorganisation, including redundancies (but excluding website development costs), in
the year to 30 June 20X1 amounted to £1.5 million. Further costs of £1 million are to be paid in
August 20X1 as a result of the reorganisation.
There have been problems with the new business model including high returns of goods from
customers compared with those sold through showrooms. There have also been errors in goods
delivered arising from customers' misunderstanding of the website.

Outsourcing of payables ledger function
Last year's audit identified a number of control issues with respect to payables and in the first
half of this year staff turnover in this department was high. Following the success of the
outsourcing of online sales to SupportTech management decided to outsource the payables
ledger function too. Staff were told of the decision including details of redundancies on 1 April
20X1. SupportTech took over responsibility for the payables ledger from 1 May 20X1. Details of
the way in which the system works are as follows:
 Purchase orders are raised by BB and a delivery note is signed on receipt of the goods.
 SupportTech is sent soft copies of the purchase orders and the signed delivery notes.
 SupportTech receives invoices from suppliers directly and matches them to the purchase
order and delivery note.
 The Finance Director of BB receives a schedule detailing all the payments to be made for a
given month one week before SupportTech processes the payments. This must be
authorised by the Finance Director before the payments are processed.
 A portal has been set up which allows the Finance Director to interrogate purchase ledger
accounts held by SupportTech. The system does not allow the Finance Director to update or
revise the accounts.
Exhibit 2: Draft management accounts: Statement of profit or loss and other comprehensive
income
Years to 30 June 20X1 20X0
£'000 £'000
Revenue
Showrooms 30,000 60,000
Online sales 33,000 –
Cost of sales (49,000) (42,000)
Less
Administration expenses (5,000) (5,000)
Distribution costs (5,000) (6,000)
Marketing costs for website (1,000) –
Website development cost – amortisation (100) –
Reorganisation costs (1,500) –
SupportTech fees (1,800) –
Premises costs (2,500) (3,000)
Pension contributions (192) –
Profit on sale of eight small showrooms 4,000 –
Profit 908 4,000
All products sold from showrooms make a gross margin of 30% on selling price.
Exhibit 3: Notes on matters arising during interim audit – A. Junior
(1) Customers ordering online pay in full at the time of ordering. BB recognises revenue when
the cash is received from SupportTech. I am concerned about revenue recognition and in
particular cut-off, but I did not have a chance to look at this more closely.
(2) A New Year promotion was held for showroom sales on 1 January 20X1. Any customers
placing an order for a complete bathroom suite were given two years' interest free credit
provided a 10% deposit was paid. Delivery of the suites was guaranteed by the end of
March 20X1. The promotion was very successful and the total value of sales made to
customers under this offer was £520,000. I have confirmed that this amount has been
recorded in sales and have traced a number of orders through the sales system as part of my
sales testing work. No cut-off issues were identified. I was told by the Finance Director that
BB's own incremental borrowing rate is 7% but that of its customers is 10% but I don't
understand the relevance of this information.

(3) The 10 small showrooms were closed down between 1 July 20X0 and 31 December 20X0.
However, two of these (Bradford and Leeds) were still not sold by 30 June 20X1. These two
showrooms are disclosed in the BB statement of financial position as property, plant and
equipment at their carrying amounts of £1 million each. The Leeds site was acquired by BB
fairly recently and is stated at cost less depreciation. The Bradford site was revalued on
30 June 20X0 from its carrying amount of £700,000 to £1 million. The original cost of the
Bradford site was £900,000.
A contract was agreed in June 20X1 for the sale of the Bradford showroom for £1.15 million,
with the sale to be completed in September 20X1. The Leeds showroom is being advertised,
but there is currently no buyer identified.
(4) I am unclear about what audit procedures should be carried out with respect to the website
development costs and how these should be treated in the financial statements.
(5) Button Bathrooms started a defined benefit pension scheme on 1 July 20X0. I have obtained
the following information at 30 June 20X1:
£'000
Present value of obligation 249.6
Fair value of plan assets 240.0
Current service cost for the year 211.2
Contributions paid 192.0
Interest cost on obligation for the year 38.4
Interest on plan assets for the year 19.2
The only entry which has been made in respect of this is the recognition of the contributions
paid as an expense in the statement of profit or loss and other comprehensive income. I
have agreed these payments to the cash book and bank statement. However, I am not sure
whether the other information is relevant and whether I should have performed any other
audit procedures.
Exhibit 4: Email from finance director of BB
Date: 15 July 20X1
From: Andrew Brown <a.brown@buttonbathrooms.com>
To: Carol Ying <c.ying@ruddandradcliffe.com>
Subject: Cyber-attack at SupportTech plc
I have just been informed by our account manager at SupportTech, to whom we outsource the
operation of our website and our payables ledger function, that the company experienced a
significant cyber attack two days ago which successfully breached its security systems. I have
been assured that the situation has been resolved however I am not clear what the potential
consequences of this for us could be and was hoping you could advise. Surely as it is
SupportTech's system that has been attacked there can be no direct consequences for us? If
there are, what measures could we take to prevent this situation arising with other suppliers?
22 Hillhire
You are an audit senior with Barber and Kennedy, a firm of ICAEW Chartered Accountants. Peter
Lanning, one of the firm's audit managers, has just been assigned to the audit of Hillhire plc after
the previous audit manager was signed off sick. Peter has given you some notes made by the
previous manager at the initial audit planning meeting (Exhibit 2), along with some other
information, and he has given you the following instructions:
"I would like you to assist me in the audit planning and first I would like you to prepare a
memorandum which identifies the key audit risks relating to Hillhire's financial statements using
extracts from the financial statements for 20X7 and 20X8 (Exhibit 1) for the year ended
31 March 20X8. You should also outline the main audit procedures that we should carry out in

respect of these matters and, where appropriate, state (Exhibit 3) the correct financial reporting
treatment including journals for any potential adjustments that you identify at this stage.
"It appears that major issues to consider include a discontinued activity, the acquisition of
Loucamion SA, the company's recent use of financial instruments for hedging purposes and the
proposal to introduce a major new system.
"In addition, the company has granted share options to senior employees as an incentive. These
have not been accounted for in the current financial statements.
"The financial controller has argued that the share options granted are not an expense and
therefore they have not been reflected in the financial statements. He is saying that even if they
were to be accounted for as an expense, they do not yet vest as the vesting period is three years.
"You are given relevant information in Exhibit 4.
"You should review all of the information to hand and identify any required adjustments and any
other considerations associated with the audit in terms of audit risk, ethics and our own practice
management, that should be addressed before commencing the detailed audit work."
Requirement
Draft the memorandum requested by the audit manager. Total: 40 marks
Exhibit 1: Extracts from draft financial statements
Statement of profit or loss and other comprehensive income for the year ended 31 March
20X8 Draft 20X7 Audited
£'000 £'000 £'000 £'000
Revenue 283,670 257,850

Cost of sales (187,220) (167,900)
Administrative expenses (excluding
amortisation) (35,020) (34,610)
Amortisation (1,960) (970)
Total administrative expenses (36,980) (35,580)
Finance costs (17,750) (15,910)
Taxation (10,090) (9,270)
Profit for the year from continuing operations 31,630 29,190
Loss for the year from discontinued

operations (4,390) –
Statement of financial position at 31 March

£'000 £'000 £'000 £'000
ASSETS
Non-current assets
Goodwill 12,000 5,000
Other intangible assets 40,680 28,740
Financial non-current assets 10,260 6,130
515,070 474,380

£'000 £'000 £'000 £'000
Current assets
Receivables 86,430 78,160
Cash and cash equivalents 19,540 15,910
110,250 97,890
Non-current assets held for sale 40,130 –
Total assets 665,450 572,270

Equity
Share capital 10,900 10,900
Share premium 63,250 63,250
Revaluation surplus 30,900 30,900
Reserves 105,330 85,030
210,380 190,080
Long term borrowings 382,340 313,100
Deferred tax liabilities 22,290 19,740
404,630 332,840
Current liabilities
Bank overdraft 11,160 10,270
Trade and other payables 32,810 33,950
Tax liabilities 6,470 5,130
50,440 49,350
Exhibit 2: Notes taken by previous audit manager at planning meeting

Hillhire plc is a long-established company that has grown rapidly, both organically and by
acquisition over the last 10 years. It hires out commercial vehicles using a large network of
depots throughout the United Kingdom and also in Europe through a number of wholly owned
subsidiaries.
The company's management has announced that 15 of its less profitable depots are to be sold
off. Each depot is viewed as a cash generating unit in its own right. The depots that are for sale
are clustered in Scotland and the decision to sell them is part of a strategic decision to withdraw
from this area. The results of these depots have been disclosed separately as discontinued
operations in the draft statement of profit or loss and other comprehensive income. The
announcement was made on 1 January 20X8 and management's intentions were minuted in the
board minutes. Marketing of the depot is not due to start until May or June 20X8 as Hillhire is yet
to find alternative storage for the vehicles currently stored in these depots which it is intending
to relocate to other parts of the business. At 1 January the carrying value of the depots was
£44.52 million. They have been classified as held for sale at a fair value less costs to sell of
£40.13 million. At 1 January the depots had a remaining useful life of 25 years. The loss on the
discontinued operations of £4.39 million is only the loss on the classification of the depots to
assets held for sale.
On 1 April 20X7 Hillhire acquired 100% of the share capital of a competitor company,
Loucamion SA, based in France. The functional currency of Loucamion is the euro. The main
reason for the acquisition was the perceived value of the customer relationships built up by
Loucamion in its local market. Assets and liabilities recognised at the date of acquisition
included £4 million in respect of customer lists. Confidentiality agreements prohibit Loucamion
from selling or exchanging information about its customers on the list. At 1 April 20X7 the useful
life of the list was estimated to be 10 years and the intangible asset has been amortised on this
basis.

A loan note was issued at nominal value on 1 April 20X7 and is included in the statement of
financial position. It is a five year note at LIBOR plus 2%. Issue and redemption of the loan is at
nominal value of £200 million. The variable interest rate payments are hedged by an interest
rate swap (see below).
The company has entered into a five year interest rate swap on 1 April 20X7 for a notional
amount of £200 million to hedge the interest rate risk of the loan note liability. A swap
agreement has been signed whereby Hillhire plc will pay a fixed rate of 8% to a counterparty on
this amount and the counterparty will pay LIBOR plus 2% to Hillhire plc. Payments are
semi-annual. This swap was designated as a cash flow hedge on 1 May 20X7 and the directors of
Hillhire plc believe that it is effective as such. No adjustment has been made for interest for the
six months to 31 March 20X8, and no entries have yet been made for the change in fair value.
LIBOR rates are as follows:
1 April 20X7 7%
30 September 20X7 7.5%
31 March 20X8 7.5%
Exhibit 3: Email from Alison Ritchie, partner responsible for Technology Risk Services in Barber
and Kennedy
Date: 10 April 20X8
From: Alison Ritchie <a.ritchie@barberkennedy.com>
To: Peter Lanning <p.lanning@barberkennedy.com>
Subject: Hillhire
I understand that you are now managing the audit of Hillhire plc. You should be aware that my
team has been approached to tender for a one-off assurance assignment for this client. This
would involve a review of risks and advice on controls in Hillhire's new online booking system,
which has been piloted in 20 of their UK depots since 2 January 20X8, prior to a planned
national launch later in the year.
At present, each depot operates its own bookings. Customers who wish to hire a vehicle must
contact the nearest depot directly and make a booking by telephone. Transactions are logged
on a networked PC system that operates independently within each branch. Every evening, this
information is uploaded to the head office's computer system. Head office then processes credit
card payments due from personal customers and invoices business customers using information
supplied by the depots.
The new system provides a centralised booking system via the company's website. Customers
can make a booking online rather than by telephone. If the vehicle type required by the
customer is unavailable at that depot, the system can arrange to have a vehicle transferred from
another depot provided the distance is not too great. All transactions are processed by the new
system immediately, thereby accelerating the billing process.
Now that the system has been piloted, it will be extended to all depots. This will require a central
register to be compiled for all vehicles held at every branch. The standing data for business
customers will also have to be transferred to the new system.
It would be useful to discuss this at the earliest opportunity.
Exhibit 4: Details of share option scheme
On 1 April 20X7, 100 share options have been granted to each of the top senior 50 employees.
The options vest after three years on condition that the employees remain in the employment of
Hillhire; the directors believe that 10% of senior employees will leave during the three-year
period. The scheme is not expected to be available to new employees.
Employing a binomial lattice model gives a fair value for the option on grant date of £10 and a
value of £8 at the year-end.

23 Hopper Wholesale
You are an audit senior in a firm of ICAEW Chartered Accountants. You receive the following
voicemail message from one of the audit managers in your office.
"I need some help urgently with one of our clients, Hopper Wholesale Ltd. Hopper is an
unquoted company that supplies retailers with basic goods such as sugar, salt and similar items.
It buys goods in bulk and packages them in its own factory using simple packets bearing the
'Hopper Value' label. Draft financial statements show revenue of £21.4 million, profit before tax
of £2.75 million and total assets of £65 million.
"Callum the senior on the audit is unwell and is likely to be off for the rest of the week. The final
audit meeting for the reporting period to 31 December 20X8 is scheduled for the day after
tomorrow. I have reviewed the audit file and have identified a number of areas where audit
procedures are incomplete. I will email you a summary of these including some background
information (Exhibit 1). I have spoken to the junior staff on the audit and they have confirmed
that these are areas where they have little experience and require some guidance. I would like
you to prepare a summary of audit procedures for each of the outstanding matters. I would also
like you to explain the key audit issues which need to be addressed in each case – this will help
the juniors to gain a better understanding of their work.
"One more point. The directors of Hopper Wholesale Ltd are interested in sustainability
reporting and are proposing to include social and environmental information in their financial
statements. They would like us to clarify whether they are required to publish this information.
Please outline the current situation so that I can pass on the information to them. If they do
include social and environmental information they would like us to produce a verification report.
I will email you a copy of the statements they are planning to make (Exhibit 2). We have not
been involved in this type of work before so I would like you to outline the evidence which we
should be able to obtain in order to verify these statements and any difficulties we may
experience in validating the information. You should also indicate any professional issues that
we need to consider if we accept this work.
"Thanks for your help on this."
Requirement
Respond to the audit manager's voicemail. Total: 40 marks
Exhibit 1: Hopper Wholesale Ltd – Audit – 31 December 20X8
Manager's review notes: Summary of outstanding matters
(a) Inventory
In September 20X8 the company took delivery of 30,000 tonnes of flour from a former
competitor who was going out of business. Normally Hopper would not carry this level of
inventory of an individual line, representing a nine-month supply at normal rates of
consumption; however, the competitor was selling at a 10% discount to open market prices.
Hopper paid £4.5 million for the flour. At the time sales budgets suggested that 10,000
tonnes would be sold at a profit by 31 December 20X8, which has proved to be the case
and that the remaining 20,000 tonnes would be sold steadily throughout the first half of
20X9.
The directors were concerned that the market price for flour can be volatile and so they
took steps to protect the company by entering into an agreement with a third party,
Sweetcall, a food manufacturer, under which Hopper has the right to sell 20,000 tonnes at
the end of June 20X9 at an agreed price of £140 per tonne. Hopper paid £250,000 for this
option and this amount is recognised in the statement of financial position within sundry
receivables. If the price of flour falls then the company will be able to retain their
competitive advantage by selling the bulk consignment to Sweetcall and replacing their
own inventory with purchases on the open market. The price of flour at 31 December had

fallen to substantially less than £140 per tonne and Sweetcall has offered £400,000 to
Hopper to cancel the option.
Audit procedures completed
The quantity of flour inventory has been established by attendance at the inventory count.
Inventory has been valued at the lower of cost and net realisable value. Satisfactory audit
procedures have been carried out in this respect.
(b) Financial assets
The company has made a number of investments in shares in listed companies. These have
been recognised in non-current assets at £3.25 million. They have been classified as at 'fair
value through other comprehensive income'. A gain has been recognised in other
comprehensive income of £515,000 in respect of these investments.
The only audit procedure performed is reperformance of the calculation of the gain
recognised in profit or loss.
(c) Receivable
The statement of financial position shows a receivable balance of £50,000. This amount is
owed to Hopper Wholesale Ltd by Bourne Ltd, a company which is controlled by Hopper's
managing director, Jack Maddison. We have been told that it is due to be repaid within the
next 12 months. No information about this transaction is provided in the notes to the
financial statements.
A written representation has been obtained confirming the amount and that the company is
controlled by Jack Maddison.
(d) Share option scheme
On 1 January 20X8, Hopper Wholesale Ltd gave 100 employees 500 share options each
which vest on 31 December 20X9. The options are dependent on the employees working
for the entity until the vesting date. During 20X8, five employees left and Hopper Wholesale
Ltd anticipates that in total 10% of the current employees will leave over the two-year
period, including the five employees who left during 20X8. The fair value of the options has
been estimated as follows:
1 January 20X8 £12
The share options have been recorded in the financial statements as an expense in profit or
loss and a credit to non-current liabilities of £700,000 (100  500  14).
Agreed number of employees in the scheme to details set out in the contract.
The fair value of the share options has been confirmed with management.
The adjustment required has been recalculated and agreed to the client's calculation.
Exhibit 2: Social and environmental report – suggested assertions:
(1) We do not use suppliers who use child labour.
(2) All our staff are paid at least 10% above the minimum wage.
(3) We have reduced staff sickness to the rate of 2.4% calendar days.

(4) We have reduced the tonnage of waste sent to landfill by 10%.
(5) Through enhanced health and safety procedures, industrial accidents have been reduced by
40%.
24 Lyght plc
The accounting firm for which you work, Budd & Cherry, is a five partner firm of chartered
accountants in general practice. It has 30 staff and it generated fee income last year of
£5.2 million.
Budd & Cherry has recently gained a new client, Lyght plc (Lyght), as a result of a competitive
tender. The formalities connected with appointment as auditor, including communication with
the previous auditor, have been completed. The tender was for the audit work, but there is a
strong possibility that Budd & Cherry may also be appointed to carry out the tax work and some
advisory work for Lyght. Gary Orton has been appointed as manager on the Lyght audit for the
year to 30 April 20X8 and you are the senior. Gary calls you into his office and explains the
situation:
"Lyght is by far the largest company that our firm has gained as a client so it's really important
that we do a good job and impress the board – not least because, if we are given the tax and
advisory work, our expected total fees from Lyght will be around £500,000 next year. The
previous three auditors have each lasted only three years before the audit was put out to tender
by the Lyght board. I want to make sure we retain them as a long-term client. They might be
looking for an AIM listing in two to three years' time and there will be major additional fees for
our firm if we are appointed as their reporting accountants for that process.
"At the moment we are likely to make a low recovery on the audit, as we had to make a low bid
to win the work. We therefore need to carry out the audit efficiently, but also look for
opportunities to sell tax and other services to the client. If I can help gain the tax and other
advisory work for a client like this, I think I could be made a partner in Budd & Cherry and, as the
senior, there could also be a big promotion in it for you.
"Harry Roberts, our ethics partner, has some concerns over the fact that this is a large client for a
firm of our size and that the audit fee is so low. He is therefore monitoring the situation. Please
provide me with a memo including some notes explaining any ethical issues that should be
drawn to his attention.
"We are commencing the audit in a fortnight, on 25 May 20X8, and I have already been out to
the client for a few days with a junior. I have provided some background notes (see Exhibit 1). I
have also been to see the board and some matters have arisen that I have recorded in my
briefing notes (see Exhibit 2). I would like you to explain the audit and ethical issues arising from
the matters raised in the briefing notes, including the relevant audit procedures we should carry
out during the audit. Where relevant, you should also describe the appropriate financial
reporting treatment in each case. In connection with Note 4 on the lease, please indicate if and
how the position would change when IFRS 16, Leases comes into force. Please include your
comments in the memo referred to above."
Requirement
Respond to the request of Gary Orton, the audit manager. Total: 40 marks
Exhibit 1: Background notes
Lyght plc is a family-owned company which is controlled and resident in the UK. It purchases
public sector assets from hospitals and from the armed forces within the EU, then sells them to
governments and private sector companies, frequently in developing countries. Sales and
purchases are invoiced either in sterling or in the currency of the foreign customer or supplier.
The assets are those which are no longer required by the public sector bodies, but they are still

serviceable. Health equipment includes expensive machinery for monitoring patients, as well as
more basic nursing equipment such as beds, blankets and appliances. Lyght does not purchase
weapons from the armed forces, as it has no licence to do so, but it acquires a wide variety of
small and large items including vehicles, equipment, boats, tents and clothing.
Draft results for 20X8 show that Lyght plc generated revenue of £107 million from which a profit
before tax of £12 million was generated. The carrying amount of its net assets at 30 April 20X8
are £36 million.
Leslie Moore is the principal shareholder of Lyght plc, with a holding of 55%. He is also
Chairman of the board and the Chief Executive. His daughter, Emma Everton, is finance director
and has a 15% shareholding. VenRisk, a venture capital company, has a 25% shareholding and
has significant influence, with the remaining shares being held by senior management.
Exhibit 2: Manager's briefing notes
(1) Lyght has grown significantly in the last few years and is in the process of updating its IT
systems with work already completed by an external contractor on the sales and purchase
ledger systems including both hardware and software. The project is ongoing and the next
stage is to install new, more sophisticated IT systems to monitor the flows of goods across
the globe and for management accounting purposes. Lyght directors have asked our firm if
we wish to tender for a small part of this work, including advice on the internal controls to be
built into the new system. The total cost of the new system will be about £9 million, of which
£5 million will be the costs of IT consultants' time in installation, data transfer and writing new
software. Work would commence in July 20X8 and would take about a year to complete.
(2) Only about £2 million of inventories (out of a total carrying amount of approximately
£20 million) are held in the UK at any time. Inventories are normally shipped shortly after
purchase. High value inventories usually have an identified buyer prior to purchasing them,
and goods are shipped to the buyer within two months of acquisition. Smaller, low value
goods are held at depots in the countries of the intended customers so they are available for
prompt sale. Our appointment as auditors was only formalised after the year end and as a
result we were not able to attend year-end inventory counts. I am therefore worried about
how we will audit inventory. I am also worried about how inventories are going to be valued.
(3) A large batch of used tyres was acquired by Lyght from an army transport depot for £1,000
in August 20X7. However, they were sold a few weeks later for £105,000 to a foreign
company, Hott, in which VenRisk has a 30% equity holding giving it significant influence.
Leslie Moore personally arranged the sale with the manager of the depot. An invoice has
been found for £3,487 for personal gifts and entertainment for the depot manager paid for
by Lyght. It also appears from a few enquiries I made that the depot manager is a cousin of
Leslie Moore.
(4) At the start of the year Lyght took out a 10-year non-cancellable lease on some offices that
were part of a new city centre development. Lyght has been keen to upgrade its offices for a
while in order to impress customers, particularly representatives of overseas governments.
The lease payments, payable each year in advance, are £150,000. The present value of lease
payments has been calculated at £1.1 million and has been recognised as a non-current
asset and a lease liability. The non-current asset is being depreciated on a straight-line basis
over 10 years.
(5) As a result of entering this lease management decided that the existing head office should
be sold. The decision was taken on 1 January 20X8 and the draft financial statements show
that the property was classified as held for sale from this date. On 1 January 20X8 the
property which had been revalued in the past had a carrying amount of £2 million prior to
being transferred to assets held for resale. Its fair value was estimated at £1.6 million and
costs to sell of £20,000. The remaining useful life of the property at the date of
reclassification was 20 years. The company is not planning to market the property until
May 20X8.

(6) Included in Lyght’s trade receivables at 30 April 20X8 is an amount due from its customer
Cristina of £2,577,000. This relates to a sale which took place on 1 May 20X7, payable in
three annual instalments of £1,000,000 commencing 30 April 20X8, discounted at a market
rate of interest adjusted to reflect the risks of Cristina of 8%. Based on previous sales where
consideration has been received in annual instalments, the directors of Cristina estimate a
lifetime expected credit loss in relation to this receivable of £1,505,760. The probability of
default over the next 12 months is estimated at 25%. For trade receivables containing a
significant financing component, Lyght chooses to follow the IFRS 9 three-stage approach
for impairments (rather than always measuring the loss allowance at an amount equal to
lifetime credit losses). The £2,577,000 was recorded in receivables and revenue, but no
other accounting entries have been made.
25 Maykem
You are an ICAEW Chartered Accountant, working as an audit senior in a firm of ICAEW
Chartered Accountants. You receive the following email message from one of the audit
managers in your office:
"I know you are unassigned today and I really need your help. Max, the senior on the audit of
Maykem Ltd for the year ended 31 May 20X8, has gone off sick and I would like you to take over
his responsibilities. There are three urgent issues I would like you to address initially:
Current liabilities
"An assistant has completed procedures on current liabilities but Max has not yet reviewed her
work. Please examine the assistant's work attached (Exhibit 1) and prepare a list of review points
explaining, for each of the current liabilities, any key weaknesses in the audit procedures
completed to date and the additional audit procedures necessary. As part of your review, select
and explain the significant financial reporting issues which need to be addressed prior to the
completion of the audit.
Pension
"Maykem operates a defined benefit pension plan. The assets of the plan are held separately
from those of the company in funds under the control of trustees. At a recent meeting with the
client I was told that the senior accountant who used to deal with the pension plan left suddenly
during the year. This individual has not been replaced and the directors are proposing that the
only amount that they need to recognise in profit or loss is the cash contribution paid by the
company in the year of £306,000. I need to speak to the directors about this tomorrow. I would
like you to prepare a schedule for me setting out the correct accounting treatment and any
adjustments that need to be made. It would also be helpful if you could set out the key audit
issues we need to consider. I do not require a detailed list of audit procedures at this stage.
Information relating to the plan is attached (Exhibit 2).
Ethical issue
"Sophie, the trainee on the audit team, who is originally from France, has sent me an email
yesterday saying that she has an investment which tracks the performance of Euronext (French
Stock Exchange), which includes ParisMet. I am fairly confident that this is not a problem, but I
would like you to confirm whether or not this is the case with reference to the ICAEW Code of
Ethics. Your notes will then provide evidence that we have considered the issue.
Other information
"Maykem Ltd manufactures and distributes refrigeration equipment and is a wholly-owned
subsidiary of a listed French company, ParisMet. ParisMet's recent results have been
disappointing and we believe that group management is under pressure to announce increased
revenues and profit for the year ended 31 May 20X8.

"Our audit approach to Maykem Ltd is wholly substantive and materiality has been set at
£250,000.
"Thanks for your help on this."
Requirement
Respond to the audit manager's email. Ignore the impact of any taxes (including indirect taxes).
Total: 40 marks
Exhibit 1: Maykem Ltd – Audit – 31 May 20X8
Work performed on current liability balances
Current liabilities are analysed as follows:
20X8 20X7
£'000 £'000
Trade payables 13,342 15,208
Accruals 5,749 4,579
Indirect taxes 2,625 2,302
Payroll taxes 1,214 1,304
Contract liabilities 15,435 18,167
Surplus property provision 500 –
38,865 41,560
Trade payables
This balance is made up as follows:
20X8 20X7
£'000 £'000
Trade payables ledger 11,023 12,586
Goods received not invoiced 2,319 2,622
13,342 15,208
From a discussion with Maggie Phillips (financial controller), the balance has decreased
compared to the prior year as fewer goods were purchased in the last month of the year,
compared with the last month of the previous year.
Audit procedures carried out:
 Agreed trade payables balance to ledger, noting there are no reconciling items.
 Reviewed trade payables ledger for unusual items. Debit balances totalling £345,601 were
noted. An adjustment has been raised to reclassify these to trade receivables.
 Reconciled the five largest balances to statements received from the suppliers. The results
of this work are summarised below:
Balance Payments Invoices Balance per
Supplier per ledger in transit in transit Other statement
£'000 £'000 £'000 £'000 £'000
Note 1 Note 2
Metalbits Ltd 2,563 – 239 – 2,802
Hingeit Ltd 2,073 451 34 – 2,558
Metallo Spa 1,491 – 302 62 1,855 Note 3
Boxit Ltd 1,282 231 459 – 1,972
Bitso Supply Ltd 1,184 104 510 – 1,798
8,593 786 1,544 62 10,985
Notes
1 All payments in transit were agreed to the trade payables ledger and to the cash book
before the year end, and to bank statements after the year end. They all appear as
reconciling items on the bank reconciliation.

2 All invoices in transit were agreed to supplier statements and to invoices posted to the
trade payables ledger after year end.
3 Metallo Spa invoices Maykem in euro. The supplier statement balance and invoices in
transit balance above have been translated at the year-end rate of €1.45:£1. Per discussion,
the balance per the trade payables ledger has been translated at a rate of €1.51:£1 as this is
the rate in a forward currency contract taken out to hedge purchases from Metallo. The
'other' reconciling item shown above arises from the difference in exchange rates used.
Accruals
Accruals and the audit work performed is analysed as follows:
20X8 20X7
£'000 £'000 Note
Commission 235 150 1
Bonus 4,000 2,300 2
General and administration 1,504 1,895 3
Legal fees 10 – 4
Royalties payable – 234 4
5,749 4,579
Notes
1 The commission accrual represents sales commission payable for May 20X8. This amount
was paid in June 20X8 and has been agreed to the June payroll. The balance is much
higher than in the prior year because of exceptionally high sales in May 20X8.
2 Staff bonuses will not be paid until September 20X8. The amount accrued is based on an
estimate prepared by the finance director. The accrual is much larger than in the prior year
as a result of a significant increase in the directors' bonuses which are based on company
performance targets agreed by group management.
3 An analysis of general and administrative accruals was obtained and all items over £25,000
were agreed to supporting documentation.
4 From a discussion with Maggie Phillips, in May 20X7 Maykem received a letter from
MegaCo plc, alleging that Maykem had breached one of MegaCo's patents and claiming
royalties on sales of all products in which the patented refrigeration technology was used.
Although Maykem disputed MegaCo's claim, a provision was made in the 20X7 accounts
for estimated royalties payable on sales to date. At that time the Maykem directors
considered it more likely than not that some payment would be made, given MegaCo's far
superior size and resources. Maykem has now sought independent legal advice and, in
April 20X8, wrote to MegaCo plc totally refuting the breach of patent claim. MegaCo's
directors acknowledged the letter, stating that they would respond after taking their own
legal advice. To date nothing further has been heard from MegaCo. On this basis, the
provision for royalties has been released. The accrual for legal fees represents the amount
payable for legal advice taken to date.
Contract liabilities
Contract liabilities represent service revenues relating to future periods. When customers buy a
refrigeration unit from Maykem, they may choose to buy a three-year maintenance contract in
addition to the normal one-year warranty. Revenue for the maintenance contracts is deferred
and released on a straight line basis over the period to which the contracts relate.
During 20X8, Maykem has reassessed the costs it incurs in providing maintenance services.
These costs have reduced considerably as the reliability of the product has improved. As a result
the margin earned on the maintenance element is far in excess of that earned on the original
product sale. An exercise has therefore been undertaken to recalculate how the total revenue
from a product and maintenance sale should be allocated between the two elements so that the
percentage margin earned on each element is equal. This revised split of revenue has been

retrospectively applied to all maintenance arrangements still in force at 31 May 20X8, resulting
in the recognition of nearly £4 million of additional revenue.
The contract liabilities balance has been agreed to a detailed analysis which has been tested for
accuracy and completeness as part of our procedures on revenue. The revised calculations
splitting the revenue between the two elements have also been tested without exception.
Surplus property provision
This relates to leasehold factory premises which, until January 20X8, were occupied by
Maykem's domestic refrigeration division. The trade of this division together with all related
inventory was sold to Coolit on 1 January 20X8. The sale excluded the leasehold premises and
manufacturing plant as Coolit did not want these.
From a discussion with Maggie Phillips, Maykem's directors believe that it will take some time to
find a replacement tenant for the leasehold factory premises, as they are not in good condition.
The lease for the factory expires in May 20Y8 (in 10 years' time) and the annual rental is
£250,000. The provision of £500,000 is based on the finance director's view that it will take two
years to let the premises.
Included within profit or loss for the year ended 31 May 20X8 is a net gain on the sale of the
domestic refrigeration business, which has been calculated as follows:
£'000
Proceeds from sale of trade and inventory 1,300
Carrying amount of assets sold (200)
Provision for surplus property (500)
Net gain on sale of business 600
Exhibit 2: Pension plan

The terms of the pension plan have been summarised by Maykem as follows.
 Employees contribute 6% of their salaries to the plan.
 Maykem contributes, currently, the same amount as the employees to the plan for the
benefit of the employees.
 On retirement, employees are guaranteed a pension which is based upon the number of
years service with the company and their final salary.
The following details relate to the plan in the year to 31 May 20X8:
£'000
Present value of obligation at 1 June 20X7 3,600
Present value of obligation at 31 May 20X8 4,320
Fair value of plan assets at 1 June 20X7 3,420
Fair value of plan assets at 31 May 20X8 4,050
Pension benefits paid 342
Total contributions paid to the scheme for year to 31 May 20X8 306
Gains and losses on remeasurement (actuarial gains and losses) are recognised in accordance
with IAS 19, Employee Benefits.
The interest rate on high quality corporate bonds at 1 June 20X7 was 5%.
Assume cash contributions are received and pension payments are made at the year end.

26 Sunnidaze
You are Jamie Spencer, the senior in charge of the final audit work on Sunnidaze Ltd for the
financial year ended 30 June 20X6.
Sunnidaze is based in Birmingham and sells and installs hot tubs, saunas and jacuzzis. It was
incorporated five years ago by John and Mary Cotton, both of whom invested money they had
earned in the music industry. John and Mary each own 50% of the issued share capital of
Sunnidaze and are also directors. They delegate the day to day running of the company to the
only other director, Arnold Murray, a more experienced businessman.
Until recently, Sunnidaze focussed on sales to wealthy individuals in its local area. Its range of
products and installation expertise made it very successful and the business grew rapidly.
However, in the year ended 30 June 20X5 it was less successful. Revenue fell to £4 million and
the company broke even. Arnold decided to expand operations to cover the whole of England
and also introduced a range of larger products suitable for spas and hotels. These changes
required investment of £2 million. John and Mary were not willing to invest more money so
Arnold arranged for Sunnidaze to borrow £2 million from a bank on 1 July 20X5.
Under the terms of the loan, Sunnidaze was required for the first time to have an audit and, in
April 20X6, your firm was appointed as auditors for the year ended 30 June 20X6. The final audit
visit commenced in September 20X6 but progressed slowly. The financial controller, Maisie
Juniper, was not ready for your team and could not provide you with the information to
complete the audit procedures. Your team left at the end of the scheduled audit visit with
matters still outstanding.
Last week Maisie contacted you to let you know she was ready for a follow up audit visit and
provided you with summary financial information (Exhibit 1) incorporating all audit adjustments
identified at your previous visit and, in addition, two late client adjustments requested by the
directors. You arranged for a junior member of staff, Sam Burrows, to visit Sunnidaze to
complete the necessary audit procedures. Sam has sent you an email (Exhibit 2) summarising
the audit procedures he has performed.
You receive a voicemail message from the Sunnidaze audit manager:
"Hello Jamie. I know you are busy at the moment but I really need to understand the status of
our audit procedures on Sunnidaze. The directors have a meeting with the bank later this week
and want to know whether we have any further audit adjustments and what our opinion on the
financial statements will look like. They have asked me to meet with them tomorrow so I really
need from you today:
(a) A memorandum setting out and explaining the additional audit adjustments and unresolved
audit matters identified at our follow up visit, together with a brief summary of any additional
audit procedures required. You should also prepare revised draft summary financial
statements to the extent that the available information permits.
(b) Your comments on any more general concerns you have in relation to the audit as a whole
including ethical issues for our firm and what our audit response to these concerns should
be.
(c) Brief notes setting out an explanation of the form of audit opinion we should give. (I have
already given them a copy of the standard unmodified opinion so you need only consider
whether we might modify this in some way.)

(d) The company is planning further expansion in the year ending 30 June 20X7. To help to fund
the expansion Arnold Murray is proposing to enter into a sale and leaseback arrangement
regarding its warehouse. Details are as follows:
 The property would be sold on 1 January 20X7 for £280,000 (the original cost was
£75,000).
 It would then be leased back on a 20 year lease at an initial rental of £32,000 per
annum.
 The sale price and the rental amount both represent market value.
 The land element of the property is not material.
 Sunnidaze has an incremental borrowing rate of 10% (annuity discount factor over 20
years = 8.5136).
Arnold would like me to explain to him the impact of this transaction on the financial
statements for the year ended 30 June 20X7 so please draft some notes that I can refer to
outlining the effects.
"I am in a meeting for the rest of the day, so please leave the information I have asked for on my
desk. Please don't worry about tax as the tax department will address any issues here."
Requirement
Prepare the information requested by the audit manager. Total: 40 marks
Exhibit 1: Sunnidaze Ltd
Summary financial information for the year ended 30 June 20X6 prepared by Maisie Juniper
Per draft
Per trial Audit Late client financial
balance adjustments adjustments statements
£'000 £'000 £'000 £'000
Operating profit 651 (134) (50) 467
Exceptional items – (42) (42)
Interest payable (100) (100)
Profit before taxation 551 (134) (92) 325
Taxation – (125) (125)
Profit after taxation 551 (259) (92) 200
Assets
Property, plant and equipment 357 35 392
Intangible assets 500 500
Trade receivables 1,629 (42) 1,587
Other current assets 40 40
4,473 35 (42) 4,466

Retained earnings 551 (259) (92) 200
Long-term borrowings 2,000 2,000
Trade and other payables 922 169 50 1,141
Tax payable – 125 125
4,473 35 (42) 4,466

Exhibit 2: Email from Sam Burrows, audit junior
To: Jamie Spencer
From: Sam Burrows
Subject: Sunnidaze audit for the year ended 30 June 20X6
Jamie
I have now completed as many of the outstanding audit procedures as I can. I've summarised
below the procedures carried out in response to each of the points on the list of outstanding
issues you gave me. Throughout my work, I used our preliminary assessment of materiality of
£30,000.
(1) Ensure that all audit adjustments identified during our previous audit visit have been
posted correctly by Maisie
Adjustments posted by Maisie all tie into our audit working papers. There is, however, one
adjustment she has not booked as Arnold told her it did not relate to the year ended
30 June 20X6. We had proposed an adjustment to provide for a credit note of £10,000
issued on 15 July 20X6 to a hotel chain as a discount for purchasing 10 jacuzzis. As the
10th and final jacuzzi was only delivered in July 20X6, Arnold believes that the discount
arose in the year ending 30 June 20X7 rather than in 20X6 and does not plan to book this
transaction until next year.
(2) Review any late adjustments made by the client
Maisie has made two additional adjustments. She has made an exceptional impairment of
receivables of £42,000 as a health club customer has refused to pay for two luxury hot tubs.
The hot tubs were supplied by DupaSpa (see (3) below). The tubs were delivered to the
health club in June 20X6 but Sunnidaze's engineer only started to install them at the end of
October. It was agreed during the installation process that they were unsuitable for the
selected site. However, there is disagreement over who is responsible and the customer has
refused to pay and has asked Sunnidaze to remove the hot tubs as soon as possible.
Maisie has also provided for a £50,000 one-off incentive payment to Arnold. This was
agreed with the shareholders as operating profit (before this payment) exceeded £350,000.
Maisie has informed me of one additional adjustment she plans to make. As in prior years,
all retained earnings are to be distributed to the owners as a dividend and this needs to be
reflected in the financial statements once the profit figure has been finalised.
(3) Perform work on the intangible asset
The intangible asset represents £500,000 paid to a third party supplier, DupaSpa, on
1 July 20X1 for a 10-year exclusive licence to distribute DupaSpa hot tubs in its local area. I
have reviewed the agreement and reconciled the original payment to the bank statement.
When Sunnidaze started in business, sales of approximately £600,000 related to products
supplied by DupaSpa which generated a profit margin of 47%. In recent years, other
suppliers' products have become increasingly popular but sales of DupaSpa products still
generated revenue of £400,000 in the year ended 30 June 20X6.
(4) Update work on cash received from customers since the year end
Of total trade receivables of £1,629,000 at 30 June 20X6, £1,391,000 has now been paid,
£42,000 provided for (see (2) – late client adjustment) and £10,000 is expected to be
credited (see (1) – discussion of audit adjustments). That leaves £186,000 unprovided and
unpaid. I selected a sample of unpaid invoices and ensured that the product they related to
was delivered before 30 June 20X6. I also enquired of Arnold and the credit controller
whether there were any customer disputes or issues and was informed that all customers
were expected to pay. Delays in payment were either due to delays in product installation
or, where customers were local builders, delays in the collection of cash from their ultimate
customers.

(5) Review of agreement for new bank loan
I obtained and reviewed a copy of the bank loan agreement. Its key terms are as follows:
 The loan capital of £2 million is repayable in five equal annual instalments commencing
on 31 December 20X6.
 Interest of 5% per annum is payable annually in arrears and an arrangement fee of
£40,000 was paid when the monies were advanced on 1 July 20X5.
 There is a covenant within the agreement that operating profit for a financial year will
fall no lower than £280,000. Should it do so, the bank has the power to require
immediate repayment of the loan or to call on personal guarantees provided by the
directors.
 Audited financial statements for each financial year must be delivered to the bank no
more than 150 days after the financial year end.
(6) Review of events and results after the reporting period
The management accounts for the three months to 30 September 20X6 show revenue of
£1 million and operating profit of £50,000. These results are in line with the equivalent prior
year period, although below budget. The cash balance at 30 September 20X6 was
£600,000. The directors' latest forecast of revenue for the year ending 30 June 20X7
remains in line with their budget of £7 million, which was a 25% increase on the previous
year. They anticipate an operating profit of £750,000 for the year ending 30 June 20X7.
Maisie has told me in confidence that she believes this budget is extremely optimistic.
My review of post year end board minutes revealed only one item of interest. John and
Mary Cotton are keen to sell their shareholding in the company and have already entered
into discussions with a number of investors. The minutes indicate that the budget is forming
the basis for negotiations on the valuation of the shares.
27 Tydaway
You are Gerry Melville, an audit senior in A&B Partners LLP. Today you receive a voicemail
message from your manager, Mary Cunningham:
"Hello Gerry. I'd like you to help me to plan our audit of Tydaway Ltd for the year ending
31 July 20X1. In particular, the inventory section of our audit did not go well last year.
"Tydaway is a long-standing audit client of A&B Partners and has for many years manufactured
metal filing cabinets at its factory in South London. On 30 September 20X0, Tydaway acquired a
division of a competitor's business which produces high-quality wooden office furniture. This
business, now known as Woodtydy, continues to operate from a factory in North London as a
division of Tydaway. It continues to maintain its own separate accounting records and its results
have not yet been incorporated in Tydaway's monthly management accounts.
"I've left on your desk extracts from Tydaway's most recently available management accounts
which are for the 10 months ended 31 May 20X1 (Exhibit 1), notes from last year's audit file on
inventory valuation (Exhibit 2) and information on Woodtydy's inventory supplied by the
Woodtydy financial controller (Exhibit 3).
"Tydaway's annual inventory count took place on 30 June 20X1 (a month before the year-end)
and it was attended by audit assistant, Dani Ford. Dani's inventory count notes are also on your
desk (Exhibit 4). As Dani is on study leave from next week, it's important that you raise any
questions with her as soon as possible.

"What I need you to do is the following:
(a) Review Dani's inventory count notes (Exhibit 4) and prepare a list of issues and queries for
her to address before she goes on study leave. Your list should include brief explanations of
the points raised so that Dani understands why any additional information is required.
(b) For each of the relevant financial statement assertions in respect of inventory:
 highlight any particular concerns or issues which you have identified from your review of
Exhibits 1, 2 and 3; and
 prepare a summary of the key audit procedures we will need to perform to ensure that
we have adequate audit assurance on inventory.
"Assume that audit planning materiality is £40,000 as in the prior year.
"We have also been asked to give our client some accounting advice. Tydaway is finding the
market for the metals required to make the filing cabinets increasingly competitive. As a result it
has been looking for new suppliers and has identified one in China. Tydaway is to be invoiced
by the Chinese company in US dollars (as this is the functional currency of the Chinese
company). On 15 July 20X1 the company intends to enter into a contract with the Chinese
company to purchase metals with a contract price of $500,000. This is a large order but it has
been made in the light of the lead time for transporting the raw materials. The metal will be
delivered to Tydaway on 15 December 20X1 and payment will be made on that date.
"The directors are concerned about the impact of foreign exchange risk and are considering
whether to enter into a forward contract on 15 July 20X1 to purchase $500,000 on 15 December
20X1. They have asked me to meet them next week to discuss their options. I would like you to
prepare some information that I can refer to in my meeting as follows:
(c) Set out, using journal entries, the impact of this contract on the financial statements for the
years ending 31 July 20X1 and 31 July 20X2 under each of the following scenarios:
 There is no hedging arrangement put in place.
 Tydaway enters into the forward contract, but does not satisfy the conditions for hedge
accounting.
 Tydaway enters into the forward contract, satisfies the conditions for hedge accounting
and chooses fair value hedge accounting.
 Tydaway enters into the forward contract, satisfies the conditions for hedge accounting
and chooses cash flow hedge accounting.
(d) Explain and compare the financial reporting treatment for the four scenarios above.
"I do not require you to consider the tax implications of these issues and I do not require you to
list hedging accounting conditions.
"I have made some additional notes and working assumptions for you to use (Exhibit 5).
"We also need to consider the implications for our forthcoming audit. If hedge accounting is
used certain documentation must be kept. Please provide a list of the documentation we would
be expecting to see.
"I look forward to reviewing your work later today."
Requirement
Respond to Mary Cunningham's instructions.
(Assume that today is 5 July 20X1.) Total: 40 marks

Exhibit 1: Extracts from Tydaway Ltd management accounts for the 10 months to 31 May 20X1
Statement of profit or loss and other comprehensive income
10 months to 31 May
20X1 20X0 Notes
£'000 £'000
Revenue generated by South London
factory
External customers 4,282 5,912
Sales to Woodtydy 135 – 1
4,417 5,912
South London factory costs
Raw materials at standard cost 2,431 3,197
Purchase price variances 296 (10) 2
Other purchase costs, including freight 77 45
Movement in inventory at standard cost (99) 20
Total raw material cost of goods sold 2,705 3,252
Movement in inventory provision – 5
Labour 873 869
Overheads and delivery costs 345 354
Total factory cost of goods sold 3,923 4,480
Margin as a percentage of total revenue 11% 24%

31 May 31 May Notes
20X1 20X0
£'000 £'000
Inventory analysis
Raw materials 340 270 3
Raw material element of work-in-progress 131 157
Raw material element of finished goods 55 – 4
526 427
Inventory provision (20) (20)
506 407
Notes
1 Represents goods sold to Woodtydy in the period since Tydaway acquired the division on
30 September 20X0.
2 Purchase price variances are adverse in the period ended 31 May 20X1 as a result of an
unexpected increase in the price of steel. In addition, normal bulk discounts were
unavailable on components bought at short notice to fulfil a major order which was shipped
in May 20X1 and gave rise to a one-off adverse price variance of £25,000.
3 Raw material inventory has increased as a result of a slow-down in customer orders. During
June 20X0, certain components were purchased in bulk in anticipation of orders which have
not materialised. Of these purchases, components costing approximately £60,000 remain in
inventory at 31 May 20X1.
4 Finished goods held in inventory represent the cost of goods produced for Swishman plc, a
customer which ordered customised products in its corporate colours for a major office
refurbishment. Swishman has recently experienced financial difficulties and has cancelled its
order, leaving Tydaway with a number of finished cabinets already painted in Swishman's
specified colours. It is possible that these cabinets can be used to fulfil other orders, but they
will need to be stripped and repainted at a total cost of around £10,000. A legal claim for
£30,000 has already been made against Swishman for breach of contract. Swishman has
offered £6,000 in full and final settlement of the liability.

Exhibit 2: Notes on inventory valuation from prior year audit file for Tydaway
 Raw materials are valued at standard cost. Standard costs are reviewed and updated on the
first day of each financial year and are then left unchanged throughout the year. Historically,
our audit testing on the valuation of a sample of items has led us to conclude that standard
costs generally represent a reasonable approximation to the actual cost of purchase.
 Standard costs include an uplift of 1.5% of the material cost to cover freight and other
purchase costs.
 Inventories of finished goods are typically very low as all goods are shipped to the customer
as soon as they are complete.
 Work in progress (WIP)* is valued initially at the standard cost of its raw material
components. An adjustment is made at the year end (for statutory accounts purposes only) to
include in inventory an appropriate percentage of labour and factory overhead, calculated as
follows:
Units in WIP × 50%
× (Total factory labour + Factory overhead)
Total units produced in the year
*WIP is on average 50% complete

 Provision is made for any obsolete raw materials. No provision is required against finished
goods or WIP as filing cabinets are typically built to order for specific customers.
Exhibit 3: Information on Woodtydy's inventory supplied by Woodtydy financial controller
(1) At 31 May 20X1, the Woodtydy business had total inventory as analysed below:
£'000
Raw materials 230
Work in progress 120
Finished goods 159
509
Provision (58)
451
(2) Raw materials are valued at the latest invoice price.

(3) Each customer order is recorded on a separate job card. As materials are allocated to an
order, they are booked out of raw materials and booked on the job card at the latest invoice
price. The time spent on the job is then recorded on the card and a cost of £30 per hour is
included in inventory to reflect the cost of direct labour and factory overhead. At the period
end, the job cards are sorted into complete and incomplete items and recorded as finished
goods or work in progress as appropriate.
(4) Provision is made on a line-by-line basis for any items which are obsolete, slow-moving or can
only be sold for less than cost.
Exhibit 4: Notes on inventory count attendance prepared by Dani Ford
I attended an inventory count at Tydaway's South London factory on 30 June 20X1. As no
inventory count is planned at 31 July, the inventory quantities from this count will be posted to
the book inventory records and updated for purchases and sales made in the last month of the
financial year.
The count was well organised and all counters were briefed beforehand. Counters worked in
teams of two, with one counting and the other recording the quantity counted and comparing it
to the quantity shown on the book inventory system, as supplied on the printed inventory list
prepared beforehand. Where the quantity counted differed by more than 10% from that on the
system, a second count was performed by a team from another area of the warehouse.

I performed independent counts on a sample of 25 types of raw material, noting the following
differences:
 Quantities of smaller components were estimated by weighing a sample of 10 to 20 items
and comparing their weight to the weight of the total inventory of that item in order to
estimate the overall quantity. When we performed our own tests, we noted differences of up
to 5% in quantity for such items. This does not appear unreasonable given the estimation
involved.
 All tins of paint and chemicals were treated as full tins although some of them were only
partly full. From a discussion with the inventory controller this is unlikely to have resulted in
any material overstatement of inventory.
 Two differences were noted in samples taken from the mezzanine area of the stores. In both
cases, the counters had recorded a count which agreed with the quantity on the system
whereas our count showed less in one case and more in the other. Our counts were agreed
with the counters and the inventory sheets were updated to record the correct quantities.
I performed counts on a sample of five types of work in progress. All counts were accurate.
I inspected the despatch areas, noting that there were no shipments in progress during the count.
In the goods received area, I noted a large consignment of filing cabinet drawers which had not
been counted. From a discussion with the inventory controller, these drawers had just been
returned from a subcontractor who finishes the premium range to a high standard. They will be
booked back into WIP after the count is complete.
Exhibit 5: Additional notes and assumptions
Proposed contract with China
Hedging
Tydaway is considering two alternatives:
 Do not hedge and therefore accept any consequent exchange rate risks.
 Enter into a foreign exchange forward contract on 15 July 20X1 to purchase $500,000 on
15 December 20X1.
At 15 July 20X1, the spot exchange rate is expected to be £1 = $1.6108.
At 15 July 20X1, the 5-month forward rate is also expected to be £1 = $1.6108. The forward rate
contract will have a zero fair value at 15 July 20X1.
At 15 July 20X1, the contract with China would be a firm commitment and, if Tydaway decides to
enter into the forward contract at that date, it is unsure whether it would be better to treat it as a
fair value hedge or as a cash flow hedge for financial reporting purposes. However, it may be
that Tydaway cannot satisfy the hedge accounting conditions, although it is hoped it will be able
to do so.
Working assumptions
For illustrative purposes I would like you to adopt the following working assumptions as one
possible scenario of future exchange rate movements:
At 31 July 20X1
Spot £1 = $1.5108
Fair value of forward contract £20,544 positive (ie, in favour of Tydaway)
At 15 December 20X1
Spot £1 = $1.4108
Fair value of forward contract £43,994 positive (ie, in favour of Tydaway)

28 Wadi Investments
The Wadi Investments Group invests in capital markets and real estate primarily in the Indian
subcontinent and Asia. Your firm is responsible for the audit of Wadi Investments and the
consolidated financial statements. The audit has already commenced but you have been asked
to join the team as the manager is concerned that there is not the appropriate level of expertise
in the current team. You have been sent the following email from your manager.
To: APerdan@ABCAccountants
From: TFlode@ABCAccountants
Date: 30 July 20X9
Subject: Audit of the financial statements for the year ended 30 June 20X9
Amar,
I am very glad that you are joining the audit as things have not been going well. I have had a
fairly inexperienced team and I am concerned about some of the work which has been prepared
to date. We are responsible for both the parent company audit and the audit of the group. Work
has already started on the audit of the parent company. I have briefly reviewed most of the
working papers produced to date but have not been able to look at them in detail. My review
has raised a number of concerns which I would like you to address in a report which I can use to
evaluate how to approach the remaining audit work. I have listed my concerns below and have
attached a number of other relevant documents including relevant exchange rates (Attachment
2). I have confirmed the exchange rates myself so you should use these in any calculations.
Audit of the parent: Wadi Investments
Acquisition of Strobosch
We have been told that Wadi purchased an 80% subsidiary on 1 January 20X9. It is an
investment company based in Ruritania and its functional currency is the Ruritanian rand (RR).
Some work has been done on the investment in the parent's statement of financial position but
from my review of the audit assistant's working paper (Attachment 1) a number of significant
issues have not been addressed. Please identify these including any audit adjustments that may
be required. You should also review the work performed by the junior and list any additional
procedures which are needed.
Investment property
The group carries all land and buildings, including investment property, at fair value. On
15 March 20X9 the head office building in London was vacated and is to be leased out for the
next five years to a company outside the Wadi Group. The building originally cost £90 million
back on 3 April 20X6 and as at the next valuation on 30 June 20X7 it was valued at £112 million.
Its fair value at 15 March 20X9 was £124 million and at 30 June 20X9 is £128 million. The
depreciation policy for buildings is straight line over 50 years, measured to the nearest month.
Our audit work to date shows that the asset has been included in property, plant and equipment
in the year end statement of financial position but any further work on this issue is outstanding.
Please can you set out how to account for the change in the use of this asset and outline the
audit adjustments required. You should also list the audit procedures which should be
performed.

Audit of Wadi Investments Group
This is still at the planning stage and there are a number of issues which I would like your help
with.
(a) The Strobosch audit is being conducted by a local firm, Kale & Co. I am familiar with the firm
and its practices and am confident that they will do a professional job. However, I need to
communicate with them and will have to draft a letter of instruction. Please draw up a
checklist of the points which I need to include so that I can ensure that all necessary matters
are covered.
(b) At a recent meeting with the finance director of Wadi, he mentioned that the investment in
Strobosch was financed by a number of Ruritanian Rand loans in order to hedge the foreign
currency exposure and that hedging provisions are to be adopted. Total exchange losses on
the loans for the six months to 30 June 20X9 are £36 million. He also mentioned a loan made
to Strobosch on 1 January 20X9 to assist with expansion plans. Further details regarding the
net investment in Strobosch and the loan to Strobosch are attached (Attachment 3). Please
identify the audit and financial reporting issues that we will need to consider.
Requirement
Respond to the manager's instructions. Total: 40 marks
Attachment 1: Audit assistant's working paper for the acquisition of Strobosch
Client: Wadi Investments
Year end: 30 June 20X9
Prepared by: Sam Brown
Investment in Strobosch
£m
Cash paid on 1 January 20X9 675
8% debentures 360
Costs 18
1,053
Analysis of costs
£m
Costs of internal merger and acquisitions team at Wadi Investments 2
Issue costs of debentures 6
Legal costs (RR23m × 0.45) 10
18
Note: I have been told that the IRR on the debentures is 4.42% per six-month period but I am
not sure what the relevance of this is. Interest on the debentures is paid every six months.
Work performed
(1) Agreed cash paid to bank statement.
(2) Agreed £360 million debentures to matching liability in the statement of financial position.
(3) Obtained a schedule of the breakdown of costs.
(4) Cast total and agreed spot rate.
Attachment 2: Exchange rates
The following exchange rates should be used for the preparation of the 20X9 financial
statements.
Date RR:£
1 January 20X9 1:0.45
30 June 20X9 1:0.47
Average for six months to 30 June X9 1:0.46
RR = Ruritanian rand

Attachment 3: Hedge of net investment
Extract from the financial statements of Strobosch as at 30 June 20X9
Draft
RRm
Investment property 1,453
Financial assets 659
Current assets 124
Total assets 2,625
Share capital 300

2,020
Non-current liabilities 518
Current liabilities 87
Total liabilities and equity 2,625
 Retained earnings at acquisition were RR1,440 million and the fair value of net assets at
acquisition was RR1,865 million.
 The long-term liabilities of Strobosch include RR444 million in respect of a five-year interest
free loan of £200 million made by Wadi on 1 January 20X9.
29 Jupiter
It is 15 January 20X9. You are the audit senior on the external audit of Jupiter Ltd. The
company's year end is 31 December 20X8. The audit manager Jane Clarke has asked you to
take responsibility for the audit procedures on development costs. You have a schedule of
development costs produced by the client (Exhibit 1), a summary of the board minutes
produced by Jane on a preliminary visit to the client (Exhibit 2) and some notes of a meeting
between the Finance Director of Jupiter Ltd and Jane Clarke (Exhibit 3).
You receive the following voicemail message from Jane Clarke.
"As you know I would like you to take responsibility for the audit procedures on development
costs. My review of the board minutes and my recent conversation with the finance director of
Jupiter Ltd have given me some cause for concern in this area so we need to get this right. I
would like you to prepare a memorandum which sets out the audit issues and the audit
procedures required to address these. You should also refer to any financial reporting issues
which arise. Please quantify, as far as you can based on the information currently available, any
adjustments required. I would also like you to consider any potential professional and ethical
implications for our firm based on the discoveries I have made – including matters we should
consider in respect of the internal audit function.
"James Brown the audit junior has been doing some work on the audit of trade payables. He has
obtained some information from the client (Exhibit 4) but is unsure how to progress. I would be
grateful if you could review the information he has obtained and make some notes for James
explaining the main audit issues and an outline of the audit procedures required to address
these.
"See you later!"
Requirement
Prepare the summary and notes requested by Jane Clarke in her voicemail message.
Total: 30 marks

Exhibit 1: Development costs recognised in the year ended 31 December 20X8
£'000
Cost
01.01.X8 10,000
Additions 2,000
At 31.12.X8 12,000
Amortisation
01.01.X8 500
For the period 500
At 31.12.X8 1,000
31.12.X7 9,500
31.12.X8 11,000
Exhibit 2: Jupiter Ltd: Summary of minutes of board meetings

Jupiter manufactures a device which converts vegetable oil into diesel, thereby creating an
inexpensive and sustainable fuel that can be used in conventional diesel-engine cars. This
device was developed over several years. Significant development costs were incurred in the
process and these were capitalised. The device went into full production at the beginning of
20X7.
A total of £4 million was capitalised on the development of this device. The development costs
are amortised on a straight line basis over the device's estimated useful life of eight years. There
is a balance of £3 million remaining after £1 million was amortised over the last two years. It was
expected that the conversion device would be replaced by more advanced technology at the
end of the eight year period.
Jupiter is in the process of developing a car engine that will run on vegetable oil. This project is
the result of an unexpected breakthrough in a research project that had not been expected to
yield useful results. A major car manufacturer has looked at a prototype engine and has agreed
in principle to offer this engine as an option on its range of compact cars. Jupiter has not
applied for a patent for the vegetable oil engine technology.
Development costs on this engine were capitalised at £6 million on 31 December 20X7. A
further £2 million has been capitalised during the year ended 31 December 20X8. None of
these costs have been amortised because development work on the car engine is not yet
completed. The car engine is currently expected to go into full production in the first quarter of
20Y0.
In December 20X8, the internal audit department completed a review on the likely impact of the
launch of the new engine on the sales of Jupiter's core product, the conversion device. The
internal auditors produced the following cash flow forecast relating to the conversion device
business over the next six years. The pre-tax discount rate specific to the conversion device is
estimated at 15%, after taking into account the effects of general price inflation.
Year 1 2 3 4 5 6
£'000 £'000 £'000 £'000 £'000 £'000
Future cash flows 770 700 520 350 330 300
Two weeks ago, Jupiter's management became aware of the fact that the company's largest
competitor is working on a car engine that will run on vegetable oil and will enter production in
the third quarter of 20X9. The competitor has a contract to supply this engine to a major car
manufacturer and is in the process of completing non-disclosure agreements with several other
manufacturers. Once this formality has been completed the competitor will offer to license their
technology to all major car companies. No formal announcement of this technology will be
made until February 20X9 at the earliest.

Jupiter is extremely concerned because the ability to run cars on vegetable oil may cut short the
life expectancy of the vegetable oil to diesel conversion device. They are also concerned that
their proposed car engine might not come into commercial production unless it is significantly
better than their competitor's forthcoming model. No details on the competitor's engine are as
yet available. Jupiter only knows about it because they used a firm of commercial investigators
to find out what progress the rest of the industry was making on alternative fuel sources. As part
of this investigation, a senior design engineer from the competitor was interviewed for a job that
did not actually exist. He was encouraged to talk about projects that he had been involved in
during his time with the competitor. He gave sufficient information about the new engine for
Jupiter's directors to be extremely concerned. The engineer then became suspicious of the
investigator who was conducting the interview and refused to disclose any further information
about the new engine.
The Board has instructed the internal audit department to conduct a detailed risk assessment of
this discovery.
Exhibit 3: Jupiter Ltd: Notes of meeting with Finance Director
The Finance Director stated that Jupiter fully intended to continue to amortise the development
costs of the diesel converter over the remainder of its eight-year estimated useful life and to
continue to capitalise development costs. She said that the internal audit department was
working on ways to complete the preparation of the financial statements as early as possible in
January 20X9 and she asked that the audit work be timetabled so that the audit report could be
signed by 31 January at the very latest. That way, any subsequent announcement by the
competitor would not constitute an event after the reporting period under IAS 10. She said that
the matters discussed in the board minutes were to be treated as confidential. Indeed, the
company had effectively obtained this information through fraudulent misrepresentation and so
it would not be appropriate to use it in the preparation of the annual report.
Jupiter has borrowed heavily in order to fund these two development projects. The bank loan
covenant specifies a maximum gearing ratio. I have done a quick calculation of the effect of an
immediate write-off of the development costs and the company would be in default of this
borrowing condition.
Exhibit 4: Jupiter Ltd: Summary of trade payables
Analysis of trade payables
31.12.X8 31.12.X7
£'000 £'000
Myton Engineering Ltd 2,400 2,400
Overseas suppliers 1,750 900
Other suppliers 995 1,107
GRNI (goods received but not invoiced) 720 288
5,865 4,695
Notes
1 Myton Engineering Ltd is the sole supplier of a key component which goes into the fuel
conversion device. In previous years the company has refused to respond to requests to
confirm any year end balance and does not issue statements. In addition this year Myton has
introduced a reservation of title clause on all invoices to Jupiter Ltd.
2 During the year the clerk responsible for managing overseas suppliers resigned as she had
found a job closer to home. The company has been unable to find a permanent replacement
for her. The overseas suppliers balance at 31 December 20X8 includes £75,000 in respect of
goods which are still in transit but which have been recognised in inventory.
3 'Other suppliers' relates to around 150–200 small suppliers which produce a range of
components. This balance is net of £125,000 of debit balances.
4 The company experienced a computer problem in the last week of the reporting period
which meant that no purchase invoices could be processed.

30 Poe, Whitman and Co
You are an audit senior with Poe, Whitman and Co, a firm of chartered accountants. Upon
returning to the office this week from vacation, you find the following email in your in-box from
Margaret Fleming, one of your firm's audit managers.
Date: 2 April 20X7

From: Margaret Fleming <m.fleming@poe.whitman.com>
To: Audit Senior <a.senior@poe.whitman.com>
Subject: Commedia Ltd
Attachments: Commedia background notes; email from Bob Kerouac
I hope you had a good holiday. As you may know I have recently been given managerial
responsibility for the firm's new audit client Commedia Ltd, and I understand that you will be the
senior on the group's audit for the year ended 28 February 20X7. We have only recently been
appointed auditor following the unexpected resignation of the previous auditor just two weeks
ago.
Please could you consider the practical and ethical issues specifically in connection with our late
appointment and the steps we should take to ensure that these issues do not affect the
performance of our duties as the group's auditor.
Please also summarise for me the relevant audit procedures and our reporting responsibilities
which arise from the Commedia engagement being a new audit for Poe, Whitman and Co.
I have also attached to this email some notes on the Commedia group (Attachment 1).
In addition to providing some background information on the group, the notes also include
information on some specific events that occurred within the group during the year. I would like
you to identify the audit risks relating to these events and draft the audit procedures required to
mitigate them.
Finally, I attach an email I received last week from Bob Kerouac (Attachment 2), requesting
advice on some financial reporting matters. Please draft a response in note form for me to use at
the meeting I have arranged with Bob for next week.
Margaret
Requirement
Respond to the email from your audit manager. Total: 30 marks
Attachment 1: Commedia group background notes
Commedia Ltd (Commedia)
Commedia is an independent television production company with annual revenues last year of
approximately £60 million. The company's creative team develops ideas for television
programmes, which are then 'pitched' to one or more of the television broadcasting companies
within the UK. If the pitch is successful, the programme is commissioned by the broadcaster and
then made by Commedia to an agreed budget.
During the year, a number of Commedia's customers changed the terms of some of their
commissions from a 'funded' to a 'licensed' basis.
Funded commissions
The broadcaster is responsible for funding the entire production budget (which includes an
agreed management fee for Commedia) in monthly instalments as the production progresses.
Upon delivery of the programme to the broadcaster, all future rights to exploit the programme
are signed over to the broadcaster.

Licensed commissions
Under these arrangements, Commedia is paid an agreed amount, in full, upon delivery of the
programme. The broadcaster acquires the rights to broadcast the programme an agreed
number of times, with Commedia retaining all residual rights to future exploitation of the
programme. The price paid by the broadcaster for a licensed commission is 25% to 30% lower
than that for the equivalent funded commission. Where the cost of making the programme
exceeds the value of the licensed commission payment, the difference is carried forward as an
intangible asset by Commedia to write off against future revenues arising from the residual
rights held.
At the start of this accounting period, 1 March 20X6, Commedia had two wholly-owned
subsidiaries, Scherzo Ltd and Riso Ltd. The subsidiaries were set up by Commedia Ltd many
years ago. All three companies have the same 28 February year end and they are all audited by
your firm.
Scherzo Ltd (Scherzo)
Scherzo is a concert and events promotion company. The company stages major popular and
classical music concerts throughout the year, which are held principally in open-air venues.
Disposal of shareholding
On 30 April 20X6, Commedia disposed of 70% of its shareholding in Scherzo to that company's
management team for a possible total sum of £20 million. £15 million of this total was paid in
cash on completion of the sale, with the remainder to be paid 15 months later, contingent on
the profit of the company for the year ended 28 February 20X7. Scherzo has also appointed
your audit firm as its auditor. Extracts from the terms of the sale of shares in Scherzo are set out
below.
Extracts from contract for sale of shares in Scherzo Ltd
(a) The completion date for the disposal of the shares was 30 April 20X6.
(b) Total possible consideration for the shares is £20m, split as follows:
 £15 million payable on completion.
 £5 million payable on 31 July 20X7 if the pre-tax profit of the company for the year
ended 28 February 20X7 is at least £5 million.
 If the pre-tax profit for the year ended 28 February 20X7 is below £3 million, no further
consideration is payable.
 For pre-tax profit between £3 million and £5 million, the further consideration payable
is calculated as follows:
Further consideration = £5m  (pre-tax profit less £3m)/£2m
(c) Pre-tax profit for the purpose of this contract is defined as 'Profit before tax per the
company's audited financial statements excluding the following items:
 Total directors' emoluments in excess of £350,000.
 Exceptional items (ie, items of income and expense of such materiality that IAS 1
requires their nature and amount to be disclosed separately).
'Rock in the Park' concert
Scherzo was responsible again this year for 'Rock in the Park', a major outdoor series of popular
music concerts spanning three days in July 20X6. On the evening of the third day, part of the
stage collapsed causing injury to some members of the stage crew and audience. The incident
also led to the cancellation of the rest of the concert, including the performance scheduled for
the event's most well known performer. Scherzo had sub-contracted the erection and
maintenance of the stage to another company, Highstand Limited.

The directors of Scherzo have included a provision in the year-end financial statements of
£2 million. This is to allow for the cost of refunding all monies received from the sale of tickets to
the concerts, and to recognise the cost of personal injury claims received by the company as at
the year end.
Riso Ltd (Riso)
Riso's sole activity is the operation of a large television studio which it hires out to customers for
the production of television programmes. The television studio is based in a former glass bottle
factory and is occupied by Riso under a 10-year lease, originally taken out on 1 March 20X3. The
studio is hired out to Commedia (on an arm's length basis) approximately 30% of the time for
the filming of its own commissions. For the remaining 70% of the time the studio was, until
recently, hired out to two different broadcast companies, each for the production of their own
competing daytime television drama serial.
During the year ended 28 February 20X7, one of these broadcasters announced that, due to
poor viewing figures, it would no longer be making a drama serial. Riso has spent the last three
months looking for an alternative customer, but has so far been unsuccessful. The directors of
Riso are aware that there is currently surplus capacity in UK-based studio facilities, due to a
reduction in UK-produced programmes. This reduction has been brought about by an increase
in programmes imported from overseas and reduced TV advertising budgets.
The directors of Riso have produced a forecast of future pre-tax cash-flows for the company as
follows:
Year ending 28 February £'000 inflow/(outflow)
20X8 (100)
20X9 (50)
20Y0 900
20Y1 1,375
20Y2 1,495
20Y3 1,695
Riso made an initial £8 million investment in the television production equipment required for its
studio on 1 March 20X3. No further capital expenditure is likely to be required for the
foreseeable future. The company expects the equipment to have an expected useful life of
10 years at which point its disposal value is estimated to be £2 million. Riso depreciates the
equipment on a straight-line basis. The carrying amount of the company's other assets and
liabilities at 28 February 20X7, was £250,000.
Attachment 2: Copy of email from Bob Kerouac
Date: 26 March 20X7
From: Bob Kerouac <bkerouac@commediagroup.com>
To: Margaret Fleming <m.fleming@poe.whitman.com>
Subject: Year end financial statements
Margaret,
It was good to meet you recently. Further to our scheduled meeting in two weeks' time, there
are some matters in connection with the current year financial statements that I want to discuss
with you. I hope that when we meet you can provide me with advice on their appropriate
treatment in the financial statements for the year ended 28 February 20X7. The matters are as
follows:
(1) Disposal of our majority holding of shares in Scherzo: as you know, we sold the majority of
our shares held in this company during the year. I would be grateful if you could provide me
with some advice on how to account for this disposal in Commedia's own financial
statements for the year; and also how the remaining investment in Scherzo is now to be
treated in the group's consolidated financial statements.

(2) Treatment of the television production equipment in Riso: as you are aware, we have
recently lost a major contract in this company due to cancellation by our customer of their
daytime TV drama serial. This has given rise to a loss in the company this year, and will mean
future losses if an alternative customer cannot be found. I am unsure how, if at all, this affects
the value and presentation of the equipment in the financial statements of Riso. I am
particularly concerned as we recently had the equipment externally valued at a figure of
£4 million. Please could you clarify this issue for me, indicating what adjustments, if any, are
required to ensure proper presentation in the financial statements for the year. I am unsure
whether this is of use to you, but the pre-tax annual rate of return that the market would
expect from this type of investment is 10%.
31 Precision Garage Access

Precision Garage Access plc (PGA) is a listed company which manufactures and installs garage
doors for private residences. You are a senior working for PGA's auditors and are currently
supervising the planning and interim audit work for the year ending 30 September 20X6. You
are also carrying out a review of the interim financial statements for the nine months to
30 June 20X6.
As part of the planning process, an audit junior, Claire Chalker, has completed some initial
analytical procedures on the management accounts for the nine months ended 30 June 20X6.
She has provided some background information (Exhibit 1) and set out some basic financial
data and notes (Exhibit 2). She does not however have the experience to analyse this data in
order to identify audit risks.
The engagement manager, Gary Megg, reviewed Claire's work and sent you the following email:
To: A. Senior
From: Gary Megg, Engagement Manager
Date: 26 July 20X6
Subject: PGA audit
I have been through the notes prepared by Claire. I think she has highlighted some interesting
points, but she has not really analysed the data in any depth or identified key audit issues. There
appear to be some financial reporting issues arising from her work which may require
adjustment to the management accounts.
Prior to our audit planning meeting next week I would like you to do the following:
(a) Carry out revised analytical procedures using Claire's data and other information provided.
This work should:
 identify any unusual patterns and trends in the data which may require further
investigation. Show supporting calculations (where appropriate assume 360 days in a
year for the purpose of computing any ratios); and
 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.
(b) Set out the financial reporting issues that arise from the above audit work with respect to the
interim financial statements for the nine months ended 30 June 20X6 and are expected to
arise for the year ending 30 September 20X6. I do not require any detailed disclosure
requirements. I do not require you to consider tax, or deferred tax, implications at this stage.

There is one further matter which I would like you to look at. I have just received an email from
David May, the finance director of PGA. The board has acknowledged that the company is
experiencing difficulties retaining key staff. This is particularly the case with senior and middle
management. Whilst a bonus scheme has been introduced this year in place of a pay rise (see
Claire's notes below) the directors realise that they need to encourage individuals to commit to
the company longer-term. David has come up with a proposal for a share based bonus scheme
but is concerned about its effects on future profits. I have attached his email which provides
details of the scheme and the information he requires (Exhibit 3). I would like you to produce
the information he has requested so that I can forward it on to him. Please use his working
assumptions. I think that his predicted share price increases may be optimistic in the current
climate but I can discuss this with him at a later date.
Many thanks,
Gary
Requirement
Respond to the engagement manager's instructions. Total: 30 marks
Exhibit 1: Background information prepared by Claire Chalker
PGA makes and installs two types of garage doors:
 Manually operated wooden doors – the 'Monty'. The list price of the Monty was increased by
5% on 1 October 20X5 to £840 each, including installation.
 An electrically operated set of metal doors with a motor – the 'Gold'. The list price of the
Gold was increased by 5% on 1 October 20X5 to £2,520 each, including installation.
Nearly all doors are made to order.
Each of the two types of door is made on a separate production line at PGA's factory in the south
of England. Production equipment is specialised and highly specific to each of the separate
production processes.
PGA makes about 70% of its sales of both products in Germany and France where it has a
network of sales offices. All selling prices are set at 1 October each year. Prices for overseas
markets are fixed in euro at this time, at the equivalent of pound sterling prices.
The company has had a difficult trading year so far, due to the general economic downturn. The
trading performance in the year ending 30 September 20X6 is thus expected to be weaker than
in the previous year.
In previous years, approximately equal quantities of Gold and Monty doors have been sold.
However, sales of the Gold have suffered particularly badly this year, as customers appear
unwilling to spend large sums on their garage doors in the current economic climate. Sales of
Gold doors are not expected to increase in the foreseeable future.
Customers are either individual householders or small building companies. Discounts may be
given to building companies for large orders but PGA sales staff have stated that door prices to
individual customers are never discounted.

Exhibit 2: Financial data and notes prepared by Claire Chalker
Management accounts – Statements of profit or loss and other comprehensive income
Draft 9 months to 9 months to Year ended
Notes 30 June 20X6 30 June 20X5 30 Sept 20X5
£'000 £'000 £'000
Revenue: 1
Monty 7,500 9,600 10,400
Gold 14,000 28,800 31,200
Cost of sales: 2
Monty (6,700) (7,800) (9,200)
Gold (15,500) (23,400) (27,600)
Gross profit/(loss) (700) 7,200 4,800
Fixed administrative and
distribution costs (1,200) (1,200) (1,600)
Exceptional item
Staff bonus scheme 3 (450) – –
Profit/(loss) before tax (2,350) 6,000 3,200
Income tax expense – (1,680) (900)
Profit/(loss) for the period (2,350) 4,320 2,300
Management accounts – Extracts from statements of financial position

At 30 June At 30 June At 30 Sept
Notes 20X6 20X5 20X5
Current assets £'000 £'000 £'000
Inventories 4 3,500 3,500 1,200
Trade receivables 4 2,400 4,300 1,000
Notes
1 Revenue
Inventory records show the number of doors sold as:
9 months to 9 months to Year ended
30 June 20X6 30 June 20X5 30 Sept 20X5
Monty 9,000 12,000 13,000
Gold 6,000 12,000 13,000
Sales volumes in the final quarter of the year ending 30 September 20X6 are expected to
be the same as the final quarter of the year ended 30 September 20X5 for both the Monty
and the Gold.
Revenue from garage doors is recognised when they are delivered to a customer's house.
Revenue from installation is recognised when the contract is completed to the customer's
satisfaction.
2 Cost of sales
The production process for the Gold is technologically advanced, so annual budgeted fixed
production costs of £12 million are expected. For the Monty, annual budgeted fixed
production costs are £4 million. These fixed costs have not changed for some years and are
incurred evenly over the year, with an equal amount being recognised in each quarter. The
variable cost per unit for each product is budgeted at 50% of selling price.
3 Staff bonus
As a result of current economic uncertainty, there was a zero general pay increase for
employees. However, a bonus scheme was introduced under which a payment to
employees of £600,000 will be made for the full year if revenue for the year ending
30 September 20X6 exceeds £26 million.

4 Inventories and receivables
Inventories consist mainly of partly-made doors. There is little finished inventory as doors
are normally made to order.
Sales are normally on 30 day credit terms.
Exhibit 3: Extract of email from David May: share based bonus scheme
To tie in middle and senior managers to the company, a bonus would be given to existing
managers after three years of continued employment from 1 October 20X6, on which date the
scheme would commence. If these employees leave before 30 September 20X9 they will
receive no bonus. Also, however, I want to link the bonus to company performance – which I
think is best achieved by basing it on share price.
The proposal is to either: (A) issue 600 shares; or (B) pay a bonus equivalent to the value of 600
shares at the date of redemption for each existing manager. The amount would only be given in
either case after three years' service. Those managers joining after 1 October in any year would
not qualify for the scheme in that year.
The problem is that these managers would probably stay for three years to receive the bonus
and then leave. My idea is – and this is the clever part – to have the same bonus scheme every
year so, whenever managers leave, they would be giving up a large sum in bonuses that have
not vested.
Using Proposal A as an example, if we start the scheme on 1 October 20X6, each eligible
manager will receive 600 PGA ordinary shares on 30 September 20X9. There would then be
another scheme on 1 October 20X7 for 600 shares which would vest on 30 September 20Y0 (ie,
three years later), and the same again in each future year. The same rolling system would apply if
we decide to go with Proposal B instead.
My working assumptions are as follows:
 The PGA share price will be £8 on 1 October 20X6 and increase by 25% in the first year and
then 20% per annum thereafter (our future order book looks strong and I believe that there
are signs that the economic outlook is improving).
 There are 80 eligible managers now. It is assumed that 10 managers (all of whom are
currently in employment) will leave during each year and 10 managers will join.
 The fair value of the share based cash settled instrument is equal to the share price.
Information required
I would like the following information:
(1) Using my working assumptions, prepare a computation of the effect on profit of this scheme
for each of the years ending 30 September 20X7, 20X8 and 20X9 under the following
alternative assumptions:
 Proposal A – the bonus is given in the form of 600 PGA shares per manager each year.
 Proposal B – the bonus is paid in cash as an amount equivalent to 600 PGA shares per
manager each year.
(2) An explanation of why the impact on profit may vary:
 from year to year for each proposal
 between the two proposals

32 Tawkcom
Note: For formatting reasons it is recommended that this question is done as home study/in a
paper-based context.
You are the senior responsible for the audit fieldwork at Tawkcom Ltd, the UK trading subsidiary
of Colltawk plc, a major international telecommunications group, listed on the London Stock
Exchange. Tawkcom provides data and communication services to commercial and public
organisations. These services utilise Tawkcom's UK-wide fibre optic network, a valuable and
unique asset built up over many years.
You are currently completing the final audit of Tawkcom for the year ended 30 September 20X9.
The audit has not gone smoothly and reporting to the group audit team is overdue. The most
significant incomplete area of audit procedures is the work on property, plant and equipment
(PPE), which has been allocated to a junior member of your team, Jo Carter. You are due to
meet the audit manager, Jan Pickering, this evening to discuss progress on this work.
Jan has just left you this voicemail:
"The Colltawk group financial statements are due to be signed off early next week and I'm very
worried about the work we have left to do on Tawkcom. PPE is a key audit area for this business
and Jo is likely to require detailed guidance if she is to complete the procedures satisfactorily. I
know you've been very busy but I need you to look today at what she's done so far (Exhibit 1),
both to identify any unresolved audit or financial reporting issues and to determine what audit
procedures we have left to do.
"I've sent you some extracts from the group audit instructions (Exhibit 2) so you can take these
into account in determining the required audit procedures.
"Please come to the meeting this evening prepared for a detailed discussion. You will need to
prepare the following documents for the meeting:
(a) Notes explaining any financial reporting and audit issues you have identified from your
review of Jo's work to date (Exhibit 1).
(b) A list of the additional steps we will need to perform to complete our audit procedures on
PPE, both for group reporting and to support our opinion on the statutory financial
statements of Tawkcom.
(c) A summary identifying where the group audit team may provide useful evidence in
completing the audit of PPE.
"I am also aware that there have been some changes to the auditing standards relating to
auditor's reports and in particular the introduction of ISA (UK) 701 on Key Audit Matters. I
haven't had time yet to look at the new standard in detail so I would be grateful if you could put
together a few notes on this and its relevance if any to Tawkcom and the group."
Requirement
Prepare the documents Jan has asked you to bring to this evening's meeting. Total: 30 marks
Exhibit 1: PPE work papers prepared by Jo Carter
Summary of balances
The group reporting pack for Tawkcom at 30 September 20X9 includes the following schedule.
All balances and movements have been agreed to the register of PPE and to the schedules used
for detailed testing.

Freehold Fixtures
land and Leasehold Network and Investment
buildings improvements assets equipment property Total
£'000 £'000 £'000 £'000 £'000 £'000
Cost/valuation
Brought forward at
1 October 20X8 32,000 4,160 162,831 19,255 0 218,246
Additions 0 3,409 34,391 2,406 0 40,206
Disposals (6,550) (102) 0 (508) 0 (7,160)
Transfer from assets
held for sale 0 0 0 0 3,936 3,936
Carried forward at
30 September 20X9 25,450 7,467 197,222 21,153 3,936 255,228
Accumulated
depreciation
Brought forward at
1 October 20X8 476 882 38,697 14,577 0 54,632
Charge for the year 0 298 2,875 4,051 0 7,224
Disposals (95) (98) 0 (129) 0 (322)
Carried forward at
30 September 20X9 381 1,082 41,572 18,499 0 61,534
Carrying amount at
30 September 20X9 25,069 6,385 155,650 2,654 3,936 193,694
Summary of procedures performed

Opening balances
Opening balances have been agreed to prior year signed financial statements with the
exception of the opening cost for Network assets. This is greater than the balance shown in the
prior year financial statements by £1.3 million due to an audit adjustment to remove from
non-current asset additions the cost of certain repairs to and maintenance on the fibre optic
network. This was recognised in the financial statements but not reflected in the register of PPE
or in the group reporting pack, as it was not considered material for group purposes.
Additions
A sample of additions was selected for each category of PPE using group materiality of
£4 million to determine the sample size. Each item in the sample was physically inspected where
possible, verified as a capital item and, where appropriate, agreed to a third party invoice.
Further information is provided below:
Leasehold improvements
Tawkcom has one leasehold property, its head office building. This building is leased under a
20-year operating lease, expiring in 20Z5. During the year ended 30 September 20X9, Tawkcom
completed a major refurbishment programme to update and improve all office accommodation.
Network assets
Additions comprise new fibre optic cable laid to extend network coverage or to connect a
particular customer to the network. Tawkcom's own staff perform much of the work and
additions could not therefore be agreed to third party invoices. Instead they were agreed to
project sheets detailing the material, labour and overhead costs incurred on each stretch of
cable.
Additions are higher than in the prior year as group management instructed the local finance
director to increase the day rates used for staff time so they were consistent with the rates used
to compute charges to external customers. A rough calculation indicates that the increase in
rates has increased additions to network assets by around £5 million.

Physical inspection of the network assets was not possible as the fibre optic cabling is laid
underground.
Disposals
There were only three significant disposals in the year ended 30 September 20X9.
(1) In June 20X9, Tawkcom disposed of office equipment with a cost of £332,000 to AR Hughes
Ltd. The accounting assistant informed me that this company is owned by friends of Max
Dudley, Tawkcom's finance director. The group finance director approved the disposal. The
accumulated depreciation of £62,000 was correctly removed from the register of PPE. There
were no proceeds and a loss of £270,000 was included within the statement of profit or loss
and other comprehensive income.
(2) In September 20X9, the company's freehold property in Scotland, Glasgow House, was sold
to LJ Finance plc, a finance company owned by the bank for the Colltawk group. The group
finance team arranged this transaction and local management has limited information.
Tawkcom is still occupying the building as it has been leased back from LJ Finance under a
20-year lease, which can be extended to 50 years at Colltawk's option. An external valuer
revalued Glasgow House at 30 September 20X7, along with the company's other freehold
properties. Its value of £5.8 million was agreed to the prior year audit work papers. The
valuation and associated accumulated depreciation were correctly removed from the
register of PPE, cash proceeds of £7 million were vouched to the bank account on
30 September 20X9 and the gain of £1,295,000 was agreed to the statement of profit or loss
(3) Tawkcom disposed of land for £1.5 million recognising a profit on disposal in profit or loss of
£750,000. The contract was entered into on 31 July 20X9 conditional upon detailed
planning approval being granted. By 30 September 20X9 outline planning consent only had
been granted. Full planning consent was received on 20 October and the sale was
completed on 30 October 20X9.
Sale proceeds were agreed to the cash book and bank statement. The cost of land was
correctly removed from the register of PPE and the profit on disposal correctly calculated.
Transfer from assets held for sale
In the financial statements for the year ended 30 September 20X8, a freehold property, surplus
to Tawkcom's requirements, was transferred out of PPE and shown separately as a non-current
asset held for sale. Our prior year audit files concluded that this treatment was correct on the
basis that the property was being actively marketed and a sale at its carrying amount of
£3.9 million was considered imminent.
This sale was not concluded and management has now decided to retain the property for the
time being until the property market has improved. To generate some return from the property,
management intends to divide the property into small office units which it will rent out as office
space under short-term rental agreements. In order to make this more attractive to prospective
tenants, Tawkcom will provide services such as telecommunications, reception, secretarial
support and meeting rooms. As the property is now being held for its investment potential, it
has been transferred back into PPE and designated as an investment property.
Depreciation charge for the year
The Tawkcom financial statements for the year ended 30 September 20X8 disclose the following
depreciation policy:
Depreciation is charged so as to write off the cost or valuation of assets over the following
periods:
Freehold buildings 50 years
Leasehold improvements 20 years (the minimum term of the lease)
Network assets 20 years
Fixtures and equipment 3–10 years

For each category of asset, an expectation for the depreciation charge for the year ended was
formed using the above rates and taking into account the timing of additions and disposals.
The following points were noted:
(1) No depreciation has been charged on freehold buildings as these properties are carried at
valuations which the finance director believes reflect their market value at the reporting date
and the buildings are maintained to a high standard.
(2) The depreciation charge for network assets is considerably lower than expected. This is as a
result of a group wide review of useful lives conducted by head office. This review concluded
that the life of network assets is greater than 20 years and a revised useful life of 22 years has
been applied to all such assets. Calculations of the revised carrying amounts for a sample of
assets were reviewed and verified as accurately reflecting for each asset the unexpired
portion of a 22-year life.
Exhibit 2: Extracts from the Group audit instructions for the Colltawk plc group for the year
ended 30 September 20X9
Risk of fraud and misstatement
The following key risks have been identified and should be considered by all subsidiary audit
teams:
(1) The group has banking covenants on long-term bank loans requiring it to maintain a certain
ratio of non-current assets to net borrowings (defined as bank borrowings and lease
creditors less cash). As a result, management may have an incentive to overstate non-current
assets or to understate net borrowings.
(2) Subsidiary management participates in the group's bonus scheme. The level of bonus to be
paid depends on the performance both of the individual subsidiary and of the group as a
whole. Management may therefore have an incentive to overstate profit either at a subsidiary
or group level.
Materiality and reporting of misstatements
Pre-tax materiality for the Colltawk group audit is £4 million. All individual misstatements over
£200,000 should be reported to the group audit team.
33 Expando Ltd
You are a supervisor in the audit department of Jones & Co. You are currently in charge of the
audit of Expando Ltd (Expando), a private limited company which imports and retails consumer
electronic equipment. Expando's year-end is 30 June 20X7. Today you are in the office when
you receive the following email from the audit senior who is working for you on the audit of
Expando:
To: Audit Supervisor

From: Audit Senior
As you are aware we are nearing the completion of the audit of Expando Ltd, however, there are
a number of outstanding issues which need to be addressed. I have summarised these in an
attachment (Attachment 1). Unfortunately I am not sure how these should be dealt with in the
financial statements so I have not been able to revise the draft financial statements provided by
the client (Attachments 2 and 3). The audit partner has specifically requested a set of revised
financial statements as he wants to take them to the meeting with Expando's finance director
tomorrow. I am also unclear whether these issues have any implications for our remaining audit
procedures. I was hoping that you may be able to help me as follows:

(a) Explain the financial reporting treatment of the outstanding issues.
(b) Complete the draft statement of profit or loss and other comprehensive income, statement
of changes in equity and statement of financial position where indicated and make any
appropriate adjustments and corrections.
(c) List any additional audit procedures which I need to do.
A couple of final points. I have found a list of procedures performed by the auditors of Titch (see
point 5 below). I am not quite sure what to do with these. Shouldn't we do the audit of Titch?
The client has a member of the accounts department who is due to go on maternity leave in
three months' time. I have been asked if we can provide temporary help to cover for their
absence. Can we do this?
Requirement
Respond to the audit senior's email. Assume that the tax figures will be audited by your firm's tax
audit specialists, so you can ignore tax (including deferred tax) for now. Total: 30 marks
Attachment 1
Notes of outstanding issues
(1) With the exception of the property referred to in Note 4, below, all of Expando's trading
premises are held on short leases, and are not shown on the statement of financial position.
The land recorded on the statement of financial position refers to the storage facility in
Northern England. This is not depreciated. During the year it was revalued upwards, by
£1 million, to £5 million. The valuation was commissioned in the early summer of 20X6, to
support the company's fundraising.
(2) New finance was taken out on 1 July 20X6, in the form of an issue of a £2 million debenture
loan. Issue costs were £150,000. The coupon rate on the debenture is 3%. Its terms provide
that it was issued at par but that it will be redeemed at a premium. The overall effective
interest rate for Expando is 7%.
(3) On 1 September 20X6, Expando acquired the business of Minnisculio, a small competitor,
for £250,000. The acquisition was structured as a purchase of trade and assets, with £20,000
allocated to inventories and the balance to goodwill. Expando has not conducted an
impairment review in respect of goodwill as there is no indication of circumstances which
would give rise to an impairment.
(4) Prior to the acquisition by Expando of its trade and assets, Minnisculio had negotiated the
acquisition of new freehold premises, to be acquired on 1 October 20X6 for a consideration
of £125,000. The asset was estimated to have a useful life of 20 years and a policy of straight-
line depreciation was to be adopted. These premises were, however, surplus to
requirements after Minnisculio's business had been acquired by Expando. On 31 March
20X7 the management took the decision to sell the premises at which date the fair value less
costs to sell amounted to £115,000.
(5) On 1 October 20X6, Expando acquired 25% of Titch Ltd, for a consideration of £400,000.
Titch is co-owned by three other UK companies, each of which holds 25% of its shares.
Unfortunately, due to unforeseen events which are not expected to be repeated, Titch made
a trading loss for its year ended 30 September 20X7 of £350,000. The results of Titch have
not been reflected in Expando's draft financial statements with the exception of the tax effect
which has been dealt with by the tax department.
(6) The tax impact of the above is being dealt with by the tax department.

Attachment 2
Summary draft statement of profit or loss and other comprehensive income and statement of
changes in equity
Year ended 30 June 30 June
20X7 20X6
(draft) (audited)
£'000 £'000
Revenue 4,430 3,660
Less operating expenses (3,620) (2,990)
Operating profit 810 670
Interest payable – Note 2 above (260) (200)
Taxation (91) ( 141)
Other comprehensive income:
Gain on property revaluation 1,000 –
Total comprehensive income for the year 1,459 329
Retained Revaluation
Statement of changes in equity 30 June 20X7 (extract) earnings surplus
£'000 £'000
Balance at 1 July 20X6 713 –
Total comprehensive income for the year 459 1,000
Balance at 30 June 20X7 1,172 1,000
Attachment 3
Summary draft statement of financial position
Period end date 30 June 30 June
20X7 20X6
(draft) (audited)
£'000 £'000
Non-current assets
Land 5,000 4,000
Premises – Note 4 above 125 –
Plant and machinery 2 2
Investments – Notes 3, 5 above 650 –
Current assets 2,155 520
Current liabilities
Taxation (91) (141)
Other (300) (149)
6% bank loan (3,333) (3,333)
3% debenture – Note 2 above (1,850) –
Deferred tax To be completed –
Net assets To be completed 899
Share capital 86 86
Share premium 100 100
Revaluation surplus – Note 1 above 1,000 –
Retained earnings 1,172 713
Equity 2,358 899

34 NetusUK Ltd
You are a senior on a large team which is planning for the audit of NetusUK Ltd, a media
company, for the year ending 30 June 20X9. NetusUK is a wholly owned subsidiary of an
Australian parent company, Netus Oceania (also audited by your firm), and contributes a very
substantial proportion of the revenue and profit reported by the Netus Oceania Group. Your
team is required to report to your firm's Australian office in Perth on the results of NetusUK and
also to report on NetusUK's statutory UK accounts. Netus Oceania is planning to raise additional
capital from shareholders and the deadlines for group reporting are very tight. Your firm is
required to provide the final report to the Perth office by 16 September 20X9.
You receive an email from the manager with overall responsibility for the NetusUK audit, Louise
Manning:
To: A. Senior
From: L. Manning
Subject: NetusUK audit planning
Date: 3 July 20X9
Welcome to the Netus team. As you know, we have a large team assigned as this is a very
significant client. I'm asking each team member to take responsibility for a particular section of
our work and to prepare a detailed audit plan, setting out the procedures to be performed at
our final audit visit in August. Materiality for planning purposes has been set at £1.5 million.
You will be responsible for staff costs and the assets and liabilities related to staff costs in the
statement of financial position. NetusUK has around 5,000 permanent employees, 1,000 of
whom are remunerated on an hourly basis. A time sheet system records time for hourly paid
staff and overtime for those salaried staff who are entitled to overtime payments. The company
runs a single computerised payroll system covering both hourly paid and salaried staff and all
staff are paid monthly. Each staff member is allocated to one of the company's 80 departments,
which range in size from three to 400 employees.
Results of our review of controls at the interim audit showed that controls were poor so a
substantive approach is to be adopted. Management's attitude regarding controls has been a
concern in the past however they are aware of the issues and have told us that they are in the
process of resolving them.
Attached to this email is an extract from NetusUK's June 20X9 draft accounts (Exhibit 1) showing
the items for which I wish you to take responsibility.
I need you to send me the following planning documentation so that I can complete the overall
planning file for this audit and submit it for manager review. Apart from item (3), your responses
should concentrate solely on the audit of staff costs and related assets and liabilities in the
statement of financial position. You do not need to consider any corporation tax or deferred tax
balances.
Planning documentation required
(a) (1) Briefing notes for Harry Thomas the Finance Director (see Exhibit 2) so he understands
what entries he needs to make to account correctly for pension costs and where he can
obtain any additional information necessary.
(2) A schedule summarising the audit procedures you believe we should complete at our
final visit in August. For the substantive procedures, please be specific about the
procedures you plan to perform on each relevant balance.
(b) Your comments on any other matters, including ethical issues, you think we should take into
account in planning our audit procedures more generally or any concerns you have as a
result of the information you have been given.
I look forward to receiving your audit planning.

In addition to this I would like your assistance with a special project. Our firm is looking into the
possibility of using data analytics in future as a means of making our audit process more
efficient. At the interim audit our IT specialists were given permission by NetusUK to use our
newly devised data analytics tool as part of a pilot scheme. A journals dashboard was produced
as a result (Exhibit 3).
I have not been part of the working party involved in the data analytics project and am unclear as
to what this is all about and its relevance to our audit work. Please produce some notes for me
explaining what data analytics is. Then I would like you to look at the information produced and
set out how this could assist in our risk assessment process. You should also indicate any further
analysis which we could perform using the data analytics tool.
Louise
Requirement
Respond to Louise Manning's email. Total: 30 marks
Exhibit 1: Extract from NetusUK's draft accounts for the year ended 30 June 20X9
Summary of staff costs reflected in the statement of profit or loss and other comprehensive
income for the year to 30 June 20X9
Total Total
Cost of Distribution Administrative year to year to
sales costs expenses 30 June 20X9 30 June 20X8
£'000 £'000 £'000 £'000 £'000
Payroll 78,301 40,815 33,974 153,090 141,496
Pension cost 10,487 5,466 4,550 20,503 12,634
Temporary staff 5,690 0 2,451 8,141 1,065
Employee expenses 341 287 2,074 2,702 2,396
Total staff costs 94,819 46,568 43,049 184,436 157,591
Summary of staff cost related balances in the statement of financial position at 30 June 20X9
30 June 30 June
20X9 20X8
£'000 £'000
Current liabilities
Employment taxes 6,903 6,287
Employer's pension contributions payable 2,397 1,484
Accruals
Temporary staff 204 119
Commission payable on June sales 454 429
Note: For the purposes of the draft accounts pension costs comprise only employer
contributions payable to NetusUK's defined benefit pension scheme. The rate of employer
contribution increased from 10% of pensionable salary to 15% of pensionable salary with effect
from 1 July 20X8 following an actuarial valuation which showed a significant deficit.
Exhibit 2: Briefing notes
To: L. Manning
From: H.Thomas@Netus.com
Subject: Audit planning
Date: 1 July 20X9
Hi Louise
You already have our draft accounts for the period ended 30 June 20X9 which have been
prepared on the same basis as last year's group reporting. As you know, the group head office

has never required us to include adjustments for the pension scheme deficit. I've just received
instructions from head office which state that, for this year's group reporting, they want full
compliance with IFRS and will not be making central adjustments for our pension scheme. I'm
going to need your help in calculating the necessary entries as I have no real experience of
accounting for pension schemes and you've always helped me with the entries for our statutory
accounts.
As you know, we have one UK defined benefit pension scheme open to all employees. Head
office has told me that I should recognise the actuarial gains and losses immediately.
I look forward to receiving your advice on these matters and to discussing your detailed audit
plan.
Regards
Harry
Exhibit 3: Journals dashboard

COMPANY: NETUSUK 01.07.X8 – 30.06.X9
Journals
Dashboard Automated vs Manual
440 Value
Total no of journals
25%
£3,874,000
Total value of journals
75%
£8,805
Average value of
journals
10 Volume
Number of users
40%
60%
Automated
Manual

Top 10 users Volume
Value
Creator ID Department Value Volume
£000 38
900 36
Andrews Finance 850 34
800 32
750 30
Conway Finance 700 28
650 26
Dalton Finance 600

550
24
22
(financial 500
450
20
18
controller) 400 16
350 14
300 12
Edwards Finance 250 10
200 8
6
Farley Finance 150
100 4
50 2
Lyndon Sales
s
ay
as
ew
on
ard
n
ey
g
y
w
m
h
to
dr
le
nd
Ridley Finance
on
ng
w
on
o
dl
al
r
An
Ed
Th
Fa
Ly
W
Ri
Si
D
C
Singh Finance Average £17k £12k £53k £8k £13k £5k £15k £18k £18k £2k
Thomas Finance
Wong Sales
35 Verloc Group
You are a newly-promoted audit manager at Marlow & Co, a firm of ICAEW Chartered
Accountants. You arrive at the office on a Monday morning and find the following email from
Leonard Kurtz, the audit engagement partner for Verloc Group.
Date: 4 October 20X9

From: Leonard Kurtz <lkurtz@marlow.co.uk>
To: Ruth Smith <rsmith@marlow.co.uk>
Subject: Verloc Group audit
Ruth,
I know that you have not been involved in the Verloc Group audit before, but as you probably
know, the audit manager on this account has just resigned and I need you to step in. I'm looking
for someone who can pick things up quickly and run with it, and you look like the right person
for the job.
I attach the following information, which I have just received from Verloc Group's Finance
Director:
 Individual statements of profit or loss and other comprehensive income for the companies in
the group (Attachment 1).
 Notes on the main transactions during the year ended 30 September 20X9 (Attachment 2).
 Draft consolidated statements of profit or loss and other comprehensive income with
supporting workings (Attachment 3).
The Finance Director has not yet sent me the statements of changes to equity and statements of
financial position but he promises to have them ready for us at the audit planning meeting this
afternoon.
I have also forwarded to you some handover notes prepared by your predecessor
(Attachment 4), which may help us in planning the audit this year.

Ahead of the audit planning meeting, please review the information provided and:
(a) explain any financial reporting and auditing issues that arise, and describe the actions that
we should take in response to each issue, including matters to be discussed with the Finance
Director; and
(b) draft the revised consolidated statement of profit or loss and other comprehensive income
that you would expect to see after adjusting for the financial reporting issues.
Come and see me at 1pm so we can go through the main points before we head off to the
meeting with Verloc Group.
Thanks,
Leonard Kurtz
Requirement
Respond to the audit partner's email. Assume that the tax figures will be audited by your firm's
tax audit specialists, so you can ignore tax for now. Total: 30 marks
Attachment 1: Statements of profit or loss and other comprehensive income for three entities
for the year ended 30 September 20X9
Verloc Winnie Stevie
£'000 £'000 £'000
Revenue 6,720 6,240 5,280
Cost of sales (3,600) (3,360) (2,880)
Gross profit 3,120 2,880 2,400
Administrative expenses (760) (740) (650)
Distribution costs (800) (700) (550)
Investment income 80 – –
Finance costs (360) (240) (216)
Profit before tax 1,280 1,200 984
Income tax expense (400) (360) (300)
Profit for the year 880 840 684
Other comprehensive income (not reclassified to P/L):
Remeasurement gains on defined benefit pension plan 110 – 40
Tax effect of other comprehensive income (30) – (15)
Other comprehensive income for the year, net of tax 80 – 25
Total comprehensive income for the year 960 840 709
Attachment 2: Notes on the main transactions during the year ended 30 September 20X9
(a) Verloc acquired 160,000 of the 200,000 £1 issued ordinary shares of Winnie on 1 May 20X9
for £2,800,000. The reserves of Winnie at 1 May 20X9 were £2,050,000. A year end
impairment review indicated that goodwill on acquisition of Winnie was impaired by 10%.
The group policy is to charge impairment losses to administrative expenses. The group
policy is to value the non-controlling interest at the proportionate share of the fair value of
the net assets at the date of acquisition.
The fair value of the net assets acquired was the same as the book value with the exception
of an investment property, which had been valued at the time of acquisition to be £960,000
above its book value. The property has an estimated total useful life of 50 years, and has
been depreciated on the cost model. At the date of acquisition Winnie had owned this
property for 10 years.
The group policy is to charge depreciation on buildings to administrative expenses on a
monthly basis from the date of acquisition to the date of disposal.

(b) Verloc disposed of 40,000 £1 ordinary shares of Stevie on 1 July 20X9 for £960,000. Verloc
had acquired 75,000 of the 100,000 £1 issued ordinary shares of Stevie for £980,000 on
1 November 20X6, when the balance on reserves was £1,020,000. The fair value of the
shareholding retained at 1 July 20X9 was £792,000. There was no evidence of goodwill
having been impaired since the date of acquisition. The reserves of Stevie at 1 October 20X8
were £1,300,000.
(c) Winnie paid a dividend of £100,000 on 1 September 20X9 and Verloc has recorded its share
in investment income.
(d) Verloc holds several investments in equity instruments, including some unquoted shares,
and accounts for these in accordance with IFRS 9, Financial Instruments. Gains on
subsequent measurement of £46,000 occurred in the year. The financial controller, however,
is unsure how this should be presented within the statement of profit or loss and other
comprehensive income and so has yet to include it.
(e) The previous year Verloc had obtained a loan of £800,000 from Inver Bank to invest in a
retail outlet. However, due to a recession the outlet did not produce the expected income,
and Verloc had difficulty servicing the debt. During the year ended 30 September 20X9,
Verloc negotiated with Inver Bank to transfer the ownership of the retail outlet to the bank in
settlement of the outstanding debt. The market value of the retail outlet is £770,000. Its
carrying amount was also £770,000 as it was measured at fair value.
The financial controller is unsure how to reflect this transaction in the financial statements of
Verloc and has not yet accounted for it.
Attachment 3: Draft consolidated statements of profit or loss and other comprehensive income
with supported workings
Verloc Group
Consolidated statement of profit or loss and other comprehensive income
for the year ended 30 September 20X9
£'000 £'000
Revenue (6,720 + (6,240  5/12) + 5,280) 14,600
Cost of sales (3,600 + (3,360  5/12) + 2,880) (7,880)
Gross profit 6,720
Administrative expenses (760 + (740  5/12) + 650 + 119 (W2)) (1,837)
Distribution costs (800 + (700  5/12) + 550) (1,642)
Finance costs (360 + (240  5/12) + 216) (676)
Income tax expense (400 + (360  5/12) + 300) (850)

Items that will not be reclassified to profit or loss
Remeasurement gains on defined benefit pension plan (110 + 40) 150
Tax effect of other comprehensive income (30 + 15) (45)
Other comprehensive income for the year, net of tax 105
Total comprehensive income for the year 1,820

£'000 £'000
Profit for the year attributable to:
Owners of the parent 1,202
Non-controlling interest (W1) 513
1,715
Total comprehensive income for the year attributable to:

1,820
WORKINGS
(1) Non-controlling interests
PFY TCI
£'000 £'000
Winnie
As stated in Attachment 1 (840  5/12) 350
Additional depreciation on fair value adjustment (10)
340
NCI share (NCI in TCI is the same as Winnie has no OCI)  20%
= 68 = 68
Stevie
As stated in Attachment 1 684 709
 65%  65%
= 445 = 461
Total NCI 513 529
(2) Goodwill (Winnie) (to calculate impairment loss for year)

£'000 £'000
Consideration transferred 2,800
NCI at proportionate share of fair value (20%  3,210) 642
Less net assets at acquisition:
Share capital 200
Reserves 2,050
(2,250)
Goodwill 1,192
Impairment (10%) 119
(3) Goodwill (Stevie)

£'000 £'000
Consideration transferred 980
Less net assets acquired:
Share capital 100
Reserves 1,020
(1,120)
140
(4) Adjustment to equity on part disposal of Stevie

£'000
Fair value of consideration received 960
Increase in NCI in net assets at disposal (483 (W5)  35%/75%) (225)
Adjustment to parent's equity 735

(5) Non-controlling interests (SOFP)
£'000
NCI at acquisition (W3) 280
NCI share of post acquisition reserves to disposal
(25%  [(1,300 + 709  9/12) – 1,020]) 203
NCI at part disposal 483
Movement in NCI (483  35%/75%)) (225)
258
(6) Intragroup dividend

Intragroup dividend income from Winnie = £100,000  80% group share = £80,000
→ Eliminate from 'investment income' bringing balance to zero.
Attachment 4: Handover notes – Verloc Group
Verloc is a family-owned retail business which had grown organically. In recent years, it has
sought to expand in the domestic market by acquiring other synergistic businesses: Stevie in
20X6 and Winnie in 20X9.
We are auditors for Verloc, and have been auditing the individual financial statements of Stevie
as well, although I am unsure whether this arrangement will continue.
The Verloc Group audit has always been extremely time-pressured. In the three years when I
have worked on this audit, the Board has insisted each time that the audit must be completed by
1 November. This deadline is completely artificial of course, but that's what the Group policy is.
Fortunately, this audit is very straightforward compared to most of the firm's other audit
engagements and presents low audit risk. Therefore, audit procedures can be simplified as
much as possible. For example, related party transactions and share capital are of low risk, so
audit procedures can be minimised on these two accounts.
Also, the timescale is such that there is insufficient time to apply the firm's statistical sampling
methods in selecting trade receivables balances for testing. It is more efficient to pick the
sample based on the audit team members' own judgement.
Materiality for the financial statements as a whole was £200,000, based on £12.8 million of
revenue, £2.1 million of profit before tax and £11.1 million of gross assets. I expect similar
materiality levels can be used on the 20X9 audit.
Last year, I gave two audit juniors the tasks of auditing trade payables and going concern. They
reviewed each other's work. This worked very well all round: reducing my review time and
providing good training for the audit juniors.
On a separate matter, I spoke with the Finance Director at a networking function two months
ago, and he mentioned that the Board is preparing for a listing on the London Stock Exchange
in a bid to raise long-term finance. I don't know where they are now on their listing plans.

36 KK
Kemsler Kessinger Ltd (KK) is a manufacturer of industrial cutting equipment.
You are a senior who has recently been assigned to the audit of KK. You work for Wight and
Jones LLP (WJ), a firm of ICAEW Chartered Accountants. WJ has recently been appointed as
auditor for the KK consolidated financial statements for the year ended 30 June 20X4. WJ is also
the auditor of all KK group companies and associates. The engagement partner, Emma Happ,
invited you to a meeting with her to plan some aspects of the KK audit.
Emma opened the meeting:
"KK is a new client of WJ and we are still trying to understand fully its management processes
and corporate governance. My particular concern is that the interim audit discovered
transactions with directors and other related parties during the year which I suspect may not be
at arm's length.
"We need to make sure that the financial reporting treatment is appropriate in the KK
consolidated financial statements for the year ended 30 June 20X4 and that all necessary
disclosures are made in each of the individual company financial statements.
"I have met with the KK chief executive, Mike Coppel. As a result of this discussion, I have
prepared some background information (Exhibit 1). In addition, the audit senior on the KK
interim audit, Russell Reed (who no longer works for WJ), raised some matters of concern
(Exhibit 2).
"One further issue is that Mike is unhappy with the due diligence work which was performed by
the accountants Trebant & Edsel LLP (TE) for KK's purchase of the shares in Crag Ltd (Exhibit 1).
Mike is considering asking WJ to review their work so the KK board can decide whether to
undertake litigation against TE. However, Mike emphasised that, while he is happy with the work
of WJ so far, he would like the audit for the year ended 30 June 20X4 to be completed to his
satisfaction before he would consider awarding this new review work to WJ, or indeed
reappointing WJ for the audit engagement next year.
"Please prepare notes for me as follows.
(a) For each of the issues in Exhibit 2:
 describe the appropriate financial reporting treatment in the KK consolidated financial
statements for the year ended 30 June 20X4. Explain and justify whether or not
disclosure of any related party transactions needs to be made in the individual financial
statements of the companies concerned for the year ended 30 June 20X4, setting out
any required disclosures; and
 explain the key audit issues and the audit procedures to be performed.
(b) Identify and explain the key audit issues which arise from the acquisition by KK of shares and
options in Crag.
(c) Explain the ethical implications for WJ of Mike's suggestion that WJ carry out review work in
respect of the due diligence assignment performed by TE.
"Please ignore tax and deferred tax for now."
Requirement
Respond to the instructions of Emma Happ, the engagement partner. Total: 30 marks
Exhibit 1: Background information
KK manufactures industrial cutting equipment at its factory in the UK. In the year ended 30 June
20X4, the KK group had revenue of £126 million, made a profit before tax of £13 million and
had net assets of £88 million at that date.

Share ownership and the board
The ordinary share ownership and directors of KK at 30 June 20X4 were as follows:
Director role Shareholding in KK
Mike Coppel Chief executive 15%

Holly Reaney Finance director 5%
Janet Coppel Production director 10%
Dans Venture Capital Co (DVC) – 40%
Harry Harker Non-executive director –
(appointed by DVC)
Yissan plc – 30%
Monica Orchard Non-executive director –
(appointed by Yissan plc)
No directors joined or left the KK board during the year ended 30 June 20X4. Mike and Janet
Coppel are married to each other.
Group structure, other investments and transactions
Most of the component parts used by KK in its manufacturing process are imported. One
supplier, Yissan, supplies 32% of KK's components. Yissan acquired its 30% shareholding in KK
in 20X1 and actively exercises its votes. Yissan has the right to appoint a director to the board.
KK owns 40% of the ordinary shares in Seal Ltd and exercises significant influence.
KK owns 35% of the ordinary shares in Moose Ltd and appoints two of its five board members.
The remaining 65% shareholding is owned by Finkle Inc, a US registered company. KK owns
30% of the ordinary shares in Finkle Inc. The remaining 70% of the shares are held by a single
unrelated individual.
On 1 August 20X3, KK acquired 45% of the ordinary shares in Crag Ltd, a competitor company.
The remaining 55% of the ordinary shares continue to be held by Woodland plc. Crag had
previously been a wholly-owned subsidiary of Woodland which is an unrelated company. Under
the terms of the share purchase, KK has an option, exercisable up to three years from the date of
the share purchase, which allows it to buy an additional 15% holding of Crag ordinary shares
from Woodland at an exercise price per share which is 10% higher than the actual price per
share paid to purchase the 45% shareholding. KK has been exercising its votes as a shareholder
of Crag. Since 1 August 20X3, the fair value per ordinary share of Crag is estimated to have risen
by 13%. Crag's marketing director, who was appointed by KK, has implemented a new
successful marketing strategy which has been a key factor in increasing the fair value per share.
The ordinary shares of all companies are voting shares. All companies have a 30 June
accounting year end.
Exhibit 2: Interim audit notes – prepared by Russell Reed
(1) Seal sold £12 million of goods to Crag, spread evenly over the year ended 30 June 20X4. I
am not clear how this should be treated and whether there should be separate disclosure of
these transactions and, if so, what needs to be disclosed.
(2) On 6 June 20X4, Seal sold goods to Moose at a price of £2 million. At 30 June 20X4, none of
these goods remained in inventories held by Moose. There were no other transactions
between Seal and Moose during the year ended 30 June 20X4.

(3) On 15 December 20X3, Mike Coppel purchased a cutting machine from KK for £300,000. At
the date of sale, the carrying amount of the machine was £240,000 and its fair value was
estimated to be £380,000.
(4) On 2 October 20X3, KK repaid a £9 million interest-free loan from Yissan. The loan was
originally raised on 12 March 20X1.
(5) On 20 January 20X4, Crag sold goods which had cost £1 million, to KK for £1.5 million. One
quarter of these goods remain unsold by KK at the end of the year. There were no other
transactions between Crag and KK during the year ended 30 June 20X4.
37 UHN
You work for Hartner as an audit senior. Hartner is a firm of ICAEW Chartered Accountants. You
have recently been asked to act as an audit senior on the audit of UHN plc, an AIM-listed
company.
UHN manufactures electronic navigation systems for the aircraft industry. It has survived the
recession and order levels have started to recover. In addition, low interest rates and the ability
to keep costs controlled have improved the company's financial performance in recent years.
The audit engagement partner, Petra Chainey, gives you the following briefing:
"We have been very short-staffed on the UHN audit and Greg Jones, the audit senior, has been
acting as the audit manager on this assignment. Greg has just gone on study leave and I would
like you to take on his role for the remainder of the audit. Before he left, Greg prepared a
handover note (Exhibit 1) which includes information on UHN's covenants and its draft summary
financial statements for the year ended 31 March 20X4. The handover note also includes Greg's
summary of the key financial reporting issues. These issues are either unresolved or, in Greg's
opinion, issues where the directors have exercised judgement in the application of accounting
policies and estimates in the preparation of the financial statements for UHN. The planning
materiality is £100,000. The audit closure meeting is scheduled for this Friday.
"I have also forwarded you an email from the UHN finance director, Melvyn Hansi, requesting
Hartner to accept a one-off assignment (Exhibit 2). I need to respond quickly to this email as the
matter is urgent. I am concerned that if we do not do as UHN requests, they may engage with
another assurance firm, not just for this one-off engagement, but also for future audits.
"We may not have the expertise in-house to complete this one-off assignment as the nature of
UHN's industry is specialised, but I am sure we can put together a convincing report.
"I would like you to prepare a working paper in which you:
(a) Set out and explain the implications of the financial reporting issues in Greg's handover note
(Exhibit 1). For each issue, recommend the appropriate financial reporting treatment,
showing any adjustments that you would need to make to the draft summary financial
statements.
(b) Using your recommendations above, evaluate and explain the overall impact of your
adjustments on the gearing ratio and the interest cover ratio at 31 March 20X4 in accordance
with the bank's loan covenants.
(c) Explain the key audit risks that we need to address before signing our audit report on the
financial statements. I do not need the detailed audit procedures; just concentrate on the
key risks.
(d) Explain the responsibility and accountability of the UHN board for cyber security and make
appropriate recommendations.

"I will ask the tax department to review any further deferred tax and current tax adjustments.
"I would also like you to prepare a file note explaining the ethical implications for our firm if we
decide to accept the one-off assignment (Exhibit 2)."
Requirement
Prepare the working paper and the file note requested by the audit engagement partner.
Total: 45 marks
Exhibit 1: Handover note prepared by Greg Jones
Loan covenants
UHN is financed by equity and debt. In 20X0, UHN was rescued from insolvency by its bank,
which provided a £20 million loan, repayable in 20X8. The loan contract with the bank stipulates
two covenants which are based on the year-end audited financial statements. Failure to meet
either covenant could result in the loan facility being withdrawn.
The covenants are as follows:
(1) The gearing ratio is to be less than 130%. The ratio is defined as:
Non- current liabilities (excluding provisions and deferred tax liability)
×100%
Equity (Share capital and reserves)
(2) The interest cover is to be greater than 3. The ratio is defined as:
Profit before finance costs (including exceptional items)
Finance costs
Covenants are determined at each 31 March year end.
As part of the loan agreement, audited financial statements must be presented to the bank
within four months of the accounting year-end.
UHN – Draft summary financial statements for the year ended 31 March 20X4
Statement of profit or loss for the year ended 31 March 20X4
£'000
Revenue 56,900
Exceptional item (Issue 1) 3,040
Statement of financial position at 31 March 20X4

£'000
ASSETS
Non-current assets
Property, plant and equipment (Issue 2) 20,040
Current assets
Inventories (Issue 3) 21,960
Trade receivables 15,982
Cash and cash equivalents 128
38,070
Total assets 58,110

£'000
Equity
Share capital – ordinary £1 shares 1,000
Share premium 15,000
Retained earnings – deficit (500)
Total equity 15,500
Loans 20,000
Long-term provision (Issue 4) 8,520
Deferred tax liability 1,000
Total non-current liabilities 29,520
Current liabilities
Trade and other payables (Issue 3) 12,350
Short-term provision (Issue 4) 740
Total current liabilities 13,090
Financial reporting issues identified by Greg Jones

Issue 1 – Sale and leaseback of factory
On 31 March 20X4, UHN entered into a sale and leaseback agreement for its freehold factory in
Swindon. The factory was originally acquired by UHN on 31 March 20W4, at which point it had a
useful life of 30 years and a zero residual value. The sale proceeds from the sale and leaseback
agreement were £6 million, which is equal to the fair value of the freehold factory. The property
was leased back on a 20-year lease from 31 March 20X4 at an annual rental of £611,120 to be
paid annually in arrears. The directors told me that, as the rentals are at market value, they have
treated the lease as an operating lease. The first lease rental will be payable on 31 March 20X5
and will be charged to the statement of profit or loss in the year ending 31 March 20X5. The
profit on the disposal of the factory and land has been included as an exceptional item as
follows:
Factory
£'000
Disposal proceeds 6,000
Less carrying amount at 31 March 20X4 (2,960)
Profit recognised as an 'exceptional item' 3,040
Although we have vouched this transaction to the lease agreement and other documents (and
there is plenty of evidence on the audit file relating to this transaction), as it is such a material
amount I thought I would draw it to your attention.
I have calculated the interest rate implicit in the lease to be 8% per annum.
I understand that the treatment of sale and leaseback is to change, following the introduction of
IFRS 16, Leases. Could you provide a brief explanation of the new treatment?
Issue 2 – Service centre in Russia
On 1 April 20X3, UHN set up a service centre in Russia at a cost of RUB266 million. The service
centre is situated at Moscow airport and operates as a repair depot for flights in and out of
Moscow airport. The service centre had an estimated useful life of six years at 1 April 20X3, with
a zero residual value.
In March 20X4, new regulations were introduced in Russia which prevented extended stays at
Moscow airport for a number of major airlines. Therefore, significantly fewer aircraft could be
serviced at UHN's Moscow service centre. The UHN finance director recognised this regulatory

change as an impairment indicator and carried out an impairment test exercise at
31 March 20X4 on the service centre.
As a consequence of this exercise, the service centre was determined to have a value in use of
RUB180 million and a fair value less cost to sell of RUB204 million at 31 March 20X4.
The finance director therefore calculated an impairment charge of RUB18 million. He translated
this at RUB48 = £1 to give an impairment charge of £375,000 in operating costs.
I haven't studied this area of financial reporting at college yet, so I thought I should bring it to
your attention. I have checked the exchange rates which are as follows:
At 1 April 20X3 RUB53 = £1
At 31 March 20X4 RUB48 = £1
Issue 3 – Hedge against increase in price of titanium
UHN uses titanium in its production process and holds titanium inventory of around 680,000
kilograms to ensure a constant supply for production. UHN's selling price of its products is
linked to the price of titanium. On 1 January 20X4, UHN had 680,000 kilograms of titanium at a
total cost of £8.2 million in inventory. At that date, UHN signed a futures contract to deliver
680,000 kilograms of titanium at £14 per kilogram on 30 September 20X4 to hedge against a
possible price fluctuation of titanium. At 31 March 20X4, the market price of titanium was £15
per kilogram and the futures price for delivery on 30 September 20X4 was £16.60 per kilogram.
The arrangement was clearly designated as hedge accounting for financial reporting purposes
in the documentation prepared on 1 January 20X4, and it meets the criteria for hedge
accounting set out in IFRS 9, Financial Instruments. However, no adjustment has been made in
the financial statements to 31 March 20X4 to use hedge accounting or to adjust the fair value of
the inventory. I was informed that, as UHN had met the interest cover requirement for its bank
covenant for the year ended 31 March 20X4, the directors want to hold back profit in order to
recognise it in the year ending 31 March 20X5. The loss on the futures contract of £1.768 million
is included in operating costs and in trade and other payables.
Issue 4 – Provision for claim for damages
In 20X0, a cargo plane, fitted with a navigation system installed by UHN, crashed in the Saharan
desert. There was no loss of life, but the owner of the plane blames the crash on a failure of the
UHN navigation system. It is alleged that UHN's computer system had been hacked and the
information used to attempt to hi-jack the plane. UHN has strenuously denied this and contested
the legal case. However, as the UHN directors believed that it was probable that there would be
a settlement, but were uncertain as to the amount, a provision was made on 31 March 20X2 for
the most likely outcome of £10 million to be settled in approximately 3 years. The provision was
discounted at 8% per annum.
In March 20X4, to avoid further bad publicity, UHN settled out of court with the owner of the
plane and agreed to pay £9.1 million. The payment terms have been agreed as 25% payable in
April 20X4 and 75% payable in April 20X5. No adjustments have been made to the financial
statements as a result of the settlement because the directors believe that the existing provision
should cover the payments they will be required to make.
Exhibit 2: Email from finance director of UHN
To: Petra.Chainey
From: M.Hansi
Date: 21 July 20X4
Subject: One-off assignment
The UHN board is in disagreement about UHN's approach to cyber security.
The operations director believes that a cyber incident would be so rare that despite the fact that
the effects would be potentially significant it is not worth spending large amounts on attempting

to mitigate risks. He pointed out that the responsibility for cyber security lies with the IT senior
manager who is not a board director but is responsible for the IT and security budget.
The finance director believes that the amount UHN pays for cyber insurance premiums could be
reduced if it could demonstrate good cyber security practices. Other directors complain that
there is a lack of information regarding security breaches. The HR director complained that she
first heard about the hacking allegations and the attempted hijacking of the cargo plane in the
press.
I would like Hartner to report to the board of directors about whether our spending on cyber
security matters is providing value for money.
I would like Hartner to accept this one-off assignment. I expect that Hartner will be able to
charge a low fee for this work as I am sure you will be able to use some of this report as part of
your audit work.
38 Couvert
You are Anton Lee, a recently-qualified ICAEW Chartered Accountant working for Pryce Gibbs
LLP (PG), a firm of ICAEW Chartered Accountants. You are currently assigned as audit senior to
the audit of Couvert plc for the year ended 31 August 20X4. Couvert is a listed company.
Couvert sells high-quality carpets. It has struggled during the recession as demand for its
products has fallen. However, the company's directors are now confident that it will benefit from
the expected recovery in the carpet industry.
Couvert has several subsidiaries, most of them carpet retailers. In 20X3, Couvert's directors
decided to implement a strategy of vertical integration in order to protect the company's
sources of supply. On 1 September 20X3, as part of this strategy, Couvert acquired 55% of the
ordinary share capital of Ectal, a carpet manufacturer based in Celonia. Background information
on the investment in Ectal is provided (Exhibit 1). On 1 March 20X4, Couvert also acquired
100% of the shares of Bexway Ltd, a UK carpet manufacturer.
Mary, the audit manager assigned to the Couvert audit for the year ended 31 August 20X4, left
PG last week to start a new job in Australia. The audit partner, Lucille Jones, has sent you the
following email:
To: Anton Lee, audit senior

From: Lucille Jones, audit partner
Subject: Couvert audit
I have assigned a new audit manager to the Couvert audit, but he is currently concluding
another engagement, and will not be able to join you until next week. In the meantime, there are
several urgent tasks outstanding on the Couvert audit. Our deadline for completion of the audit
work is 12 November 20X4. Couvert is due to release its preliminary results to the stock market
one week later.
I am concerned that Couvert has only today received year-end financial information from its
subsidiary Ectal (Exhibit 2) for consolidation into the Couvert group financial statements. I am
also perturbed by the apparent lack of involvement by Couvert's management in Ectal's affairs.
Ectal has not prepared regular management accounting reports during the year.
Another concern is the conduct of the audit of Ectal by the local Celonian auditor, Stepalia LLP;
they have not communicated the results of their audit to us. We originally assessed audit risk for
Ectal as moderate, but given the lack of information received we may need to look at this
assessment again. Ectal is material to Couvert's consolidated financial statements.
Also, I've just received a request for advice regarding two financial reporting issues from
Couvert's finance director. His email is attached (Exhibit 3).

I would like you to prepare a working paper in which you do the following:
(a) Analyse and explain, using analytical procedures, the financial performance and position of
Ectal for the year ended 31 August 20X4 (Exhibit 2). Include enquiries that will need to be
made of Ectal's management and its auditor Stepalia arising from these analytical
procedures.
(b) Identify and explain your concerns about the corporate governance arrangements at Ectal
and the impact of these on the financial reporting of the investment in Ectal in Couvert's
consolidated financial statements for the year ended 31 August 20X4.
(c) Explain, in respect of the audit of Ectal by Stepalia:
 the actions to be taken by PG; and
 the potential implications for the group auditor's report.
(d) Explain the appropriate financial reporting treatment for the two issues identified by
Couvert's finance director (Exhibit 3).
Requirement
Respond to the audit partner's email. Total: 40 marks
Exhibit 1: Background information on Couvert's investment in Ectal
Ectal was incorporated 20 years ago in Celonia, a country well known in the carpet industry for
the high quality of its wool products and its skilled labour force. The currency of Celonia is the
Celonian dollar (C$).
Ectal was founded by Ygor Vitanie, who held a majority shareholding until, on
1 September 20X3, Couvert purchased 55% of Ectal's ordinary share capital from him, at a
substantial premium. The remaining 45% of the shares are now held as follows:
Ygor Vitanie 35%
Other members of the Vitanie family 10%
Corporate governance arrangements
Ygor is Ectal's managing director, and his daughter, Ruth, is the manufacturing director. There
are three other directors nominated by Couvert. These are Couvert's marketing director, finance
director and operations director. Ygor has the casting vote in cases where voting is tied. Since
1 September 20X3, Couvert's operations director has attended four of Ectal's monthly board
meetings, Couvert's finance director has attended one board meeting in November 20X3 and
Couvert's marketing director has been unable to attend any of the meetings because of other
commitments.
External audit arrangements
PG does not have a correspondent or branch office in Celonia. The audit of Ectal continues to be
conducted by a local Celonian audit firm, Stepalia, which was first appointed to the Ectal audit
several years ago. PG issued group audit instructions to Stepalia several months ago, but has
received very little information from Stepalia. Component materiality for the Ectal audit was set
at the planning stage at C$20 million.
Due diligence
Due diligence in respect of Couvert's acquisition of Ectal was carried out jointly by PG and
Stepalia. The principal member of PG's staff involved in the due diligence exercise was Mary, the
PG audit manager who has just left the firm.

Exhibit 2: Year-end financial information received from Ectal
The Ectal financial statements have been prepared in compliance with IFRS.
Ectal: Statement of profit or loss for the year ended 31 August 20X4
20X4 20X4 20X3
Actual Budget Actual
C$m C$m C$m
Revenue 305.4 358.6 350.4

Other income 4.8 – –
310.2 358.6 350.4
Change in finished goods and WIP 5.9 (8.3) (18.6)

Raw materials and consumables used (192.8) (205.7) (194.1)
Employee expenses (26.3) (25.8) (21.0)
Depreciation expense (52.4) (60.8) (59.4)
Impairment of property, plant and equipment (60.0) – –
Other expenses (29.7) (21.0) (21.2)
Finance costs (5.1) (5.0) (5.0)
(Loss)/profit before tax (50.2) 32.0 31.1
Tax – (10.0) (9.3)
(Loss)/profit after tax (50.2) 22.0 21.8
Ectal: Statement of financial position at 31 August 20X4

20X4 20X4 20X3
Actual Budget Actual
C$m C$m C$m
Property, plant and equipment 551.3 622.5 603.7
Inventories 98.0 90.0 92.1

Trade receivables 50.7 55.0 57.0
Cash 1.5 15.0 10.1
Current assets 150.2 160.0 159.2
Total assets 701.5 782.5 762.9
Ordinary share capital 5.0 5.0 5.0

Retained earnings 529.0 621.5 599.2
Loan from director 50.0 50.0 50.0

Provisions 16.0 – –
Non-current liabilities 66.0 50.0 50.0
Trade and other payables 98.7 96.0 99.4

Short-term borrowings 2.8 – –
Current tax payable – 10.0 9.3
Current liabilities 101.5 106.0 108.7
Total equity and liabilities 701.5 782.5 762.9

Exhibit 3: Email to Lucille Jones from Couvert's finance director
Lucille
I would appreciate your advice on the following two financial reporting issues that affect
Couvert's consolidated financial statements for the year ended 31 August 20X4.
Issue 1 – Accounting for retirement benefits
As you know, the Group's pension plan is a defined contribution plan, which is open to
employees in most, but not all, of our subsidiaries. However, as part of our vertical expansion
strategy we purchased 100% of the shares of Bexway Ltd halfway through the financial year, on
1 March 20X4. Bexway has a defined benefit scheme for senior staff. Bexway's accountant
retired shortly after the takeover and there is now no one at the company who understands the
accounting for a defined benefit scheme. The only accounting entry that has been made since
recognising the net pension liability on acquisition is in respect of employer contributions paid.
This amount has been debited to staff costs.
I have the following information about the pension plan between 1 March 20X4 and
31 August 20X4:
£'000
Current service cost for six months (estimated by actuary) 604
Fair value of plan assets at 1 March 20X4 8,062
Present value of plan liabilities at 1 March 20X4 8,667
Contributions paid into plan by Bexway on 31 August 20X4 842
Retirement benefits paid out by plan 662
Fair value of plan assets at 31 August 20X4 (estimated by actuary) 8,630
Present value of plan liabilities at 31 August 20X4 (estimated by actuary), not 8,557
including amendment to plan (see below)
On 14 April 20X4, Bexway's directors decided to amend the pension plan by increasing the
benefits payable to members with effect from 1 September 20X4. From this date benefits will
increase, as will the contributions payable by Bexway. I am informed by the actuary that the
present value of plan liabilities should be increased by £500,000 at 31 August 20X4 in this
respect.
The applicable six-month discount rate is 3%.
I am unfamiliar with current practice in respect of accounting for defined benefit plans.
Please advise me of the correct accounting treatment for the plan for the six months ended
31 August 20X4 and provide me with the appropriate journal entries for Bexway.
Issue 2 – Financial asset
On 1 April 20X4 Couvert's board bought a put option contract over 500,000 shares in an
Australian wool-producing company, The Brattle Company. The exercise price of the option is
£6.00 per share and it will expire on 31 March 20X5. The bank has supplied me with the
following information about the put option:
1 April 20X4 31 August 20X4
Market price of one share in Brattle £6.00 £5.90
Value of put option contract £63,000 £95,000
I recorded the initial investment of £63,000 as an investment in equity instruments, but I have
made no other accounting entries in respect of this asset and I am not sure whether any
adjustment is necessary. Please explain the appropriate financial reporting treatment for this
item, and set out the appropriate journal entries.
I look forward to your response to my queries.

39 ERE
ERE Ltd designs (ERE), manufactures and installs medical equipment for healthcare providers.
ERE is currently unlisted but its shareholders are considering an AIM listing within the next three
years. The chief executive, Frank Mann, owns 30% of the shares in ERE and the remaining 70%
are owned by private equity investors. ERE has a 31 July accounting year end.
You are Tom Tolly, an audit senior with Ham and Heven LLP (HH), a firm of ICAEW Chartered
Accountants. HH has audited ERE for a number of years. You have just returned to work after
study leave and you have received the following email from your audit manager setting out your
assignment for today.
To: Tom Tolly

From: Audit manager
Subject: ERE – audit of payables and deferred tax for the year ended 31 July 20X4
ERE's financial controller, Josi Young, is a former employee of HH. She left HH in August 20X4
before completing her training contract and shortly afterwards secured a job with ERE. Josi had
been a member of the ERE audit team for a number of years before leaving HH.
I assigned Chris King, a junior audit assistant, to the payables and deferred tax sections of the
ERE audit as I felt confident that Josi would be able to provide him with some assistance.
However, I now have some concerns with the work that he has produced. I have attached a
working paper that I asked Chris to prepare summarising the audit procedures he has
performed on payables and deferred tax (Exhibit). I would like you to review this working paper
and prepare a report for me in which you:
(a) explain the key weaknesses in the audit procedures performed by Chris. Identify the audit
risks arising in respect of ERE's payables and deferred tax and the audit procedures that
should be completed in order to address each risk;
(b) identify and explain the financial reporting issues and recommend appropriate adjustments.
With regard to the lease of the factory, briefly explain what, if anything, will change when
IFRS 16, Leases comes into force;
(c) summarise on a schedule of uncorrected misstatements the adjustments that you have
recommended. Explain the further action that we should take in respect of the uncorrected
misstatements; and
(d) identify and explain any ethical issues for HH, and recommend any actions for HH arising
from these issues.
Requirement
Prepare the report requested by your audit manager. Total: 34 marks
Exhibit: Working paper: prepared by Chris King
ERE: Audit procedures for payables and deferred tax for the year ended 31 July 20X4
The planning materiality is £120,000.
Payables and deferred tax per the statement of financial position are as follows:
Reference to audit
procedures 20X4 20X3
£'000 £'000
Trade payables (1) 13,709 14,628
Other payables (2) 2,620 550
Deferred tax (3) 440 950

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

I reviewed a sample of 10 supplier statement reconciliations selected for me by Josi, who
has performed reconciliations for all the major suppliers.
I re-performed the reconciliations for the three largest suppliers, which represented 89.8%
of the total trade payables balances at 31 July 20X4, as follows:
Mesmet plc KH GmbH Medex
£'000 £'000 £'000
Balance per ledger 2,563 1,739 1,962
Payments in transit 950 – 250
Invoices in transit 525 – 540
Mesmet invoices 'on hold' 1,230 – –
Disputed Medex invoices – – 850
Balance per supplier statement 5,268 see below 3,602
% of trade payable ledger balances 44.6 14.7 30.5

I agreed payments in transit to the cash book and to the bank reconciliation. All payments
were presented within 30 days of the year end.
All invoices in transit were agreed to invoices posted in August 20X4.
Mesmet invoices 'on hold'
I queried the invoices 'on hold' on Mesmet's supplier statement. Josi was unsure about
these invoices, but said that they have now 'disappeared' from Mesmet's most recent
supplier statement. ERE's finance director has told her not to contact Mesmet to query
these invoices as he deals personally with the Mesmet finance department.
KH
KH is a new supplier and invoices ERE in euro. The supplier statement shows a balance of
€2 million at 31 July 20X4. On 1 October 20X3, ERE purchased a large consignment of
monitors from KH for €4 million and recorded this transaction at the exchange rate on that
date. ERE paid €2 million to KH on 1 April 20X4 and made a final payment of €2 million on
1 November 20X4 at the exchange rate on that date of €1.28:£1. The year-end ledger
balance has been adjusted for an exchange gain. I have checked the calculation of the
exchange gain using the following exchange rates:
€/£ €'000 £'000
1 October 20X3 1.15 4,000 3,478
1 April 20X4 1.20 (2,000) (1,667)
Exchange gain (72)
Year-end balance 1,739
The €/£ exchange rate at 31 July 20X4 was €1.27:£1.

Disputed Medex invoices
I queried the £850,000 of disputed Medex invoices with Josi and have noted below her
explanation:
Medex supplies components to ERE. ERE used these components to manufacture its
oxygen units, which are installed for hospital customers in operating theatres. On

10 August 20X4, legal proceedings were commenced against ERE by a hospital which
claims that failure of the oxygen units installed by ERE during the year ended 31 July 20X4
caused delays to the performance of operations. The hospital is claiming £1.2 million
compensation for loss of income.
On 14 September 20X4, ERE appointed legal advisers who suggested that it is possible, but
not likely, that the claim will succeed. However, the legal advisers estimate that, if the case is
settled, it would be in July 20X6. Also, they have advised that legal costs will be £100,000,
which will also be settled at that date. Josi has included an accrual for the legal fees as part
of 'other payables' (see below). The ERE board does not want to disclose any information
regarding the legal case as the directors believe that it will cause reputational damage for
ERE.
ERE believes that the Medex components were faulty. Therefore Josi has requested credit
notes from Medex in respect of invoices for these components and has credited purchases
with £850,000 and debited the Medex payable ledger account.
Debit balances
This is an adjustment to reclassify debit balances as receivables. I have checked that the
debit entry of this adjustment is included in receivables.
Goods received not invoiced
I reviewed the list of goods received not invoiced and noted several items dating from
January 20X4. Josi informed me that she is still chasing invoices from the suppliers for these
goods but as the amount involved is only £115,000, and therefore less than materiality, I
have not carried out any further audit procedures.
(2) Audit procedures for other payables
Other payables comprises:
20X4 20X3
£'000 £'000
Legal fees (see above) 100 –
Provision for restructuring:
Redundancy payments 270
One-off payments to employees for relocation costs 50
Costs of removing plant and machinery 400
720 –
Lease cost of factory 1,100 –

Payroll and other current taxes 200 200
Other accruals 500 350
Total 2,620 550
Provision for restructuring

On 1 October 20X4, ERE closed down a manufacturing division which operated from a
factory in the North of England. I have agreed the provision for restructuring to the budget
and also to the board minutes which stated that negotiations with employee
representatives and the factory landlord were completed on 30 July 20X4 and a formal
announcement was made to all employees on 31 July 20X4.
Lease cost of factory
ERE signed a 10-year lease for the factory on 1 August 20X0 at an annual rental of
£240,000, payable annually in arrears. It was noted in the board minutes that, following the
closure of the division on 1 October 20X4, ERE has the choice of subleasing the factory to
another company for the remaining six years at an annual rental of £60,000 payable
annually in arrears; or paying £1.1 million as compensation to the factory landlord to
terminate the lease. The directors asked Josi to obtain more information and to prepare
calculations using an annual discount rate which reflects the time value of money of 5%.

Until this information is made available, a provision of £1.1 million has been made in the
draft financial statements.
(3) Audit procedures for deferred tax
Josi has provided the following deferred tax computation and notes:
Deferred tax computation
£'000
Taxable temporary difference:
Carrying amount of plant and equipment at 31 July 20X4 12,800
Tax base of plant and equipment at 31 July 20X4 (8,600)
Taxable temporary difference on plant and equipment 4,200
Deferred tax liability on taxable temporary difference at 20% 840

Deferred tax asset in respect of carried forward trading losses (400)
Deferred tax balance 440
Notes
1 Accounting profits equal taxable profits except in respect of depreciation.
2 ERE made a tax loss of £2 million in the year ended 31 July 20X4. Under current tax
legislation this loss can be carried forward indefinitely. ERE has prepared a budget for
20X5 and 20X6 which shows taxable profits of £500,000 and £750,000. No projections
are available after this date due to the uncertainty of tax law.
3 ERE revalued its head office building on 31 July 20X4. The revalued carrying amount at
31 July 20X4 was £5 million and its tax base was £4 million. Gains on property are
charged to tax at 20% on disposal. However, ERE has no intention of selling its head
office therefore no deferred tax liability has been recognised.
4 I have agreed the carrying amount of plant and machinery to the financial statements
and the tax base to the company tax return.

Real exam (July 2015)
40 Congloma
Congloma plc is a UK listed company and it is the parent of a group of manufacturing
companies located across the UK. Your firm, A&M LLP, a firm of ICAEW Chartered Accountants,
has audited Congloma and its subsidiaries for three years.
You are assigned to the group audit team for Congloma for the year ending 31 August 20X4.
Your manager, Harri Merr has asked for your help to finalise audit planning. Other audit teams
from your firm are responsible for the individual audits of Congloma's subsidiaries.
You meet with Harri, who gives you the following instructions:
"I've provided some background information (Exhibit 1). The Congloma finance director, Jazz
Goring, has asked A&M to assist her in determining how a number of significant transactions
should be treated in the Congloma consolidated financial statements for the year ending
31 August 20X4. She also wants to understand the overall impact of these transactions on the
consolidated profit before taxation.
"I've forwarded her email to you (Exhibit 2), together with an attachment comprising briefing
notes from the Congloma corporate finance team which provides some further details of the
transactions (Exhibit 3). These briefing notes were presented at the Congloma board meeting in
May 20X4 before the significant transactions were completed. Jazz has assured me that none of
the details changed when the deals were finalised, so we can use this information for audit
planning purposes.
"I would like you to:
(a) draft a response to Jazz's email (Exhibit 2) and its attachment (Exhibit 3). In your response
you should:
(1) set out and explain, for each of the transactions she identifies, the correct financial
reporting treatment in Congloma's consolidated financial statements for the year
ending 31 August 20X4. Recommend and include appropriate adjustments and
calculations; and
(2) calculate the consolidated profit before taxation for the year ending 31 August 20X4,
taking into account the adjustments you have identified; and
(b) set out, in a working paper, the additional audit procedures that we will need to perform as
a result of the transactions Jazz has identified. Include an explanation of the impact that the
transactions will have on the scope of our audit procedures and the identification of
components that we consider to be significant.
"The additional audit procedures that you identify should include those we will perform
both at the significant component subsidiaries and head office. These procedures should
only be those of relevance to our opinion on the Congloma consolidated financial
statements for the year ending 31 August 20X4. At this stage, I am not interested in the
procedures we will need to perform in order to sign an audit opinion on each individual
group company."
Requirement
Respond to Harri's instructions. Total: 40 marks
ICAEW 2019 July 2015 questions 119

Exhibit 1: Background information provided by the audit manager, Harri Merr
Our experience of the Congloma audit is that the group is generally well managed and
maintains reliable accounting records. We have noted, however, that the finance team's
experience of more complex transactions is limited and they do not always make the correct
accounting entries or appreciate fully the financial reporting implications of such transactions.
The scope of the work to be performed by the group audit team in respect of the group financial
statements is as follows:
 Audit procedures on the group financial statements and consolidation
 Direction and review of the audit procedures performed by other teams from our firm at all
significant components
 Review procedures on the results of components which are not significant
Based on the group's latest financial projections, I have determined planning materiality for the
group audit at £350,000.
Exhibit 2: Email from Congloma Finance Director, Jazz Goring
To: Harri Merr
From: Jazz Goring
Date: 17 July 20X4
Subject: Significant transactions
After a period of over a year with no acquisitions or disposals, June 20X4 was a busy month for
our corporate finance team. In addition to the information provided below, you will find further
details in the attached briefing notes from the Congloma corporate finance team which were
presented at our board meeting in May 20X4 (Exhibit 3).
The board is pressing me for a forecast of the consolidated profit before tax for the year ending
31 August 20X4. Therefore it would be helpful to have your advice on the financial reporting
treatment of the transactions set out below. Before accounting for the effect of any adjustments
arising from these transactions, our latest forecasts show a consolidated profit before tax of
£7 million for the year ending 31 August 20X4.
Further investment in Oldone Ltd
In 20W4, 10 years ago, Congloma subscribed £9.6 million for an 80% shareholding in Oldone
on the incorporation of the company. At that date, Anthony Myers, the Oldone chief executive
subscribed for the remaining 20% of Oldone shares.
On 1 June 20X4, Anthony retired and sold his shares in Oldone to Congloma for £4 million.
Oldone is expected to make a profit before taxation of £500,000 in the year ending 31 August
20X4. As for all our group companies, Oldone's profits are not seasonal, but accrue evenly
throughout the year.
The identifiable net assets of Oldone at 31 May 20X4 were £14 million and, in our interim
financial statements at that date, we recognised a non-controlling interest of £2.8 million, using
the proportion of net assets method always adopted by Congloma. I will instruct an expert
valuer to determine the fair value of Oldone's assets so that I can calculate the goodwill to be
included in the consolidated financial statements for the year ending 31 August 20X4. However,
I need your advice on how to eliminate the non-controlling interest balance of £2.8 million from
the consolidated statement of financial position at 31 August 20X4.
Issue of convertible bonds
On 1 June 20X4, Congloma raised £10 million through an issue of convertible bonds to third
party investors. Further details are included in the attached briefing notes (Exhibit 3). For the
time being, I have recognised the £10 million as a liability.

Investment in Neida Ltd
On 1 June 20X4, Congloma acquired 45% of Neida's issued ordinary share capital and voting
rights for £3 million. Neida's remaining ordinary shares and voting rights are currently held
equally by the two individuals who founded the company. Congloma has an option to acquire a
further 20% of Neida's ordinary share capital in the future.
Neida is engaged in developing practical applications for Lastlo, an innovative new material. We
expect that the use of Lastlo will improve the durability and performance of a number of
Congloma's products.
I believe that Congloma's holding of 45% of Neida's ordinary share capital and voting rights
gives it significant influence and so propose to account for Congloma's investment in Neida as
an associate. As you will see from the attached briefing notes (Exhibit 3), Neida has very few
assets or liabilities, so the key impact on the group financial statements will be the recognition of
the investment of £3 million.
Disposal of 75% interest in Tabtop
On 30 June 20X4, 75% of the ordinary shares and voting rights in Tabtop Ltd, which was wholly
owned by Congloma, were sold to a third party for £6 million. The carrying amount of the net
assets (excluding goodwill) of Tabtop on 30 June 20X4 was £5.6 million and the carrying
amount of goodwill relating to Tabtop in Congloma's consolidated statement of financial
position at that date was £1.5 million. Therefore I have calculated, and propose to include, a
group profit on the sale of £0.3 million (£0.3 million = £6.0 million – (75% of £5.6 million)
– £1.5 million).
Further details of this transaction are included in the attached briefing note (Exhibit 3).
I propose to equity account for our non-controlling interest following the share sale. The
disposal should save you some time on the audit compared to last year, as now you will not
need to perform group audit procedures on Tabtop.
Impairment of investment in Shinwork Ltd
Congloma has an 80% holding of the ordinary share capital of Shinwork Ltd.
Demand for Shinwork's products has fallen and cash flow projections show that its business will
have a value in use of £9.2 million at 31 August 20X4. We will therefore need to record an
impairment in our group financial statements for the year ending 31 August 20X4.
I am not quite sure how to calculate this impairment charge from the information I have and
would welcome your advice. It would be helpful if you could highlight any other financial
reporting points that I should consider.
At 31 August 20X4, key financial data for Shinwork is projected to be as follows:
£m
Carrying amount of net separable assets 8.0
Carrying amount of goodwill relating to Shinwork in Congloma
consolidated statement of financial position 4.0
Non-controlling interest (determined using the proportion of net assets
method) 1.06
Exhibit 3: Briefing notes from the Congloma corporate finance team, presented to the
Congloma board meeting on 21 May 20X4
Issue of convertible bond
Proposed terms for the convertible bond issue have now been agreed. On 1 June 20X4,
Congloma will raise £10 million by issuing 100,000 5% convertible bonds, each with a par value
of £100. Each bond can be converted on or before its maturity date of 31 May 20X7 into
10 shares in Congloma plc. Interest will be payable annually in arrears.

By issuing a convertible bond, we not only obtain longer-term finance for the group, but also
secure a lower interest rate. The annual interest rate for similar debt without the conversion
rights would be 8%.
Investment in Neida
We propose to proceed with the acquisition of 45% of the issued share capital of Neida for
£3 million on 1 June 20X4. We will also have a call option to acquire, from the two founding
shareholders, a further 20% of Neida's ordinary share capital and voting rights for £1.5 million.
Neida expects to exercise this option before 1 June 20X9.
The draft shareholder agreement states that the board of Neida will comprise the two founding
shareholders and two individuals nominated by Congloma. Most decisions will be made by a
majority of the directors, but decisions about major research and development projects cannot
be made without the agreement of both of the Congloma-nominated directors.
Neida is expected to make a loss of £300,000 in the year ending 31 August 20X4 and the
projected carrying amounts of its net assets at the date of acquisition (1 June 20X4) are as
follows.
£'000
Net current assets 50
Net assets 200
Given the nature of these assets and liabilities, their fair values are equal to their carrying
amounts.
Disposal of 75% interest in Tabtop
Tabtop has been making losses for a number of years and is also incurring net cash outflows to
an extent that the Congloma group no longer wishes to fund. Its projected loss for the year
ending 31 August 20X4 is £3 million. We have received an offer of £6 million for 75% of the
Tabtop ordinary shares which we believe we should accept. In addition, Congloma will retain a
holding of 25% Tabtop's ordinary share capital, which experts tell us would have a fair value of
£1 million. Congloma would continue to exercise some influence on the business through a seat
on the board.
41 Heston
Heston plc is a listed company which manufactures engines. It has four autonomous divisions,
which operate from separate factories. Heston has no subsidiaries.
You recently joined Heston as deputy to the finance director, Edmund Rice. Edmund sent you
the following email.
To: Deputy finance director

From: Edmund Rice, finance director
Date: 20 July 20X5
Subject: Finalisation of the annual report – year ended 30 June 20X5
The past few years have been difficult for Heston, but a new chief executive, Franz Zinkler, was
appointed in 20X4 and he is beginning to change things. Despite this, the year ended 30 June
20X5 was again a challenging year. I have provided you with a document giving some
background information about Heston and its recent history (Exhibit 1).
We need to publish our financial statements shortly. Draft financial statement information has
been prepared (Exhibit 2), but there are a number of issues which will require adjustment
(Exhibit 3).

I need to provide an explanation of Heston's financial performance for the year ended 30 June
20X5 and its position at that date. This is for the finance director's section of the management
commentary in the annual report. I also need to make a presentation to financial analysts about
Heston's financial performance and position following publication of the annual report. This will
include some tough questions about the financial statements and the company's underlying
performance.
I need your assistance with the following:
(1) I would like you to:
 set out and explain the financial reporting adjustments required in respect of the issues
in Exhibit 3; and
 prepare an adjusted statement of profit or loss for the year ended 30 June 20X5 and
an adjusted statement of financial position at that date in a form suitable for publication
(including comparative figures for the year ended 30 June 20X4, in the form that they
would appear in the financial statements for year ended 30 June 20X5). Do not worry
about the tax or deferred tax effects of your adjustments at this stage.
(2) To help me to prepare my section of the management commentary and to help me answer
questions, please analyse Heston's performance and position for the year ended
30 June 20X5. Include calculations and use the adjusted financial statements. Outline any
further information needed, so I can ask somebody to investigate.
Requirement
Respond to the instructions of the finance director. Total: 30 marks
Exhibit 1: Company background – prepared by the finance director
Heston produces engines. Heston has four divisions which are not separate subsidiaries and are
part of the Heston plc legal entity; they are autonomous and operationally independent of each
other. Each of its four separate divisions produces a different type of engine for: cars, motor
bikes, boats and lawn mowers.
Trading has been difficult for all the divisions in recent years, but particularly for the Lawn Mower
Division, because there was a major new entrant into this industry in August 20X4. The chief
executive, Franz, therefore decided that Heston should sell off the Lawn Mower Division
(Exhibit 3).
For the other three divisions, the key risk was a potential fall in future sales volumes. Such a fall
would affect Heston significantly because about 70% of cost of sales comprises fixed
manufacturing costs, which need to be incurred irrespective of sales volumes. To counter the
risk of falling volumes, Franz decided to reduce all selling prices in these three divisions by 10%
from 1 July 20X4.
Financial analysts have responded favourably to these decisions, but have been enquiring about
their impact on profit.

Exhibit 2: Draft financial information for the year ended 30 June 20X5 – prepared by the
finance director
Draft financial information for the statement of financial position at 30 June
20X5 20X4
£'000 £'000
ASSETS
Development costs 10,380 10,380
Trade and other receivables 36,100 30,400
(Overdraft) / Cash (8,400) 5,600
184,040 189,980
Current tax payable 4,420 6,060
Provision for redundancy costs 3,800 –
184,040 189,980
Draft financial information for the statement of profit or loss for the year ended 30 June
20X5 20X4
£'000 £'000
Revenue 436,000 451,700
Cost of sales (306,180) (318,500)
Distribution costs and administrative expenses (107,200) (101,400)
Finance costs (1,500) (1,500)
Income tax expense (4,420) (6,060)
Exhibit 3: Issues requiring adjustment in the financial statements – prepared by the finance
director
(1) Disposal of the Lawn Mower Division
Impact on results
On 1 January 20X5, Franz decided to dispose of the Lawn Mower Division, which had
recently started making losses. The Heston board formally approved the decision on
1 March 20X5 and the division's assets were advertised for sale at their fair value from
1 April 20X5.
Heston intends to sell only the division's non-current assets (including its brand name,
GrassGrind). It is expected that these assets will be sold to a range of different buyers.
The land and buildings are expected to be sold at their fair value of £13 million and plant at
its fair value of £7 million. Selling costs are expected to be 4% of the fair value for these
assets.
The Lawn Mower Division brand name, GrassGrind, including the legal right to trade under
that name, is expected to realise only £800,000. The brand was internally generated by
Heston and so is not recognised in the financial statements.

Draft financial information for the year ended 30 June 20X5 (Exhibit 2) includes the
following amounts in respect of the Lawn Mower Division:
20X5 20X4
£'000 £'000
Revenue 92,000 119,300
Cost of sales (72,084) (77,400)
Distribution costs and administrative expenses (Note) (33,800) (34,700)
(13,884) 7,200
Income tax credit/(charge) 2,600 (1,400)
(Loss)/profit after tax (11,284) 5,800
Note: Staff working in the Lawn Mower Division will be made redundant when the division
is sold and a provision for redundancy costs of £3.8 million has been recognised in
distribution costs and administrative expenses for the year ended 30 June 20X5.
Impact on property, plant and equipment
Heston uses the cost model for property, plant and equipment.
An analysis of the property, plant and equipment figure in the draft financial statements is
as follows:
Plant and
Land Buildings equipment Total
£'000 £'000 £'000 £'000
Lawn Mower Division:
Cost at 30 June 20X4 and 5,600 6,000 12,000 23,600
30 June 20X5
Accumulated depreciation at – (960) (3,400) (4,360)
1 July 20X4
Depreciation charge for the year
ended 30 June 20X5 – (120) (860) (980)
Carrying amount at 30 June 20X5 5,600 4,920 7,740 18,260
Continuing activities:
(ie, the other three divisions)
Carrying amount at 30 June 20X5 32,200 34,700 28,500 95,400
Total carrying amount at 30 June 20X5 37,800 39,620 36,240 113,660
The buildings are being depreciated over a 50-year life to a zero residual value. The plant
and equipment is being depreciated on a 10% reducing balance basis. The company's
policy is to recognise all depreciation charges in cost of sales.
There were no acquisitions or disposals of property, plant and equipment during the year
ended 30 June 20X5.
(2) Cash flow hedge
On 1 May 20X5, Heston entered into a contract to purchase 6,000 tonnes of steel. The
contract is for delivery in September 20X5 at a price of £165 per tonne. Heston uses steel to
make most of its engines and makes regular purchases of steel.
At 30 June 20X5, an equivalent new contract, for delivery of 6,000 tonnes of steel in
September 20X5, could be entered into at £158 per tonne.
Heston does not intend to take physical delivery of the 6,000 tonnes of steel, but intends to
settle the contract net in cash, then purchase the actual required quantity of steel as regular
production needs arise.

The contract is designated as a cash flow hedge of the highly probable forecast purchase of
steel. All necessary documentation was prepared to qualify the contract as a cash flow
hedge, and the arrangement meets the criteria in IFRS 9, Financial Instruments to qualify for
hedge accounting and the hedge effectiveness tests. No accounting entries have been
made in the draft financial statements.
42 Homehand
You are Jan Jenkins, an audit senior with Brine & Weel (BW) LLP, a firm of ICAEW Chartered
Accountants which is engaged as auditor to Homehand Ltd. Homehand manufactures and sells
production machinery to the food processing industry.
You are working on the final stages of the audit of Homehand for the year ended
31 March 20X5. Your predecessor, Min Wall, is on study leave. You receive the following email
from the manager responsible for the Homehand audit, Leigh Moore:
To: Jan Jenkins

From: Leigh Moore
Date: 20 July 20X5
Subject: Finalisation of Homehand audit for the year ended 31 March 20X5
I attach to this email a schedule of uncorrected misstatements prepared by Min Wall (Exhibit 1)
together with Min's audit procedures on current and deferred tax (Exhibit 2), which are
incomplete.
As the misstatements identified by Min (Exhibit 1) do not appear to be material, the Homehand
finance director told me that he does not wish to adjust for these, or make any further
adjustments we may identify. However, I have told him that we will need to consider audit
adjustments when we have completed all our procedures. In particular, we will need to take
into account, not only the overall level of any uncorrected misstatements, but also their effect
on individual line items within the financial statements.
I would like you to review the schedules prepared by Min (Exhibits 1 and 2) and prepare a file
note for me in which you:
(a) explain the financial reporting issues you have identified and recommend appropriate
adjustments;
(b) prepare a revised schedule of all uncorrected misstatements, including your adjustments
from (a) above. Identify and explain the misstatements, if any, that we require Homehand
to correct;
(c) set out the audit procedures we need to perform to complete our audit of the current tax
and deferred tax balances; and
(d) identify and explain the ethical issues for our firm and any actions you believe we should
take.
Requirement
Respond to Leigh Moore's instructions. Total: 30 marks
Exhibit 1: Schedule of uncorrected misstatements for the year ended 31 March 20X5 –
prepared by Min Wall
Planning materiality for Homehand is £120,000. Misstatements below £6,000 are regarded as
clearly trivial and are not reported to those charged with governance.
Last year (ie, the year ended 31 March 20X4) there was only one uncorrected misstatement, an
over-provision of warranty costs of £60,000.

The schedule below does not include any adjustments arising from my audit procedures on
current and deferred tax (Exhibit 2) as these procedures are incomplete.
Description of misstatement Statement of
Statement of profit or loss financial position
Debit Credit Debit Credit
£'000 £'000 £'000 £'000
(1) Over-provision of warranty costs due to
error in formula used to derive
general provision for warranty – 75 75 –
(2) Estimated over-valuation of inventory
based on a sample testing of
inventory costs 115 – – 115
(3) Understatement of cost of sales due to
lease of production machinery (see
Note below) 34 – – 34
Note: Lease of production machinery
On 1 April 20X4, Homehand recognised as revenue £44,000 received from a customer,
HodFoods Ltd, in respect of a lease of production machinery.
The sales director explained to me that instead of selling the machinery outright for £123,000,
Homehand instead leased it to HodFoods over its three-year life. The lease requires three
payments of £44,000, paid annually in advance. The annual market rate of interest would have
been 8%.
HodFoods made the first lease payment of £44,000 on 1 April 20X4. However, the machinery is
still included in Homehand's inventory at its production cost of £102,000. Therefore I believe
that there is an overstatement of Homehand's inventory and an understatement of cost of sales
of £34,000 (being £102,000 divided by three years). BW's tax department has informed me that
the tax treatment and accounting treatment of leases are the same.
Exhibit 2: Audit procedures on current and deferred tax – prepared by Min Wall
Current tax liability
I have reconciled the current tax liability in the statement of financial position at 31 March 20X5
to the prior year balance as follows:
£'000
Current tax liability at 1 April 20X4 465
Current tax expense for year ended 31 March 20X5 (Note 1) 436
Taxation paid in respect of the year ended 31 March 20X4 (Note 2) (512)
Current tax liability at 31 March 20X5 389
Note: Current tax expense for year ended 31 March 20X5

The current tax expense of £436,000 is the amount expected to be paid by Homehand to the tax
authorities for the year ended 31 March 20X5. This has been calculated by Karen Barnes, a
trainee ICAEW Chartered Accountant who works in the Homehand finance department. I have
performed audit procedures on the tax computation prepared by Karen as detailed below:
£'000 Audit procedures
Profit for the year ended 31 March 20X5 2,050 Agreed to the draft financial statements.
Add back:
Expenses not deductible for tax purposes:
Depreciation of non-current assets for 1,185 Agreed depreciation charges to audit
accounting purposes and disallowed for working papers. There were no disposals
tax of non-current assets in the year.
Warranty cost 350 Agreed to analysis of warranty costs – see
below.
Other non-deductible expenses 45 Not material so no detailed procedures

£'000 Audit procedures
performed.
Deduct:
Capital allowances for tax purposes (1,450) Confirmed with BW tax department that
the capital allowances are calculated
correctly according to tax law.
Taxable profit for the year ended
31 March 20X5 2,180
Tax at 20% 436 Recalculated tax due
Explanation of warranty costs

BW's tax department informed me that the tax rules in respect of warranty costs are as follows:
 Increase/decrease in the warranty provision is disallowed for tax purposes.
 Warranty costs paid are allowed as tax deductions.
I agreed Karen's tax adjustment for the warranty cost above to an analysis of the warranty
provision as follows:
£'000
Warranty provision at 1 April 20X4 400
Warranty costs paid in the year (150)
Charge for warranty costs per the statement of profit or loss 350
Warranty provision at 31 March 20X5 600
Note: Taxation paid in respect of the year ended 31 March 20X4

Karen Barnes informs me that the tax payment of £512,000 was higher than the £465,000
liability recognised in the financial statements for the year ended 31 March 20X4 because of an
arithmetical error found by the tax authority on the company tax return which Karen had filed on
1 November 20X4. Karen revised and re-filed the company tax return and Homehand paid the
revised amount of tax of £512,000 on 1 January 20X5.
When revising the company tax return for the year ended 31 March 20X4 Karen noted a further
error. Legal expenses of £105,000 were treated as tax-deductible when they should have been
added back as non-deductible expenses. As the amount is not material, Karen does not propose
to notify the tax authority of this error.
Deferred tax balance
Karen has provided the following analysis of the deferred tax balance at 31 March 20X5:
Taxable temporary difference £'000
Carrying amount of plant and equipment at 31 March 20X5 6,400
Tax base of plant and equipment at 31 March 20X5 (5,300)
Deductible temporary difference 1,100
Warranty provision at 31 March 20X5 (600)

500
Deferred tax balance (20%) 100
The deferred tax liability at 31 March 20X4 was £87,000. Therefore, as the difference is not
material, Karen proposed that it is not worth adjusting the deferred tax liability at
31 March 20X5. I have therefore not carried out any further audit procedures.
I have identified the following further issue which may require adjustment to the current and
deferred tax liabilities:

Share option scheme
An expense of £450,000 is included in the statement of profit or loss for the year ended
31 March 20X5 in respect of share options granted on 1 April 20X4. The share option expense is
based on 1,000 options vesting for each of 450 employees on 31 March 20X7. Each option has
an exercise price of £4 and had a fair value of £3 at 1 April 20X4.
The BW tax department informed me that Homehand will receive a tax deduction only when the
options are exercised and that this will be calculated on the basis of the options' intrinsic value at
that date. (The intrinsic value is the difference between the share price and the exercise price on
the exercise date.) The price of one Homehand share at 31 March 20X5 was £8.50.

Real exam (November 2015)
43 Larousse
You are Alex Chen, an ICAEW Chartered Accountant. You have just started work as financial
controller at Larousse plc, an unlisted company, which is the parent company of the Larousse
Group. The Larousse Group is a successful business, supplying fashion clothing to supermarkets
and department stores both in the UK and internationally.
Larousse plc designs clothes, but does not manufacture them. However, about 18 months ago
the board decided on a new business policy of vertical integration with its key suppliers. On
1 October 20X4, Larousse plc acquired 100% of the ordinary share capital of two separate
companies, HXP Ltd and Softex Ltd. HXP and Softex are manufacturers of clothing and both
companies supply to Larousse plc.
Currently, Larousse's finance director, Dennis Speed, who is an ICAEW Chartered Accountant, is
out of the country negotiating new contracts with some of the company's significant customers.
The accounting assistant, Marie Ellis, has just started a two-week period of study leave.
Larousse's managing director, Hal Benny, sends you the following email:
To: Alex Chen

From: Hal Benny
Subject: Draft consolidated financial statements for the year ended 30 September 20X5
Welcome to Larousse. It is unfortunate that both Dennis and Marie are away as there is a lot of
urgent accounting work to complete.
Consolidated financial statements
Marie started to draft consolidated financial statements for the year ended 30 September 20X5,
but she did not have time to complete the task before going on study leave. Her draft
consolidation schedule (Exhibit 1) is unfinished and she has prepared some notes that will help
you to complete it (Exhibit 2). I need you to check Marie's work carefully as she has told me that
she is not very knowledgeable about advanced aspects of financial statement preparation.
Performance analysis
Following the acquisition of HXP and Softex on 1 October 20X4, I would like to understand the
difference in the post-acquisition performance of the two subsidiaries, particularly as there is
significant intra-group trading between them (Exhibit 2, Note 3).
Social responsibility reporting and assurance
The board would like to discuss some proposals for social responsibility reporting and
assurance for the Larousse Group. I have prepared a brief summary of these proposals and
related performance targets (Exhibit 3). Also, it has been suggested to me by one of my fellow
directors that our auditors could be asked to provide an additional assurance report which could
be published in our annual report.

Instructions
In summary, I would like you to:
(a) prepare the consolidated statement of profit or loss for the Larousse group for the year
ended 30 September 20X5 and the consolidated statement of financial position at that
date, correcting any errors. Provide explanations and journal entries for any adjustments
you make. You may assume for now that tax and deferred tax will remain unchanged as a
result of your adjustments;
(b) prepare notes for the board analysing and comparing the performance and profitability of
the two subsidiaries for the year ended 30 September 20X5; and
(c) respond to the proposals from the board about social responsibility reporting by:
 explaining the responsibilities of the Larousse Group's external auditors in respect of
the proposed social responsibility reporting (Exhibit 3); and
 determining the scope of an additional assurance report by the external auditors and
describing the type of work that might be involved in providing verification of progress
on the four key targets (Exhibit 3).
Requirements
43.1 Respond to the instructions in Hal Benny's email.
43.2 Identify any potential ethical issues arising for you and for Dennis Speed from the
circumstances set out in the file note in Exhibit 4. Describe the actions that you should
take.
Work to the nearest £100,000. Total: 40 marks
Exhibit 1: Larousse Group – draft consolidation schedule for the year ended 30 September
20X5 – prepared by Marie Ellis
Larousse plc HXP Softex Adjustments Notes Group
£m £m £m £m £m
Revenue 56.5 12.0 16.0 84.5
Cost of sales (33.3) (7.5) (12.5) (53.3)
Administrative expenses (8.3) (1.5) (1.5) (1.0) 4 (12.3)
Selling and distribution (4.7) (0.7) (1.4) (6.8)
costs
Finance costs (1.6) – – (1.6)
Profit before tax 8.6 2.3 0.6 (1.0) 10.5
Income tax expense (1.7) (0.5) (0.2) (2.4)
Profit for the year 6.9 1.8 0.4 (1.0) 8.1

Non-current assets
PPE 38.0 10.8 16.0 64.8
Goodwill – HXP – – – 2.6 1
5.6
Goodwill – Softex – – – 3.0 2
Investment in HXP 12.0 – – (12.0) 1 –

Investment in Softex 22.0 – – (22.0) 2 –
ICAEW 2019 November 2015 questions 131

Larousse plc HXP Softex Adjustments Notes Group
£m £m £m £m £m
Current assets
Inventories 9.2 1.9 1.7 12.8
Trade receivables 10.8 2.0 2.1 14.9
Cash and cash equivalents – 0.6 2.0 2.6
Total assets 92.0 15.3 21.8 (28.4) 100.7

Share capital 10.0 4.0 5.0 (4.0) 1
10.0
(5.0) 2
Share options – – – 1.0 4 1.0

Retained earnings at
1 October 20X4 35.8 7.4 14.0 (7.4) 1
35.8
(14.0) 2
Profit for the year 6.9 1.8 0.4 (1.0) 4 8.1
Non-current liabilities 28.4 – – 2.0 1 30.4

Current liabilities
Trade and other payables 8.2 1.6 2.2 12.0
Current tax payable 1.7 0.5 0.2 2.4
Short-term borrowings 1.0 – – 1.0
Total equity and liabilities 92.0 15.3 21.8 (28.4) 100.7
Exhibit 2: Notes for completion of draft consolidated financial statements for the year ended
30 September 20X5 – prepared by Marie Ellis
Notes
1 Acquisition of HXP
On 1 October 20X4, Larousse plc acquired 100% of the ordinary share capital of HXP for
£12 million in cash. The fair values of the recognised net assets at the date of acquisition
were equivalent to their carrying amounts. Additional deferred consideration of £6 million
will be payable in cash on 30 September 20X7. Dennis told me to use an annual discount
rate of 5%. However, I was not sure what to do with this information, so have ignored it. I
have added one-third of the deferred consideration into the goodwill calculation, as
follows:
£m
Consideration in cash 12.0
Deferred consideration 2.0
14.0
Less: share capital and retained earnings at date of acquisition (11.4)
Goodwill on consolidation 2.6
2 Acquisition of Softex
On 1 October 20X4, Larousse plc acquired 100% of the ordinary share capital of Softex for
£22 million in cash. The fair values of the recognised net assets at the date of acquisition
were equivalent to their carrying amounts. Dennis left a note on the file saying that Softex
also had an unrecognised internally-generated research asset valued at £2 million at the
date of acquisition. This asset relates to the development of a waterproof fabric coating
developed by Softex's manufacturing team. As it is an intangible asset, I felt that it was
prudent to ignore this in my goodwill calculation, shown below:

£m
Consideration in cash 22.0
Less: share capital and retained earnings at date of acquisition (19.0)
Goodwill on consolidation 3.0
3 Intra-group trading
I know that some adjustments will be required for intra-group trading, but I have not had
time to do them. I have set out information about intra-group trading in the following table:
HXP Softex
Percentage of revenue from sales to Larousse plc 50% 50%

Percentage of revenue from sales outside the group 50% 50%
Gross profit margin on intra-group sales 40% 20%
Percentage of intra-group purchases for the year remaining in
Larousse plc's inventories at 30 September 20X5 20% 25%
Intra-group receivable from Larousse plc at 30 September 20X5 £1.2 million £1.4 million
Following a review of inventories at 30 September 20X5, the board decided that the
inventories in Softex were impaired and should be written down by £1.2 million. I have
therefore adjusted Softex's cost of sales and inventories by £1.2 million, producing revised
figures of £12.5 million for cost of sales and £1.7 million for inventories.
4 Share options
On 1 October 20X4, Larousse plc introduced a share option scheme for senior staff. Each
share option entitles the holder to subscribe for one Larousse plc share. On 1 October
20X4, 1,000 share options were granted to each of 50 employees and directors. The share
options will vest on 30 September 20X8 to those employees who are still in employment
with Larousse plc at that date. In the year ended 30 September 20X5, four of the
50 employees left the company and it is expected that a further two employees will leave in
each of the remaining years until the shares vest. The fair value of each option was £20.00 at
1 October 20X4, and £21.74 at 30 September 20X5.
I have calculated the cost of the share option scheme in the financial statements for the year
ended 30 September 20X5 as follows:
1,000  (50 – 4)  £21.74 = £1m (to nearest £100,000)
This expense is included in administrative expenses and is credited to equity.
Exhibit 3: Proposals for social responsibility reporting and assurance – prepared by Hal Benny
In recent years, the fashion industry has been subject to criticism. This criticism results from the
fashion industry's perceived indifference to issues such as the wellbeing of staff in developing
countries, the use of child labour and the environmental impact of its activities in cotton
production and dyeing. Now that the Larousse Group has direct interests in production and
supply through our new shareholdings in HXP and Softex, it is timely to reconsider our social
responsibility policies and reporting.
Both HXP and Softex produce a significant proportion of their fashion range in countries with
low economic standards of living. We know that staff in their factories are paid very low wages
and that working conditions are challenging. I have provisionally set four key performance
targets for achievement by HXP and Softex:
(1) A clean water initiative is to be undertaken to mitigate the environmental effects of fabric
dyeing and cotton production. Scientists will monitor water quality regularly.
(2) An effective health and safety programme is to be launched in the factories.

(3) The use of child labour (children under 16 years of age) is to be eliminated within three
years.
(4) Training and development programmes are to be carried out to improve the skills of all
factory workers.
Progress towards achievement of these targets will be disclosed as part of sustainability
reporting to stakeholders in the social responsibility section of the Larousse Group's annual
report for the year ending 30 September 20X6.
Exhibit 4: Ethics file note prepared by Alex Chen
On my first day at Larousse, I was sitting in the staff coffee bar where I overheard a conversation
between two of the office administrators. They were gossiping about Dennis Speed, the
Larousse finance director.
According to their conversation, Dennis Speed may have been involved in unethical activities in
respect of Larousse plc's takeover of HXP. Dennis is married to Lola Gonzalez, a director of HXP.
Prior to the takeover, Lola owned 30% of the shares in HXP. It was suggested that Larousse
overpaid substantially for HXP, and that Dennis facilitated the overpayment in order to benefit
his wife. He did this, allegedly, by colluding with his wife to falsify records submitted to the
accountants who undertook due diligence in respect of the takeover. Dennis is apparently not
well liked; the administrative staff regard him as intimidating and it seems they would be
pleased if he lost his job.
44 Telo
You are Sophie Blake, an ICAEW Chartered Accountant. You have been appointed as the
financial accountant of Telo plc, an unlisted company engaged in running marketing campaigns
for its clients. Telo was established five years ago and its ordinary share capital is held equally by
its three founder shareholders. All three remain directors, and are actively involved in running
the business. The directors' intention is to achieve an AIM listing within the next three years.
Your predecessor was John Birch, a part-qualified accountant who left Telo last month. Before
he left, John prepared a draft trial balance as at 31 August 20X5, the company's year end,
together with some notes (Exhibit).
Telo's auditors are TCC Associates who were appointed three years ago. TCC completed a brief
interim audit in May 20X5, and is due to start work on the final audit next week.
Telo's operations director has given you the following instructions:
"Sophie, I have discussed with TCC the information that they will require next week. I would
like you to review John's draft trial balance and related notes (Exhibit) and prepare a
working paper in which you:
(a) explain the appropriate financial reporting treatment of the four matters highlighted in
John's notes, setting out any necessary adjustments; and
(b) prepare, including your adjustments, a draft statement of profit or loss and other
comprehensive income for the year ended 31 August 20X5, and a statement of
financial position at that date.
"The current tax charge in the trial balance of £350,000 was estimated by John, and you can
assume for the purpose of preparing the draft financial statements that it is correct.
Adjustments in respect of deferred tax may, however, be required."
Requirement
Respond to the instructions of the operations director.
Work to the nearest £1,000. Total: 30 marks

Exhibit – Draft trial balance at 31 August 20X5 − prepared by John Birch
Notes Debit Credit
£'000 £'000
Operating costs 1 11,353 –
Inventories and work-in-progress at 1 September 20X4 1 4,355 –
Sales 2 – 15,680
Selling costs 1,162 –
Administrative expenses 2,340 –
Other income: property letting – 70
Current tax charge 350 –
Ordinary share capital – 60
Trade receivables 2 3,281 –
Trade payables – 3,965
Current tax payable – 350
Cash 82 –
Retained earnings at 1 September 20X4 – 5,051
Revaluation surplus at 1 September 20X4 3 – 971
Property at 53 Prospect Street 3 3,335 –
Computer and office equipment – at cost 242 –
Computer and office equipment – depreciation at
31 August 20X5 – 110
Deferred tax at 1 September 20X4 4 – 243
26,500 26,500
Notes
1 Cost of sales is calculated by adjusting operating costs for opening and closing inventories
and work-in-progress. Inventories and work-in-progress are estimated at each year end in
respect of all of Telo's current marketing campaigns. Unfortunately, I have recently found
that an addition error was made in the calculation of inventories and work-in-progress at
31 August 20X4 and brought forward on 1 September 20X4. Inventories and work-in-
progress at that date should actually have been recognised at £3,742,000.
On 31 August 20X5, inventories and work-in-progress are valued at £4,437,000.
2 In September 20X4, Telo won the contract to provide marketing services to a client,
Sourise, which is based in Nemisland. The contract specified that services should be
invoiced twice a year, and that invoices should be denominated in Nemisland dollars (N$).
Telo sent an invoice for N$220,000 on 31 December 20X4, and another invoice for
N$180,000 on 30 June 20X5. Sourise experienced financial difficulties during the year, but
following refinancing was able to pay Telo N$250,000 on 31 August 20X5. I recorded the
invoices using the relevant exchange rates on the invoice dates, as follows:
Date Rate Invoice amount
(to nearest £'000)
31 December 20X4 £1 = N$1.06 £208,000
30 June 20X5 £1 = N$1.16 £155,000

On 31 August 20X5, I translated the cash receipt of N$250,000 at the exchange rate at that
date of £1 = N$1.12. I set the cash receipt first against the 31 December 20X4 invoice,
which settled it in full, then set the balance against the 30 June 20X5 invoice. Following
further correspondence with Sourise, Telo's directors have decided to make a specific
allowance of 50% against the outstanding receivable at 31 August 20X5. I have not had
time to make this adjustment.
3 The property at 53 Prospect Street was bought by Telo on 1 September 20X2 for £2 million
(land £300,000 and buildings £1.7 million). The directors decided to measure the property
under the revaluation model, and to apply an annual depreciation rate to the buildings of
1%, assuming no residual value.
The first revaluation of the 53 Prospect Street property took place on 31 August 20X4. A
chartered surveyor valued the property at £3,180,000 (of which land comprised £600,000).
No change was made to the expected useful life of the property at that date.
It was clear by late 20X4 that the property was too small for Telo's rapidly-increasing scale
of operations, and the business moved to offices at 15 Selwyn Road on 1 January 20X5. The
15 Selwyn Road offices are occupied under a short-term operating lease.
The Telo directors decided to retain ownership of 53 Prospect Street, and to let it out as an
investment property. A five-year lease was agreed with an unrelated party, which moved
into the property on 1 January 20X5.
The carrying amount of 53 Prospect Street in the trial balance is £3,335,000 and comprises:
£'000
Property at valuation at 31 August 20X4 3,180
Installation of air conditioning system (March 20X5) 100
Professional fees in respect of leasing 53 Prospect Street 25
Costs of relocation to 15 Selwyn Road 30
3,335
As commercial property prices in the area are rising rapidly, the same chartered surveyor
who conducted the valuation at 31 August 20X4 was asked to revalue the property again at
1 January 20X5 and at 31 August 20X5. She produced the following valuations:
Date Land Buildings
£'000 £'000
1 January 20X5 620 2,600
31 August 20X5 650 2,850
On 1 January 20X5, the Telo directors decided to measure 53 Prospect Street using the fair
value model.
4 The deferred tax balance of £243,000 brought forward at 1 September 20X4 arose in
respect of the property at 53 Prospect Street. It was calculated at a tax rate of 20% which
continues to be the applicable rate at 31 August 20X5. Gains on property, plant and
equipment are taxed when the asset is sold. However, the tax rules for calculating gains on
investment properties follow the accounting rules: gains are taxed when they are
recognised in the statement of profit or loss. No other temporary differences arose,
including on computer and office equipment, either at 31 August 20X4 or 31 August 20X5.

45 Newpenny (amended)
You are Cary Lewis, an ICAEW Chartered Accountant working for a firm of accountants and
auditors, Linton LLP. You are the senior assigned to the audit of Newpenny plc, a UK company
which manufactures and distributes a range of vacuum cleaners. You are currently planning the
Newpenny audit for the year ending 31 December 20X5.
Your audit manager calls you into his office and briefs you:
"I have received an email (Exhibit 1) from Rosa Evans, the Newpenny finance director. She
needs our advice on some financial reporting matters and has also provided information about
the purchasing procedures Newpenny now has in place (Exhibit 2). She would like us to take
these updated procedures into account when planning our audit approach, so that we can place
more reliance on internal controls in our audit of trade payables and accruals.
"Our audit of Newpenny's trade payables and accruals for the year ended 31 December 20X4
relied wholly on substantive audit procedures. The results of these audit procedures are
summarised in a memorandum (Exhibit 3).
I need you to prepare the following:
(a) An email replying to Rosa Evans in which you provide, with explanations, the financial
reporting advice she has requested (Exhibit 1)
(b) A memorandum to me in which you respond to Rosa's suggestion that we should place
more reliance on internal controls in our audit of Newpenny's trade payables and accruals
for the year ending 31 December 20X5. I have set out in a note (Exhibit 4) how you should
structure this memorandum and the information you should include. (Ignore the results of
the data analytics noted below.)
(c) I have some concerns about Newpenny's purchase order and receipt of materials systems. I
have therefore taken the opportunity to analyse the purchase data using Linton's new data
analytics system, DAACA. I have provided a 'dashboard' showing the results of this analysis
(Exhibit 5). Using this data, set out and explain any further concerns (in addition to those
identified in (b) above) regarding Newpenny's internal control system for purchase orders."
Requirement
Prepare the documents requested by your audit manager. Total: 40 marks
Exhibit 1: Email from Rosa Evans
Advice needed on financial reporting matters
(1) Jones Engineering Ltd (JE) supplies Newpenny with vacuum cleaner motors. Historically we
have agreed with JE annually in advance the price per motor and JE has invoiced
Newpenny at the agreed price on delivery. In the year ended 31 December 20X4,
Newpenny purchased 75,000 JE motors and the budget, prepared at 1 January 20X5, for
the year ending 31 December 20X5 showed that Newpenny would require 100,000 JE
motors. The price agreed on 1 January 20X5 was £20 per motor.
When our new purchasing manager joined Newpenny in May 20X5, he renegotiated the
contract with JE, resulting in a revised contract for the year ending 31 July 20X6. The
renegotiated contract has the following terms:
 The price per JE motor is reduced to £19 for all motors delivered to Newpenny on or
after 1 August 20X5 and this is invoiced by JE to Newpenny on delivery.
 If the total number of motors ordered in the year ending 31 July 20X6 is less than
100,000 then Newpenny will pay an additional £1 for each motor purchased in the year
ending 31 July 20X6 (resulting in a price per motor of £20).

 If the total number of motors ordered in the year ending 31 July 20X6 exceeds
110,000, then JE will give Newpenny a refund which will reduce to £18.50 the price per
motor supplied in the year ending 31 July 20X6.
At the moment, we are recording the liability to pay JE as invoices are received. Please
explain to me any further accounting entries or disclosures I should make in Newpenny's
financial statements for the year ending 31 December 20X5.
(2) In the last month, Newpenny had an issue with a few of its Model2000 industrial vacuum
cleaners. Customers complained that the vacuum cleaners overheat and one customer
alleged that their vacuum cleaner was the cause of a serious fire. Under its one-year
warranty, Newpenny provides free replacement cleaners to those who complain within the
warranty period. To date, eight vacuum cleaners at a total cost of £1,200 have been
replaced and Newpenny made an offer of £5,000 in compensation to the customer who
reported a fire. Newpenny sells around 10,000 Model2000 vacuum cleaners each year.
The costs to date have been covered by the warranty provision made each year on the basis
of past claims. Please advise me of the approach I should take when assessing the need for
any additional provision in the financial statements for the year ending 31 December 20X5.
Your audit approach
I understand that in last year's audit of trade payables and accruals you relied wholly on
evidence obtained from substantive testing and did not test the operating effectiveness of our
controls. We have introduced updated purchasing internal control procedures and I would like
you to rely as much as possible on the controls we now have in place. Please give this some
consideration as you perform your detailed audit planning.
I attach a copy of our updated purchasing internal control procedures (Exhibit 2) to assist you.
Rosa
Exhibit 2: Newpenny's updated purchasing internal control procedures – prepared by
Newpenny purchasing manager in July 20X5
Background
Newpenny's purchases can be categorised as follows:
(a) Materials (including components) used in the manufacture of vacuum cleaners
(b) Services such as utilities and agency staff.
Purchase orders
Purchase orders for materials are prepared by the manufacturing department and sent to the
relevant supplier. The orders are authorised by a manufacturing manager in accordance with the
authorisation limits set by the finance department and are entered in the purchasing IT system
by an assistant in the purchasing department. Manufacturing managers each have a limit of
£5,000 for a single order and have a maximum total order value of £100,000 per month.
Authorisation by a senior manufacturing manager is required for orders above these limits.
Purchase orders for services are prepared and authorised by the relevant departments.
Receipt of materials
When materials are received at the factory, staff in the goods received department match the
quantity and type of materials received to a purchase order on the system. If matched, the
delivery is accepted and the purchasing IT system is updated. This entry automatically generates
a 'goods received not invoiced' (GRNI) accrual at standard cost and the printing of a 'received'
sticker which is attached to the goods. The store's manager checks for the presence of this
sticker before moving the goods into the store area.
Goods are moved out of the store area when requested for use in production. The goods are
then deducted from stores records (inventory) and transferred to production costs.
Standard costs for each material or component are set at 1 January each year.

The goods received department staff are instructed that if there is no matching purchase order
on the system, materials should not be accepted.
Receipt and posting of invoice
Invoices are received by various departments and forwarded to the finance department. If the
invoice is for materials, it is matched to the goods received entry (thus removing the GRNI
accrual) and posted to the purchase ledger.
If the invoice is for services for which there is an authorised purchase order, it is posted to the
purchase ledger immediately without further authorisation. If there is no authorised purchase
order, the invoice is sent to the relevant department for approval and only posted to the
purchase ledger once that approval has been obtained.
Month end accruals process
At the end of each month, an assistant in the finance department reviews open purchase orders
(ie, those orders which have not been matched to goods received or invoice) on the system and
determines whether the ordered materials or services were supplied before the month end.
Accruals are made for all items supplied before the month end. The accruals listing is reviewed
by the financial controller, who requests supporting information for a sample of items selected
at random.
Where a supplier provides a monthly statement, this is reconciled to the balance on the
purchase ledger and GRNI accrual for that supplier by a member of staff in the finance
department.
Cash payments
Every two weeks, all items due for payment are selected from the purchase ledger and added to
the automated payment run. The payment run is reviewed and authorised by the financial
controller and one of the other bank signatories before being notified to the bank. The payment
is posted to both the cash book and the purchase ledger. Bank and purchase ledger control
account reconciliations are performed at each month end by the financial controller.
Exhibit 3: Memorandum on trade payables and accruals from the audit working papers for the
year ended 31 December 20X4
We performed the planned audit procedures on trade payables and accruals. The following
findings were noted:
 Our audit procedures on post year-end invoices identified omitted accruals of £103,000
relating to invoices for agency staff work performed before the year end, but invoiced a
month later.
 A review of the GRNI accrual listing revealed old items amounting to £50,000. Newpenny
staff were unable to explain why invoices had not been received and matched to these
receipts of materials.
Exhibit 4: Audit manager's note − memorandum on Newpenny's controls over purchasing
Your memorandum should first explain any general points about Newpenny's control
environment for payables and accruals.
You should then consider the audit assertions relevant to payables and accruals balances,
setting out the following for each assertion:
 An explanation of the assertion as it relates to trade payables and accruals
 The key control activities you have identified from the information provided
 Your initial assessment as to whether the controls you have identified individually or in
combination with other controls are capable of ensuring that the audit assertion is met

 An explanation of any potential internal control deficiencies identifying:
– any gaps you have identified in the control activities;
– matters on which you require additional information; and
– areas where you are concerned that the controls may not be designed effectively to
meet the relevant assertion.
Exhibit 5: Dashboard of results from the application of DAACA data analytics
Newpenny management has made available to Linton all its data files with respect to its
purchases, stores and payables system. Linton's Data Analytics and Controls Assessment system
(DAACA) has been applied to this data.
The DAACA system tested 100% of items for all types of product ordered and received, in the
year ended 31 December 20X4. It analysed data and identified outliers in respect of each of the
following:
Test 1: Size and timing of individual orders and monthly totals for each manufacturing manager.
Test 2: Matching of all orders with goods received notes (GRNs).
Based on the above analytics, the following results have been obtained in the form of the
standard output of the DAACA system, which is the data dashboard.
Test 1: DAACA system – data dashboard
Test Outcome
Frequency of value of
Number of manufacturing managers 30
individual orders for the
Average value per individual order £2,343 year
Average value of monthly total orders £45,864
2500
per manager 2000
1500
Frequency of managers exceeding 16 1000
£90,000 in any one month 500
0
Frequency of managers exceeding zero 00 00 00 00 00
£100,000 in any one month (requiring £10 £20 £30 £40 £50
0- 1- 1- 1- 1-
approval from senior manager) £ 00 00 00 00
£1 £2 £3 £4

Outliers
One manufacturing manager, John Fuller, was identified as an outlier showing the following
data:
Test Outcome
Frequency of
value of individual
Average value per individual order £3,246 orders for John Fuller for
Average value of monthly totals of £64,379 the year
orders
35%
% of individual orders exceeding £4,000 35% 30%
25%
% of individual orders in last three days 27% 20%
15%
of the month 100%
5%
Frequency of John exceeding £90,000 7 0%
of orders in a month 00
0
0
0
0
00
00
00
00
0
£1
£5
£4
£3
£2
-
£0
1-
1-
1-
1-
00
00
00
00
£4
£3
£2
£1
Test 2: DAACA system – data dashboard Top 4 suppliers
Average no of days
Test Outcome delivery terms exceeded
Number of orders matched with GRN 13,546
Number of unmatched orders 1,175 Wilson
Number of unmatched orders over 22

Man Inc
2 months old
Number of unmatched GRNs 17 UUP Ltd
Jones plc
-5 0 5 10

46 Earthstor
Earthstor plc is listed on the AIM of the London Stock Exchange. It is a retailer of clothing and
footwear and sells products to customers in the UK.
You are a newly-qualified ICAEW Chartered Accountant working for the auditors of Earthstor.
Your firm is currently undertaking the audit of Earthstor for the year ended 30 June 20X6 and
you have replaced Greg Troy, the audit senior who has recently been reassigned to another
client. You report to Tom Chang, the audit manager.
Tom Chang gives you the following briefing:
"I have provided you with a draft statement of financial position at 30 June 20X6, prepared by
Earthstor's finance department (Exhibit 1).
"Greg reviewed the minutes of the directors' quarterly board meetings and prepared a file note
in respect of some financial transactions undertaken by Earthstor during the year ended
30 June 20X6 (Exhibit 2).
"Greg has set out Earthstor's draft financial reporting treatment and some additional information
for these transactions, but Greg had concerns about whether the financial reporting treatment is
correct (Exhibit 3).
"Planning materiality is £2.4 million, which represents 5% of profit before tax. We agreed with
the audit committee that we will report to them each misstatement above £120,000 identified
during our audit.
"Please prepare a working paper in which you:
(a) explain the financial reporting implications of each of the transactions noted by Greg from
the board minutes (Exhibits 2 and 3). Recommend appropriate accounting adjustments.
Please ignore any tax or deferred tax implications of these adjustments;
(b) identify the key audit risks arising from each of the transactions (Exhibits 2 and 3) and
recommend the audit procedures that we will need to complete in order to address each
risk;
(c) prepare a revised draft statement of financial position at 30 June 20X6 (Exhibit 1). This
should include any adjustments identified in (a) above; and
(d) explain any corporate governance issues for Earthstor that you identify from Greg's file note
(Exhibit 2). Also, identify any ethical issues for our audit firm and recommend the actions
that our firm should take."
Requirement
Prepare the working paper requested by Tom Chang. Total: 40 marks

Exhibit 1: Earthstor − Draft statement of financial position at 30 June 20X6 – prepared by
Earthstor finance department
ASSETS £'000
Non-current assets
Intangible assets – website development costs 31,300
Financial asset – investment in TraynerCo 8,000
Current assets
Inventories 144,380
Trade and other receivables 22,420
Cash and cash equivalents 71,139
Total assets 333,548

Equity
Ordinary share capital (£1 shares) 10,000
Translation reserve (TraynerCo) (1,500)
171,862
Non-current liabilities 12,175
Current liabilities 149,511
Exhibit 2: File note – Transactions noted from review of the minutes of the directors' quarterly
board meetings – prepared by Greg Troy
I have summarised the key points from the minutes of the board meetings which relate to
complex financial transactions during the year. I have also set out in a separate file note
(Exhibit 3) Earthstor's draft financial reporting treatment for the year ended 30 June 20X6, for
each transaction. I am not sure that the draft financial reporting treatment is always correct.
Meeting on 10 September 20X5
TraynerCo is an unquoted Malaysian company which supplies Earthstor with footwear, a core
product for Earthstor. An interruption in supply from TraynerCo would affect Earthstor's ability to
trade successfully in the footwear market.
TraynerCo suffered a serious cash flow problem in June 20X5 and Earthstor's CEO, Dominic
Roberts, reports that, on 1 July 20X5, he instructed the finance director to provide emergency
finance to TraynerCo. This is an interest-free loan of MYR20 million, repayable at par on 30 June
20X7. (MYR is the currency of Malaysia.) Loans of equivalent risk in the marketplace have an
annual effective interest rate of 6%. In order to secure footwear supplies, the directors
retrospectively approve the loan.
Dominic proposes a long-term investment in TraynerCo. Henry Min, an entrepreneur, owns
100% of the share capital in TraynerCo. Dominic states that Henry Min has agreed to sell 10% of
his shareholding in TraynerCo to Earthstor for MYR45 million. The date of the transaction will be
1 October 20X5.
Although the board approves the purchase of the 10% shareholding in TraynerCo, there is a
dissenting vote from the finance director, who believes that the price to be paid for the shares is
above the market price. The finance director states that he will provide further evidence of the
market price valuation.

Meeting on 10 January 20X6
The board records the resignation of the finance director on 1 January 20X6. In his resignation
letter to the board, the finance director states that he can no longer work with Dominic, who is
dominating the board and allowing a close friendship with Henry Min to compromise his
judgement.
The HR director presents a short report on the process for recruiting a new finance director.
Dominic joins the meeting via teleconference from Singapore. Dominic tells the board that, in
the interim period, the finance department will have to cope until a replacement finance director
is appointed.
Dominic is negotiating the purchase of an office building in Singapore for Earthstor, which will
be rented out entirely to third parties. He asks the board to approve this transaction in advance.
Although details of the purchase are not available, Dominic considers that it is a good
investment opportunity for Earthstor.
After the Singapore office building has been purchased by Earthstor, TraynerCo will relocate its
administration function on 1 August 20X6 to Singapore for tax reasons and has agreed to
occupy one floor of this Singapore office building. Dominic states that no rent will be charged to
TraynerCo as he recently agreed a very low price for Earthstor's purchases of footwear from
TraynerCo.
Meeting on 10 March 20X6
Dominic decided to cancel this board meeting.
Meeting on 30 June 20X6
Dominic reports that the purchase of the Singapore office building has been successful and
presents details of the deal. Earthstor paid SG$10 million on 1 February 20X6 when the
exchange rate was £1 = SG$2.1. (SG$ is the currency in Singapore.) Dominic states that this is a
good price as a similar property was sold for SG$11 million in June 20X6.
Dominic announces the launch on 1 May 20X6 of the new Earthstor website which fully
integrates with Earthstor's inventory and order processing systems. The website now enables
goods to be despatched to the customer within four hours of the order being placed. The
website will provide future benefits to the business for seven years.
Exhibit 3: Draft financial reporting treatment for the year ended 30 June 20X6
Set out below are Earthstor's draft financial reporting treatment and some additional information
for the financial transactions during the year noted from my review of the minutes of the
directors' quarterly board meetings (Exhibit 2).
MYR20 million interest-free loan to TraynerCo
This loan is recognised in trade and other receivables, translated at the exchange rate on
1 July 20X5 of £1 = MYR5. No other entries have been made in respect of this loan. The average
exchange rate for the year ended 30 June 20X6 was £1 = MYR5.5 and the exchange rate at
30 June 20X6 was £1 = MYR6.
Investment in 10% of TraynerCo's shares
The investment in TraynerCo is recognised as a financial asset at its cost on 1 October 20X5 of
£9.5 million (MYR45 million at £1 = MYR5, plus legal fees of £0.5 million). It is translated at the
year-end exchange rate at 30 June 20X6 of £1 = MYR6. A loss of £1.5 million is presented
through other comprehensive income in a translation reserve in the statement of financial
position. On initial recognition, an irrevocable election was made to recognise valuation gains
and losses in other comprehensive income.
In July 20X6, Henry Min sold a further 10% holding of his shares in TraynerCo to a Malaysian
entity for MYR36 million. This valuation reflects a fall in the value of TraynerCo's shares since
1 October 20X5 caused by poor trading results since 1 October 20X5. This fall is due to market
conditions.

Purchase of Singapore office building
The Singapore office building is held at cost in property, plant and equipment. It is translated at
the date of acquisition. No depreciation has been charged and the accounting policy for
investment properties states that they should be recognised at fair value. The exchange rate at
30 June 20X6 was £1 = SG$2.7.
New Earthstor website
The following website development costs have been included in non-current assets:
£'000
Planning costs 3,000
Professional fees for photography and other graphic design 1,300
Fee paid to Tanay (Note) 5,000
Internal software development costs 22,000
31,300
Note: £5 million was paid to Tanay, an internationally-famous singer, who is the 'name behind
the Earthstor brand'.
The above costs have not been amortised in the financial statements.
47 EyeOP
You are Greta Hao, an ICAEW Chartered Accountant working in the finance department at
HiDef plc, an AIM-listed company which manufactures medical equipment. HiDef has several
wholly-owned subsidiaries and prepares consolidated financial statements. Its year end is
30 November.
On 1 December 20X4, HiDef bought 50,000 of the 1 million issued ordinary shares in EyeOP
Ltd, for £700,000. EyeOP makes medical imaging cameras. On initial recognition, HiDef made
an irrevocable election to recognise valuation gains and losses on its investment in 50,000
EyeOP shares in other comprehensive income. On 30 November 20X5, the fair value of the
50,000 shares was £2.5 million and the increase in fair value of £1.8 million was recognised in
HiDef's consolidated other comprehensive income for the year ended 30 November 20X5.
HiDef intends to buy a further 650,000 of EyeOP's ordinary shares on 1 August 20X6 for
£85 million. The fair value of EyeOP's net assets at 1 August 20X6 is expected to be £63 million.
EyeOP has a 31 December year end.
The fair value of HiDef's original shareholding of 50,000 shares is expected to be £6.2 million on
1 August 20X6. HiDef intends to use the proportion of net assets method to value
non-controlling interests.
You receive the following briefing from the HiDef CEO:
"A finance assistant has provided some financial information, which comprises:
 a draft forecast statement of profit or loss and other comprehensive income for EyeOP for
the year ending 31 December 20X6; and
 some notes on outstanding financial reporting issues and assumptions for 20X7 (Exhibit 1).
"The HiDef directors want to understand the impact of buying a further 650,000 shares in EyeOP
on the group's ability to achieve the key group performance targets. I have provided you with
the forecast consolidated statement of profit or loss and other comprehensive income for the
HiDef group (excluding the impact of the proposed purchase of 650,000 EyeOP shares) for the
year ending 30 November 20X6, together with other information and key group performance
targets (Exhibit 2)."

The CEO's instructions
"I would like you to prepare a report for me in which you:
(a) calculate the goodwill relating to the proposed purchase of 650,000 ordinary shares in
EyeOP on 1 August 20X6, which would be included in HiDef's consolidated statement of
financial position as at the year ending 30 November 20X6. For this purpose, use the
expected fair value of EyeOP's net assets at 1 August 20X6 of £63 million;
(b) explain the impact of each of the outstanding financial reporting issues (Exhibit 1) on
EyeOP's forecast financial statements for the year ending 31 December 20X6. Recommend
appropriate adjustments using journal entries;
(c) prepare a revised forecast consolidated statement of profit or loss and other
comprehensive income for HiDef for the year ending 30 November 20X6. Assume that
HiDef buys 650,000 shares in EyeOP on 1 August 20X6 and include any adjustments you
recommend in respect of the outstanding financial reporting issues (Exhibit 1); and
(d) analyse the impact of the purchase of 650,000 shares in EyeOP on HiDef's key performance
targets (Exhibit 2) for the year ending 30 November 20X6 and, where possible, for the year
ending 30 November 20X7.
"Please ignore any tax or deferred tax consequences."
Requirement
Respond to the CEO's instructions. Total: 30 marks
Exhibit 1: Financial information provided by the EyeOP finance assistant
EyeOP – Draft forecast statement of profit or loss and other comprehensive income for the year
ending 31 December 20X6
£m
Revenue (Note 2) 178.9
Cost of sales (Note 2) (92.6)
Gross profit 86.3
Administrative expenses (Note 1) (36.3)
Non-recurring item – development costs (Note 2) (14.0)
Profit from operations 36.0
Finance costs (12.2)
Profit before tax 23.8
Income tax (4.8)
Profit for the year 19.0
Other comprehensive income for the year –
Total comprehensive income for the year 19.0
Depreciation of £4.1 million and operating lease rentals of £5.5 million are included in cost of
sales.

Outstanding financial reporting issues
Notes
1 Pension schemes
EyeOP contributes to two pension schemes on behalf of its employees: Scheme A and
Scheme B. The total contribution paid to the company's pension schemes of £9.2 million is
recognised in administrative expenses. The breakdown of the contribution and details of
the schemes are as follows:
Scheme Details
A EyeOP will make a contribution of £6.4 million to scheme A in the year ending
31 December 20X6.
This scheme is for directors and employees who have worked for more than five
years for the company. EyeOP has a contractual obligation to ensure that its
contributions are sufficient to provide a pension to the scheme members at
retirement. The pension is based on an average of the member's final three years'
salary. Scheme A is separately constituted from Scheme B (see below). Scheme A is
now closed to new members.
B EyeOP will make a contribution of £2.8 million to Scheme B in the year ending
31 December 20X6.
This scheme is for employees who are not eligible for Scheme A.
Contributions create, for an employee, a right to a portion of the scheme assets,
which can be used to buy an annuity on retirement. Contributions are fixed at 7% of
the annual salary for the employer and 3% for the employee.
The following information relates to Scheme A as reported in the financial statements for
the year ended 31 December 20X5:
£m
Pension scheme assets 22.0
Present value of the obligation (60.0)
Post-employment net benefit obligation (38.0)
The scheme actuary provided the following information:

 During the year ending 31 December 20X6, 15 senior employees will be made
redundant and as a consequence, EyeOP will commit to pay additional pensions to
these employees under the terms of their redundancy. This contributes an additional
£4.2 million to the present value of the pension obligation.
 The valuation of the pension scheme assets and the present value of the pension
obligation at 31 December 20X6 are now expected to be £32.6 million and
£74.5 million respectively.
 Other information estimated for the year ending 31 December 20X6:
Yield on high-quality corporate bonds 5% pa
£m
Current service cost 5.9
Benefits paid to former employees 2.1
Actual return on scheme assets 6.3
Except for the recognition of the pension contributions of £9.2 million in administrative
expenses, no adjustments have been made to the draft forecast statement of profit or loss
for the year ending 31 December 20X6.

2 Medical imaging camera – Medsee
On 1 October 20X4, EyeOP started to develop a new medical imaging camera, the
Medsee. Monthly development costs of £4 million were incurred from that date until
1 January 20X6, when EyeOP made a technical breakthrough in relation to this project. On
1 January 20X6, the Medsee was deemed financially and commercially viable and
thereafter development costs decreased to £3.5 million per month until development work
was completed on 30 April 20X6.
Marketing and production of the Medsee began on 1 May 20X6. EyeOP expects to receive
orders for 600 cameras priced at £60,000 each in the year ending 31 December 20X6. The
terms of trade require a non-refundable payment of 25% of the selling price on receipt of
the order. The order is non-cancellable. There will be 50 cameras manufactured and
delivered to customers in the year ended 31 December 20X6 who will pay EyeOP the
remaining 75% of the selling price in January 20X7.
EyeOP anticipates the Medsee having a commercial life of four years, with total sales of
3,500 cameras over that period. It is anticipated that 875 cameras will be delivered in the
year ending 31 December 20X7.
Variable production costs are £22,000 per camera.
In the forecast statement of profit or loss for the year ending 31 December 20X6, EyeOP
intends to expense all Medsee development costs. Because the orders are non-cancellable,
EyeOP intends to recognise revenue in respect of the 600 cameras which customers will
order by 31 December 20X6.
Entries made in the forecast financial statements for the year ending 31 December 20X6 to
reflect the above are:
£m £m
DEBIT Cash 9.0
DEBIT Receivables 27.0
CREDIT Revenue 36.0
DEBIT Cost of sales 13.2

CREDIT Inventories 13.2
DEBIT Non-recurring item – development costs 14.0

CREDIT Cash 14.0
Assumptions for year ending 31 December 20X7
It is expected that the variable production cost per Medsee camera, and its selling price,
will remain unchanged in the year ending 31 December 20X7. Other revenue and costs are
also expected to remain constant.

Exhibit 2: HiDef consolidated forecast statement of profit or loss and other comprehensive
income for the year ending 30 November 20X6 (excluding the impact of the proposed
purchase of 650,000 EyeOP shares)
20X6
£m
Revenue 383.0
Cost of sales (264.2)
Gross profit 118.8
Administrative expenses (102.0)
Finance costs (5.5)
Income tax (2.3)
Other comprehensive income for the year –
Other information
Depreciation of £28.1 million and operating lease rentals of £35.5 million are included in cost of
sales. HiDef's consolidated revenue and costs are expected to remain constant for the
foreseeable future. Revenue for the year ended 30 November 20X5 was £400 million.
Key group performance targets for HiDef
Revenue growth Increase of 7% each year
Gross profit percentage Greater than 35%
EBITDAR/Interest Greater than 12
48 Topclass Teach
You are Mo Ranza, an ICAEW Chartered Accountant who recently joined Jones, Smith & Wilson
LLP (JSW) as an audit senior. You receive the following briefing from Sue Jessop, the JSW
engagement partner:
"Welcome to JSW. I need your help on the audit of Topclass Teach plc (TT) for the year ending
31 August 20X6. TT provides education and training, and it operates from an extensive campus.
TT has been an audit client of JSW for a number of years.
"Our interim audit visit at TT starts next week and I am concerned that we have not yet planned
our audit approach on property, plant and equipment (PPE). The TT financial controller has sent
me the PPE note from the management accounts for the nine months ended 31 May 20X6. This
gives you an idea of the significance of the PPE balances (Exhibit 1). Planning materiality for the
TT audit is £2 million and we will report each proposed misstatement over £40,000 to the audit
committee.
"The only documentation regarding PPE on our audit file is a planning memorandum prepared
in June 20X6 (Exhibit 2) by an audit assistant, Naomi Wills. This was not reviewed by the audit
senior or manager and, while it includes some useful information, it does not specifically identify
or comment on the audit risks.
"I've received an email from the TT finance director, Karel Kovic, which requests advice on the
financial reporting implications of a proposed agreement and updates us on some recent
developments at TT (Exhibit 3)."

Partner's instructions
"What I need you to do is to use the information I have provided to do the following:
(a) Draft a response to Karel's request for advice on the financial reporting implications of the
proposed agreement with Beddezy on the TT financial statements for the year ending
31 August 20X6 (Exhibit 3). You can ignore any tax or deferred tax consequences.
(b) Identify and explain the inherent, control and detection audit risks associated with the audit
of PPE in TT's financial statements for the year ending 31 August 20X6.
(c) Prepare an outline audit approach for TT's PPE balance at 31 August 20X6 which explains
those aspects of our audit of PPE where:
(1) we are able to test and place reliance on the operating effectiveness of controls;
(2) we will need expert input;
(3) audit software can be used to achieve a more efficient audit;
(4) substantive analytical procedures will provide us with adequate audit assurance; and
(5) tests of details should be performed during our interim audit visit.
We can discuss detailed audit procedures once we have agreed on the audit approach."
Requirement
Respond to the instructions of Sue Jessop, the JSW engagement partner. Total: 30 marks
Exhibit 1: PPE note from TT management accounts for the 9 months ended 31 May 20X6 –
prepared by TT financial controller
Freehold land Assets under Fixtures, fittings
and buildings construction and equipment Total
£m £m £m £m
Cost or valuation
At 1 September 20X5 129.5 2.8 29.5 161.8
Additions – 21.8 4.1 25.9
Assets coming into use 13.5 (13.5) – –
Disposals – – (1.5) (1.5)
At 31 May 20X6 143.0 11.1 32.1 186.2
Depreciation
At 1 September 20X5 6.1 – 15.4 21.5
Charge for the period 2.4 – 2.8 5.2
Disposals – – (0.9) (0.9)
At 31 May 20X6 8.5 – 17.3 25.8
Carrying amount
At 1 September 20X5 123.4 2.8 14.1 140.3
At 31 May 20X6 134.5 11.1 14.8 160.4

The forecast for the three months ending 31 August 20X6 includes movements in PPE as
follows:
Freehold land Assets under Fixtures, fittings
and buildings construction and equipment Total
£m £m £m £m
Cost or valuation
At 31 May 20X6 134.5 11.1 14.8 160.4
Additions – 8.0 0.5 8.5
Depreciation charge for the
period (0.8) – (1.0) (1.8)
Revaluation gain 40.0 – – 40.0
At 31 August 20X6 173.7 19.1 14.3 207.1
The revaluation gain shown above is an estimate as the valuation will not be completed until
early September 20X6.
Exhibit 2: Interim audit memorandum on PPE – prepared by Naomi Wills in June 20X6
This memorandum summarises relevant information from our prior-year audit file and
discussions with TT management to date to assist us in determining the risks associated with our
audit of the PPE balance at 31 August 20X6. Points noted are as follows:
 TT's freehold land and buildings comprise teaching facilities, including lecture theatres,
classrooms and specialised laboratories. TT also has surplus land on its campus.
 No audit adjustments were raised in relation to PPE balances during our audit of TT for the
year ended 31 August 20X5.
 Prior-year audit work concluded that controls over the TT purchasing function (including the
purchase and classification of PPE) were appropriately designed and operating effectively.
 The TT register of PPE is maintained on a system which is separate from the main
accounting ledger. This system was developed by the TT finance department and uses
spreadsheets run on a laptop to calculate month-end journals and prepare year-end
reports.
 Freehold land and buildings are recognised at fair value in the financial statements. The
most recent valuation was performed by a professional valuer on 31 August 20X3. TT is
planning to use its own estate's department to determine the value of freehold land and
buildings at 31 August 20X6. A significant increase in value is expected as property values
in the area have increased by an average of 25%.
 During August 20X6, the TT finance department plans to conduct a physical verification
exercise focussing on small equipment and IT assets, as these are considered the
categories of PPE most susceptible to theft or other loss.
 TT has a number of major capital projects in progress during the financial year ending
31 August 20X6. The construction of a new business school was completed in May 20X6 at
a total cost of £13.5 million. Assets under construction include the refurbishment of two
science laboratories and the replacement of the IT system for recording attendance and
marks.

Exhibit 3: Email from Karel Kovic to Sue Jessop – Request for advice and update
I need your advice on the financial reporting implications of a proposed agreement with
Beddezy plc, a UK company which runs an international chain of hotels. Under this agreement,
which we plan to finalise before 31 August 20X6, Beddezy will build both a hotel and a
management training centre using surplus land on our campus. An outline of the key terms of
the proposed agreement is as follows:
 TT will sell land with a carrying amount of £3 million to Beddezy for £5 million.
 Beddezy will build two separate buildings on that land: a hotel and a management training
centre. Each building will occupy half of the land bought by Beddezy.
 The hotel will be operated by Beddezy. TT expects to use approximately half of the hotel
capacity for its visitors, but it has no commitment to do so. The prices of hotel rooms will be
determined by Beddezy based on market conditions and are expected to vary over time. TT
has no rights to acquire the hotel, or the land occupied by the hotel, at any stage in the
future.
 The management training centre will comprise lecture theatres and teaching facilities, with
a wide variety of uses. It will be built by Beddezy and is expected to cost £4 million to build,
excluding the cost of the land. It will be completed by 31 August 20X7. For 15 years from
that date, TT will have exclusive use of the management training centre to run training
courses and conferences.
In return, TT will pay to Beddezy (on 1 September each year) £300,000 to cover both the
rental of the management training centre and the supply of Beddezy staff to clean and
maintain the building, provide security and run the main reception. These staff will work
under the direction of a building manager employed by TT. If TT employed the staff it
would cost approximately £100,000 per annum. At the end of the 15-year period, TT will
have the right to purchase from Beddezy the management training centre and the plot of
land it occupies at a price equal to the market value at that date.
Update on other matters
Here is an update on some other matters before you begin your interim audit visit.
Harry George, our PPE accountant, is on long-term sick leave so his role is being covered by one
of the surveyors within the estates department. Key aspects of Harry's role include maintaining
our PPE register and reviewing all accounting for major building projects.
Work on the two science laboratories refurbishment is progressing. Work on Laboratory 1 was
completed on 1 July 20X6 and the laboratory is now back in use.
Work on Laboratory 2 is also well advanced, but progress has slowed as new regulatory
requirements for some of our advanced engineering courses mean that TT needs to make
changes to the plans. The changes we need to make include additional building work to
demolish and reposition a number of dividing walls, which is expected to add approximately
£100,000 to the total cost.

49 Zego
You are Andy Parker, an audit senior working for Terry & Jonas LLP (TJ), a firm of ICAEW
Chartered Accountants. You have just been assigned to the audit of Zego Ltd, a 100% subsidiary
of Lomax plc, a listed company. Lomax and its subsidiaries operate in the aerospace sector. You
have received the following email from Grace Wu, the audit manager with overall responsibility
for the Lomax Group audit.
To: Andy Parker

From: Grace Wu
Subject: Zego audit for the year ended 31 October 20X6
As you are new to this audit, I have provided some background information about Zego and the
Lomax Group (Exhibit 1). The final audit starts next week.
Zego's finance director, Carla Burton, went on maternity leave in September 20X6. Before she
left, Carla prepared a schedule of information relating to Zego's non-current assets (Exhibit 2).
Our contact in Zego's finance department is now Julia Brookes, a part-qualified accountant who
was appointed as the financial controller earlier this year. Julia has prepared draft financial
statements for the year ended 31 October 20X6 (Exhibit 3).
Two days ago, I met with Grahame Boyle, the Lomax Group finance director, and I attach notes
relating to Zego from that meeting (Exhibit 4).
Yesterday I had a meeting with Zego's chief executive, Jurgen Miles, where we discussed some
important issues arising from the draft financial statements and the current risks and difficulties
that Zego is facing. I attach notes of that meeting (Exhibit 5).
Prepare the following documents.
(a) Notes explaining and, where possible, calculating adjustments that are required to Zego's
draft financial statements for the year ended 31 October 20X6 (Exhibit 3).
Do not prepare revised financial statements, but you should clearly identify areas where
more information is required to make appropriate adjustments.
(b) A working paper setting out the results of preliminary analytical procedures. Include
relevant calculations and explain any issues arising for the audit from the analytical
procedures. Your calculations should take into account any adjustments that you have
proposed to the financial statements.
(c) A memorandum explaining the key audit risks for Zego. Set out the implications of these
risks for the financial statements for the year ended 31 October 20X6 of:
 Zego
 Lomax plc
 The Lomax Group
Requirement
Prepare the documents requested by Grace Wu, the audit manager. Total: 40 marks

Exhibit 1: Background information about Zego and the Lomax Group – prepared by Grace Wu,
audit manager
The Lomax Group supplies communication products to the aerospace industry. The Lomax
Group's strategy in recent years has involved the development of new markets and products,
partly through its own research and development activities and partly through acquisitions of
related businesses.
Zego Ltd specialises in fibre-optic aerospace products. During 20X3 and 20X4 Zego's research
and development team developed a product called Ph244. By 31 October 20X5, orders were
received for this product and the criteria had been fulfilled for recognition of a significant
amount of development expenditure as an intangible asset.
During November and December 20X5, Ph244 achieved expected sales targets. However, in
January 20X6, Zego's largest competitor announced the launch of a rival product which has
proved superior to Ph244. Zego's sales of Ph244 since January 20X6 have fallen.
Planning materiality for Zego has been estimated at £250,000 and for the Lomax Group at
£5 million. We consider all adjustments under £10,000 to be clearly trivial.
The Lomax Group has committed to make a preliminary announcement of its earnings on
5 January 20X7.
Exhibit 2: Schedule of information relating to Zego's non-current assets – prepared in
September 20X6 by Carla Burton, Zego's finance director
Analysis of forecast non-current assets between Ph244 related assets and other assets for the
year ending 31 October 20X6
Property, plant and equipment (PPE)
20X6 20X6
Forecast Forecast 20X5 20X5
Ph244 Other PPE Ph244 Other PPE
£m £m £m £m
Balance at 1 November 5.8 10.0 0.3 8.9
Additions 1.8 2.2 6.0 1.5
Depreciation (0.5) (0.7) (0.5) (0.4)
Balance at 31 October 7.1 11.5 5.8 10.0
Intangible asset: research and development (R&D)

20X6 20X6
Forecast Forecast 20X5 20X5
Ph244 Other R&D Ph244 Other R&D
£m £m £m £m
Balance at 1 November 7.2 8.2 – 7.9
Additions – 1.6 7.2 2.3
Amortisation (1.2) (1.8) – (2.0)
Balance at 31 October 6.0 8.0 7.2 8.2
In the above analysis R&D comprises capitalised development costs.

Recoverable amounts
(1) I believe it is unlikely that impairment losses will arise in respect of 'Other PPE' or 'Other
R&D'.
(2) Included in the £7.1 million forecast for Ph244 PPE at 31 October 20X6 is £6.2 million for a
specially-constructed building for the production of Ph244. It is likely that this building
could be sold for £8 million if it were adapted for more general use. Adaptation costs are
currently estimated at £1.5 million. This building could continue to be used in Zego's
business if future research and development projects are undertaken.

(3) A market is likely to continue to exist for Ph244, although at a much reduced level of
activity. Estimated net cash inflows are:
Year ending 31 October 20X7 £1.4 million
We would need to discount these at around 8% per annum. No significant cash flows are
expected to arise after 31 October 20X9.
Exhibit 3: Zego Ltd – Draft financial statements for the year ended 31 October 20X6 – prepared
by Julia Brookes, Zego's financial controller
Zego Ltd: Statement of profit or loss for the year ended 31 October 20X6
20X6 20X5
£m £m
Revenue 24.8 31.4
Cost of sales (15.2) (18.8)
Operating expenses (7.2) (8.8)
Operating profit 2.4 3.8
Profit before tax 0.6 2.4
Income tax – (0.6)
Zego Ltd: Statement of financial position at 31 October 20X6
20X6 20X5
£m £m
ASSETS
Non-current assets
Intangible asset: R&D 14.0 15.4
32.6 31.2
Current assets
Trade receivables 4.6 5.8
Cash and cash equivalents – 3.6
16.6 17.2
Ordinary share capital 4.0 4.0
Retained earnings 17.0 16.4
21.0 20.4
Long-term liabilities: borrowings 20.6 22.4
Deferred tax 0.6 0.6
21.2 23.0
Current liabilities
Trade payables 3.8 4.4
Tax payable – 0.6
Overdraft 3.2 –
7.0 5.0

Zego Ltd: Statement of cash flows for the year ended 31 October 20X6
20X6 20X6 20X5 20X5
£m £m £m £m
Cash flows from operating activities
Adjustments for:
Depreciation 1.2 0.9
Amortisation 3.0 2.0
Finance costs 1.8 1.4
6.6 6.7
Change in inventories (4.2) 0.4
Change in trade receivables 1.2 (0.7)
Change in trade payables (0.6) 0.9
Cash generated from operations 3.0 7.3
Interest paid (1.8) (1.4)
Tax paid (0.6) (0.7)
Net cash from operating activities 0.6 5.2
Purchase of property, plant and equipment (4.0) (7.5)
Investment in development assets (1.6) (9.5)
Net cash used in investing activities (5.6) (17.0)
Loan (repayment)/financing (1.8) 13.0
Net change in cash and cash equivalents (6.8) 1.2
Opening cash and cash equivalents 3.6 2.4
Closing cash and cash equivalents (3.2) 3.6
Exhibit 4: Notes of a meeting with Grahame Boyle, the Lomax Group Finance Director –
prepared by Grace Wu, audit manager
(1) Lomax paid £18 million for 100% of the shares in Zego on 1 August 20X3, resulting in
£3.75 million of goodwill on consolidation. Zego's performance until the year ended
31 October 20X5 was slightly worse than expected. In particular, the investment in Ph244
was a big disappointment.
(2) Lomax made loans of around £10 million to Zego and Lomax's main board directors have
stated that no more cash will be forthcoming to support Zego. From now on, Zego's
directors must raise all of its finance from sources external to the Lomax Group.
(3) Lomax has no plans to sell its investment in Zego in the near future, but it is likely to take
more steps to exercise control.
Exhibit 5: Notes of a meeting with Jurgen Miles, Zego's Chief Executive – prepared by Grace
Wu, audit manager
(1) The development of Ph244 has been expensive and a disappointment. At 31 October
20X6, Zego had a balance of capitalised development costs of £6 million in respect of the
Ph244 product technology (Exhibit 2). How much of this investment can be recovered is
now uncertain.
Zego recently received an offer of £2.4 million for the Ph244 product technology from a
non-UK competitor. This offer includes the rights to use this intangible development asset
and related plant and equipment, but not the existing inventories or the specially-
constructed production building for Ph244.
The Zego board is considering the offer. It is likely that Zego would incur around £200,000
in legal and related fees if it accepts the offer.

(2) Zego needs to renegotiate its bank finance. Of the long-term borrowings of £20.6 million in
the statement of financial position at 31 October 20X6, £11 million is owed to the
company's bank. The remainder is owed to Lomax plc. Zego met a required repayment of
£1 million to the bank on 1 June 20X6. A further repayment of £1 million is due on
1 December 20X6.
The bank holds fixed and floating charges over Zego's assets, and agreed covenants
requiring an interest cover ratio of at least 1.2 and the gearing ratio to be no higher than
130% (calculated as net debt/equity). Although these covenants were not breached at
31 October 20X6, based on the draft financial statements, the bank has called for a meeting
which will take place next week.
It seems likely that further conditions will be imposed by the bank in order to continue the
existing level of financing. Jurgen thinks that additional financial support will be provided
by Lomax, and is hopeful that finance will be provided for a new project which will require
development investment of around £7 million. Jurgen knows that Lomax has stated that
there will no more finance available for Zego. However, he is confident that finance will,
ultimately, be provided by Lomax if it becomes really necessary.
(3) Of the inventories of £12 million at 31 October 20X6, £3.6 million relates to Ph244
products. Production of Ph244 ceased in June 20X6. Sales of £1.4 million of Ph244 at a
gross profit margin of 40% are expected in the year ending 31 October 20X7.
50 Trinkup
Trinkup plc operates a chain of coffee shops which sell coffee, tea and cakes. Its accounting year
end is 30 September.
On 1 October 20X5, Trinkup acquired 80% of the ordinary share capital of The Zland Coffee
Company (ZCC), a coffee producer and distributor. Trinkup has no other subsidiaries.
You have recently started a new job as the financial accountant at Trinkup. The financial
controller gives you the following briefing:
"I need your help in preparing the consolidated financial statements for the Trinkup group now
that we have acquired ZCC.
"ZCC operates in Zland, a country where the currency is the krone (K). Trinkup paid K350 million
for its investment in ZCC. As ZCC is not a listed company, Trinkup intends to use the proportion
of net asset method to value the non-controlling interest.
"ZCC prepares its financial statements using Zland GAAP. Although there are similarities
between Zland GAAP and IFRS, there are differences in pension accounting and deferred tax is
not recognised under Zland GAAP. I have provided you with a working paper which contains the
draft financial statements for Trinkup and ZCC for the year ended 30 September 20X6, and
notes on the outstanding financial reporting issues (Exhibit).
"I would like you to do the following.
(a) Set out and explain the appropriate adjustments for the outstanding financial reporting
issues (Exhibit) for the year ended 30 September 20X6 for:
(1) the individual company financial statements of Trinkup and ZCC; and
(2) the consolidated financial statements.
You should assume that the current tax charges are correct, but you should include any
deferred tax adjustments.
(b) Prepare Trinkup's consolidated statement of comprehensive income for the year ended
30 September 20X6. Please use the adjusted individual company financial statements.

(c) Calculate Trinkup's consolidated goodwill and consolidated foreign exchange reserve at
30 September 20X6. Show your workings."
Requirement
Respond to the financial controller's instructions. Total: 32 marks
Exhibit: Working paper prepared by the financial controller
Draft statements of comprehensive income for the year ended 30 September 20X6
Notes Trinkup ZCC
£m Km
Revenue 1 189.2 494.6
Cost of sales 1 (124.0) (354.2)
Other operating income 2 15.7 –
Operating expenses 2 (35.0) (188.8)
Profit/(loss) before tax 45.9 (48.4)
Tax 3 (9.0) –
Profit/(loss) for the year 36.9 (48.4)
Other comprehensive loss 4 – (56.6)
Total comprehensive income/(loss) for the year 36.9 (105.0)
Draft statements of financial position at 30 September 20X6

Notes Trinkup ZCC
£m Km
Non-current assets
Property, plant and equipment 6 127.3 244.5
Financial asset – investment in ZCC 64.8 –
Amount owed by ZCC 5 36.4 –
Net current assets 1 30.8 101.0
259.3 345.5
Equity
Share capital 150.0 50.0
Retained earnings at 1 October 20X5 52.8 240.5
Pension reserve 4 – (56.6)
239.7 185.5
Deferred tax 19.6 –
Long-term loan owed to Trinkup 5 – 160.0
259.3 345.5
Notes: Outstanding financial reporting issues

1 In the year ended 30 September 20X6, Trinkup bought coffee from ZCC for K294 million.
Trinkup paid for the coffee on delivery and there are no trading amounts owing to ZCC at
the year end. At 30 September 20X6, Trinkup's inventory includes £18 million of coffee
bought from ZCC. ZCC charges a mark-up of 30% on cost of goods sold.
2 Trinkup's 'other operating income' comprises a management charge to ZCC of
K75.3 million for management support given to ZCC. This charge was paid by ZCC on
30 September 20X6 and is included in ZCC's operating expenses. In future years there will
be no management charge as it is expected that ZCC will not require Trinkup's
management support.

3 ZCC has a K100 million tax trading loss arising in the year ended 30 September 20X6. Zland
tax law allows tax trading losses to be carried forward only against future taxable trading
profits. ZCC expects to make a taxable trading profit next year.
ZCC's accountant has suggested that the Zland tax authorities could investigate the
K75.3 million management charge made by Trinkup to ZCC and challenge the recovery of
ZCC's tax loss. The tax rate for Trinkup and ZCC is 20%.
4 In October 20X5, ZCC set up a defined contribution pension scheme for its directors and
has accrued a contribution of K56.6 million for the year ended 30 September 20X6. This
contribution was paid to the pension fund on 15 October 20X6. Under Zland GAAP,
pension contributions are recognised directly in reserves through other comprehensive
income. Tax relief for pension contributions is claimed in the accounting year in which the
cash is paid to the pension company.
5 On 1 April 20X6, Trinkup made an additional investment in ZCC when it provided a loan of
K160 million to ZCC with interest payable at 5.25% annually in arrears. Trinkup does not
require repayment of this loan in the near future. No adjustments have been made for this
loan other than to include it in Trinkup's non-current assets at the rate of exchange at 1 April
20X6. ZCC has recognised the loan in non-current liabilities. No entries have been made in
either company in respect of the interest on the loan. Interest is taxed on an accruals basis.
6 At 1 October 20X5, there were no differences between the fair value of ZCC's net assets
and the carrying amounts, except for the valuation of land owned by ZCC. PPE included
land, at cost, of K156 million which had a fair value at 1 October 20X5 of K232 million. The
directors do not intend to sell the land. Zland GAAP does not allow revaluations.
The following tax rules apply to PPE in Zland:
 No tax is charged on disposals of PPE.
 Depreciation is an allowable expense for tax purposes.
Other information
£1/K exchange rates were as follows:
1 October 20X5 £1 = K5.4
1 April 20X6 £1 = K4.4
30 September 20X6 £1 = K4.2
Average for the year to 30 September 20X6 £1 = K4.8
51 Key4Link
You are an audit manager, working for ICAEW Chartered Accountants, HJM LLP. You have just
been assigned to finalise the audit procedures for Key4Link Ltd for the year ended
30 September 20X6. Key4Link installs media systems.
You receive the following briefing note from the engagement partner:
Carey Knight, the senior manager working on the Key4Link audit, has had a cycling accident and
will be off work for two weeks. Our audit procedures on Key4Link need to be finalised this week
as I have a meeting with the finance director, Max Evans. I therefore need to understand the
current position regarding our audit work. I have provided you with background information on
Key4Link (Exhibit 1).
Most of our audit procedures are complete and have been reviewed by Carey. Carey's file note
(Exhibit 2), prepared a week ago, lists a number of matters which were at that time unresolved.

Updated information
I asked Kevin Jones, the audit assistant, to find out more information about the unresolved
matters in Carey's file note (Exhibit 2). I have now received a memorandum (Exhibit 3) from
Kevin.
I have also received an email from Max, the Key4Link finance director (Exhibit 4) responding to
some of the unresolved matters in Carey's file note and asking for advice. I have not had time to
review Max's email in detail, but I did note that he is keen for HJM to bid for Key4Link's tax work.
Instructions
I would like you to review all of the documentation provided and complete the following tasks:
(a) For each of the matters identified in Carey's file note (Exhibit 2), taking into account the
procedures already undertaken by Kevin (Exhibit 3) and the observations in Max's email
(Exhibit 4), identify and explain:
(1) any additional financial reporting adjustments required, including journals,
(2) any auditing issues and the additional audit procedures required in order to complete
our audit and reach a reasoned conclusion on the unresolved matters. Identify any
further information required from Key4Link.
You do not need to consider any current tax or deferred tax adjustments.
(b) Explain any ethical issues for HJM arising from Max's request for HJM to bid for Key4Link's
tax advisory work (Exhibit 4). Set out any actions that HJM should take.
Requirement
Respond to the engagement partner's instructions. Total: 28 marks
Exhibit 1: Background information on Key4Link – provided by the engagement partner
At 30 September 20X6, the three directors of Key4Link had the following shareholdings:
Name Position % shareholding in Number of £1

Key4Link ordinary shares held
Jan Furby CEO 50% 50,000

Max Evans Finance director 25% 25,000
Carol Furby (wife of Jan) Marketing director 25% 25,000
Key4Link's draft financial statements for the year ended 30 September 20X6 recognise revenue
of £25 million and a profit before taxation of £3.2 million.
Planning materiality for the financial statements as a whole has been set at £150,000.
Performance materiality is £100,000. Each potential audit adjustment of £5,000 or over should
be recorded for further consideration.
From the audit procedures completed and reviewed to date, we have identified only one
uncorrected misstatement – an understatement of accruals by £50,000 due to an error in the
calculation of the sales commission payable for the quarter ended 30 September 20X6.
Key4Link uses the revaluation model for freehold land and buildings and the cost model for all
other non-current assets.

Exhibit 2: File note – prepared by Carey Knight, HJM senior manager
Set out below is the status of the Key4Link audit as at 28 October 20X6. Our audit procedures
are almost complete, but I have identified the following unresolved matters:
(1) The audit procedures on trade payables are largely complete but the supplier statements
for two key suppliers still need to be obtained and reconciled.
(2) Our audit procedures on the valuation of the company's freehold premises are substantially
complete, but we are awaiting a final signed copy of the report from the external valuer,
Mason Froome. Our audit procedures to date have been based on a draft report which we
understand is unlikely to change. We concluded that specialist input from an auditor's
expert was not required as a third party valuer with appropriate qualifications had
performed the valuation.
(3) Max called me yesterday to say that he has adjusted the financial statements to include a
provision of £175,000 for restructuring costs. I have asked him to provide Kevin, the audit
assistant, with more details.
(4) A Key4Link staff member mentioned to me that some of the senior staff are expecting to
exercise share options as soon as the financial statements for the year ended 30 September
20X6 are signed off. This worried me as no accounting entries or disclosures have been
made in respect of any share option scheme. Therefore, I have asked Max to provide me
with information about the share options.
(5) I have reviewed the Key4Link draft annual report and I believe that the related party
disclosures may be incomplete. The only related party transaction identified is the
remuneration paid to Key4Link's directors, which we have already audited. However, I know
that the Key4Link CEO, Jan Furby, has other business interests and I am therefore
concerned that there may be other transactions to disclose.
Exhibit 3: Update memorandum – prepared by Kevin Jones, HJM audit assistant
This memorandum records the audit procedures I performed during my visit to Key4Link on
4 November 20X6.
Supplier statements
I obtained supplier statements for the remaining two key suppliers, Barnes Communications
(Barnes) and Farnell Engineering (Farnell). I have summarised below how the statements
reconcile to the purchase ledger balance for each supplier at 30 September 20X6.
Balance per Included in Balance per
Supplier Note purchase ledger accruals Difference supplier statement
£ £ £ £
Barnes 1 231,650 21,560 57,230 310,440
Farnell 2 148,000 – 160,000 308,000
Notes
1 The difference of £57,230 relates to a missed accrual for inventory delivered on
28 September 20X6 direct to a customer's premises rather than to Key4Link. As the amount
is not material, no adjustment has been proposed.
2 Farnell's statement is dated 5 October 20X6. It includes an invoice for £160,000 dated
1 October 20X6 for engineering services. I discussed this invoice with Max Evans who
referred me to Jan Furby (CEO), as Farnell is owned by Jan and his brother. Jan told me
that Farnell had performed these engineering services in September 20X6. As this amount
relates to services performed before the year end and is material, I have proposed an audit
adjustment to increase trade payables and cost of sales.

Restructuring costs
I obtained from Max details of the provision for restructuring costs. The board has decided to
outsource its delivery function, which will result in redundancy payments to its drivers and the
disposal of its fleet of trucks. The provision comprises:
£
Carrying amount of trucks at 30 September 20X6 100,000
Anticipated redundancy costs 75,000
175,000
I agreed the carrying amount of the trucks to the non-current asset register at 30 September
20X6, which was tested by our audit procedures on non-current assets. I obtained calculations
for the anticipated redundancy costs; agreed the basis of the calculations to documented advice
obtained from Key4Link's employment lawyer; and agreed all details for each affected
employee to the relevant employment records. I also ensured that all the drivers were included
in the calculation.
Exhibit 4: Email from Max Evans, Key4Link finance director
To: Engagement partner
From: Max Evans
Subject: Audit of Key4Link for the year ended 30 September 20X6
Valuation of freehold premises
Carey asked me to contact our valuer, Mason Froome, for a final copy of his valuation report. I
now have a copy of this.
Jan told me that he had a conversation with Mason at the golf club last week and Mason has
now revised some of the assumptions in his draft report. The final valuation is now £1.2 million,
£200,000 higher than in the draft version of the report which you have audited. We will need to
adjust the financial statements for this.
Share option scheme
Carey also asked me about the company's share option scheme. On 1 December 20X2, five key
members of staff, including me, were each granted options over 500 £1 ordinary shares. Each
option grants the right to acquire one share at an exercise price of £5 per share. These options
vest on 30 November 20X6, provided that the company makes a profit before tax of £2.6 million
or more for the year ended 30 September 20X6. As you know, this profit level is expected to be
achieved and all five of us are planning to exercise our options. I should have mentioned this
scheme to you before but forgot to do so, as there have been no cash entries to account for.
When the options were granted I calculated that each option had a fair value of £45.
Key4Link's tax work
There is also one other matter I would like to discuss at our meeting. Our current tax advisors,
Blethinsock Priory, have told me that they intend to resubmit the company tax return for last year
as they have identified an error, leading to an underpayment of Key4Link's tax. This seems
ridiculous to me – I cannot see why we need to draw attention to this error and I am not happy at
the prospect of paying more tax. I am considering changing advisors and would like HJM to bid
for this work. We are likely to need tax advice in the next few years, so there would be lots of
work for HJM.

52 Konext
Scenario
You work for Noland, a firm of ICAEW Chartered Accountants. Your firm is the auditor of Konext
plc and its subsidiaries. Konext is AIM-listed and is in the business communications sector. It sells
mobile devices to businesses and provides related software and repair services.
Noland has been asked to provide an assurance report on Konext's interim financial statements
for the six months ended 30 June 20X4. You have been assigned to act as audit senior.
The recently-appointed Konext financial controller, Menzie Mees, has provided the following:
 Extracts from the draft consolidated interim financial statements for the six months ended
30 June 20X4 (Exhibit 1)
 An extract from the proposed management commentary drafted by the finance director,
Jacky Jones, who is an ICAEW Chartered Accountant (Exhibit 2)
 A summary of financial reporting issues on which Menzie needs advice (Exhibit 3)
The engagement partner gives you the following briefing:
"I had a meeting with Jacky last week and she mentioned that there had been an information
security issue. She has made some disclosure about this in her proposed management
commentary (Exhibit 2). I have asked her to send more details to you (Exhibit 4)."
"I would like you to:
(a) explain the appropriate financial reporting treatment of the issues in the summary provided
by Menzie (Exhibit 3). Recommend appropriate adjustments, including journals, to the draft
consolidated interim financial statements for the six months ended 30 June 20X4;
(b) prepare a revised consolidated statement of profit or loss for the six months ended
30 June 20X4. Set out analytical procedures on the revenue and gross profit in the revised
statement of profit or loss. Identify potential risks of material misstatement arising from
these analytical procedures; and
(c) set out briefly the key audit procedures required to address each of the risks of
misstatement relating to revenue that you have identified. For these risks, set out separately
the audit procedures for:
 the interim financial statements; and
 the financial statements for the year ending 31 December 20X4.
(d) In respect of the details you receive from Jacky about the information security issue
(Exhibit 4):
 evaluate the adequacy of the management commentary disclosure in relation to the
information security issue (Exhibit 2); and
 explain any ethical issues for Noland and set out the actions Noland should take."
Requirement
Respond to the engagement partner's instructions. Total: 40 marks

Exhibit 1: Extracts from the draft consolidated interim financial statements for Konext for the
six months ended 30 June 20X4 prepared by Menzie Mees, financial controller
Consolidated statement of profit or loss for the six months ended 30 June 20X4
Six months ended Year ended
30 June 31 December
Notes 20X4 20X3 20X3
£'000 £'000 £'000
Revenue
Customised mobile devices 1 30,300 20,700 51,700
Software services 1 18,010 10,800 25,900
48,310 31,500 77,600
Other mobile devices 2 15,700 6,100 20,500
Mobile device repairs 3 2,100 5,200 7,800
Total revenue 66,110 42,800 105,900
Gross profit 39,541 21,625 54,025
Distribution costs (3,823) (3,122) (8,547)
Administrative expenses (6,563) (6,054) (13,755)
Operating profit 29,155 12,449 31,723
Finance costs (1,280) (1,550) (4,125)
Profit before tax 27,875 10,899 27,598
Taxation (2,000) (2,180) (5,520)
Profit for the period 25,875 8,719 22,078
Notes: Operating segments

The type of mobile devices Konext sells are tablet computers. The following are the operating
segments used by the board to make strategic decisions:
1 Konext develops a software service specific for each client which enables the clients'
employees to access the clients' business processes. In each case, the software service
contract includes data security and storage services.
Konext buys mobile devices to which it uploads software specific to the client business. It
then sells the customised mobile devices to the client together with a software service
contract.
2 Konext also sells other mobile devices to customers without customised software services.
3 Mobile device repairs for Konext clients and other customers are undertaken by a division
of Konext called 'Refone' (Exhibit 3).
Exhibit 2: Draft management commentary for the six months ended 30 June 20X4 prepared by
Jacky Jones, finance director
Financial performance
The Konext group had a good financial performance across all operating segments in the first
half of 20X4.
Total revenue increased by 54.5% to £66.11 million in comparison with the equivalent six-month
period ended 30 June 20X3. Konext's sales of all mobile devices are seasonal, with 40% of
mobile devices delivered in the first six months of 20X4.
The directors forecast that total revenue for the year ending 31 December 20X4 will grow by
20% in comparison with the year ended 31 December 20X3.

The directors estimate that the number of devices to be delivered in the year ending
31 December 20X4 will be as follows:
20X4 20X3
Number of devices Number of devices
Customised mobile devices 650,000 636,000
Other mobile devices 392,000 205,000
The combined gross profit margin on sales of customised mobile devices and software services
has increased from the 60% margin achieved in 20X3. The gross profit margins on sales of other
mobile devices and mobile device repairs have remained at 25% and 30% respectively.
Future prospects − New product, the Denwa+
Konext has signed a contract with JUI, a Japanese manufacturer of mobile devices. JUI will sell a
new device called the Denwa+ to Konext. This device will be sold exclusively by Konext to its
customers together with specific software and services where relevant. From August 20X4, sales
of the Denwa+ will gradually replace sales by Konext of its current mobile device.
All the Denwa+ devices will be sold with a guarantee of a replacement device if the original is
damaged. This guarantee will apply regardless of the reason for the damage.
An advertising campaign for the launch of the new Denwa+ device began in May 20X4 in
anticipation of the sales starting in August 20X4.
Information security issue
An information security issue in a Konext subsidiary is under investigation. There is no evidence
that client accounts have been compromised.
Exhibit 3: Summary of financial reporting issues – prepared by Menzie Mees
I have set out below some financial reporting issues. I am not sure that the transactions are
correctly treated in the draft consolidated interim financial statements.
Revenue
In June 20X4, Konext received deposits totalling £2 million from clients for the new Denwa+
device. The clients will make final payments totalling £13 million on delivery of the devices on
1 August 20X4. These clients will also receive a software service contract for two years and a free
guarantee for replacement should the device be damaged or faulty. Revenue in relation to these
sales has been recognised in full and presented in the interim financial statements as follows:
£'000
Customised mobile devices 10,000
Software services 5,000
15,000
An estimate of the cost of sales for these devices has been recognised in the interim financial
statements, assuming a gross profit margin of 60%.
Jacky, the finance director, said that we should recognise the Denwa+ sales in full because the
contracts were signed before 30 June 20X4 and are legally binding. Jacky added that, because
the devices will be delivered before 31 December 20X4, it does not make much difference
whether we recognise the revenue in the first or second half of the year.

Impairment of Refone
In January 20X2, Konext bought the trade and net assets of Refone, a mobile device repair
business. Refone's cash flow is independent of other group cash flows and it is regarded as a
separate cash generating unit. At 30 June 20X4, the carrying amounts of the net assets of
Refone were:
£'000
Brand name 4,175
Goodwill 1,975
Inventory 225
Receivables 1,950
15,875
Payables and other liabilities (3,425)
Net assets 12,450
Recently Konext received an offer of £8 million after selling costs for the Refone trade and net
assets. Jacky told me that there is currently no plan to sell the business as the budget shows that
it can generate pre-tax cash flows of £1,200,000 per annum for the five years to 30 June 20X9.
With a pre-tax annual discount rate of 5%, Jacky believes this business can be a success.
However, I wonder if there should be an adjustment to reflect the fall in value of the assets.
Deferred advertising costs
In March 20X4, Nika, an advertising company, was engaged to market the new mobile device,
Denwa+. On 30 June 20X4, Konext recorded invoices totalling £1 million from Nika for
marketing services delivered by that date by debiting the statement of profit or loss and
crediting the Nika payable account. Konext has agreed to issue 100,000 of its £1 ordinary shares
to Nika, in full settlement of the £1 million owed to Nika. The date of the share issue is expected
to be 1 September 20X4.
However, Jacky has accounted for the £1 million as a prepayment in the interim financial
statements for the six months ended 30 June 20X4 by debiting prepayments and crediting the
statement of profit or loss. She explained to me that the final cost for the marketing services will
depend on the share price on 1 September 20X4 and it should, in any case, be matched against
the deliveries of the Denwa+, which start in August 20X4. I am concerned that this treatment is
not correct.
Defined benefit scheme
Konext operates a defined benefit pension scheme for its senior executives and a defined
contribution scheme for other employees. Konext's employer contributions to the schemes for
the six months to 30 June 20X4 have been charged to the interim statement of profit or loss as
follows:
£'000
Defined benefit scheme 900
Defined contribution scheme 3,600
4,500
The service cost for the defined benefit scheme for the year ending 31 December 20X4 is
expected to be £2.8 million. The six-month interest rate to 30 June 20X4 on a selection of
corporate bonds is 3.25%. The net benefit pension obligation of £2.3 million reported at
31 December 20X3 comprised assets at fair value of £12.2 million and the present value of the
obligations of £14.5 million. To date the scheme has not paid out pensions or other benefits to
beneficiaries of the scheme.

Jacky did not want to incur the cost of asking the scheme actuary to provide measurements of
the scheme's assets and liabilities at 30 June 20X4 as there have been no significant changes
since the actuarial valuation at 31 December 20X3. For simplicity, Jacky told me to charge the
employer contributions to the interim statement of profit or loss and leave the net pension
obligation unchanged.
Exhibit 4: Confidential details about information security issue – prepared by Jacky Jones,
finance director
Last week the Konext IT department emailed me with details of a cyber attack on a Konext data
server in Poland. The data server held clients' business details and bank accounts. It is possible
that data from 500 client accounts could have been accessed during the attack.
There is no evidence so far that client accounts were accessed, so we have not informed the
clients. However, there is some risk that clients could suffer a financial loss.
I have included a statement disclosing the security issue in my management commentary in the
interim financial statements. As this is still being investigated, I don't want to say too much
publicly about it at the moment. Further details will be announced in the year-end consolidated
53 Elac
Scenario
Elac plc is listed on the London Stock Exchange and supplies metal-framed windows for use in
industrial buildings. Elac has investments in several wholly-owned subsidiaries.
You are Elac's financial accountant and you report to Elac's finance director. You have just
returned to work after a holiday. Your assistant, Daniel, an unqualified accountant, has prepared
the first draft of the consolidated financial statements for the year ended 31 May 20X7 using
briefing papers prepared by Elac's finance director. These briefing papers include details of the
following significant matters:
 The increase in Elac's investment in Fenner Ltd and transactions with Fenner Ltd (Exhibit 1)
 Trading outside the UK (Exhibit 2)
The first draft of Elac's consolidated statement of profit or loss for the year ended 31 May 20X7
and its consolidated statement of financial position at that date (Exhibit 3) exclude the results
and balances of Fenner Ltd. Fenner has prepared draft financial statements for the year ended
30 June 20X7. These are shown in a separate column in Exhibit 3.
Exhibit 3 also includes Daniel's notes showing the adjustments that he has made to Elac's draft
consolidated financial statements. The notes explain areas where he is uncertain about the
appropriate financial reporting treatment.
Elac's finance director has asked you to draft a working paper in which you:
(a) explain the financial reporting adjustments required in respect of the matters described in
the briefing papers (Exhibits 1 and 2) and in Daniel's notes (Exhibit 3). Include relevant
journal entries. Identify any further information required. Ignore the effects of accounting
adjustments on taxation; and
(b) prepare Elac's revised consolidated statement of profit or loss for the year ended 31 May
20X7 and consolidated statement of financial position at that date. These should include
the adjustments identified in (a) above.
Requirement
Prepare the working paper requested by Elac's finance director.
Work to the nearest £0.1 million. Total: 30 marks

Exhibit 1: Elac's investment in Fenner Ltd – briefing paper prepared by Elac's finance director
Fenner, an important supplier to Elac, manufactures toughened glass. In 20X4, Elac bought 5%
of the ordinary share capital of Fenner for £50 million. This investment is recognised at cost
(which approximates to its fair value) in Elac's draft consolidated statement of financial position
at 31 May 20X7 (Exhibit 3).
On 1 February 20X7, Elac bought an additional 20% of the ordinary share capital of Fenner for
£350 million in cash from one of Fenner's principal shareholders. This payment was debited to a
suspense account. The additional investment entitles Elac to appoint a director to Fenner's
board. The remaining 75% of Fenner's shares are held equally by three institutional investors,
each of which is entitled to appoint a director to the Fenner board.
Fenner has made losses during its financial years ended 30 June 20X6 and 30 June 20X7 but it
has continued to pay dividends throughout this period. Fenner paid a dividend of 20p per share
on 1 October 20X6 and a dividend of 40p per share on 30 April 20X7.
Trading with Fenner
Fenner sells goods to Elac at cost plus a mark-up of 20%. During Elac's financial year ended
31 May 20X7, Fenner supplied goods to Elac at a price of £145.2 million. Trade takes place
evenly throughout the year. At 31 May 20X7, Elac's inventories included goods supplied by
Fenner at a price of £35.0 million and Elac's trade payables included an amount of £37.6 million
due to Fenner.
Exhibit 2: Trading outside the UK – briefing paper prepared by Elac's finance director
Until recently, all Elac's sales were to the UK construction industry. During the financial year
ended 31 May 20X7, the group started trading with construction companies in Otherland.
Otherland contract
The currency of Otherland is the Otherland dollar (O$).
In September 20X6, an agent for several construction companies in Otherland agreed a one-
year contract with Elac to supply a single type of office window at a price of O$5,000 per
window. The contract started on 1 January 20X7 and Elac expects to make a gross profit margin
of approximately 30%, which is a much larger margin than UK sales.
The contract includes a commitment by Elac to pay the agent a commission of 5% of sales value
in O$, provided that total sales for the calendar year 20X7 exceed 16,000 windows. If total sales
for 20X7 are below 16,000 windows the rate of commission is reduced to 3%. The commission is
payable annually in arrears.
Average monthly sales for the five-month period from 1 January 20X7 to 31 May 20X7 were
1,600 windows and this level of sales is expected to continue for the rest of the 20X7 calendar
year.
Exchange rates:
Spot rate at 1 January 20X7 £1 = O$2.2
Spot rate at 31 May 20X7 £1 = O$2.4
Forward rate (at 1 June 20X7) for 31 December 20X7 £1 = O$2.8

Exhibit 3: Draft financial statements
Draft statements of profit or loss for the year
Elac: consolidated
(excluding Fenner) Fenner to
to 31 May 20X7 30 June 20X7
Notes £m £m
Revenue 1,855.4 382.4
Cost of sales 1 (1,482.9) (272.0)
Operating expenses (270.8) (91.2)
Investment income 2 3.6 –
Profit/(loss) before tax 95.9 (58.5)
Income tax (19.1) 12.0
Draft statements of financial position

Elac: consolidated
(excluding Fenner) Fenner to
to 31 May 20X7 30 June 20X7
Notes £m £m
Non-current assets
Tangible assets 1,799.7 1,180.0
Investments 456.0 –
Suspense account 350.0 –
Current assets
Trade receivables 1 238.9 88.8
Cash 16.4 –
Total assets 3,104.8 1,312.0
Equity
Ordinary share capital (£1 shares) 150.0 10.0
Reserves 2,255.4 208.4
Long-term liabilities 388.3 1,003.2
Current liabilities
Trade payables and accruals 305.6 65.6
Provisions and borrowings 1 5.5 24.8
Total equity and liabilities 3,104.8 1,312.0
Notes to Elac's draft consolidated financial statements for the year ended 31 May 20X7 –
prepared by Daniel
1 Cost of sales includes a provision relating to the Otherland contract. I have classified this as
an onerous contract because of the exchange losses I expect to occur between 31 May and
31 December 20X7. I have calculated expected sales over this period as O$56 million
(7 months  1,600  O$5,000). Using the 1 January 20X7 exchange rate, £ equivalent sales
would have been £25.5 million, but at the 31 December 20X7 forward rate, the £ equivalent
sales will be only £20 million. I have recognised a provision of £5.5 million under current
liabilities.
Elac's trade receivables at 31 May 20X7 include £4.8 million due from Otherland
customers. This is the equivalent of O$10.1 million translated at O$2.1 = £1, which was the
average exchange rate during the period 1 January 20X7 to 31 May 20X7.

I have not recognised any accrual for agent's commission as this is a contingent liability
depending on performance, and should therefore be disclosed only as a note to the
2 Investment income includes the dividends received from Fenner on 1 October 20X6
(£100,000) and on 30 April 20X7 (£1 million). I have made no adjustments in respect of
trading with Fenner.
54 Recruit1
Scenario
You are an audit manager working for Hind LLP, a firm of ICAEW Chartered Accountants with
offices in several countries. You have been assigned to the group audit of Recruit1 plc for the
year ended 30 April 20X7. Recruit1 is the parent of an international group of companies
engaged in executive recruitment and training. You receive a briefing from the engagement
partner on the Recruit1 group audit:
"Our scoping and materiality planning summary (Exhibit 1) provides an overview of the audit
procedures planned at each entity within the Recruit1 group.
"Our audit is nearly complete but I need your help with outstanding matters relating to
Recruit1's subsidiaries in the countries Arca and Elysia. These subsidiaries are R1-Arca Inc and
R1-Elysia Ltd. The local currency in Arca is the Arcan dollar (A$) and in Elysia is the Elysian dollar
(E$).
"Last week I received a reporting memorandum from the Hind audit team in Arca (Exhibit 2)
which I need you to review. I was relieved to receive their report as the team has not replied to
any of our other requests for information.
"During audit planning, R1-Elysia was assessed as an immaterial subsidiary. However, our review
procedures, completed last week, identified that the company bought a property during the
year, resulting in material property and loan balances at 30 April 20X7. I asked the audit senior
to find out more about this property transaction and she has provided additional information
(Exhibit 3).
(a) I would like you to review the reporting memorandum from the Hind audit team in Arca
(Exhibit 2) and for each account identified:
 describe any weaknesses in the audit procedures;
 explain any potential financial reporting and audit issues; and
 set out further audit procedures that either the UK group audit team or the Hind team
in Arca should perform, and identify any additional information needed for these
procedures.
(b) In respect of R1-Elysia's property transaction and loan, review the further information
provided (Exhibit 3) and:
 explain the financial reporting implications for the consolidated financial statements of
Recruit1 for the year ended 30 April 20X7. Recommend appropriate accounting
adjustments; and
 set out any additional audit procedures that should be performed."
Requirement
Respond to the partner's instructions. Total: 30 marks

Exhibit 1: Scoping and materiality planning summary for the Recruit1 group audit for the year
ending 30 April 20X7 (Prepared by Hind UK group audit team in January 20X7)
Recruit1 has trading subsidiaries, located in many countries around the world. All subsidiaries
are wholly owned by Recruit1. All subsidiaries report under IFRS.
The Hind UK audit team is responsible for the audit of the parent company, Recruit1 plc, the
Recruit1 UK subsidiaries and the audit of the consolidated financial statements. The audits of
Recruit1 plc's non-UK subsidiaries are performed by Hind audit teams in the countries where the
subsidiaries are located.
Group planning materiality has been determined at £1.2 million. Scoping and component
materiality are shown below:
Entity Level of component materiality Audit procedures to be

performed by Hind
Recruit1 plc – the parent £850,000 UK audit team

company
UK subsidiaries Materiality will be determined UK audit team
separately for each.
R1-Arca This entity is not required to issue Hind audit team in Arca
audited financial statements and so to perform audit
Results are expected to be
work will be performed using procedures
material to the Recruit1
component materiality of £300,000
group.
(A$600,000 as at 31 December
20X6).
Other non-UK subsidiaries £500,000 UK audit team to perform
(including R1-Elysia) review procedures for
unexpected fluctuations
Results are not expected to
or material balances
be material to the Recruit1
group.
Exhibit 2: Reporting memorandum received from the Hind audit team in Arca on 14 July 20X7
The table below sets out the audit procedures we have performed on the financial statements of
R1-Arca for the year ended 30 April 20X7 and highlights matters arising. All accounts have been
agreed to the consolidation schedules provided to Recruit1. These are reported in A$. At
30 April 20X7, the exchange rate was £1 = A$1.8.
Account A$'000 Notes on audit procedures and matters arising
Revenue 11,172 Selected a sample of items recorded within revenue and

agreed them to invoices and either to the receivables ledger
as at 30 April 20X7 or to a cash receipt. No exceptions were
noted.
Staff costs (4,924) Agreed the total staff costs to payroll schedules provided by
the service company which processes the payroll for R1-Arca.
Other operating (2,652) Agreed a sample of items to supporting documentation,
expenses ensuring that each item is a valid business expense, recorded
in the correct period and correctly classified within operating
expenses. No exceptions were noted.
Interest income 350 No audit procedures carried out as below materiality of
A$600,000.

Profit before 3,946

taxation
Taxation Agreed to draft tax computation prepared by R1-Arca's tax
advisors. Checked that current tax payable is correctly
calculated as taxable profit of A$4.9 million at the Arcan
(1,715) corporate tax rate of 35%.
Retained earnings Reconciled to prior-year financial statements. Retained
at 1 May 20X6 earnings as reported to Recruit1 as at 30 April 20X6 were
A$6,488,000.
The difference of A$2,250,000 is due to the reversal of
revenue which was incorrectly included in the reporting pack
for the year ended 30 April 20X6 as it relates to recruitment
services provided in May and June 20X6.
This error was discovered during the preparation of the
4,238 financial statements for the year ended 30 April 20X7.
at 30 April 20X7
Property, plant 1,065 In accordance with group policy, property, plant and
and equipment equipment is measured at cost and depreciated over its useful
life.
Movements in this account during the year ended 30 April
20X7 relate to immaterial additions and depreciation.
As all movements are below component materiality of
A$600,000, no further audit procedures have been performed.
Trade receivables 2,987 This balance was agreed to a detailed list of receivables which
was reviewed for any related party or unusual balances. No
such items were noted.
A sample of balances with a total of A$453,000 was selected to
be tested for agreement to cash received after the year end.
Of the sample, A$198,000 has been received to date.
As the unpaid element is below component materiality of
A$600,000, no further audit procedures have been performed.
Other receivables 592 No audit procedures carried out as below component
and prepayments materiality of A$600,000.
Cash and short- Agreed to bank statements or investment confirmations.
term investments 4,143
Total assets 8,787
Trade payables 2,218 The only material balance within this account is A$1,715,000
and accruals relating to tax payable – this is discussed above.
Share capital 100 No audit procedures carried out as below component
materiality of A$600,000.

Retained earnings
at 30 April 20X7 6,469
Total equity and 8,787
liabilities
Exhibit 3: Further information on property transaction and loan in R1-Elysia – prepared by audit
senior
I discussed the increase in property and loan balances in R1-Elysia with the group finance
director as I was concerned that the carrying amounts are incorrect.
On 30 September 20X6, R1-Elysia bought a property for E$6 million with a bank loan of
E$6 million taken out on the same date. The loan is repayable in full after five years and interest
is payable annually in arrears at a fixed rate of 6% per annum. In Elysia, a tax deduction for
interest is available only when the interest is paid.
After buying the property, R1-Elysia converted it into a training facility. The conversion took six
months and was completed on 1 April 20X7 when the property was ready for use.
From 1 April 20X7, R1-Elysia has used the property to run training courses for its clients. Also,
training rooms are rented to third parties on a daily or weekly basis. The rental income includes
the use of all facilities, together with some administrative support. Catering is provided as an
optional service. As the property generates rental and other income, it has been classified as an
investment property in the consolidation reporting pack submitted by R1-Elysia. The property is
expected to have a useful life of 25 years.
The carrying amounts of the property and the loan in the consolidation reporting pack at
30 April 20X7 are as follows:
Property Loan
E$'000 E$'000
Initial purchase transaction on 30 September 20X6 6,000 6,000
Conversion and start-up costs incurred (funded from
cash)
External contractor costs 4,200
Allocated salary costs of R1-Elysia employees 850
Marketing costs 900
Security, insurance and other running costs 750
incurred while the building was empty
Interest for 7 months to 30 April 20X7 210
Fair value gain on property due to increase in Elysian 500
property prices in the 7 months to 30 April 20X7
Carrying amounts in the consolidation reporting pack at 13,200 6,210
30 April 20X7
Under Elysian tax rules, capital allowances of 50% of the cost of buying business property,
including all conversion and marketing costs, are given in the year of purchase. Therefore capital
allowances of E$6.35 million, based on a total cost before fair value changes of E$12.7 million,
have been taken correctly into account in calculating the Elysian current tax charge. No tax
deduction is given for depreciation.
No other accounting entries have been made in respect of the current or deferred tax on the
property or the loan. The tax base does not change if the property is subsequently revalued for
accounting purposes. The Elysian corporate tax rate is 35%.
Spot exchange rates are as follows:
30 September 20X6 £1 = E$4.0
30 April 20X7 £1 = E$3.6
Average for seven months from 1 October 20X6 to 30 April 20X7 £1 = E$3.8

55 EF
You are an audit senior working for a firm of ICAEW Chartered Accountants, MKM LLP. You have
been assigned to the audit of EF Ltd, a UK company which sells home furnishings.
In July 20X7, your team completed audit planning and interim audit procedures on EF for its
year ending 31 December 20X7. You prepared a file note (Exhibit 1) outlining the key elements
of your planned audit approach.
The MKM audit manager for the EF audit engagement gives you the following briefing:
"On 31 August 20X7, EF was acquired by a listed multinational company, MegaB plc. I have
received an email from the EF chief financial officer (CFO) (Exhibit 2) which provides information
that may affect our audit plan. MegaB has told the CFO to make some adjustments to EF's
financial statements for four matters. These matters are included in an attachment to the email.
"MegaB is a client of MKM's consulting division and we know its finance team well. We have not
done much work for the MegaB group in the last 12 months but MKM is currently tendering for a
large consultancy contract with MegaB which MKM is keen to win. It is therefore important that
we perform well on the EF audit this year.
"MegaB is audited by Lewis-Morson LLP and today I received a telephone call from the
Lewis-Morson group audit partner. The telephone call raises issues for our audit approach and I
have summarised it in a brief note (Exhibit 3).
Instructions from the MKM audit manager
"I need to respond to the CFO's email (Exhibit 2) and consider its implications for the EF audit.
To help me, please prepare a briefing note in which you:
(a) Explain, for each of the four matters in the email attachment (Exhibit 2), the appropriate
financial reporting treatment in the financial statements of EF for the year ending
31 December 20X7. Identify any additional information you need to finalise the accounting
entries required. Ignore any adjustments for current and deferred taxation.
(b) Identify and explain the changes that we need to make to each element of the planned
audit approach summarised in the file note (Exhibit 1). You should also consider any
additional key areas of audit focus and risk using all the information available.
(c) Explain any ethical matters which MKM now needs to consider in respect of the 20X7 EF
audit and any actions that MKM should take."
Requirement
Respond to the MKM audit manager's instructions. Total: 40 marks
Exhibit 1: File note – planned approach for EF audit – prepared by audit senior in July 20X7
The key elements of our planned audit approach for EF for the year ending 31 December 20X7
are set out below.
We have done the following:
 Agreed engagement terms and an audit fee of £60,000, giving us an inflationary increase
from the prior year.
 Established planning materiality at £800,000 based on a forecast profit after tax of
£16 million for the year ending 31 December 20X7.

 Considered factors affecting the inherent risk associated with the client, noting:
– no new business risks;
– no unusual pressures on management; and
– no factors which cause us to question the effectiveness of the general control
environment.
 Assessed the risk of material misstatement, identifying the following balances and
assertions as key areas of audit focus:
– The accuracy and cut-off of revenue recognition
– The valuation of future obligations for the defined benefit pension scheme
 Evaluated the design of the controls over revenue and trade receivables. We also
performed testing to ensure that these controls had been implemented and we also tested
their operating effectiveness for the six months ended 30 June 20X7. No exceptions were
identified from this work so we plan to rely on the operating effectiveness of controls over
revenue and trade receivables.
 Scheduled our final audit visit for March 20X8 in line with the timing of our audit procedures
in previous years. During this final visit, we plan to update our testing of operating
effectiveness to cover the operation of controls in the six months ending
31 December 20X7.
Exhibit 2: Email from EF CFO
To: MKM audit manager
From: EF CFO
Subject: Information and attachment including adjustments required by MegaB
Change in ownership of EF
EF was acquired by MegaB on 31 August 20X7. As a result, there have been some changes in
EF's staff, systems and procedures. With effect from 1 November 20X7, responsibility for routine
accounting was transferred to the MegaB shared service centre. This now processes all our
accounting transactions. As EF CFO, I still have overall responsibility for the EF financial
statements. I am responsible for reviewing the draft financial statements and for processing
journal entries for judgemental, complex or one-off items.
MegaB does not get involved in detailed operational matters but expects the EF board to
achieve the forecast results. MegaB has made it clear that EF will face cuts in staff if we fail to do
so.
In the future, it may make sense to appoint the MegaB group auditor as the EF auditor.
However, the board has decided that it would like MKM to complete the audit of EF for the year
ending 31 December 20X7. Cost control is very tight under our new owners so I am unlikely to
be able to approve any increase in the £60,000 audit fee already agreed.
Pension scheme
MegaB asked its actuary to provide a valuation of the EF defined benefit pension scheme at
31 August 20X7, as it questioned the assumptions that EF's actuary used last year. Because of
changes in the actuarial assumptions used, the revised valuation resulted in a reduction of
£10.5 million in the net pension obligation recognised at 31 August 20X7. The MegaB auditor
has reviewed the actuarial calculations and is happy with them.
The MegaB actuary has confirmed that he expects his actuarial assumptions to be very similar at
31 December 20X7 and he plans to use the same assumptions at that date.

Re-organisation and bonus costs
Because of MegaB's acquisition of EF, there are several employees whose services will not be
required. A redundancy programme was announced on 1 October 20X7 and 12 members of the
finance and administration staff have already left the company, together with three directors and
six other members of senior management. They received redundancy payments totalling
£1.25 million, which will be recognised in our October 20X7 management accounts.
A further 50 members of staff are due to leave on 28 February 20X8, by which time we hope to
have signed off our financial statements. They will receive redundancy payments totalling
£635,000.
There is a new executive bonus scheme for me and the two other remaining directors of EF. If
the company exceeds its forecast operating profit of £34 million, we will each receive a bonus
payment of £100,000. I have not accrued for this cost, as the bonus will be payable in 20X8.
I summarise below key financial data from EF's management accounts for the nine months
ended 30 September 20X7. The results for October 20X7 are not yet available. I hope to
provide these in early December 20X7.
9 months ended Year ending Year ended
30 September 20X7 31 December 20X7 31 December 20X6
Actual Updated forecast Actual
£m £m £m
Revenue 175.0 274.3 214.0
Gross profit 51.0 76.2 64.2
Operating profit 18.9 34.0 21.4
Profit after tax 14.7 26.0 16.1
Net assets 53.1 74.9 38.4
Performance for the eight months to 31 August 20X7 was in line with the forecast and the previous
year.
In September 20X7, revenue increased by around £15 million because of sales of EF products to
MegaB subsidiaries outside of the UK. These sales represent our first international revenue and
are expected to continue at the same level for the rest of the year. The gross margin is lower
than on EF's other sales, as the prices charged to group companies are lower than those
charged to third parties. I have updated the whole forecast to reflect these sales.
There have been no changes to costs and revenue other than the additional international sales.
Attachment to CFO's email – adjustments required by MegaB

Bob Wright (the MegaB group financial controller) has reviewed EF's accounting policies and
estimates at the acquisition date, 31 August 20X7. He has told me to adjust EF's financial
statements for the year ending 31 December 20X7 for the four matters set out below.
Brand
At 31 August 20X7, an expert valued the EF brand at £20 million and Bob expects to see this
asset in the EF statement of financial position. We have not previously recognised any value for
the brand and I am unsure as to what costs were incurred to acquire or develop it.
Goodwill
MegaB has recognised goodwill of £11.2 million relating to the EF business and Bob wants me
to recognise this in the EF statement of financial position.

Investment property
MegaB has a policy of measuring both its investment properties and all other land and buildings
at fair value and it requires EF to adopt the same policy, although we have historically used the
cost model for all property, plant and equipment (PPE).
MegaB valued EF's PPE as at 31 August 20X7. There was no difference between the carrying
amount and fair value of PPE, except for EF's head office property. The carrying amount of the
property at 31 August 20X7 was £1.3 million, including land at £0.7 million. The property had a
remaining useful life of 30 years at that date.
Because there are plans for EF to vacate the head office property and to rent it to tenants,
MegaB wants us to treat it as an investment property. At 31 August 20X7, MegaB valued the
head office property at £3.7 million, including land at £0.7 million, based on anticipated rental
income.
The head office property has three identical floors and each floor can be rented to tenants
separately. Until 1 September 20X7, EF occupied the whole building. At that date, it signed a
10-year lease with a tenant for the third floor, at an annual rental of £40,000. EF continues to
occupy the other two floors.
Trade receivables allowance
Historically, EF has taken the IFRS 9 simplified approach for trade receivables, measuring the
loss allowance at the lifetime expected credit losses from initial recognition, which typically gave
a small total allowance. Bob has now also asked us to apply the three stage approach that, at
31 August 20X7, would give us an impairment allowance of £1.35 million. An impairment
allowance calculated on the same basis as at 31 December 20X6 would have amounted to
£800,000.
I would welcome your advice as to what, if anything, we should adjust. I am not sure Bob has
really considered the effect on EF's single company financial statements. The above four matters
are not recognised in EF's management accounts.
Exhibit 3: Note of my telephone call with Petra Newton – prepared by MKM audit manager
I received a telephone call today from Petra Newton, the group audit partner from Lewis-
Morson, MegaB's auditor.
Lewis-Morson LLP expects to sign off the group audit opinion by 28 February 20X8.
EF is a significant component of the MegaB group. By 15 February 20X8, Lewis-Morson needs
us to do a full audit of EF's financial statements for the year ending 31 December 20X7, based
on the component materiality of £3 million, and to prepare a reporting memorandum to
Lewis-Morson.
The partner confirmed that Lewis-Morson has completed audit procedures on the defined
benefit pension scheme obligations at 31 August 20X7, so we may not need to perform
separate procedures on these. He will send an email confirming the work done and that no
issues were noted.
It is likely that, during 20X8, the EF business will be transferred into an existing MegaB
subsidiary. As a result, the audit this year may be MKM's last for EF. The MegaB board is
interested only in ensuring that there is no material misstatement at group level. Therefore, it
expects MKM to adopt component materiality of £3 million for the single company EF audit. The
MegaB board sees no great value in the single company audit and just wants it to be completed
as quickly and efficiently as possible.

56 Wayte
You are Damian Field, an ICAEW Chartered Accountant and the financial controller at Wayte Ltd,
a manufacturer of industrial weighing machines. The ordinary shares in Wayte are held equally
by four members of the Benson family, who are also the directors of the company. You have just
returned to work after a period of sick leave. During your absence, Wayte employed an
unqualified accountant, Jenny Smith, on an interim contract.
On your return to work, you received the following note from Gerard Benson, the production
director who is your line manager.
Wayte needs to expand production facilities and requires a loan of £10 million from the bank to
invest in plant and machinery. The bank has asked for information to support Wayte's
application for this loan.
Jenny has prepared a draft information schedule as requested by the bank (Exhibit 1). She has
also prepared a draft statement of cash flows for the year ended 30 September 20X7 (Exhibit 2).
Jenny told me that her work is incomplete and adjustments are still required. She has left some
handover notes for you (Exhibit 3).
I believe that Wayte will have no problem obtaining bank finance because profitability is high
and increasing, liquidity is generally good and there is ample security for the loan.
Instructions
I would like you to do the following:
(a) Explain the financial reporting adjustments required for the year ended 30 September
20X7 in respect of the issues identified in Jenny's handover notes (Exhibit 3). Include
journal entries for each adjustment.
(b) Prepare a revised information schedule for the bank (Exhibit 1) including your financial
reporting adjustments to both the figures and the key ratios.
(c) Prepare a report for the board in which you analyse and interpret the financial position and
performance of Wayte using your revised information schedule and the draft statement of
cashflows (Exhibit 2). Provide a reasoned conclusion on whether the bank is likely to
advance the £10 million loan.
Requirement
Respond to Gerard Benson's instructions. Total: 30 marks
Exhibit 1: Wayte draft information schedule requested by the bank – prepared by Jenny
Performance information for the year ended 30 September
20X7 20X6
£'000 £'000
Revenue 35,400 34,500
Extracts from statement of financial position at 30 September
20X7 20X6
£'000 £'000
Total liabilities 8,490 8,730
Equity 27,180 24,830
Net debt 450

Non-current assets available as security at 30 September 20X7
20X7
£'000
Land 1,000
Buildings 18,200
Financial assets: fair value through OCI 430
Financial assets: fair value through profit or loss 192
Plant and equipment 8,678
28,500
Key ratios
20X7
Gearing (Net debt/equity)  100 1.7%
Gross profit margin 28.3%
Return on capital employed (Operating profit/net debt + equity)  100 16.0%
Exhibit 2: Wayte draft statement of cash flows for year ended 30 September 20X7 – prepared
by Jenny
20X7 20X6
£'000 £'000
Cash generated from operations (Note) 6,320 3,990
Tax paid (810) (790)
Net cash from operating activities 5,510 3,200

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

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

Cash and cash equivalents brought forward 610 496
Cash and cash equivalents carried forward (450) 610
Note: Reconciliation of profit before tax to cash generated from operations
20X7 20X6
£'000 £'000
Investment income (30) –
Depreciation charge 1,100 690
Decrease (increase) in inventories 250 (400)
Decrease (increase) in trade receivables 330 (360)
Increase in trade payables 230 20

Exhibit 3: Handover notes for Damian, financial controller – prepared by Jenny
(1) Financial instruments
I have accounted for the foreign exchange implications of all trading transactions, and I am
satisfied that these are correctly recognised. However, I was unsure about the correct
treatment of the two financial assets and have made no year-end adjustments in respect of
them.
 On 30 September 20X6, Wayte invested in 2% of the issued ordinary share capital of
PSN, a company based in Ausland, where the currency is the Auslandian dollar (AS$).
The investment comprised 2,000 shares and was recognised as a financial asset at fair
value through other comprehensive income with a value of £430,000. Wayte had made
an irrevocable election to treat it in this way. On 30 September 20X7, the shares in PSN
were quoted in an active market at AS$310 per share.
 On 1 January 20X7, Wayte invested in 1% of the issued ordinary share capital of
another Auslandian company, LXP. Wayte bought 50,000 shares at AS$5 each, and the
investment was recognised by Wayte at £192,000. Wayte correctly classified this
investment as fair value through profit or loss. On 30 September 20X7, the shares in
LXP were quoted in an active market at AS$7 per share.
The exchange rates for the Auslandian dollar were:
At 30 September 20X6 £1 = AS$1.4
At 1 January 20X7 £1 = AS$1.3
At 30 September 20X7 £1 = AS$1.6
(2) Revenue
Until recently, Wayte sold weighing machines without service contracts. On 31 July 20X7,
Wayte signed a new contract with a large customer, JM Ltd, to supply weighing machines
together with a two-year fixed-term service contract. For two years after delivery of the
machines, Wayte's engineers will make quarterly visits to JM to service them.
Sales made under this contract in August and September 20X7 were £4,500,000,
comprising machine sales of £3,750,000 and services valued at £750,000. No service visits
are due until December 20X7 at the earliest, so no service costs were incurred under this
contract before 30 September 20X7.
I have left the full amount of £4,500,000 in revenue, but I am not sure if this is correct under
IFRS 15, Revenue from Contracts with Customers.
(3) Deferred tax
A deferred tax balance of £1,200,000 was brought forward on 1 October 20X6. This relates
entirely to temporary differences in respect of the revaluation of land and buildings. I have
made no adjustment to the balance of £1,200,000, but I think it is likely that adjustments will
be required in respect of the following:
 Land and buildings are carried at revalued amounts. I have adjusted for the revaluation
on 30 September 20X7, which increased the value to £19,200,000. The original cost of
the land and buildings was £11,400,000. In Wayte's tax jurisdiction no tax allowances
are given for depreciation charged on land and buildings. A taxable capital gain will
arise in future on the sale of land and buildings. This capital gain is calculated as the
difference between the sale proceeds and the original cost. A tax on capital gains of
20% will apply when the land and buildings are sold.

 Any temporary differences arising in respect of adjustments you make from note (1)
above. The tax treatment for financial instruments follows the accounting treatment in
respect of gains and losses recognised through profit or loss. Deferred tax arises in
respect of gains or losses on financial instruments which are recognised in other
comprehensive income.
(4) Current tax
Adjustments from notes (1) and (2) above may require adjustments to the current tax
charge. Tax is charged at 20%.
57 SettleBlue
SettleBlue plc (SB) is a UK AIM-listed company, operating in the outdoor retail sector. SB owns
several subsidiaries and has an investment in CeeGreen Ltd (CG). Owen-Grey LLP, a firm of
ICAEW Chartered Accountants, is the auditor of SB and its subsidiaries. It also audits CG.
You are an audit senior working on the SB group audit and SB parent company audit for the
year ended 30 September 20X7. Other audit teams from Owen-Grey are responsible for the
individual audits of SB's subsidiaries and CG.
The group audit engagement manager left you the following briefing note including
instructions:
Briefing note
The draft consolidated financial statements for SB for the year ended 30 September 20X7
show profit after tax of £5.3 million. SB uses the proportion of net asset method to value
non-controlling interests when preparing consolidated financial statements.
Our audit procedures are nearly complete and I need your help in respect of the following:
Investment in CG
The SB financial controller, Geri Hawes, has sent me a note with information about two key
matters concerning SB's investment in CG (Exhibit 1).
Audit of parent company's trade and other payables
SB's purchases and its trade and other payables balances have been identified as high audit risk
balances. Ann Zhang, the Owen-Grey audit associate responsible for this area of our work, has
just gone on leave. She has left a file note summarising two issues arising from her audit
procedures for the year ended 30 September 20X7 (Exhibit 2). Ann asked Owen-Grey's data
analytics team to analyse SB's purchase data using our new data analytics system, Titan. This
analysis was delayed and has only just been provided. It includes a dashboard summarising the
results (Exhibit 3).
Instructions
(a) Explain, for each of the two matters identified in Geri's note (Exhibit 1), the appropriate
financial reporting treatment in SB's consolidated financial statements for the year ended
30 September 20X7. Set out appropriate adjustments. Ignore any potential adjustments for
current and deferred taxation.
(b) Review the file note prepared by Ann (Exhibit 2) and the dashboard (Exhibit 3) and:
 identify and explain any weaknesses in the audit procedures completed by Ann on the
two issues;
 analyse the information provided in the dashboard to identify the audit risks; and
 set out any additional audit procedures that we will need to perform.

Requirement
Respond to the audit engagement manager's instructions. Total: 30 marks
Exhibit 1: Note prepared by Geri Hawes, SB's financial controller
There are two key matters concerning SB's investment in CG which have arisen during the year
ended 30 September 20X7.
(1) Additional investment in CG
CG was set up by the Troon family 10 years ago to manufacture tents. CG is one of SB's key
suppliers. On 1 June 20X5, CG issued 100,000 new ordinary £1 shares to SB for cash at
£20 per share. At 30 September 20X5 and 20X6, the issued ordinary share capital was held
as follows:
Shareholder Number of £1 ordinary shares
John Troon 600,000
Ken Troon – John's son 200,000
Sharon Troon – Ken's wife 100,000
SB 100,000
1,000,000
John, Ken and Sharon were the only directors of CG until 1 January 20X7. At 30 September
20X5, SB recognised its investment in CG as a financial asset at fair value through other
comprehensive income at its fair value of £2 million, making an irrevocable election to
recognise it as such. At 30 September 20X6, the SB board estimated the fair value of the
investment to be £2.5 million and an increase of £0.5 million was recognised in other
On 1 January 20X7, John offered to sell his 600,000 shares to SB for £15 million. SB bought
40% of John's shares on 1 January 20X7 for a consideration of £6 million. SB also holds a
call option to buy the remaining 60% of John's shares on 1 January 20X8 for £9 million.
On 1 January 20X7, John resigned as a director of CG. SB appointed two representatives to
the CG board as marketing and production directors. Since they joined the board, CG's
performance has improved significantly and this trend is expected to continue.
In SB's consolidated financial statements for the year ended 30 September 20X7, the
investment in CG is recognised at £8.5 million, as a simple investment in equity instruments,
since SB does not own the majority of the shares in CG.
(2) Share options
On 1 January 20X7, as an incentive to work more closely with SB, Ken and Sharon were
appointed as directors of SB. The service agreement includes the following key terms:
 Ken and Sharon are not paid cash salaries.
 On 1 January 20X9, Ken and Sharon have the right to receive (provided that they are
still directors of SB at 1 January 20X9) either 32,000 SB shares or cash to the equivalent
value of 28,000 SB shares.
 At 1 January 20X7, the fair value of the share route has been calculated at £20 for the
right to receive one SB share on 1 January 20X9.
 The market value of SB's shares at 1 January 20X7 was £22 per share and at
30 September 20X7, it was £24 per share. I have not made any adjustment for this
service agreement in the consolidated financial statements as no cash has been paid.

Exhibit 2: File note: Key issues arising from audit procedures on purchases, trade and other
payables – prepared by Ann Zhang, Owen-Grey audit associate on SB audit
Issue 1: Goods received not invoiced (GRNI) accrual of £610,000
When goods are received in SB's factory, they are matched to a purchase order on SB's
computer system and a goods received note (GRN) is produced and recorded on a list of goods
received not invoiced (GRNI). When the purchase invoice is received from the supplier, it is
matched to the GRN, which is removed from the GRNI list on SB's computer system. The
purchase invoice is then authorised for payment and recorded in the purchases and payables
accounts.
At 30 September 20X7, SB has calculated an accrual of £610,000 from the list of GRNI and made
the following adjustment:
DEBIT Cost of sales £610,000
CREDIT Trade and other payables £610,000
My controls testing of the matching of GRNs to purchase invoices showed that the controls did
not operate effectively during the year ended 30 September 20X7. This was due to
inexperienced SB staff members not matching purchase invoices to the correct GRNs.
Therefore, I tested a sample of 10 GRNs included on the GRNI list at 30 September 20X7 to
make sure that the goods were received before the year-end. I also tested completeness by
agreeing large payments made to suppliers after 30 September 20X7 to the payables account
for the appropriate supplier.
Issue 2: Accrual for a debit balance of £290,000 on MAK Ltd payables account
At 30 September 20X7, the payable account of MAK Ltd, a large supplier of goods to SB, shows
a debit balance of £290,000. This balance arose because SB did not receive purchase invoices
from MAK for goods received in June and July 20X7 when MAK's accountant was on sick leave.
To authorise payments to MAK without purchase invoices, SB's accounts staff used GRNs
prepared by SB's warehouse and recorded on the GRNI list as evidence that the goods had
been received from MAK. SB accounted for the payments to MAK for these goods by crediting
the cash account and debiting MAK's payables account. No adjustment has been made to the
GRNI list for these payments.
SB has corrected the transaction by recording the following journal entry:
DEBIT Cost of sales £290,000
CREDIT Trade and other payables £290,000
I agreed payments of £290,000 made to MAK before 30 September 20X7 to SB's bank
statements. I confirmed that SB did not receive the invoices from MAK by agreeing the amounts
to GRN on the GRNI list at 30 September 20X7. Invoices relating to these goods have been
received by SB and recorded after 30 September 20X7. I have asked SB to provide a supplier
statement from MAK but have not yet received a response.

Exhibit 3: Dashboard of results from the application of the Titan analytics system
SB provided Owen-Grey with its purchases data files for the year ended 30 September 20X7.
Owen-Grey's Titan analytics system has been applied to this data. The system analysed 100% of
purchase orders and goods received notes raised in the year ended 30 September 20X7. The
following results have been obtained:
Test for all data (including MAK Ltd) Outcome Largest 4 suppliers:
Average number of days
Number of purchase orders raised 7,246 from GRN to receipt of
Number of GRNs raised and 6,884 purchase invoice
matched to purchase orders
Average number of days from GRN 10 days MAK Ltd
to receipt of purchase invoice
Number of GRNs not invoiced at 311 CG Ltd
30 September 20X7 (GRNI)
UMD Ltd
Number of GRNs over 2 months old 156
not invoiced at 30 September 20X7
Pegs Ltd
Average order value £1,900
0 10 20 30
One supplier, MAK Ltd was identified as an outlier showing the following data:
Test for MAK Ltd Outcome

Frequency of order value
Number of purchase orders raised 771 for MAK Ltd
Number of GRNs raised and 732 40%
matched to purchase orders 35%
Average number of days from GRN 21 days 30%
to receipt of purchase invoice 25%
Number of GRNs not invoiced at 142
20%
30 September 20X7 (GRNI) 15%
10%
Number of GRNs over 2 months old 122 5%
not invoiced at 30 September 20X7 0%
01 ,400
01 100
0
–£ 0
01 ,80
50
0
£7 –£7
2,
3,
1
2
–£
–£
–£
£0

01
,4
,1
,8
£1
£2
£2

58 EC
EC Ltd is the UK parent company of a diversified manufacturing group. EC Ltd supplies water
irrigation systems.
You are Jess Rowe, and you work for Myner LLP, a firm of ICAEW Chartered Accountants. Myner
LLP has been responsible for the audit of EC Ltd and the companies in the EC group for several
years.
You are assigned to the audit of the EC group for the year ended 31 May 20X8. You report to
Gaynor Fodes, the EC audit engagement partner. The individual company audits of EC Ltd and
its subsidiaries for the year ended 31 May 20X8 are in progress. Gaynor gives you the following
briefing and instructions:
"The EC Ltd audit team has identified three audit issues for my attention (Exhibit 1). These issues
involve judgements made by the EC Ltd directors which increase audit risk and therefore
require extra audit time. I will be discussing these issues with the EC Ltd directors at a meeting
next week.
"I have provided you with the EC group draft summary consolidated statement of profit or loss
and notes (Exhibit 2). This statement of profit or loss does not include any adjustments arising
from the three audit issues identified by the EC Ltd audit team."
Instructions
Gaynor provides the following instructions.
(1) For each of the three audit issues:
(a) Explain and set out the correct financial reporting treatment in the EC group financial
statements and EC Ltd individual financial statements. Ignore the tax impact arising
from any adjustments.
(b) Set out the key audit risks and the relevant audit procedures that we should perform.
(2) Prepare a revised summary consolidated statement of profit or loss including, where
appropriate, your adjustments for the three audit issues.
(3) Explain briefly, without calculations, the impact of your adjustments on the income tax
expense.
Requirement
Respond to Gaynor's instructions. Total: 40 marks
Exhibit 1: Audit issues identified by EC Ltd audit team
Issue 1: Disposal of shares in Luka Ltd
Ten years ago, EC Ltd paid £10.5 million for 75,000 shares in Luka Ltd, which represented 75%
of Luka's 100,000 issued ordinary shares. An unconnected Japanese company owns 25% of
Luka's issued ordinary shares.
Luka Ltd manufactures water pumps.
On 1 December 20X7, EC Ltd sold 60,000 of its shares in Luka for £7.9 million to Walter Brown,
Luka's CEO. The fair value of EC Ltd's remaining 15% investment in Luka was estimated to be
£1 million at that date.

The directors have made a judgement that EC Ltd no longer has control over Luka and it should
not consolidate Luka as a subsidiary. They also judged that EC Ltd does not have significant
influence over Luka. EC Ltd's financial statements and the EC draft consolidated financial
statements for the year ended 31 May 20X8 show an investment in 15,000 shares in Luka at cost
of £2.1 million.
In the draft consolidated financial statements for the year ended 31 May 20X8, the directors
have treated Luka as a discontinued operation as they believe that Luka represents a major line
of business from which EC has now withdrawn. Luka's loss for the six-month period to
1 December 20X7 has been presented as one figure in the consolidated statement of profit or
loss. A loss of £500,000 on disposal of the shares in Luka is also included. This is calculated as
proceeds of £7.9 million less cost of £8.4 million, being £10.5 million  60,000/75,000 shares
(Exhibit 2, note 2).
We believe that the financial reporting treatment of the sale of Luka shares may not be correct.
The following information was noted during our audit procedures:
 Two of the four members of Luka's board are also EC Ltd board directors. The Japanese
company is represented by one director on the Luka board.
 Luka buys filter systems from WFT Ltd, a 100%-owned subsidiary of EC Ltd. The filter system
is designed specifically for Luka's water pumps.
 Luka continues to use the EC group's shared service centre, which provides Luka with
marketing and accounting services for a monthly fee.
Issue 2: Contingent liability
EC Ltd competes internationally for large contracts to supply irrigation systems for farms. The
contracts are with governments and local contractors. Local law often requires EC Ltd to use
commercial intermediaries and, in some countries, the tender process is open to corruption.
EC Ltd has control procedures to ensure that all contracts are compliant with UK and local law.
Breaches of laws can lead to fines and restrictions on future business.
In January 20X8, a fraud investigation commenced into bribery and corruption, in a country in
which EC Ltd operates. EC Ltd is being investigated and is cooperating with the authorities.
We reviewed minutes of EC Ltd directors' meetings which show that the fraud investigation was
discussed on 12 January 20X8. The directors are satisfied that EC Ltd's control procedures have
mostly been complied with, but that there could be isolated occurrences where intermediaries
were paid sums of money by EC Ltd personnel to secure contracts. Advice from EC Ltd's internal
legal department was presented to the directors as follows:
 Similar investigations in other countries have taken five years to be resolved.
 Estimates of the likelihood of EC Ltd being found liable for fines are as follows:
Estimate of fines Probability
No fines payable 52%
£1.0 million 38%
£1.5 million 10%
The directors have made a judgement that because the investigation is ongoing and it is difficult
to identify if, or when, any fines will be payable, only a contingent liability note should be
included in the financial statements for the year ended 31 May 20X8.
The board minutes also record that future operating losses caused by the restriction of trade
during the anticipated five-year investigation are expected to be £100,000 each year, regardless
of the outcome of the fraud investigation. Therefore, a provision of £433,000 (using a 5% pa
interest rate for the time value of money) is included in operating expenses in the financial
statements for the year ended 31 May 20X8.

Issue 3: Sale of manufacturing division in Spain
EC Ltd owns a manufacturing division in Spain which consists of a factory, an office building and
plant and equipment. The division makes water pumps which EC Ltd uses for its irrigation
systems. Because of wage increases in Spain, it is now cheaper for EC Ltd to buy a similar pump
from a UK supplier. Therefore, on 1 March 20X8, the EC Ltd board decided to sell some of the
Spanish division's assets. The carrying amounts of the division's property, plant and equipment
are as follows:
Factory Office
(including (including Plant and
land) land) equipment
£'000 £'000 £'000
Cost at 31 May 20X7 and 31 May 20X8 4,385 4,640 4,850
Accumulated depreciation at 1 June 20X7 (685) (800) (1,986)
Depreciation for the year ended 31 May 20X8 (137) (160) (286)
Carrying amount at 31 May 20X8 3,563 3,680 2,578
The factory and office buildings are depreciated over 25 years with zero residual values and
plant and equipment is depreciated at 10% pa on a reducing balance basis.
On 1 March 20X8, a surveyor in Spain valued the factory (including land) and office (including
land), in euro, as follows:
€'000 Notes on valuation method
Factory 5,040 The valuation is based on the price per square
metre achieved in the sale of a similar property in
February 20X8.
Office 5,570 As no similar properties have recently been sold,
the valuation is based on forecast rental income
per square metre and occupancy rates.
EC Ltd advertised the factory for sale in March 20X8 and expects to sell it within six months.
EC Ltd decided that it would achieve a higher return by renting out the office building. On
1 March 20X8, EC Ltd signed a three-year agreement to lease the office building to an
unconnected company. EC Ltd's accounting policy is to recognise investment properties at fair
value.
On 30 June 20X8, EC Ltd received an offer from a Spanish company to buy the plant and
equipment for €2,519,000.
Exchange rates for the € are:
1 March 20X8 £1 = €1.20
31 May 20X8 £1 = €1.10
30 June 20X8 £1 = €1.12
The directors told the audit team that, because of the uncertainty regarding the recoverable
amount of the manufacturing division's assets, no adjustments have been made to EC Ltd's
non-current assets in the draft consolidated financial statements at 31 May 20X8.

Exhibit 2: EC group − draft summary consolidated statement of profit or loss for the year
ended 31 May 20X8
Continuing operations £'000
Revenue 31,170

Income tax expense (Note 1) (380)
Profit from continuing operations 1,516
Discontinued operations
Loss from discontinued operations (Note 2) (1,250)
Notes
1 Income tax expense
The income tax expense includes adjustments for current tax and deferred tax at 20%.
Income tax is calculated for each group company based on 20% of the accounting profit,
except for the following tax rules relating to non-current assets:
 No tax implications arise from a profit or loss on disposal of shares.
 No tax relief is given for a depreciation expense or an impairment charge for buildings
or plant and equipment.
 Tax depreciation is available for purchases of plant and equipment. No tax
depreciation is available for buildings.
 Tax is payable on gains when a building is sold and is calculated based on the
difference between the disposal proceeds and the original cost.
2 Loss from discontinued operations of Luka
On 1 December 20X7, EC Ltd sold 60,000 of its shares in Luka. Luka's loss for the six-month
period from 1 June 20X7 to 1 December 20X7, together with the loss on the disposal of
these shares, are presented as a single line in the statement of profit or loss as discontinued
operations. This comprises:
£'000
Loss before taxation (890)
Income tax 140
Loss after taxation (750)
Loss on disposal of shares in Luka (500)
Loss from discontinued operations (1,250)
Luka's net assets at 31 May 20X8 were £9.25 million. Luka's revenue for the year ended
31 May 20X8 was £15 million. It made a loss of £1.5 million after tax for the year ended
31 May 20X8. Luka's revenue and loss arise evenly throughout the year. Goodwill arising on
the consolidation of Luka was fully impaired at 1 June 20X7. EC Ltd measures non-controlling
interests using the proportion of net assets method.
59 Raven plc
Raven plc is an unlisted company which manufactures electrical products.
You are an ICAEW Chartered Accountant. You have just been appointed as financial controller
at Raven. The previous financial controller left in July 20X7 and, since then, Raven's accounting
has been under the temporary control of Simon, a part-qualified accountant.

Simon has prepared draft financial statements for the year ended 30 April 20X8 with extracts
provided in Exhibit 1. Simon has been unable to deal with some complex financial reporting
matters and has left you notes on the issues that require further work (Exhibit 2).
Requirements
(1) Explain the appropriate financial reporting treatment for each of the items in Simon's notes
(Exhibit 2) and set out the adjusting journal entries required.
(2) Prepare revised financial statement extracts which include your adjustments.
(3) Explain the implications of the new leasing financial reporting standard, IFRS 16, Leases for
Raven's future financial statements in respect of the sale and leaseback of Raven's
administration building.
Total: 30 marks
Ignore current tax and deferred tax
Exhibit 1: Raven plc: Extracts from draft financial statements – prepared by Simon
Extracts from statement of comprehensive income for the year ended 30 April 20X8
£'000
Other comprehensive income −
Extracts from statement of financial position at 30 April 20X8
Notes (see Exhibit 2) £'000
Non-current assets
Property, plant and equipment 3 and 4 53,860
Suspense account − one 1 6,757
Financial asset 1 706
61,323
Current assets 17,859

TOTAL ASSETS 79,182
Equity
Share capital (£1 ordinary shares) 200
Revaluation reserve 3 and 4 6,200
Cash flow hedge reserve 1 706
Other reserves 600
33,626
Loans 18,650
Pension – net defined benefit liability 5 136
Suspense account − two 4 7,000
25,786
Current liabilities 2 19,770

TOTAL EQUITY AND LIABILITIES 79,182

Exhibit 2: Notes on financial reporting issues – prepared by Simon
(1) Cash flow hedge
On 1 March 20X7, Raven signed an agreement to purchase a new machine from a supplier
in Ruritania, where the currency is the Ruritanian dollar (R$). The machine, costing
R$50 million, was delivered and paid for on 31 July 20X7. On 1 March 20X7, to provide a
hedge against exchange rate movements, Raven entered into a forward contract to buy
R$50 million on 31 July 20X7 at a rate of £1 = R$7.4. All necessary documentation was
prepared for hedge accounting and the contract was designated as a cash flow hedge.
In respect of the forward contract, a financial asset of £705,930 was recognised in the
statement of financial position at 30 April 20X7. An equal amount was recognised, through
other comprehensive income, in a cash flow hedge reserve.
This was the first time that Raven had designated a hedging arrangement. The arrangement
meets the requirements for hedge accounting specified in IFRS 9, Financial Instruments,
including the hedge effectiveness criteria.
On 31 July 20X7, the machine was purchased as planned and the forward contract settled.
On that date, the following journal entries were made:
£ £
DEBIT Suspense account − one (R$50,000,000/5.7) 8,771,930
CREDIT Cash 8,771,930
DEBIT Cash 2,015,173

CREDIT Suspense account − one 2,015,173
The net debit to suspense account − one was £6,756,757. No further entries have been
made in respect of the machine purchase or the cash flow hedge. The machine is to be
depreciated on a straight-line basis over five years, assuming zero residual value.
Spot and forward exchange rates were as follows:
Forward
Spot (for delivery on 31 July 20X7)
1 March 20X7 £1= R$7.3 £1= R$7.4
30 April 20X7 £1= R$6.5 £1= R$6.7
31 July 20X7 £1= R$5.7 £1= R$5.7
(2) Issue of ordinary shares

On 1 May 20X7, Raven had 200,000 £1 ordinary shares in issue.
On 1 November 20X7, Ester Ltd, one of Raven's suppliers, agreed that each month it would
supply goods at a fair value of £2,000 in exchange for 50 new £1 shares in Raven. This
agreement is for a period of two years until 31 October 20X9.
As a result, in the year ended 30 April 20X8, 300 £1 ordinary shares were issued to Ester.
No accounting entry has yet been made in respect of the share issue, but the following
entry has been made in respect of goods purchased from Ester between 1 November 20X7
and 30 April 20X8:
£ £
DEBIT Cost of sales 12,000
CREDIT Trade payables 12,000

(3) Non-current assets: fixed production line
Raven has a fixed production line. It has a policy of revaluing this production line because of
its specialist nature. No annual transfer for depreciation is made from revaluation reserve to
retained earnings.
This production line cost £8 million on 1 May 20X2. It was to be depreciated on a
straight-line basis over 10 years, with an estimated nil residual value. The asset was revalued
on 30 April 20X5 to £6.3 million. The asset's estimated useful life and residual value were
unchanged.
An impairment review of the asset took place on 30 April 20X8, at which date the
production line had an estimated fair value less costs to sell of £2.6 million and a value in
use of £2.8 million. No impairment has been recognised in respect of this fixed production
line in the draft financial statements.
Depreciation on the production line has been correctly calculated for the year ended
30 April 20X8 before taking into account any revaluation or impairments.
(4) Leased asset: administration building
Because of a shortage of cash in the business, Raven's directors decided to sell the
company's administration building for £7 million on 1 May 20X7, leasing it back
immediately from the building's new owners for a period of 10 years. Raven does not have
an option to buy back the building.
The market value of the building on 1 May 20X7 was estimated by an independent surveyor
to be £9 million. The carrying amount of the building immediately before the sale was
£10 million.
Raven has a policy of revaluing its land and buildings. The revaluation reserve includes an
amount of £1 million in respect of this building. No annual transfers for depreciation are
made from revaluation reserve to retained earnings.
The receipt of cash of £7 million on 1 May 20X7 was debited to cash and credited to
Suspense account − two. No other accounting entries have been made in respect of the
disposal of the building.
The building's lease requires an annual rental payment of £540,000, payable in advance
every 1 May. The first payment was made on 1 May 20X7 and was debited to rental
expenses in profit or loss. The payment of £540,000 represents an annual market rate for
the lease of the building. Raven expects to continue to occupy the building, which has a
remaining useful life of 50 years, for the next 10 years.
As a separate matter, the CEO has heard about a new leasing standard and has asked
about the implications for future financial statements in respect of this lease.
(5) Pension scheme
Raven operates a defined benefit pension scheme for its directors.
On 1 May 20X7, the fair value of the pension scheme assets was £2,830,000 and the
present value of the pension scheme obligations was £2,966,000, resulting in a net defined
benefit liability in the statement of financial position at that date of £136,000.
During the year ended 30 April 20X8, the scheme received contributions of £575,000 from
Raven. This amount has been debited to staff costs.
According to Raven's actuary, the current service cost for the year ended 30 April 20X8 was
£390,000. Benefits were improved during the year resulting in past service costs of
£120,000. The amount of benefits paid in the year by the pension scheme was £330,000.

Raven's actuary estimates the fair value of the pension scheme assets at 30 April 20X8 to be
£3,248,000 and the present value of the pension scheme obligations at that date to be
£3,457,600.
An annual discount rate of 5% is to be applied to the pension scheme assets and liabilities.
60 MRL
You are an audit senior working for Cromer Bell LLP, a firm of ICAEW Chartered Accountants.
You have been assigned to the audit of Miles Recruitment Ltd (MRL) for the year ending
31 August 20X8. MRL provides recruitment services to the financial services, transport and
technology sectors. It earns revenue by charging business customers a fee for identifying
appropriate employees to fill job vacancies.
MRL is a wholly-owned subsidiary of Milcomba, a listed company incorporated in Elysia. Cromer
Bell's Elysian office is responsible for the group audit of Milcomba.
You receive a briefing note and instructions from the Cromer Bell audit manager responsible for
the MRL audit:
Briefing note from MRL audit manager

We need to complete our planning for the MRL audit for the year ending 31 August 20X8. I want
you to plan substantive audit procedures to test operating expenses.
Last year, we relied wholly on substantive analytical procedures to test all operating expenses,
but that approach was criticised in a recent external cold review of our audit. The reviewer's
comments stated that some of the expectations developed by the audit team in their substantive
analytical procedures were imprecise. In addition, the reviewer considered that some of the
expenses should have been tested using tests of details. As a result, I would expect us to use
analytical procedures in a more selective and focused way for this year's audit.
Although the group audit team in Elysia has performed interim review procedures on the
Milcomba consolidated financial statements for the six months ended 28 February 20X8, it did
not require us to perform any interim review procedures locally on MRL.
Planning materiality for MRL has been determined at £50,000, based on 5% of forecast profit
before tax for the year ending 31 August 20X8.
MRL's finance director, Gil Moore, was appointed on 1 March 20X8. We know Gil well, as he
was, until February 20X8, a senior audit manager with Cromer Bell. Gil was the manager
responsible for the audit of MRL for the year ended 31 August 20X7, which we completed in
December 20X7.
Gil has provided details of MRL's operating expenses for the 10 months to 30 June 20X8.
I asked the Cromer Bell specialist data analytics team to analyse these. The team has provided a
report (Exhibit 1).
I met with Gil last week and have summarised our discussion in a note for the file (Exhibit 2).
Instructions from MRL audit manager

Please consider all the information I have provided and:
(a) Identify and explain the key audit risks for our audit of MRL for the year ending 31 August
20X8. Where appropriate, set out and explain any related financial reporting issues,
including relevant calculations;
(b) For each of the operating expenses (Exhibit 1) explain whether substantive analytical
procedures and/or tests of detail would be the more appropriate audit approach. Identify
the key substantive audit procedures that we should perform to test each operating
expense; and

(c) Explain any potential ethical issues in respect of Gil Moore's behaviour and summarise the
actions that Cromer Bell should take to address them.
Requirement
Respond to the audit manager's instructions. Total: 30 marks
Exhibit 1: Report from Cromer Bell specialist data analytics team on MRL's operating expenses
for the 10 months ended 30 June 20X8
MRL's financial statements for the 10 months ended 30 June 20X8 include total operating
expenses as shown below.
10 months to 10 months to
30 June 20X8 30 June 20X7
£'000 £'000
Wages and salaries for administrative staff 2,324 2,159
Other staff expenses 315 287

Rent 595 850
Insurance, electricity, gas and other utilities 725 678
Depreciation of office equipment and leasehold offices (120) 200
Movement in allowance for receivables 80 200
Legal and professional fees 210 50
Movement in provision for claims and other legal matters 40 180
Start-up costs for MP Ltd 230 –
Other administrative expenses 76 63
Total operating expenses 4,475 4,667
MRL's operating expenses have fluctuated over the 10 months to 30 June 20X8, as shown in the
chart below:

Data analytics − potentially unusual or one-off items
Our analysis of the underlying data on operating expenses identified the following potentially
unusual or one-off items:
 There are no monthly rent costs from April 20X8 onwards.
 In February 20X8, a credit entry of £100,000 was made to reduce the movement in the
allowance for receivables.
 In February 20X8, a credit entry of £300,000 was made to reduce the depreciation charge
for leasehold improvements.
 December 20X7 expenses include a one-off legal fee of £150,000.
 October 20X7 expenses include start-up costs of £230,000.
 Movements in the provisions for claims and other legal matters were:
– a credit entry of £40,000 in February 20X8
– a debit entry of £80,000 in March 20X8.
Analysis of journal entries
You also asked us to identify any unusual journal entries posted to operating expenses. Our
analysis identified two entries posted by Gil Moore, the MRL finance director:
(1) In April 20X8:
DEBIT Wages and salaries for administrative staff £50,000
CREDIT Accruals £50,000
Half-year bonus for MRL executive team.
(2) In May 20X8:
DEBIT Other staff expenses £9,000
CREDIT Cash £9,000
New tablet computers for finance team.
Exhibit 2: File note summarising meeting last week with Gil Moore, MRL finance director –
prepared by Cromer Bell audit manager
Key points noted from my discussion with Gil were as follows.
Group performance
The Milcomba group is facing challenges in the financial year ending 31 August 20X8, with
falling profits at several international subsidiaries. While MRL's trading is reasonably good, a
weakening of the £ has meant that MRL's profit is lower than in the year ending 31 August 20X7
when translated into Elysian $, the presentation currency for the group.
Strong financial management and cost control at group level ensured that the group's reported
results for the six months ended 28 February 20X8 were in line with market expectations. The
Milcomba board has made it clear that it expects MRL to deliver profit above budget for the
6 months to 31 August 20X8.
Review of receivables
The first monthly report provided for Gil, after his appointment, was for February 20X8 and he
spent the limited time available reviewing provisions and other judgemental areas. A significant
adjustment he made was to reduce the bad debt allowance for receivables by £100,000. His
decision to do this was based on a review of receivables written off as irrecoverable in the six
months ended 28 February 20X8, which showed that write-offs were lower than anticipated.

Revenue
MRL's revenue for the 10 months ended 30 June 20X8 was in line with budget but its customer
base has changed. MRL recruited fewer candidates for its traditional financial services customers
but attracted new customers in the transport and technology sectors. This resulted in a greater
number of candidates but a lower average recruitment fee per job vacancy filled.
The terms of business for the new customers are similar to those for existing customers.
Recruitment fees are invoiced when a job applicant identified by MRL accepts employment with
an MRL customer. The customer can claim a refund of 75% of the recruitment fee if the new
employee leaves within 1 month of starting employment and a refund of 50% of the fee if the
employee leaves within 3 months.
Start-up of MP Ltd
Recruiting a large number of candidates has put pressure on MRL's staff resources. To relieve
some of this pressure, MRL has entered into an arrangement with another recruitment company,
Peerless Ltd. In October 20X7, MRL and Peerless each invested initial capital of £230,000 in a
newly-formed company, MP Ltd. The shares of MP are held equally by MRL and Peerless. MRL's
investment is included in operating expenses as start-up costs.
MP was created to provide administration and research services to MRL and Peerless. It focuses
on lower-salaried positions and utilises advanced technology to obtain efficiencies. MP
recharges its costs, plus a margin of 5%, to Peerless and MRL in proportion to the time its staff
spend working for each investor.
MP did not start trading until May 20X8, because of delays in the installation of its computer
system. This computer system and other non-current assets cost £400,000 in total. MP has
30 staff and is performing well, relieving the pressure on MRL's consultants and allowing them to
focus on recruitment of higher-salaried positions. MP is expected to make a profit of £50,000 in
the period ending 31 August 20X8.
Leasehold premises and depreciation
The lease for MRL's premises was originally for 10 years starting on 1 April 20X3. At that date,
the remaining useful life of the building was 45 years. In March 20X8, the terms of the lease were
renegotiated and it was extended for a further 5 years, so that it now expires on 31 March 20Y8.
In return for extending the lease, MRL received a rent-free period of 6 months from 1 April 20X8
and a reduced rent of £960,000 pa for the remaining term of the lease. At the start of the
original lease, MRL spent £1.8 million on leasehold improvements which were being
depreciated over 10 years. As the lease has now been extended, Gil revised the depreciation
calculation, such that the total cost is now spread over the total lease term of 15 years.
Cold review
Gil enquired about our planned audit approach for operating expenses. He had heard about the
comments made by the external reviewer who conducted the cold review of the MRL audit file
for the year ended 31 August 20X7. Gil hoped that we would not pay too much attention to
these comments as they were, in his view, not valid.

61 Zmant plc
You are Trina Briggs, an ICAEW Chartered Accountant, working for Dealy and Brant (DB), a firm
of ICAEW Chartered Accountants. DB has audited Zmant plc and its subsidiaries for some years
and you are the audit manager for the Zmant group audit.
Zmant plc supplies specialist audio equipment and has several 100%-owned subsidiaries. Zmant
and its subsidiaries have a 30 September year end. During the year ended 30 September 20X7,
Zmant made the following acquisition:
Investment in KJL
Zmant made an investment in KJL, a company that produces and sells audio equipment to
Zmant. KJL is based in Otherland where the currency is the Otherland $ (O$).
On 1 January 20X7, Zmant bought 60% of the issued ordinary share capital of KJL for
O$52,800,000. On acquisition, there were no fair value adjustments needed to the carrying
amounts of the assets and liabilities of KJL.
On 1 January 20X7, Zmant made a loan of O$21,000,000 to KJL, at an annual interest rate of 6%,
repayable at par on 30 September 20X9.
KJL prepares its financial statements under IFRS and has a 30 September year end. DB is not the
auditor for KJL.
DB's individual audits of Zmant and its subsidiaries are almost finished and the audit of the
consolidation is now in progress. The DB audit partner responsible for the Zmant group audit
has given you the following briefing:
Briefing from audit partner
"KJL was identified as a significant component in the group audit plan. KJL is audited by Welzun,
an audit firm based in Otherland. The audit plan included an assessment of Welzun's
professional qualifications and independence and no issues were noted. We performed a
review of KJL's financial statements for the year ended 30 September 20X7 and identified two
matters of potential significance to the group audit:
 Research and development (R&D) expenditure of O$10,700,000
 Income tax receivable balance of O$8,025,000
"We asked Welzun to prepare a report explaining these two matters and the audit procedures
that it performed. I have provided you with Welzun's report (Exhibit 1).
"Zmant has a new finance director, Janet Gray, who is an ICAEW Chartered Accountant. She has
asked for help in finalising Zmant's consolidated financial statements and has sent some extracts
and queries to me (Exhibit 2). She has also sent me a newspaper article published in the
Otherland News (Exhibit 3) which I find very concerning.
"I need you to prepare a working paper which addresses the following:
(1) For each matter in Exhibit 1:
 set out and explain the appropriate financial reporting treatment for KJL's financial
statements for the year ended 30 September 20X7;
 identify and explain any weaknesses in the audit procedures completed by Welzun;
and
 set out any additional audit procedures that should be performed by DB and by
Welzun to provide assurance for the group audit opinion.

(2) Set out and explain the appropriate adjustments for the financial reporting queries raised
by Janet (Exhibit 2) for the year ended 30 September 20X7 for:
 the individual financial statements of Zmant
 the consolidated financial statements of Zmant
(3) Calculate goodwill to be recognised for KJL in Zmant's consolidated financial statements
for the year ended 30 September 20X7. Assume Zmant uses the proportion of net assets
method to value the non-controlling interest in KJL.
(4) Explain the ethical issues for DB arising from the newspaper article (Exhibit 3) and any
related matters. Set out and explain how DB should respond. Advise Janet on any actions
she should take."
Requirement
Prepare the working paper requested by the audit partner. Total: 42 marks
Exhibit 1: Report on matters of significance to the group audit – prepared by Welzun, KJL's
auditor
We set out below our report on the matters of significance identified by DB in its review of KJL's
financial statements for the year ended 30 September 20X7.
Audit procedures have been performed in accordance with component materiality determined
by DB at O$1,800,000.
Research and development (R&D) expenditure of O$10,700,000
The government in Otherland gives generous tax relief for R&D costs provided that the costs are
expensed in the statement of profit or loss. O$10,700,000 has been expensed in the year ended
30 September 20X7, comprising the costs of the following two R&D projects:
Project Sound: O$7,900,000
Project Sound commenced on 1 January 20X7. The project's objective was to adapt an existing
speaker produced by KJL for the car industry. The project started after L-Motors, a customer of
KJL, requested a customised speaker for its cars. On 1 April 20X7, L-Motors placed a large order
for the speaker. Costs of this project, which have been expensed to the statement of profit or
loss, are:
O$'000
Materials for prototype model 1,725
New computer equipment – bought on 1 January 20X7 1,700
Salary costs of development staff
incurred after 1 April 20X7 1,270
incurred before 1 April 20X7 790
Registration fees for design 910
Car used for speaker testing – bought on 1 January 20X7 555
Allocated general overheads 950
7,900
As each cost was less than component materiality, no detailed audit procedures were
performed.
We asked KJL whether the computer equipment and the car should have been included in PPE
rather than expensed.
 KJL informed us that the cost of the computer equipment was expensed because it was
being used for this project. If capitalised, this computer equipment would have been
written off over two years under KJL's depreciation policy.
 KJL informed us that, since completion of the project, the CEO of KJL has driven the car.
Including the cost of the car in PPE would result in a personal tax liability for the CEO under
Otherland tax rules.

Project Entertain: O$2,800,000
The project's objective is to determine the success of product events. KJL obtains new business
by arranging product events for existing and potential customers. A product event involves sales
staff and other KJL personnel entertaining customers with food and drink and at the same time
demonstrating and selling KJL's products. KJL paid O$2,800,000 to a public relations company,
GetGo, which made all the arrangements for the product events and carried out analysis of the
new business generated.
We agreed the cost of O$2,800,000 to invoices from GetGo, authorised by KJL's CEO, and also
to the bank statements. We requested a copy of GetGo's report showing the analysis of the new
business generated and we were told by KJL that GetGo will provide the report in 20X8.
Income tax receivable balance of O$8,025,000
The income tax receivable balance is in respect of a tax refund for R&D expenditure. Welzun's
tax department confirmed that a tax refund will be received based on the following formula:
250%  R&D expenditure included in the statement of profit or loss  30% tax rate.
Welzun's tax department confirmed that KJL pays tax at 30% and that the receivable balance of
O$8,025,000 has been correctly calculated. As the R&D tax claim was prepared by Welzun's
own tax department, no audit procedures were performed.
Exhibit 2: Financial statement extracts and queries from Janet Gray
Extracts from financial statements for the year ended 30 September 20X7
Zmant group KJL
£'000 O$'000
Equity
Retained earnings at 1 October 20X6 9,200 45,000
21,400 85,000
Janet Gray's queries

Before I complete the consolidation of KJL with Zmant, I would like your advice on the correct
financial reporting treatment of the following:
Loan to KJL £3,500,000
In Zmant's statement of financial position, there is a receivable balance of £3,500,000 which
represents the O$21,000,000 loan made to KJL on 1 January 20X7.
My predecessor translated the O$21,000,000 loan using the exchange rate at 1 January 20X7,
which was £1 = O$6.0. The exchange rate at 30 September 20X7 was £1 = O$4.8.
I do not know whether I need to include any adjustments for exchange differences because,
under Zmant's and KJL's tax jurisdictions, there is no tax payable on exchange differences
recognised in the statement of profit or loss. Instead, gains and losses are taxed at 20% when
the loan is repaid. In any case, I understand that the balances will cancel on consolidation.
Inventory
In the year ended 30 September 20X7, Zmant bought goods from KJL for £5,500,000. KJL
charges Zmant a mark-up of 35% on cost. There are no intra-group trading balances outstanding
at the year end between KJL and Zmant.

Zmant's inventory at 30 September 20X7 includes £2,500,000 of goods which were bought from
KJL. I believe I need to adjust for the intra-group profit. I have calculated the adjustment as
follows, but I am not sure that it is correct:
Profit on goods bought by Zmant from KJL = £5,500,000  35% £1,925,000
Profit on goods bought by Zmant from KJL for 9 months from
1 January 20X7 to 30 September 20X7 = £1,925,000  9/12 £1,443,750
£1,443,750 translated at the average rate for the period from
1 January 20X7 to 30 September 20X7 of £1 = O$5.7 O$8,229,375
The journal is:
DEBIT KJL Retained earnings O$8,229,375
CREDIT Inventory O$8,229,375
Exhibit 3: Article from the Otherland News – sent by Janet Gray
Otherland News: 31 October 20X7

An Otherland government official has resigned after accusations of corruption were made
following his attendance at a 'product event' paid for by KJL. The official, who is the husband of
a KJL board member, attended the 5-day event at a luxury spa hotel. An undercover journalist
reported that the guest list for the event comprised KJL's directors and their families and a
representative from L-Motors, a long-standing customer of KJL.
A former KJL finance assistant told the Otherland News that KJL is manipulating its financial
statements to claim large refunds of tax. The Otherland tax authority stated that it investigates
any incidence of tax fraud.
62 Chelle plc
You are Aiden Clark, an ICAEW Chartered Accountant. You have recently been appointed as
financial controller at Chelle plc, a company listed on the London Stock Exchange. Chelle was
incorporated 15 years ago to import delicatessen products, such as olive oil and luxury tinned
goods, to the UK. Suppliers deliver goods to Chelle's distribution centre near London and
Chelle's own vans transport goods to the company's customers (supermarket chains and smaller
retailers). The company's year end is 31 October.
During the seven years ended 31 October 20X5, Chelle experienced steady growth in revenue
and profits. However, the company has become less profitable in the years ended 31 October
20X6 and 31 October 20X7 and its share price has fallen.
Chelle's directors own 20% of the company's ordinary shares. The remaining shares are owned
40% by several institutional investors and 40% by individual investors. Each investor owns no
more than 5% of the company's ordinary shares. A significant source of finance for Chelle is
long-term convertible bonds. The bonds will mature at the end of October 20X9.
Chelle's finance director is on long-term sick leave. The financial controller, Joe Bold, left Chelle
in early November 20X7. Before he left, he prepared draft financial statements for the year
ended 31 October 20X7 (Exhibit 1) and notes on outstanding matters (Exhibit 2).

Jen West, Chelle's managing director, emails you:
Chelle has not been doing well. The depreciation of £ sterling since June 20X5 has increased
costs. Profits have suffered as a result. Revenues have been adversely affected by increased
competition. The board is concerned about the company's cash flows over the next year or two.
As you are new to the company, you can help us by providing a fresh interpretation of the draft
financial information (Exhibit 1).
The company's shareholders are not happy because of the falling share price. Chelle did not
declare a dividend for the year ended 31 October 20X7. This was the first time in many years
that a dividend was not declared and some of the directors think we should recommence paying
dividends as soon as possible. The board wants to know when Chelle can start paying dividends
again.
Please:
(1) Set out and explain any adjustments required to the draft financial statements for the year
ended 31 October 20X7, in respect of the outstanding matters (Exhibit 2). Provide
supporting journal entries.
(2) Prepare a revised statement of profit or loss for the year ended 31 October 20X7 and a
revised statement of financial position at that date. Include calculations of earnings per
share and diluted earnings per share.
(3) Prepare a report to the board, analysing the key elements of the financial position,
performance and cash flow for the year ended 31 October 20X7, in comparison with the
two previous financial years. Use your revised financial statements and other information
provided.
(4) Calculate the amount of Chelle's legally distributable reserves at 31 October 20X7,
providing explanations to support your calculations.
Requirement
Respond to Jen West's email. Total: 30 marks
Note: Ignore deferred tax
Exhibit 1: Chelle plc draft financial information for the year to 31 October 20X7 prepared by
Joe Bold
Draft statement of profit or loss and other comprehensive income
20X7 20X6 20X5
Draft Final Final
£'000 £'000 £'000
Revenue 30,600 31,800 35,700
Cost of sales (22,803) (23,044) (25,444)
Gross profit 7,797 8,756 10,256
Operating costs (8,235) (7,904) (6,996)
Finance costs (500) (617) (609)
(Loss)/profit before tax (938) 235 2,651
Tax 178 (47) (530)
(Loss)/profit for the year (760) 188 2,121
Other comprehensive income – (273) 46

Additional information
20X7 20X6 20X5
Earnings per share To be calculated 1.9p 21.2p
Dividend per ordinary share Nil 1p 2p
Chelle share price at 31 October 980p 1139p 1711p
£1 = 100 pence (p)
Draft statement of financial position
20X7 20X6 20X5
Draft Final Final
£'000 £'000 £'000
Non-current assets
Property, plant and equipment 53,675 51,497 48,574
Financial asset 1,503 1,503 1,776
55,178 53,000 50,350
Current assets
Inventories 2,770 2,910 3,307
Trade receivables 7,710 7,503 7,997
Tax asset 178 – –
Cash – 525 2,273
10,658 10,938 13,577
Total assets 65,836 63,938 63,927
Equity
Share capital (£1 shares) 10,000 10,000 10,000
Other components of equity 1,416 1,416 1,689
Retained earnings 37,294 38,054 37,966
48,710 49,470 49,655
Long-term liabilities (5% convertible bonds) 9,603 9,603 9,486

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

20X7 20X6 20X5
Draft Final Final
£'000 £'000 £'000
Net cash inflows from operating activities 11,316 11,173 10,516
Net cash (outflows) from investing activities (13,060) (12,821) (8,462)
Net cash (outflows) from financing activities – (100) (200)
Change in cash (1,744) (1,748) 1,854
Cash brought forward 525 2,273 419
Cash carried forward (1,219) 525 2,273

Exhibit 2: Notes on outstanding matters in respect of the financial statements for the year to
31 October 20X7 – prepared by Joe Bold
(1) Convertible bond instrument
On 31 October 20X1, Chelle issued a £10 million 5% convertible bond for proceeds of
£10 million. The bond is repayable at par on 31 October 20X9, but can instead be
converted at that date, at the choice of the bondholders, into one new ordinary share for
every £10 unit held. At the date of issue, the market interest rate for similar debt without
conversion rights was 6.5%. Interest was paid on 31 October 20X7 and recorded in finance
costs, but I have not made any other accounting entries in respect of the convertible bond
in the year ended 31 October 20X7.
(2) Investment in equity instruments
Several years ago, Chelle paid £1 million for 100,000 of the 1,500,000 £1 ordinary shares of
Spence plc, its main supplier of refrigeration equipment. On initial recognition, an
irrevocable election was made to record gains and losses in other comprehensive income.
Of the other components of equity, amounts relating to the accumulated gains and losses
on this investment were £776,000 in 20X5 and £503,000 in 20X6. I have not recorded any
entry in respect of the financial asset since the 31 October 20X6 year end. The price of one
ordinary share in Spence plc at 31 October 20X7 was £18.50.
(3) Tax
The applicable corporation tax rate during the financial year ended 31 October 20X7 can
be assumed to be 19%, chargeable on accounting profits before tax. A current tax credit,
calculated at 19%, can be recognised in respect of accounting losses.
63 Solvit plc
Solvit plc is a listed company supplying accounting software and related services to education
and public-sector customers. Some of Solvit's customers purchase only software but others
enter into multiple element contracts, purchasing software together with customisation,
integration and maintenance services.
Kanes LLP, a firm of ICAEW Chartered Accountants, recently won the audit of Solvit from Fenn
Yo LLP, following a competitive tender. You are a senior working for Kanes LLP and have been
assigned to the audit of Solvit for its financial year ending 31 March 20X8.
The audit manager calls you into her office:
"I need you to help plan the audit of Solvit for the year ending 31 March 20X8. The Audit
Committee Chair has requested that we present our audit plan at next week's Audit Committee
meeting and has asked that this plan sets out our initial assessment of the key audit matters we
expect to include in our audit report.
"I have provided you with extracts from last year's audit report (Exhibit 1) so that you can see the
key audit matters that Solvit's previous auditor, Fenn Yo LLP, identified. This is a good starting
point for us, but we will need to update last year's key audit matters and identify additional key
audit matters. It's important that where we identify a key audit matter (KAM), we are precise
about the audit objectives and where the greatest audit risk arises.
"I have also provided notes from my meeting with the Fenn Yo LLP audit partner and manager
(Exhibit 2) and a summary of points from my initial audit planning meeting with the Solvit
Finance Director, Sam Browne (Exhibit 3).

"I need you to do the following:
(1) In respect of the key audit matters to be included in our plan for the Solvit audit for the year
ending 31 March 20X8:
(a) Explain why the key audit matters identified by Fenn Yo LLP (Exhibit 1) continue to be
relevant and explain how each of these has changed this year.
(b) Identify additional key audit matters for this year's audit and explain the factors which
have led you to select each of them as a key audit matter.
(2) For each of the key audit matters identified in (1) above:
(a) Identify the relevant financial reporting standard and explain how it should be applied
to the key audit matter in Solvit's financial statements for the year ending
31 March 20X8.
(b) Explain the specific audit objectives and set out the audit procedures to provide
assurance in respect of the key audit matter.
(3) Draft a brief response to the Finance Director's question (Exhibit 3) about the likely impact
of IFRS 16, Leases, on Solvit's financial statements for the year ending 31 March 20X9."
Requirement
Respond to the audit manager's instructions. Total: 28 marks
Exhibit 1: Extract from last year's audit report on the financial statements of Solvit plc for the
year ended 31 March 20X7 – prepared by Fenn Yo LLP
Key audit matters
Revenue recognition
We identified revenue recognition as a key audit matter because the allocation of revenue to
each component of a sale (software, services and maintenance), when sold together in a bundle,
requires the application of judgement. We assessed this risk to be greatest in larger, more
complex transactions, where there is increased likelihood of multiple components or the
delivery of customised software.
Our audit procedures focused on the larger, more complex revenue transactions with the
objective of checking that the allocation of revenue between components was consistent with
the terms of the sale contracts and in line with Solvit plc's accounting policy. In particular, we
audited the basis upon which management had calculated the fair value attributable to the
components of revenue. Our audit procedures identified one contract where, because of a
calculation error, too much revenue was allocated to the initial software supplied rather than
deferred to cover future maintenance. An adjustment of £1.3 million was recorded to correct this
error.
Provision for onerous lease
We identified as a key audit matter the provision of £1.4 million made by management to reflect
the anticipated net future cost of leased office premises no longer required by Solvit. Offices in
London were vacated during March 20X7 with 15 years of the lease term remaining. Judgement
was required to assess both the period for which the premises would remain empty and the
level of rental income the premises would generate once sublet to a new tenant.
We reviewed the lease, together with professional advice received by Solvit about the rental
market in London. Our objective was to challenge the judgements made by management in
determining the assumptions to be used in the calculation of the provision. We then
recalculated the provision based on the assumptions selected. We concluded that the provision
made was reasonable.

Exhibit 2: Kanes LLP audit manager's notes from handover meeting with Fenn Yo LLP audit
partner and manager
These notes summarise key points from my meeting with the Fenn Yo LLP audit partner and
manager responsible for the Solvit audit for the financial years ended 31 March 20X5, 20X6 and
20X7. They clearly knew the client well and could provide helpful insights into the work they
performed and their audit report.
In addition to meeting with the engagement partner and manager, we performed a detailed
review of the Fenn Yo LLP audit working papers. This review identified no issues with the audit
procedures performed or the conclusions reached.
Key points from meeting with the Fenn Yo audit team
 Materiality for the year ended 31 March 20X7 was set at 5% of profit before taxation, giving
a materiality figure of £1 million.
 The error noted in revenue recognition was a calculation error and arose in March 20X7
when a new revenue accountant was appointed. He lacked the experience of his
predecessor and made an error in determining the separate prices of the component parts.
 The provision for the onerous lease was calculated on the assumption that the property
would remain empty for two years. The property would then be sublet for the rest of the
lease term, at a rent sufficient to cover all Solvit's rental cost. No discounting was applied, as
the effect of the time value of money was considered immaterial.
 In addition to the revenue error identified, there was one other item on the schedule of
misstatements. This was in relation to the allowance for aged receivables where a
judgemental excess allowance of £700,000 was identified. This was not adjusted in the
 In addition to the key audit matters included in the audit report for the year ended
31 March 20X7, Fenn Yo also considered the presumed risk of material misstatement
arising from management override of controls. Management was judged to have a
relatively low incentive to overstate results for the year, as Solvit had far exceeded the target
performance required for the maximum management bonus to be paid. Therefore, Fenn Yo
did not identify this as a key audit matter.
Exhibit 3: Summary of meeting with Solvit Finance Director, Sam Browne – prepared by Kanes
LLP audit manager
Revenue
A typical customer relationship for Solvit starts with a contract for the supply of software. In most
cases this is standard software for which the customer pays a one-off, up-front licence fee.
However, there are also complex contracts under which Solvit supplies standard software
together with other elements such as customisation, integration and maintenance services. At
the end of the contract period, customers can renew the maintenance agreement at the
standard price quoted in Solvit's price list.
Customisation and integration services are also sold separately at standard day rates.
Sam commented that IFRS 15 is a relatively new standard, and applying it was challenging and
he has relied heavily on Solvit’s revenue accountant.
Revenue for the six months ended 30 September 20X7 is at the same level as the same period
last year but is £5 million lower than forecast. This is largely because sales of new software for
the education market have grown more slowly than expected because of issues with the
software. The education market has proved to be very price-competitive and Solvit has
incentivised customers to purchase its software by giving large discounts on maintenance
agreements for up to three years.

Management bonus
Lower than budgeted revenues for the six months ended 30 September 20X7 have resulted in
lower than expected profit and Solvit will need to perform exceptionally well in the second half
of the year to meet its profit target. Sam is confident that it will do so and has therefore accrued
half of the maximum management bonus for the year in the results for the six months ended
30 September 20X7.
Receivables
The new education clients have been slow to settle their debts and receivables days have
increased from 45 days at 31 March 20X7 to 75 days at 30 September 20X7. On initial
recognition of all receivables, Solvit created an allowance equal to twelve months' expected
credit losses in accordance with IFRS 9, Financial Instruments. Sam intends to keep the
allowance for receivables at the same level as at 31 March 20X7, as he is confident that most
receivables will be paid once the issues with the software are sorted out.
Onerous leases
The London offices vacated in March 20X7 were sublet with effect from 1 August 20X7 and so
the entire provision of £1.4 million has been released. The sub-tenant has a break clause and
can choose to terminate the arrangement after five years, but Sam is hopeful that the sub-tenant
will remain longer than this. A rent-free period of six months was given but, after that initial
period, the rent received will be equal to the rent which Solvit pays under the lease.
Sale and leaseback
On 1 October 20X7, Solvit sold its northern office property to a property company for
£18 million and leased it back. The lease has a term of 10 years and rentals of £600,000 per
annum paid quarterly in advance. Immediately prior to the transaction with the property
company, the office property had a carrying amount of £11 million and a fair value of
£15 million. It has an estimated remaining useful life of 20 years.
Sam informed me that Solvit does not intend to adopt IFRS 16, Leases early. However, he would
like to understand its impact when it is adopted in the financial statements for the year ending
31 March 20X9. In addition to the lease transactions discussed above, Solvit has operating
leases for cars and equipment with terms of 3 to 10 years and combined annual rentals of
£1.3 million.

Answer Bank
Financial reporting answers
1 Kime
Marking guide
Marks
(a) Explain the potentially contentious financial reporting issues.
Determine any adjustments you consider necessary and explain

the impact of your adjustments on the financial statements,
identifying any alternative accounting treatments
 Renovation of Ferris Street 3
 Sports stadium (IFRS 15) 6
 FX House disposal 5
 Estate agency buildings 4
 Property management contract 2
 Foreign currency receivable and forward contract 4
 Taxation 3
Total 27
Maximum 22
(b) After making adjustments for matters arising from your review of
the outstanding issues, prepare a draft statement of financial
position and statement of comprehensive income. 8
Maximum available marks 30
Scenario
The candidate has been appointed to assist an FD for a property company, in the preparation of
the financial statements. The auditors are due to start their work and the FD would like to be
aware of any contentious issue in advance of their arrival. The candidate is required to
determine whether the accounting treatment applied is correct and determine the appropriate
treatment given directors' instructions to maximise the profit in the current period. The
adjustments in respect of current tax and deferred taxation are to be completed given the
assumptions in the scenario. The financial reporting issues include IAS 16 (recognition of
appropriate costs and depreciation), IFRS 15 (construction of a long-term asset), lessor
accounting, asset held for sale and foreign currency adjustment in respect of a receivable, and a
cash flow hedge. The candidate is required to prepare a summary statement of financial position
and statement of profit or loss and other comprehensive income.
Email
From: Jo Ng
To: FD
Sent: xx July 20X2
Subject: Draft financial statements
Please find attached a draft statement of financial position and statement of profit or loss and
other comprehensive income (Attachment 1). I have also attached an explanation of my
adjustments and a determination of their impact and proposed alternative accounting
treatments (Attachment 2).
Regards
Jo
ICAEW 2019 Financial reporting answers 209

Attachment 1
Draft statement of profit or loss and other comprehensive income for the year ended
30 June 20X2
£m
Revenue (549.8 + 10.2 – 1) 559.0
Cost of sales (322.4 + 18) 340.4
Gross profit 218.6
Distribution costs 60.3
Administrative expenses (80.7 – 21.5 + 8) 67.2
Finance costs (4.8 + 2.0 – 1.3 + 0.2 + 1.3 ) 7.0
Finance income (1.0)
Income tax expense (17.1 + 3.4) (20.5)
Cash flow hedge 1.3
Reclassification of cash flow hedge (1.3)
Draft statement of financial position as at 30 June 20X2

ASSETS £m
Non-current assets
Property, plant and equipment
(80.7 – 18 + 120 – 22.8) 159.9
Current assets
Finance lease receivable 20.5
Gross amounts due from customers 10.2
Trade receivables (174.5 – 10 + 1.3) 165.8
Cash and cash equivalents 183.1
379.6
Non-current assets classified as held for sale 2.0
Total assets 541.5

Equity
Share capital 100.0
Share premium 84.0
Retained earnings b/f 102 Profit for year 64.6 166.6
Long-term borrowings 80.0
Deferred tax liability (33 + 3.4) 36.4
Current liabilities
Trade and other payables (54.9 + 17.1) 72.0
Contract liability 1.0
Financial liabilities 1.5
Total equity and liabilities 541.5
Attachment 2
Freehold land and buildings
(a) Additions
Renovation of Ferris Street property – allocation of costs
The basis on which the renovation costs have been allocated between repairs and
maintenance and capital appears somewhat arbitrary and has not been supported by
adequate analysis.

IAS 16 requires that only direct expenditure on property improvements should be
capitalised and that maintenance costs should be written off to profit or loss. The 80:20 split
was based on budgeted costs but has been used to allocate actual spend to date.
It is possible that the expenditure to date may include a higher or lower proportion of
maintenance than that expected for the project as a whole. As repairs should be expensed
as the work is performed, this could affect the result for the period. Hence it is important to
review a breakdown of the costs actually incurred for the period.
For costs which are capital in nature, we need to evaluate whether any could more
appropriately be recorded as plant and machinery rather than included within building
costs. The asset lives and depreciation rates would then differ if the asset is not treated as a
single composite property asset. I need much more information on the nature of the project
to do this.
No disposals have been recorded in the year for any previous renovation or construction
work on the Ferris Street building which has been replaced by the work done in the year. In
a major project of this type it is likely that there will be elements of the original cost or of
previous renovation projects which should be written off. I need to ascertain the nature of
building and previous work on it in order to determine what element of the carrying
amount, if any, should be written off. For example there may be partition walls which have
been demolished and replaced.
I need to review the budget and the basis of the 80:20 split proposed by the project
manager. The project manager may not understand the requirements of accounting
standards and in particular of IAS 16 and may have been motivated by capital budget
constraints or other funding/approval limits than by an analysis of the true nature of the
costs to be incurred.
The allocation of costs on a project which includes both types of cost is open to
manipulation and can be judgmental and be challenged by our auditors.
Adjustments required?
I cannot at present quantify whether any adjustment is required without further analysis
being performed on the additions accounts in the general ledger.
Construction of a sports stadium
The cost of £18 million has been incorrectly treated as an addition to PPE and I have
therefore corrected this as follows:
Kime as the contractor should account for the construction of the sports stadium in
accordance with IFRS 15, Revenue from Contracts with Customers. This appears to be a
contract specifically negotiated for the construction of an asset for which a fixed contract
price has been agreed. It is a contract in which the performance obligation is satisfied over
time because it meets the following IFRS 15 criteria:
(1) "The entity's performance creates or enhances an asset (eg, work in progress) that the
customer controls as the asset is created or enhanced."
(The contract specifies that control is transferred to the local authority as the stadium is
constructed.)
(2) "The entity's performance does not create an asset with an alternative use to the entity
and the entity has an enforceable right to payment for performance completed to
date."
Kime can have no alternative use for the sports stadium.

For a performance obligation satisfied over time, IFRS 15 states that revenue should be
recognised by measuring progress towards complete satisfaction of that performance
obligation. Appropriate methods of measuring progress include output methods and input
methods. An appropriate output method allowed by IFRS 15 is 'surveys of performance
completed to date', often referred to in the construction industry as 'work certified'. An
appropriate input method allowed by IFRS 15 is costs incurred.
Contract costs were predicted to be £16 million. However, the estimated total costs to
complete the project have now increased to £22.5 million. The project is still expected to
make a profit of £11.5 million.
This is a fixed price contract and therefore there is reasonable reliability in respect of the
measurement of contract revenue but there is less certainty regarding the costs to be
incurred. However, the surveyor has determined that these can now be reliably measured.
Under the input method, ie, using the costs incurred as a method of measuring progress
towards satisfaction of the performance obligation, the obligation is ((£18m/£22.5m)
× 100 =) 80% satisfied. Therefore £27.2 million representing 80% of the contract revenue
would be recognised.
Using the output method, ie, work certified, the contract is 70% complete ((£23.8/34.0)
× 100). Revenue of £23.8 million would therefore be recognised.
In the statement of financial position gross amounts due from customers should be
presented as contract costs incurred plus recognised profits less invoices raised to
customers. Trade receivables should include the amounts invoiced less amounts received
from the local authority.
A comparison of the two methods (assuming costs are recognised on an incurred basis) is
as follows:
Costs incurred Work certified
basis basis
£m £m
Revenue 27.2 23.8
Cost of sales (18.0) (18.0)
Profit 9.2 5.8

Costs incurred Work certified
£m £m
Gross amounts from customers
Costs incurred 18.0 18.0
Recognised profit 9.2 5.8
27.2 23.8
Progress billings (17.0) (17.0)
10.2 6.8
Receivables (£17.0m – £17.0m) 0 0
Implication for the financial statements

Using the work certified to date method results in a lower profit, although this method is
also less subjective since it does not rely on estimations of future costs to calculate the
percentage complete. To maximise the amount of profit recognised the directors could
select the costs incurred method. Ultimately the profit recognised overall on the contract is
the same over time, but the allocation to accounting periods is affected by the choice of
presentation.

As £17 million of revenue has already been recognised, the following adjustment to the
financial statements is required if the maximum amount of profit is to be recognised:
DEBIT Gross amounts from customers £10.2m
CREDIT Revenue £10.2m
Also I have reversed the additions to property, plant and equipment as follows:
DEBIT Cost of sales £18m
CREDIT PPE £18m
The assumption has been made that this has been classified as an asset under construction
and no depreciation has been charged.
(b) Disposals
FX House
The lease does appear to be a finance lease given the transfer to the lessee at the end of
the contract; this appears to be the case for both the buildings and the land.
As the lease to the third party is a finance lease it is correct to treat the property sale as a
disposal. However the junior assistant has failed to account correctly for the disposal and
the new finance lease following the guidance for lessor accounting as set out in IAS 17. As
title to both land and buildings transfer to the lessor at the end of the lease period, the
lease should be accounted for as a single lease comprising both land and building
elements. Assuming that the new lease is at fair market rates, Kime should realise a gain on
the asset disposal and show a new lease receivable equal to the net investment in the lease.
This will be equal to the minimum lease payments discounted at the rate implicit in the
lease.
Correcting journal entries
Hence entries required to correct the accounting are:
At inception of lease on 1 January 20X2:
DEBIT Non-current assets – net investment in lease £21.5m
CREDIT Gain/loss on non-current asset disposal £21.5m
DEBIT Gain/loss on non-current asset disposal £5.8m

CREDIT Administrative expenses £5.8m
Thus giving rise to a gain on disposal of £21.5 million less carrying amount at date of
disposal of £5.8 million = £15.7 million.
As this is material it will require disclosure.
To record correctly the receipt of annual rental payment on 1 January 20X2:
DEBIT Finance costs £2m
(reversing incorrect entry made by the assistant)
CREDIT Non-current assets – net investment in lease £2m
To record interest income for 6 months to 30 June 20X2:
DEBIT Non-current assets – net investment in lease £975,000
(6/12 of interest income at 10% on
(£21.5m less £2m)
CREDIT Interest income £975,000
Therefore the net investment in the finance lease receivable will be £20.475 million
(£21.5m – £2m + £0.975m).
To confirm that these are the correct entries, I need to see evidence that £21.5 million is the
fair value of the property at its disposal date.

Estate agency buildings
As the properties were not sold at the year end, it is incorrect to derecognise the assets and
recognise a gain in profit or loss. IFRS 5 requires that a non-current asset should be
classified as 'held for sale' when the company does not intend to utilise the asset as part of
its ongoing business but intends to sell it. The Estate agency buildings, having been closed,
potentially fall in this category. To be held in this category, the likelihood of a sale taking
place should be highly probable. As the sale is to be completed within 12 months of the
year end, then this categorisation would appear to be appropriate. Therefore the following
adjustment has been made:
DEBIT Assets held for sale £10m
CREDIT Trade receivables £10m
DEBIT Admin expenses (Gain on disposal) £8m

CREDIT Assets held for sale £8m
Separate disclosure in the statement of profit or loss as 'discontinued operations' may also
be required.
The question of whether the closures are a withdrawal from the market is a question of
judgment as the business is now operated entirely online.
There is insufficient information in the summarised trial balance to determine this issue but
it will be required before the auditors can commence their work next week.
Depreciation
The depreciation charge suggests a cost of £295 million based upon the accounting policy
of the company (£5.9m × 50 years).
This is significantly greater than the cost in the financial statements and is an issue which
should be investigated.
Foreign currency receivables and forward contract
£m
Receivable originally recorded (R$60.48m/5.6) 10.8
Receivable at year end (R$60.48m/5.0) 12.1
Exchange gain 1.3
£m £m
DEBIT Trade receivables 1.3
CREDIT Profit or loss (other income) 1.3
Forward contract:
This is a cash flow hedge:
DEBIT Equity – (Other comprehensive income) 1.3
DEBIT Finance cost 0.2
CREDIT Financial liability 1.5
As the change in cash flow affects profit or loss in the current period, a reclassification
adjustment is required:
DEBIT Profit or loss 1.3
CREDIT Equity – (Other comprehensive income) 1.3
Foreign currency and financial instruments gains and losses are taxed on the same basis as IFRS
profits. As the finance cost and the exchange gain are both in profit or loss, there are no further
current or deferred tax implications.

The scenario states that "the arrangement satisfies the necessary criteria in IFRS 9, Financial
Instruments to be accounted for as a hedge". This is an objective-based test that focuses on the
economic relationship between the hedged item and the hedging instrument, and the effect of
credit risk on that economic relationship. This transaction could be treated as either a fair value
or cash flow hedge. However, as a receivable is created there is no need for hedge accounting
as the exchange difference on the receivable and the future are both recognised through profit
or loss.
Therefore an alternative accounting treatment would be not to apply hedge accounting.
Property management services contract
Following IFRS 15, revenue should be recognised when, or as, a performance obligation is
satisfied. The performance obligation in the property management services contract with the
local authority is the provision of those services (a contract in which the performance obligation
is satisfied over time). As at 1 June 20X2, when the deposit is received, those services have not
been provided and so the performance has not been satisfied.
Therefore it was incorrect to recognise the £1 million as revenue. Instead, it is a contract liability,
defined by IFRS 15 as "an entity's obligation to transfer goods or services to a customer for
which the entity has received consideration (or the amount is due) from the customer".
The following journal is required to correct the error:
DEBIT Revenue £1m
CREDIT Contract liability £1m
Taxation
The following journal is required to adjust for current and deferred tax as noted in the
assumptions:
DEBIT Income tax expense £17.1m
CREDIT Current tax obligation £17.1m
Being current tax adjustment – revised profit (85.1 – 14) × 24%
DEBIT Income tax expense
£14m × 24% £3.4m
CREDIT Deferred tax obligation £3.4m
Being adjustment for increase in temporary differences
Deferred tax summary
£m
Deferred tax liability brought forward 33.0
Increase in taxable temporary differences
(£14m  24%) 3.4
Deferred tax liability at 30 June 20X2 36.4

2 Mervyn plc
Marking guide
Marks
(a) Explanations:
Sale of land: The Ridings/Event after reporting period 2
Sale of land: Hanger Hill/sale and leaseback 4
Pensions 6
Provision 3
Revenue 2
Share appreciation rights 2
(b) Adjusted profit calculations:

Elimination of gain on sale of The Ridings 1
Sale and leaseback 4
Pensions 5
Provision 1
SARs 5
Revenue 1
Closing inventories 1
Quality of discussion 2
Total marks 39
Maximum marks 30
(a) Sale of land: The Ridings

This sale and profit earned have been treated as an adjusting event after the reporting
period. This appears to contravene IAS 10, Events After the Reporting Period. The
completion of the sale in November does not give evidence of circumstances as at the
reporting date. This would only have been the case if the contract in existence at
30 September had been unconditional, or if the condition, that is, detailed planning
consent, had been met by the year-end.
The gain, and associated tax effect, should be eliminated from the financial statements, to
be recognised in the following accounting period.
The land probably met the criteria to be classed as 'held for sale' under IFRS 5, Non-current
Assets Held for Sale and Discontinued Operations at the year-end. However, this has no
profit impact as IFRS 5 only requires recognition of a loss when fair value less costs to sell is
below book value, which is clearly not the case here.
The transaction may be disclosed in the notes as a non-adjusting event after the reporting
period if considered material to the user.
Sale of land: Hanger Hill
IAS 17, Leases requires sale and leaseback transactions to be treated according to their
substance, which may differ from their legal form.
The first consideration is whether a sale has taken place. In this case, the lease is clearly an
operating lease, as it is short-term and the lease payments are significantly less than the fair
value of the asset. It is therefore appropriate to derecognise the asset but the true nature of
the profit must be established.

According to IAS 17, the excess of fair value over the carrying amount of the asset is a
normal profit and should be recognised immediately in profit or loss. Any excess profit,
here £200,000 (W1) should be deferred and amortised over the period the asset is
expected to be used, and therefore eliminated from the profit or loss for the year at the
point of the sale and leaseback contract.
IAS 17 does not provide guidance as to how the excess profit should be amortised. One
method is to spread the gain of £200,000 over the life of the lease on a straight line basis.
This gives an annual credit of £40,000 to profit or loss for the year (200,000/5). The balance
of £160,000 is deferred income and recognised as a liability.
Under IFRS 16, Leases, the lease would not be an operating lease, as this distinction does
not apply for lessees. The transaction would need to meet the criteria in IFRS 15, Revenue
from Contracts with Customers for a genuine sale. There is some doubt as to whether it
does. If it does, the asset sold is derecognised and a right-of-use asset recognised together
with a lease liability relating to the right of use retained and a gain/loss in relation to the
rights transferred.
Pensions
The contributions paid have been charged to profit or loss in contravention of IAS 19,
Employee Benefits.
Under IAS 19, the following must be done:
 Actuarial valuations of assets and liabilities revised at the year-end
 All gains and losses recognised:
– Current service cost
– Transfers In profit or loss
– Interest on net defined asset/liability

– Remeasurement (actuarial) gains and losses – In other comprehensive income (per
IAS 19, as revised in 2011)
Deferred tax must also be recognised. The deferred tax is calculated as the difference
between the IAS 19 net defined benefit liability less its tax base (ie, nil as no tax deduction is
allowed until the pension payments are made). IAS 12, Income Taxes requires deferred tax
relating to items charged or credited to other comprehensive income to be recognised in
other comprehensive income hence the amount of the deferred tax movement relating to
the actuarial losses charged directly to OCI must be split out and credited directly to OCI.
Provision
According to IAS 37, Provisions, Contingent Liabilities and Contingent Assets a provision
shall be recognised when:
 an entity has a present obligation as a result of a past event;
 it is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; and
 a reliable estimate can be made of the amount of the obligation.
If these conditions are met then a provision must be recognised.
The assessment of a provision for a legal claim is always a difficult area as it will be based
upon the evidence available but it could also be argued that any provision or disclosure
could be prejudicial to the court case itself.
In this case it would appear that the lawyers and management are fairly certain that
damages and costs will be payable. The problem is the amount of any provision to be
made. As there is a timescale involved here then the first stage will be to calculate the

present value of each of the outcomes. Management have also assigned probabilities to
each of the three possible outcomes so a further decision must be made as to whether to
calculate an expected value or take the value of the most likely outcome. IAS 37 states that
where a single obligation is being measured the individual most likely outcome may be the
best estimate of the liability. Although in some circumstances the range of outcomes may
mean that a higher figure is required.
Outcome Discount factor Expected
@ 10% Present value Probability value
£'000 £'000 £'000
Best 200 1/1.10 182 25% 46
Most likely 800 1/1.102 661 60% 397
3 169
Worst 1,500 1/1.10 1,127 15%
612
IAS 37 requires the estimated value of the provision to be the amount that the entity would
rationally pay to settle the obligation. The directors are likely to want as low a provision as
possible so they are likely to prefer the expected value of £612,000. However, this is a
single event, and IAS 37 requires £661,000 as the most likely outcome or £612,000.
Bill and hold sales
When a buyer requests that the delivery of goods purchased does not take place
immediately even though the buyer takes legal title of the goods and pays for them, such
arrangements are commonly referred to as 'bill and hold' sales. Revenue from such sales
should be recognised when the buyer takes title to the goods provided that (IFRS 15: paras.
B64–B76):
 the reason for the bill-and-hold arrangement must be substantive (for example, the
customer has requested the arrangement, as here)
 the product must be identified separately as belonging to the customer (as here, since
it is in a separate storage area)
 the product currently must be ready for physical transfer to the customer (as here – the
product is ready for delivery)
 the entity cannot have the ability to use the product or to direct it to another customer –
in this case the product is exclusively for one customer.
In this case it would appear that these sales are bill and hold sales. Therefore the goods
must be removed from closing inventories in the statement of financial position at their cost
price of £99,000, with a corresponding increase in cost of sales, and the additional revenue
of £138,000 for the year to 30 September 20X7 must be recognised in the profit or loss for
the year.
Share appreciation rights
The granting of share appreciation rights is a cash settled share based payment transaction
as defined by IFRS 2, Share-based Payment. IFRS 2 requires these to be measured at the fair
value of the liability to pay cash. The liability should be re-measured at each reporting date
and at the date of settlement. Any changes in fair value should be recognised in profit or
loss for the period.
However, the company has not remeasured the liability since 30 September 20X6. Because
IFRS 2 requires the expense and the related liability to be recognised over the two-year
vesting period, the rights should be measured as follows:
£'000
At 30 September 20X6: (£6  10,000  ½) 30
At 30 September 20X7 (£8  10,000) 80
At 1 November 20X7 (settlement date) (£9  10,000) 90

Therefore at 30 September 20X7 the liability should be re-measured to £80,000 and an
expense of £50,000 should be recognised in profit or loss for the year.
The additional expense of £10 million resulting from the remeasurement at the settlement
date is not included in the financial statements for the year ended 30 September 20X7, but
is recognised the following year.
(b) Amended profit
£'000
Profit for the year – per question 1,471
Eliminate net gain on sale – The Ridings (100 – 27) (73)
Eliminate gain on sale in excess of fair value – Hanger Hill Estate (W1) (200)
Portion of gain credited to P/L (200,000  5) (W1) 40
Pension contributions 405
Current service cost (374)
Interest on obligation (W2) (253)
Interest on plan assets (W2) 216
Transfers (400,000 – 350,000) (50)
Share appreciation rights (50)
Deferred tax on pension obligation (W3) 13
Provision for damages for court case (see above) (661)
Additional revenue from bill and hold sales 138
Reduction in closing inventories (99)
Amended profit for the year 523
WORKINGS
(1) Sale and leaseback (Hanger Hill Estate)
£
Proceeds (bal. fig.) 1,150,000
Carrying value 900,000
Gain 250,000
FV – CV Proceeds – FV
£50,000 £200,000
= 'true' profit = loan
Rentals £80,000 pa
(2) Pension scheme
Pension scheme Pension scheme
assets liabilities
£'000 £'000
At 1 October 20X6 2,160 2,530
Interest cost (10%  2,530,000) 253
Interest on plan assets (10%  2,160,000) 216
Contributions 405
Transfers (400) (350)
Pensions paid (220) (220)
 Loss on remeasurement through other
comprehensive income* (71) 38
At 30 September 20X7 2,090 2,625
*Note: IAS 19 (revised) stipulates that remeasurement losses must be recognised in other
comprehensive income in the period in which they arise.

(3) Deferred tax on pension liability
Current tax Deferred tax
(P/L) OCI asset
£ £ £ £
Net pension liability at
30 September 20X6 370,000 85,100
Contribution (405,000) Cr (93,150) (93,150)
Profit and loss debits
service cost 374,000 +
interest costs 37,000 411,000 Dr 94,530 94,530
Transfers (400,000 – 350,000) 50,000 11,500 11,500
Loss on remeasurement to OCI 109,000 25,070 25,070
Profit or loss/OCI movement 12,880 25,070 37,950
Net pension liability/deferred tax
asset at 30 September 20X8 535,000 123,050
3 Billinge
Marking guide
Marks
Explanations and calculations of deferred tax implications of: 1
(1) Fair value adjustment 5
(2) Share-based payment 6
(3) Unrealised profit 5
(4) Unremitted earnings 5
(5) Property, plant and equipment 5
(6) Lease 8
Total marks 35
Maximum marks 30
MEMO
To: Peter McLaughlin
From: Anna Wotton
Subject: Deferred Tax Issues relating to Billinge
(1) Fair value adjustment
IFRS 3, Business Combinations requires the net assets in the subsidiary acquired to be
recognised at their fair value in the group financial statements. Therefore, in the group
financial statements at the acquisition date of 1 November 20X2, the net assets of Hindley
will be recognised at their fair value of £8 million.
The revaluation gain of £1 million will not be recognised by the tax authorities until the item
of property, plant and equipment has been disposed of or taxable income has been
generated through use of the asset. This gives rise to a temporary difference.
As Hindley will have to pay tax on the taxable income generated through use of the asset
and ultimately on any gain on disposal, this temporary difference results in a deferred tax
liability in the group financial statements.
£m
Carrying amount in group financial statements 8
Tax base (7)
Temporary difference 1
Deferred tax liability (30%) (0.3)

The deferred tax is recognised as a liability in the statement of financial position and results
in an increase in goodwill, rather than a charge to other comprehensive income, as the fair
value gain is recognised on acquisition.
The deferred tax is recognised even though the entity does not intend to dispose of the
asset. The fair value adjustment still represents a taxable temporary difference as the asset's
value will be recovered through use rather than sale, generating taxable income in excess
of the depreciation (based on original cost) allowed for tax purposes.
In Hindley's individual accounts, no fair value adjustment is required and no deferred tax
liability will arise as both the carrying amount and the tax base will be the same ie,
£7 million.
The initial recognition of goodwill that arises on acquisition (£10m – £8m = £2m) will not
give rise to any deferred tax: IAS 12 does not permit recognition of deferred tax as goodwill
is measured as a residual and the recognition of a deferred tax liability would increase the
carrying amount of the goodwill.
(2) Share-based payment
IFRS 2, Share-based Payment requires equity settled share based payments to be
recognised at the fair value at the grant date ie, £5. The expense should be spread over the
vesting period of three years with a corresponding increase in equity.
For the year ended 31 October 20X2, the equity and expense would have been recorded at
£666,667 (1,000 options  500 employees  80% to remove estimated leavers  £5 fair
value at grant date  1/3 vested).
As at 31 October 20X3, equity would be revised to £1.25m (1,000 options  500 employees
 75% to remove revised estimated leavers  £5 fair value at grant date  2/3 vested). The
movement in the year of £583,333 (£1.25m – £666,667) would be posted to profit or loss.
The tax authorities, however, do not give tax relief until exercise. This gives rise to a
temporary difference.
The tax relief is based on the intrinsic value so this is the value used to measure the
deferred tax asset.
The deferred tax asset correctly recognised at 31 October 20X2 would have been
calculated as follows:
£m
Carrying amount of share-based payment expense 0
Tax base (1,000 options  500 employees  80% to remove leavers  £3
intrinsic value  1/3 vested) (0.4)
Temporary difference (0.4)
Deferred tax asset (30%) 0.12
The deferred tax asset to be recognised at 31 October 20X3 is calculated as follows:

£m
Carrying amount of share-based payment expense 0
Tax base (1,000  500  75%  £8  2/3) (2)
Temporary difference (2)

The amount of deferred tax that relates to the excess of the intrinsic value over the fair value
at the grant date should be recognised in equity as there is no corresponding expense to
match it to in profit or loss:
£m
Cumulative tax deduction 2.000
Cumulative expense (1,000  500  75%  £5 at grant date  2/3) (1.250)
Excess 0.750
Deferred tax to be recognised in equity (30%) 0.225
The remaining movement in the deferred tax asset of £0.255 million (£0.6m – £0.12m b/d –
£0.225m to equity) should be credited to profit or loss for the year.
(3) Unrealised profit
In the group accounts, the unrealised profits on goods sold internally, which still remain in
inventories at the year-end, must be cancelled. In future years, once the inventories have
been sold on to third parties, this cancellation is no longer required.
This gives rise to a temporary difference as the tax authorities still tax the sale regardless of
whether it is internal or external as they work from the individual companies' profit figures
not the group figures.
The unrealised profit is calculated as follows:
£5m  25%/125%  ¾ in inventories = £0.75m
The temporary difference results in a deferred tax asset as, in the group accounts, there is a
tax charge on a non-existent profit which needs to be removed.
The deferred tax asset in the group accounts is calculated as follows:
£m
Carrying amount in group accounts – inventories [(£5m  3/4) – £0.75m] 3.000
Tax base – inventories (£5m  ¾) (3.750)
The result is a deferred tax credit to profit or loss of £0.225 million in the current period.
There is no deferred tax impact in Ince's individual accounts because the unrealised profit is
not cancelled.
(4) Unremitted earnings
There is a potential deferred tax liability of £0.4 million on the unremitted earnings of
Quando. This is because the Quando's profits of 5 million corona have been consolidated
in the group accounts, but the additional tax will not be paid by Billinge until these profits
are remitted to owners as dividends, giving rise to a temporary difference. However, as
Billinge controls the timing of the Quando's dividends (being a 100% shareholder) and it is
probable that the temporary difference will not reverse in the foreseeable future as Billinge
intends to leave the profits within Quando for reinvestment, IAS 12, Income Taxes dictates
that no deferred tax liability should be recognised.
(5) Property, plant and equipment
The carrying amount of property, plant and equipment is its net book value. The grant may
either be deferred and released to profit or loss over the useful life of the asset or deducted
from the cost of the asset.
The tax base is the tax written down value.
Since the depreciation and capital allowances are charged at different rates, this gives rise
to a temporary difference.

The resultant deferred tax liability is calculated as follows (on the assumption that the grant
is recognised as deferred income):
£m £m
Carrying amount:
Property, plant & equipment (£12m – £12m/5) 9.60
Deferred grant (£2m – £2m/5) (1.60) 8.00
Tax base (£12m – £2m) – [(£12m – £2m)  25%] (7.50)
Temporary difference 0.50
Deferred tax liability (30%) (0.15)
A deferred tax liability has arisen because the capital allowances granted to date are
greater than the depreciation and grant amortisation recognised in profit or loss. Therefore
too much tax relief has been granted and this needs to be reversed.
The deferred tax liability of £0.15 million is charged to profit or loss as that is where the
effect of the depreciation and grant amortisation have been shown.
Tutorial note
It the grant had been deducted from the cost of the asset, the carrying amount would have been
calculated as [(£12m – £2m) – ((£12m – £2m)  1/5)] ie, £8 million, resulting in the same carrying
amount as if it had been treated as deferred income.
(6) Lease
This is a finance lease as the risks and rewards incidental to ownership have been
transferred to the lessee (Billinge). The evidence for this is that the present value of the
minimum lease payments (£6 million) is the same as the fair value and the economic life of
the asset is the same as the lease term.
Under IAS 17, Leases, the accounting treatment for a finance lease follows the substance of
the transaction rather than the form. This results in recognising an asset and a
corresponding liability.
A temporary difference arises because in the accounts, the asset is written off over its useful
life and the finance cost is recognised at a constant rate on the carrying amount of the
liability; whereas the tax authorities give tax relief as the rentals are paid.
The deferred tax is calculated as follows:
£m £m
Carrying amount:
Property, plant and equipment (£6m – £6m/5 years) 4.800
Lease liability (£6m + [8%  £6m] – £1.5m) (4.980) (0.180)
Tax base 0.000
The resultant deferred tax is an asset (and credit in profit or loss) because the tax relief is
based on the rental of £1.5 million yet the expense in the profit or loss is £1.68 million (ie,
depreciation of £1.2 million and interest of £0.48 million) which means that part of the
future tax saving on rental deductions is recognised now for accounting purposes, so the
tax charge is reduced representing the tax recoverable in the future.

4 Longwood
Marking guide
Marks
Change in tax rate 8

Revised tax losses adjustment 8
Fair value adjustments 7
Goodwill calculation 7
Deferred taxes, goodwill and share versus asset deals 8
Total marks 38
Maximum marks 30
(a) Change of tax rate

Per IAS 12, Income Taxes, the tax rate to be used is that expected to apply when the asset is
realised or the liability settled, based upon laws already enacted or substantively enacted
by the year end.
The deferred tax assets and liabilities therefore need to be measured using the enacted
rate for 20X7 of 23%, rather than 30%.
The net change in the carrying amount of the deferred tax assets and liabilities
(£0.26 million, as shown in the table below) arising from a change in rates will normally
need to be taken to profit or loss for the year of Portobello Alloys. However, this will not be
the case where it relates to a transaction or event which is recognised in equity (in the same
or a different period), when the resulting deferred tax is also included in 'other
comprehensive income'. This is the case for the investments.
The schedule below calculates the adjustments to the deferred tax assets and liabilities by
reworking the temporary differences at the new rate.
Deferred tax schedule (in £m)
at 30% at 23% Adjustment
Property, plant and equipment (1.54) (1.18) 0.36
Equity investments at FVTOCI (0.32) (0.25) 0.07
Post-retirement liability 0.11 0.09 (0.02)
Unrelieved tax losses – recognised 0.66 0.51 (0.15)
(1.09) (0.83) 0.26
Deferred tax liability (1.86) (1.43) 0.43
Deferred tax asset 0.77 0.60 (0.17)
(1.09) (0.84) 0.26
The resultant adjustments are:

Debit Credit
£m £m
Tax charge – profit or loss 0.19
Equity – in respect of investments 0.07

(b) Deferred tax asset recognition for losses
The increased forecast profitability may allow Portobello Alloys to recognise a deferred tax
asset in respect of all the thus-far unrecognised unrelieved tax losses incurred. However,
there is a risk that no losses will be available to carry forward. This will be the case if there is
a major change in the nature and conduct of the trade post-acquisition. The amount of
unrecognised losses is shown below.
Tax losses working
£m
Total losses for tax purposes 7.40
Already utilised (1.20)
Remaining 6.20
Recognised (2.20)
Unrecognised 4.00
The analysis of the adjustment between current and non-current deferred taxes can be
derived from the profit forecast as below.
Profit forecasts for tax loss utilisation
20X7 20X8 Total
£m £m £m
Forecast taxable profit – original 0.98 1.22 2.20
Forecast taxable profit – revised 1.90 4.74 6.64
Additional taxable profits 0.92 3.52 4.44
Additional recoverable losses 0.92 3.08 4.00
Addition to deferred tax asset at 23% 0.21 0.71 0.92
Note that the additional recoverable losses for 20X8 are restricted to £3.08 million (rather
than being equal to the additional taxable profits of £3.52 million) since the total of
unrecognised losses is only £4.00 million.
Note that the change in the deferred tax asset must be recognised in profit or loss:
£m £m
DEBIT Deferred tax asset 0.92
CREDIT Tax charge – profit or loss 0.92
(c) Deferred taxes on fair value adjustments
These adjustments will arise as consolidation adjustments rather than in the financial
statements of Portobello Alloys.
The deferred tax adjustment in respect of the PPE should be to equity since the underlying
revaluation on land will be recognised through equity in the revaluation reserve. The land
will not be depreciated, and the deferred tax on the temporary difference will only
crystallise when the land is sold. It is clear that there is no intention to sell the property in the
current horizon.
The required adjustments to the deferred tax assets and liabilities are summarised in the
table below.
Carrying Temporary Deferred
Fair value amount difference tax at 23%
£m £m £m £m
Property, plant and
equipment 21.65 18.92 (2.73) (0.63)
Development asset 5.26 0.00 (5.26) (1.21)
Post-retirement liability (1.65) (0.37) 1.28 0.29
25.26 18.55 (6.71) (1.55)
Deferred tax liability (1.84)
(1.55)

The resulting consolidation adjustment is:
Debit Credit
£m £m
Goodwill adjustment 1.55
(d) Goodwill calculation
The first step is to determine the fair value of the consideration.
Deferred consideration must be measured at its fair value at the date that the consideration
is recognised in the acquirer's financial statements, usually the acquisition date. The fair
value depends on the form of the deferred consideration.
Where the deferred consideration is in the form of equity shares:
 Fair value is measured at the date the consideration is recognised, usually the
acquisition date. Consequently, the share price used must be £1.88.
Where the deferred consideration is payable in cash:
 Fair value is measured at the present value of the amount payable, hence the present
value of the £10 million cash.
Under IFRS 3 all acquisition-related costs must be written off as incurred. They are not
included in the consideration transferred.
Fair value of consideration
£m
Cash payment 57.00
Deferred equity consideration (5m  £1.88) 9.40
Deferred cash consideration (£10m/1.13) 7.51
73.91
The value of the net assets acquired needs to be adjusted for the changes to reflect the fair
value of PPE, the development asset, the pension and deferred taxes as shown below.
Fair value of net assets acquired
£m
Book value per statement of financial position provided 9.90
Fair value adjustment to PPE 2.73
Fair value adjustment to development asset 5.26
Fair value adjustment to pension liability (1.28)
Deferred tax – rate change 0.26
Deferred tax – tax losses (0.21 + 0.71) 0.92
Deferred tax – fair value adjustments (0.29 – 1.84) (1.55)
16.24
The resulting fair value of goodwill, on which no deferred tax is applicable is:
£m
Fair value of consideration 73.91
Fair value of net assets acquired (16.24)
Goodwill 57.67
(e) Deferred taxes and goodwill

Goodwill and share acquisitions
When an entity purchases the shares in a target and gains control, IFRS 3 requires that
consolidated financial statements are produced and the target is introduced at fair value,
including any attributable goodwill.

The goodwill arising in this manner does not appear in any of the companies' individual
financial statements, but arises as a consolidation adjustment in the consolidated financial
statements.
Tax authorities look at the individual financial statements of the companies within the group
and tax the individual entities. As such, no goodwill is recognised for tax purposes. The
individual financial statements of the buyer will simply reflect an investment in shares in its
statement of financial position, not the subsidiary assets, liabilities or goodwill.
Under IAS 12, Income Taxes, a deferred tax liability or asset should be recognised for all
taxable and deductible temporary differences, unless they arise from (inter alia) goodwill
arising in a business combination. As such, no deferred tax is recognised.
Goodwill and asset acquisitions
The essential difference here is that the buyer has not purchased shares, but the assets and
liabilities of the target. The assets and liabilities are measured and introduced at fair value,
including any purchased goodwill. These are introduced directly into the individual financial
statements of the buyer.
It is this goodwill that the tax authorities will recognise as a purchased asset and on which
they may charge tax.
As tax relief is permitted over 15 years but goodwill is not amortised, then the tax base and
the accounting base are not the same, therefore a taxable temporary difference arises and
deferred tax recognised.
5 Upstart Records
The candidate is required to reply to a request by a group finance director to assist with the
finalisation of the group accounts. The group's investment in Liddle Music Ltd has increased
twice during the year such that the investment has moved from being accounted for as an
associate to a subsidiary requiring the calculation of a profit to be recognised in the statement of
profit or loss on crossing the 'control' threshold. A further acquisition of more shares later in the
year however, requires no further profit to be recognised but does require changes to the
percentage of non-controlling interest. Adjustments are required for a restructuring provision
and for share-based payment.
The candidate is required to explain the impact of the acquisition of shares in Liddle Music on
goodwill and non-controlling interest, to explain and calculate any required adjustments with
regard to restructuring provisions and share options, to prepare a consolidated statement of
profit or loss including Liddle Music and finally to explain the impact of Upstart adopting an
alternative accounting policy regarding the recognition of the non-controlling interest.

Marking guide
Requirement Marks Skills
Show and explain with supporting 16  Apply technical knowledge to

calculations, the appropriate identify implications of crossing
financial reporting treatment of control threshold.
goodwill and non-controlling  Apply technical knowledge to
interests for Liddle in Upstart's distinguish between and calculate
consolidated statement of financial the deferred and contingent
position as at 30 June 20X5. Use the consideration.
proportion of net assets method to
determine non-controlling interests.  Identify the incorrect treatment of
the professional fees.
 Apply technical knowledge to
calculate goodwill including the fair
value adjustment and subsequent
depreciation adjustment.
 Appreciate that the second
acquisition does not create a further
profit and recommend the
appropriate adjustment.
 Identify intra-group transactions and
recommend adjustments.
 Explain incorrect treatment of the

German loan and recommend the
accounting adjustment required.
Explain, with supporting 9  Apply technical knowledge to
calculations, the appropriate determine whether a provision
financial reporting treatment for the should be recognised and calculate
restructuring plans and the share the amount of the provision.
options.  Appreciate that no provision should
be made in respect of the second
proposal.
 Identify that the share options
represent an equity-settled share-
based payment.
 Apply technical knowledge to
account for the share-based
payment correctly.
Prepare Upstart's consolidated 8 Assimilate adjustments and prepare
statement of profit or loss for the revised consolidated statement of profit
year ended 30 June 20X5, to include or loss.
Liddle.

Explain (without calculations) the 5 Assimilate information, and apply

impact on Upstart's consolidated technical knowledge to explain that NCI
financial statements if the fair value valuation would impact on goodwill.
method for measuring
non-controlling interests were to be
used instead of the proportion of net
assets method.
Total marks 38
Maximum marks 30
To: Susan Ballion

From: Thomas Mensforth
Subject: Liddle
(a) Explanation of financial reporting treatment of goodwill and non-controlling interest
Goodwill
Goodwill arises at the date when control is achieved. In the case of Upstart and Liddle this is
on 1 October 20X4, when Upstart's investment in Liddle passes the 50% threshold.
Until that date, Liddle has been treated as an associate. Under the equity accounting
method the group's share of Liddle's profits after tax is credited to the consolidated
statement of profit or loss, and the investment is measured at cost plus share of post-
acquisition profits in the consolidated statement of financial position. In the year ended
30 June 20X5 Liddle is therefore treated as an associate for the period 1 July to 1 October
20X4.
On 1 October 20X4, the equity value of Liddle was £7.174 million (W8) and this was
remeasured to fair value of £7.5 million (W8) for the purposes of calculating goodwill. The
difference between the two figures (£326,000) was credited to the statement of profit or
loss.
Goodwill is measured as the fair value of consideration paid less the fair value of the net
assets acquired.
The fair value of the consideration consists of the following elements:
 Cash paid of £2 million.
 The fair value of the original 25% investment in Liddle at 1 October 20X4.
 The shares issued on 1 October 20X4.
 The £3 million payable on 1 October 20X6 is discounted to fair value, and the interest
is then unwound in the statement of profit or loss.
 The £3 million contingent consideration payable on 1 October 20X7 is measured at its
fair value (determined by the probability of it occurring), again discounted to a present
value, and unwound in the statement of profit or loss.
The professional fees of £250,000 are excluded from the goodwill calculation and instead
expensed to the statement of profit or loss as incurred.
As a result of applying these principles a goodwill figure of £13.077 million arose on the
acquisition of Liddle (W3).

There is no further adjustment to goodwill when Upstart acquired a further 100,000 shares
in Liddle on 1 April 20X5. Instead, the difference between the consideration paid and the
decrease in the non-controlling interest's share of net assets is taken to group reserves
(W6).
Goodwill is subject to annual impairment reviews.
Non-controlling interests (NCI)
When Upstart acquired a controlling interest in Liddle on 1 October 20X4, NCI arose in
relation to the 30% of Liddle not owned by Upstart at this date.
There are two permitted methods of determining the NCI, the proportionate and fair value
method, and Upstart chose the former.
The NCI is therefore measured at its share of the net assets of Liddle at the control date,
adjusted for fair value movements.
In the six months between 1 October 20X4 to 1 April 20X5 the NCI are allocated 30% of the
profits of Liddle (W4). This is added to the original NCI total.
On 1 April 20X5 the NCI reduce their investment in Liddle from 30% to 20%. The reduction
in net assets (W4) is compared to the cost of the shares bought by Upstart, and the
difference is taken to group reserves (W6).
From 1 April to 30 June 20X5 the NCI are allocated 20% of the profits of Liddle (W4).
In the statement of financial position the NCI are effectively given their share (20%) of the
fair value of Liddle's net assets at 30 June 20X5. This gives a figure of £3.664 million (W4).
(b) Financial reporting treatment of restructuring plans and share options
Restructuring plans
Plan 1:
A provision for restructuring should be recognised in respect of the closure of the retail
outlets in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
The plan has been communicated to the relevant employees (those who will be made
redundant) and the outlets have already been identified. A provision should only be
recognised for directly attributable costs that will not benefit ongoing activities of the entity.
Thus, a provision should be recognised for the redundancy costs and the lease termination
costs, but none for the retraining costs:
£'000
Redundancy costs 300
Retraining –
Lease termination costs 50
Liability 350
DEBIT Profit or loss £350,000

CREDIT Current liabilities £350,000
Plan 2:
No provision should be recognised for the reorganisation of the finance and IT department.
Since the reorganisation is not due to start for two years, the plan may change, and so a
valid expectation that management is committed to the plan has not been raised. As
regards any provision for redundancy, individuals have not been identified and
communicated with, and so no provision should be made at 30 June 20X5 for redundancy
costs.

Share options
IFRS 2, Share-based Payment requires that the expense in respect of the share options must
be recognised in profit or loss for the year. This is an equity-settled share-based payment,
so the fair value of the share options is that at the grant date, and the corresponding credit
is to equity:
CREDIT Equity £133,333
The expense is calculated as follows:
£'000
30 June 20X4 Equity b/d: 1,000  4  £50  1
3 66.67
Profit or loss (balancing figure) 133.33

30 June 20X5 Equity c/d: 1,000  6  £50  2
3 200.00
(c) Consolidated statement of profit or loss for year ended 30 June 20X5
£'000
Revenue (see (W5)) 34,420
Cost of sales (10,640)
Gross profit 23,780
Profit from operations 18,422
Investment income 905
Fair value gain on associate 326
Associate income 424
Interest paid (625 + 169 + 78 + 123 + 141) (1,136)
Taxation (3,700)
Profit for year 15,241
Profit attributable to:

Shareholders of the parent 13,901
Non-controlling interests 1,340
15,241
(d) Fair value method implications

If the fair value method in relation to the non-controlling interest was used instead of the
proportion of net assets method, the potential implications would be as follows:
 Goodwill would be higher, because the non-controlling interest (NCI) would include
their share of goodwill in addition to their share of net assets.
 If a goodwill impairment arose, the NCI would bear a share of the impairment, this
would decrease the NCI allocation in the consolidated statement of profit or loss.
 Assuming that the NCI is higher for the reasons discussed above, gearing would be
lower as NCI is deemed to be part of equity.
WORKINGS
(1) Group Structure
Upstart
25% 3 months
70% 6 months
80% 3 months
Liddle

(2) Net Assets 30 Jun 1 Apr 1 Oct 1 Jan
20X5 20X5 20X4 20X3
£'000 £'000 £'000 £'000
Share capital 1,000 1,000 1,000 1,000
Reserves: At 1 January 20X3 6,600
Reserves: At 1 July 20X4 9,000 9,000 9,000
Profits for 12/9/3 months 6,780 5,085 1,695
Fair value adjustment 1,600 1,600 1,600

Depreciation on FV adjustment (60) (40)
(1,600  1/20  9/12 and 6/12) 18,320 16,645 13,295 7,600
Movement 1,675 3,350 5,695
(3) Goodwill
Consideration: £'000
Shares issued (800,000  £11.50) 9,200
Cash 01.10.20X4 2,000
2
Deferred cash (£3 million/1.09 ) 2,525
Contingent cash ((£3 million  50%)/1.09 )
3
1,158
Fair value of previously held equity investment (250,000  £30) 7,500
Non-controlling interest at 01.10.X4 3,989 (13,295  30%)
Less: Net assets at control (W2) (13,295)
Goodwill 13,077
(4) Non-controlling interests £'000

At 1 October 20X4 (W3) 3,989
Share of profit to 1 April 20X5
£5,025,000 (W5)  6/9  30% 1,005
NCI at 1 April 20X5 4,994
*Share transferred to Upstart
(4,994  10/30) see working below (1,665)
Share of profits 1 April–30 June 20X5
(1,675 (W2)  20%) 335
At 30 June 20X5 3,664
*Share of net assets based on old interest = 16,645  30% 4,994

Share of net assets based on new interest = 16,645  20% 3,329
Adjustment required 1,665

(5) Group SPL Liddle
Upstart (9/12) Adjust Group
£'000 £'000 £'000 £'000
Revenue 23,800 11,700 (1,080) 34,420
Additional depreciation (60)

Cost of sales (7,400) (4,050) 1,080 (10,640)
Unrealised profit (210) (W9)
Operating costs (3,500) (1,125) (5,358)
Professional fees (250)
Restructuring provision (350)
Share-based payment (133)
Investment income 890 135 (120) (W9) 905
Gain on previously held equity 326 326
investment (W8)
Associate income (6,780  25%
 3/12) 424 424
Interest paid (520) (225) 120 (W9) (625)
Unwinding of discount on deferred
consideration (W10) (169) (169)
Unwinding of discount on
contingent consideration (W10) (78) (78)
Foreign loan interest (W11) (141) (141)
Exchange loss on loan (W7) (123) (123)
Taxation (2,350) (1,350) (3,700)
Profit for year 9,676 5,025 15,241
NCI: (5,025  6/9  30%) 1,005

(5,025  3/9  20%) 335
Total 1,340
(6) Increase in investment in Liddle 1 April 20X5

£'000
CREDIT Cash 3,500
DEBIT NCI 1,665
DEBIT Group Reserves (balance) 1,835
(7) Exchange loss on loan

£'000
Borrowed at 1 October 20X4
(€4 million at £1 = €1.30) 3,077
Restate at 30 June 20X5 (€4 million at £1 = €1.25) 3,200
Exchange loss (123)
(8) Associate
£'000
Cost 5,750
Share 01.01.20X3 to 01.10.20X4 1,424
(25%  5,695 (W2)) 7,174
Fair value at 1 October 20X4 (250  £30) 7,500
Increase in value to SPL 326

(9) Profit in inventories
100% 60% 160%
Cost Profit Sales Price
210 560
Reduce profit by £210,000
Intra-group transactions
£120,000  9 months = £1,080,000 – remove from revenue and cost of sales
Cancel £2 million  8%  9/12 = £120,000 from investment income and finance cost
(10) Deferred consideration
At 01.10.20X4 At 30.6.20X5 Movement
£'000 £'000 £'000
2 2,694 169
Deferred cash (£3 million/1.09 ) 2,525
Contingent cash
((£3 million  50%)/1.09 )
3
1,158 1,236 78
Also acceptable = £2,525,000  9%  9/12 = £170,000
(11) Foreign loan interest
€4 million  6%  9/12 = €180,000 at £1 = €1.28 = £141,000
6 MaxiMart plc
Marking guide
Marks
(a) Share option scheme 7

(b) Pension scheme 14
(c) Reward card 5
(d) Futures contract 7
(e) Proposed dividend 5
Total marks 38
Maximum marks 30
MEMO
To: Jane Lewis
From: Vimal Subramanian
Transactions of MaxiMart
(a) Share options awarded
This is an equity-settled share-based payment. An expense should be recorded in profit or
loss, spread over the vesting period of five years with a corresponding increase in equity.
Each option should be measured at the fair value at the grant date ie, £2. The year-end
estimate of total leavers over the five-year vesting period (25%) should be removed in the
calculation of the expense as they will never be able to exercise their share options.

There are two other vesting criteria here:
(1) The average profit which should be taken into account because it is a performance
criterion. The average profit for the next five years is £1.3 million ([£0.9m + £1.1m +
£1.3m + £1.5m + £1.7m]/5 years), resulting in 120 options per employee.
(2) The share price which should not be taken into account because it is a market
condition which is already factored into the fair value. So the fact that the share price
target of £8 has not been met by the year end does not need to be taken into account.
The expense and the corresponding increase in equity for the year ended 30 September
20X1 is calculated as follows:
= 1,000 employees  75% employees remaining  120 options  £2 FV  1/5 vested
= £36,000
(b) Pension scheme
Statement of financial position as at 30 September 20X1 (extract)
30 September 30 September
20X1 20X0
£'000 £'000
Non-current assets
Defined benefit pension plan – 100
Defined benefit pension plan 40 –
Statement of profit or loss and other comprehensive income for the year ended
30 September 20X1 (extracts)
£'000
Profit or loss
Defined benefit expense 185
Actuarial gain on defined benefit obligation (30)
Return on plan assets (excluding amounts in net interest) 53
Net remeasurement loss 23
Note: IAS 19 requires remeasurement gains and losses to be recognised in other
Notes to the financial statements
Defined benefit plan: amounts recognised in the statement of financial position
30 September 30 September
20X1 20X0
£'000 £'000
Present value of defined benefit obligation 2,410 2,200
Fair value of plan assets (2,370) (2,300)
40 (100)
Defined benefit expense recognised in profit or loss for the year ended
30 September 20X1
£'000
Net interest on the net defined benefit asset (115 – 110) (5)
Past service cost 100
185

Changes in the present value of the defined benefit obligation
£'000
Opening defined benefit obligation at 1 October 20X0 2,200
Interest on obligation (2,200  5%) 110
Benefits paid (60)
Remeasurement gain through OCI (balancing figure) (30)
Closing defined benefit obligation at 30 September 20X1 2,410
Changes in the fair value of plan assets
£'000
Opening fair value of plan assets at 1 October 20X0 2,300
Interest on plan assets (2,300  5%) 115
Contributions 68
Benefits paid (60)
Remeasurement loss through OCI (balancing figure) (53)
Closing fair value of plan assets at 30 September 20X1 2,370
(c) Reward card

The reward points provide a material right to customers that they would not receive without
entering into a contract. Consequently, the promise to provide goods and services to the
customer in exchange for points is a performance obligation under IFRS 15, Revenue from
Contracts with Customers. Total revenue of £100 million is allocated between the food sales
and the reward points based on standalone prices.
Here, total reward points have a face value of £5 million at the year end but only two in five
customers are expected to redeem their points, giving a value of £2 million (ie, £5m  2/5).
£'000
Food sales £100m/£102m  £100m 98,039
Loyalty points £2m/£102m  £100m 1,961
100,000
In substance, customers are implicitly paying for the reward points they receive when they
buy other goods and services and hence some of that revenue should be allocated to the
points, as a separate performance obligation.
£98.04 million would be recognised as revenue in the year ended 30 September 20X1 and
£1.96 million would be recognised as a contract liability in the statement of financial
position until the reward points are redeemed.
(d) Futures contract
IFRS 9, Financial Instruments has an objective-based assessment for hedge effectiveness,
under which the following criteria must be met.
(1) There is an economic relationship between the hedged item and the hedging
instrument ie, the hedging instrument and the hedged item have values that generally
move in the opposite direction because of the same risk, which is the hedged risk.
(2) The effect of credit risk does not dominate the value changes that result from that
economic relationship ie, the gain or loss from credit risk does not frustrate the effect
of changes in the underlyings on the value of the hedging instrument or the hedged
item, even if those changes were significant.
(3) The hedge ratio of the hedging relationship (quantity of hedging instrument vs
quantity of hedged item) is the same as that resulting from the quantity of the hedged
item that the entity actually hedges and the quantity of the hedging instrument that the
entity actually uses to hedge that quantity of hedged item.

The loss on the forecast sale should not be accounted for as the sale has not yet taken
place. However, the gain on the future should be accounted for under IFRS 9, Financial
Instruments. Assuming the hedge effectiveness criteria have been met, hedge accounting
can be applied.
The double entry required is:
DEBIT Financial asset (future) £2m
CREDIT Retained earnings (with effective portion) £1.9m
CREDIT Profit or loss (with ineffective portion) £0.1m
(e) Proposed dividend
The dividend was proposed after the end of the reporting period and therefore IAS 10,
Events After the Reporting Period applies. This prohibits the recognition of proposed equity
dividends unless these are declared before the end of the reporting period. The directors
did not have an obligation to pay the dividend at 30 September 20X1 and therefore there
cannot be a liability. The directors seem to be arguing that their past record creates a
constructive obligation as defined by IAS 37, Provisions, Contingent Liabilities and
Contingent Assets. A constructive obligation may exist as a result of the proposal of the
dividend, but this had not arisen at the end of the reporting period.
Although the proposed dividend is not recognised it was approved before the financial
statements were authorised for issue and should be disclosed in the notes to the financial
statements.
7 Robicorp plc
Marking guide

Recommend any 26 Apply technical knowledge of IAS 38 to the scenario to
adjustments, with determine appropriate accounting treatment of the
accompanying application.
journal entries, that
Identify need for amortisation of development costs.
are required to
make the Analyse and interpret journal to determine reversal of accrued
accounting production costs required.
treatment comply
Link information to determine the correct accounting
with IFRS,
treatment for the revenue from the XL5 order.
explaining the
reasons for your Apply technical knowledge to determine treatment of bond.
proposed changes. Explain the appropriate treatment required to reflect the
share option scheme and the adjustment required.
Calculate the profit on disposal of the Lopex shares and the
appropriate recognition of the investment in Saltor.
Identify the difference between the fair value and the face
value of the interest-free loan to the employees as being the
cost to the employer, to be treated as compensation under
IAS 19.
Apply the IFRS 9 rules in accounting for the loan at amortised
cost using the effective interest method.\

Revise the draft 8 Assimilate adjustments and prepare revised profit after tax.
basic earnings per
Calculate basic EPS and diluted EPS.
share figure (Exhibit
2) taking into
account your
adjustments and
calculate the diluted
earnings per share.
Total marks 34
available
Maximum marks 30
To: Alex Murphy

From: Marina Nelitova
Subject: Review of financial statements for year ended 30 September 20X4
XL5 costs and revenues
In order for development costs to be capitalised, the following criteria have to be satisfied. The
project must:
 be technically feasible
 be intended to be completed and used/sold
 be able to be used/sold
 be expected to generate probable future economic benefits
 have sufficient resources to be completed
 have costs that can be separately recognised
In the period to 1 January 20X4 not all these criteria appear to have been satisfied, and so the
costs of £2 million a month should have been expensed in the statement of profit or loss.
Once the breakthrough was made on 1 January, the development costs should have been
capitalised until the project was completed on 30 June. An intangible asset of £15 million
(6  £2.5 million) should therefore have been created.
The following journal is therefore required:
DEBIT Profit or loss £6m
CREDIT Intangible asset £6m
Once sales of the XL5 commenced on 1 August 20X4 the development costs should be
amortised. This could be done either on a time or sales basis. I have amortised the £15 million
over the number of XL5 units delivered to customers by 30 September 20X4, and this gives an
amortisation charge of £500,000 (£15 million  1,200/36,000).
CREDIT Intangible asset £500,000
Revenue should only be recognised once the risks in relation to the XL5 orders have been
transferred to the buyer. This normally is upon delivery, and so revenue in respect of 1,200 units
should be included in the statement of profit or loss.
The accrual for cost of sales should therefore be removed in relation to the original journal for
revenue and the cash received in relation to orders not yet fulfilled should be treated as a
contract liability.

DEBIT Revenue (1,800  £25,000) £45m
CREDIT Contract liability £45m
DEBIT Accrued expenses £19.8m

CREDIT Cost of sales (1,800  £11,000) £19.8m
The net impact is to reduce profits by £25.2 million.
Convertible bond
Per IFRS the bond should be split between a debt and equity element at the issue date. The
debt element is calculated by discounting the cash flows in relation to the bond by the rate
chargeable for a similar non-convertible instrument.
This gives a debt bond element of £33.037 million (W1) and the balance of the bond is taken
directly to equity, giving a figure of £6.963 million.
DEBIT Share capital £4m
DEBIT Share premium £36m
CREDIT Bond liability £33.037m
CREDIT Equity £6.963m
An interest charge of £2.478 million (£33.037m  10%  9/12) should therefore have been
charged in the statement of profit or loss and added to the liability and the interest accrual
reversed.
DEBIT Profit or loss £2.478m
CREDIT Bond liability £2.478m
DEBIT Accruals £0.9m

CREDIT Finance costs £0.9m
Share option scheme
Robicorp's share option scheme is equity settled because the company is committed to issuing
shares if the scheme conditions are satisfied.
The scheme is partially market based as the options will only vest if a share price target is
achieved. Because this part of the scheme is market based the achievement of the share price
target is ignored when calculating the option cost.
The scheme is also non-market based because the shares will only be issued if the executives
are still employed by Robicorp at 1 October 20X6. Therefore the total cost of the options takes
into consideration the expected number of executives at the vesting date.
Per IFRS 2 the fair value of the options at 1 October 20X3 should be expensed over the vesting
period of the scheme.
This gives a cost for the year to 30 September 20X4 of £1.568 million (28 execs (30 – 2 leavers) 
48,000 options  350 pence  1/3).
An expense is recognised for this amount and an equal sum credited to equity at
30 September 20X4.
DEBIT Profit or loss £1.568m
CREDIT Equity £1.568m
Investment in Lopex/Saltor
Robicorp's original investment in Lopex is insignificant in terms of group accounting, and is
therefore governed by IAS 32/IFRS 9.
Because they were being treated as investments in equity instruments at FVTOCI at
30 September 20X3, they would have been measured at fair value of £3.68 million (400,000 
£9.20) and a credit to other comprehensive income and other components of equity in equity of
£1.28 million would have been credited (400,000  £3.20).

The takeover by Saltor means that the investment in Lopex should be derecognised because
Robicorp no longer has any rights to cash flows in respect of the Lopex shares. A further gain
would be recognised in other comprehensive income/other components of equity of
£1.82 million, to reflect the gain on fair valuing the Lopex shares to their fair value at the
takeover date of £5.5 million (400,000  2.5  £5.50). This £5.5 million is the deemed
consideration at the takeover date. The gains on the Lopex shares are not reclassified to profit or
loss.
Robicorp should also have recognised a new financial asset in the form of the shares in Saltor at
1 August 20X4 at the fair value of £5.5 million.
DEBIT Financial asset (shares in Saltor) £5.5m
CREDIT Financial asset (shares in Lopex) (3.68 + 1.82) £5.5m
At 30 September 20X4 the shares in Saltor should be remeasured at fair value, which per IFRS 9
is the bid price of £4.80. This gives a value of £4.8 million (1m  480 pence) and the movement
in fair value of £700,000 (£5.5 million less £4.8 million) is taken to profit or loss.
CREDIT Financial asset £700,000
The sales commission of 4 pence per share is ignored.
Loans to employees
IFRS 9, Financial Instruments requires financial assets (except those at FVTPL or FVTOCI) to be
measured on initial recognition at fair value plus transaction costs. Usually the fair value of the
consideration given represents the fair value of the asset. However, this is not necessarily the
case with an interest free loan. An interest free loan to an employee is not costless to the
employer, and the face value may not be the same as the fair value.
To arrive at the fair value of the loan, Robicorp needs to consider other market transactions in
the same instrument. The market rate of interest for a two year loan on the date of issue
(1 October 20X3) and the date of repayment (30 September 20X5) is 6% pa, and this is the rate
that should be used in valuing the instrument. The fair value may be estimated as the present
value of future receipts using the market interest rate. There will be a difference between the
face value and the fair value of the instrument, calculated as follows:
£'000
Face value of loan at 1 October 20X3 8,000
Fair value of loan at 1 October 20X3: (£8m/(1.06)2) 7,120
Difference 880
The difference of £880,000 is the extra cost to the employer of not charging a market rate of
interest. It will be treated as employee compensation under IAS 19, Employee Benefits. This
employee compensation must be charged over the two year period to the statement of profit or
loss and other comprehensive income, through profit or loss for the year.
The question now arises as to how to measure the loan under IFRS 9, Financial Instruments. To
measure the loan at amortised cost, the following criteria must be met:
(1) Business model test. The objective of the entity's business model is to hold the financial
asset to collect the contractual cash flows (rather than to sell the instrument prior to its
contractual maturity to realise its fair value changes).
(2) Cash flow characteristics test. The contractual terms of the financial asset give rise on
specified dates to cash flows that are solely payments of principal and interest on the
principal outstanding.
These tests have been satisfied. Accordingly, the loan should be measured at 30 September
20X4 at amortised cost using the effective interest method. The effective interest rate is 6%, so
the value of the loan in the statement of financial position is: £7,120,000  1.06 = £7,547,200.
Interest will be credited to profit or loss for the year of: £7,120,000  6% = £427,200.

The double entry is as follows:
At 1 October 20X3
DEBIT Loan £7,120,000
DEBIT Employee compensation £880,000
CREDIT Cash £8,000,000
At 30 September 20X4
DEBIT Loan £427,200
CREDIT Profit or loss – interest £427,200
Earnings per share
After taking into consideration the above changes basic earnings per share decreases to 75.7
pence (W2).
A diluted earnings per share figure is calculated to take into account the worst case scenario in
respect of potential increases in the equity base of the company. This therefore takes into
consideration that:
(a) the convertible bond could potentially increase Robicorp's share capital by 4 million new
shares, but the interest saved by conversion is added back to profit. This is usually
calculated net of tax, but as per your instructions I have ignored the tax consequences; and
(b) the share option scheme could increase Robicorp's share capital by a number of free
shares. This is calculated by converting the amount to be recognised in the profit or loss to
a per share amount. This is then added to the exercise price to work out the amount that is
expected to be received on exercise. Dividing this by the exercise price and comparing to
the total number of shares to be issued results in the number of free shares.
Diluted earnings per share is 75.2 pence (W3).
WORKINGS
(1)
Robicorp convertible bond £'000
PV Interest 31/12/X4 @10% 1,091
PV Interest 31/12/X5 @10% 992
PV Interest and capital 1/1/X7 @10% 30,954
Total 33,037
(2)
Basic earnings per share Earnings Shares
£'000
Draft 66,270 44,000,000
Development costs expensed (6,000)
Development costs amortised (500)
Revenue/costs not recognised (25,200)
Bonds instead of shares (4,000,000)
Interest expense (2,478)
Finance cost previously charged 900
Share option expense (1,568)
Fair value loss on Saltor (700)
Employee compensation (loan to employees) (880)
Interest on employee loan 427
Revised totals 30,271 40,000,000
Basic EPS 75.7 pence

(3)
Diluted EPS
£'000
Basic totals 30,271 40,000,000
Convertibles (see below) – –
Share options (free shares) – 232,611
Total 30,271 40,232,611
Diluted EPS 75.2 pence
Options calculation
Fair value of services yet to be rendered (48,000  (30 – 2))  £3.50  2/3) £3,136,000
Per option £3.136m/(48,000  (30 – 2)) £2.33
Adjusted exercise price (£4.00 + £2.33) £6.33
Number of shares under option: 48,000  29 = 1,392,000

Number that would have been issued at average market price
[1.392m  £6.33/£7.60] (1,159,389)
 Number of shares treated as issued for nil consideration (free shares) 232,611
Convertibles calculation – dilution test
 9 
Earnings/shares = £2,478,000/  × 4m  = 82.6p
 12 
As 82.6p is more than the basic EPS of 75.2p then the convertibles are anti-dilutive and
therefore must not be included in the diluted EPS calculation.
8 Flynt plc
Scenario
The candidate is in the role of a newly appointed financial controller who is asked to produce
journals and adjust a statement of profit or loss and other 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 statement of profit or loss and other comprehensive income.
Marking guide
Marks
(1) Redraft consolidated statement of profit or loss and other comprehensive income 28
(2) Calculate EPS and diluted EPS where appropriate 7
Total marks 35
Maximum marks 30

To: Andrea.Ward@flynt.co.uk
From: Miles.Goodwin@flynt.co.uk
Re: Finalisation of financial statements for year ended 31 May 20X6
I would respond to your email as follows:
Share option scheme
Shane Ponting's treatment of the option scheme is incorrect. IFRS 2, 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 profit or loss
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 profit or loss. 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 journal entry is as follows:
CREDIT Equity (retained earnings) £378,000
The charge to profit or loss is therefore £378,000 (10,000 × 16 × £12.60 × ¼ × 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. IFRS 2 does
not state where in equity this entry should arise, and many companies add it to retained
earnings.
When calculating diluted EPS it will normally be necessary to take into consideration the number
of 'free' shares being allocated to executives assuming the whole scheme will vest. Also,
normally, there is an adjustment to be made to the option exercise price in terms of the
remaining IFRS 2 cost to be expensed in future (per IAS 33 example 5A). However in the case of
Flynt there is a share price condition to be satisfied, in addition to the mere passage of time.
There are therefore performance based share options and, in accordance with para 48 of IAS 33,
these should be treated as contingently issuable shares.
Para 54 of IAS 33 therefore applies which states that 'the calculation of diluted EPS is based on
the number of ordinary shares that would be issued if the market price at the end of the
reporting period were the market price at the end of the contingency period'. In the case of
Flynt, to satisfy this contingency the price would need to rise to £58.5 (ie, £39 × 150%). At the
period end it is only £52, so in accordance with para 54 there is no dilution.
Lease of machinery
Shane Ponting's 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; and
(b) the present value of the lease payments received, plus the residual value guaranteed by
Prior plc come to £607,000 (Appendix 2), 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 profit or loss over the lease
term as part of interest receivable.
The rental income of £150,000 is removed from profit or loss. Interest receivable of £61,000 is
credited to profit or loss (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 20X6 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.
Journal entries are as follows:
DEBIT Depreciation provision £122,000
CREDIT Profit or loss £122,000
Being removal of the depreciation charge
DEBIT Net investment in lease £1,000
Being adjustment re-allocation of direct costs
CREDIT Net investment in the lease £150,000
Being removal of rental income
DEBIT Net investment in the lease £61,000
Being interest income
The treatment under IFRS 16 will be the same – accounting for lessors is largely unchanged.
IFRS 16 still makes a distinction between finance and operating leases, but this is a finance lease
under both standards.
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 profit or loss charge is split into two 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) Net interest on the net defined benefit liability. This in turn consists of two elements:
(1) Interest on plan assets:. This works out as £55,000 (5% × £2.2m × 6/12). IAS 19 does
not specify where this should appear in the statement of profit or loss and other
comprehensive income. I have treated it as investment income but it would not be
incorrect to offset it against operating costs.
(2) Interest on obligation: 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 £65,000 (5% × £2.6m × 6/12) should therefore be made in profit or
loss. Because it relates to a present value, I have added this to finance costs, but once
again IAS 19 is silent on the issue.

The net charge to profit or loss is thus £(65,000 – 55,000) = £10,000
The actuarial difference reflects that so me 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 net liability
will appear in the statement of financial position as a liability.
Per Appendix 4 there is a net remeasurement loss of £180,000. IAS 19 requires immediate
recognition of this in other comprehensive income.
CREDIT Pension obligation £560,000
Being recognition of service costs
DEBIT Pension asset £480,000
Being contributions paid into the scheme
DEBIT Interest on assets £55,000
Being recognition of interest on assets
CREDIT Pension obligation £65,000
Being recognition of interest on obligation
DEBIT Other comprehensive income £205,000
CREDIT Pension asset £205,000
Being recognition of remeasurement loss on pension asset
DEBIT Pension obligation £25,000
CREDIT Other comprehensive income £25,000
Being recognition of gain on pension obligation
Goodwill impairment
The goodwill impairment should be charged to profit or loss rather than other comprehensive
income. The entries to correct are:
Being correct treatment of goodwill
This will impact on EPS.
Summary of adjustments
As a result of these adjustments EPS has increased from £1.21 to £1.50 per share from the
previous year.

Appendix 1 – Flynt plc: Revised statement of profit or loss and other comprehensive income for
20X6 Options Lease Pension Goodwill Total
£'000 £'000 £'000 £'000 £'000 £'000
Revenue 14,725 14,725
Cost of sales (7,450) (7,450)
Operating costs (3,296) (378) 122 + 1 (80) (3,631)
Goodwill impairment (400) (400)
Other operating income 150 (150) 0
Investment income 39 61 100
Finance costs (452) (10) (462)
Taxation at 23% (1,003) (663)
Remeasurement loss on
pension (180) (180)
Goodwill impairment (400) 400 0
2,313 2,039
Appendix 2 – PV of lease agreement at 10%
Cash flow PV
Year £'000 £'000
1 150 136
2 150 124
3 150 113
4 150 103
5 211 131
5 Unguaranteed 9 6
Total 613
Fair value plus the direct costs is equal to the net investment in the lease.
£612,100 + 1,000 = 613,100
Appendix 3 – Net investment in lease
Bal b/f Interest income Instalment At 31 May
£'000 £'000 £'000 £'000
1 June 20X5 613 61 (150) 524
1 June 20X6 524 52 (150) 426
Appendix 4 – Pension calculations
Asset Obligation
£'000 £'000
Balance at Acquisition 2,200 2,600
Interest on assets 55
Unwinding of discount (interest on liability) 65
Service cost 560
Contributions 480
Pension Paid (450) (450)
Expected closing bal 2,285 2,775
Actual closing balance 2,080 2,750
Difference on remeasurement through OCI (205) 25
Net actuarial loss (180)

Appendix 5 – Basic EPS
20X6 20X5
£'000 £'000
Shares at start and end of year (000s) *1,475 1,400
Basic EPS £1.50 £1.21
*6/12 × 1,400,000 = 700,000

6/12 × 1,550,000 = 775,000
1,475,000
As reported above, there is a share price condition to be satisfied, in addition to the mere
passage of time. There are therefore performance based share options and, in accordance with
para 48 of IAS 33, these should be treated as contingently issuable shares. Para 54 of IAS 33
applies and there should therefore be no dilution.
9 Gustavo plc
Scenario
The candidate is in the role of a newly appointed financial controller of a company called
Gustavo who is asked to prepare a draft consolidated statement of profit or loss and other
comprehensive income incorporating the results of two subsidiaries. The company has sold and
purchased shares in the subsidiaries during the year.
The sale of shares in its UK subsidiary called Taricco involves the candidate recognising that the
investment should be consolidated as a subsidiary for the six months until the date of disposal
takes place. On sale of the shares the investment decreases to 35% and is therefore a partial
disposal. Candidates need to recognise that because Gustavo has the ability to appoint directors
to the board this is a strong indication that Taricco would be treated as an associate for the
remaining six months of the year.
The acquisition of shares is an investment in 80% of the share capital of an overseas company.
The investment is made on 1 January and therefore should be treated as a subsidiary from that
date.
The candidate is specifically asked to explain the impact on the consolidated statement of profit
or loss and other comprehensive income and to show separately the impact on the non
controlling interest and the impact of future changes in exchange rates on the consolidated
statement of financial position. The candidate must also deal with issues involving revenue
recognition.
Marking guide
Marks
(1) Prepare the draft consolidated statement of profit or loss and other 27
comprehensive income for the year ended 30 September 20X6 including other
comprehensive income showing separately the profit attributable to the
non-controlling interest
Prepare briefing notes to explain the impact of the share transactions (Exhibit 2)
on the consolidated statement of profit or loss and other comprehensive
income.
(2) Advise on the impact that any future changes in exchange rates will have on the 7
consolidated statement of financial position.

Marks
(3) Advise on how to account for the impaired receivable under IFRS 9 rules, and
show what effect taking account of credit risk would have. 5
Total marks 39
Maximum marks 30
To: Antonio Bloom

From: Anita Hadjivassili
Subject: Gustavo plc financial statements
I attach the draft consolidated statement of profit or loss and other comprehensive income for
the year ended 30 September 20X6, the explanations you requested, and supporting workings.
Gustavo plc: Consolidated statement of profit or loss and other comprehensive income for year
ended 30 September 20X6 (Requirement 1)
£'000
Revenue 57,357
Cost of sales (37,221)
Gross profit 20,136
Gain on sale of subsidiary 13,340
Profit from operations 23,987
Share of profit of associate 160
Profit before taxation 21,573
Income tax expense (2,974)
Exchange differences on translating foreign operations 7,369
(Restatement of goodwill 4,370
Exchange gain in year 2,999)
Non controlling interests (W9) 170
Owners of parent company 18,429
18,599
Total comprehensive income attributable to:
Non controlling interests (W9) 1,644
Owners of parent company 24,324
25,968
Supporting notes (Requirement 2)

(1) Taricco Limited
Taricco is treated as a subsidiary for the six months until disposal takes place. This is
because Gustavo has a 75% stake in the company until that date. Upon the sale of the
shares on 1 April 20X6 the investment decreases to 35%. Because Gustavo still has the
ability to appoint directors to the board Taricco should be treated as an associate, and the
equity accounting method used for the last six months of the year.
The non-controlling interest (NCI) have a 25% share of profit of Taricco for the first six
months of the year until disposal takes place.

A gain on disposal arises of £13.34 million in the statement of profit or loss and other
comprehensive income. The dividend received by Gustavo from Taricco of £210,000
should be eliminated on consolidation, as it is replaced by share of Taricco's profits. As the
dividend is paid after the disposal of the majority stake in Taricco it is not deducted from
the net asset total at disposal.
It should be noted that in future years Taricco will make less of a contribution to group
profit due to the reduction in the investment.
(2) Arismendi Inc
Gustavo acquired an 80% stake in Arismendi, and so the investment should be treated as a
subsidiary from 1 January 20X6.
The acquisition fees of £400,000 have been incorrectly treated, and should be expensed in
profit or loss in the year of purchase.
The results of Arismendi are translated into sterling at the average rate for the nine months
post acquisition in the statement of profit or loss and other comprehensive income.
The impact that any future changes in exchange rates will have on the consolidated statement
of financial position (Requirement 3)
An exchange difference will arise each year, due to the movement in exchange rates from each
statement of financial position date in relation to net assets, and also because the profits in the
statement of profit or loss and other comprehensive income will be retranslated from the
average to the closing rate in the statement of financial position. This gives a gain on translation
of £2.999 million, and is taken to other comprehensive income, and 20% is allocated to the NCI,
representing their share of Arismendi.
The cost of the investment is restated each year for consolidation purposes to take into
consideration the movement in exchange rates.
As a consequence goodwill is restated at the year end to take into account the change in
exchange rates, as it is deemed to be an asset of the subsidiary.
As a consequence goodwill has increased from £8.739 million to £13.109 million (W7). This is
taken to other comprehensive income in the statement of profit or loss and other
comprehensive income, and 20% is allocated to the NCI, representing their share of Arismendi.
WORKINGS
Taricco Arismendi
(1) Gustavo 6 months 9 months Adjust Total
£'000 £'000 £'000 £'000 £'000
Revenue 35,660 14,472 7,225 57,357
Cost of sales (21,230) (11,082) (4,639) (37,221)
Depreciation (£14.4m/8 years ×
9/12)/5 (270)
Operating costs (5,130) (2,478) (1,481) (9,489)
Acquisition fees (400)
Gain on disposal (W4) 13,340 13,340
Share of associate's profit (W6) 160 160
Investment income 580 54 – (210) 424
Interest paid (2,450) (330) (218) (2,998)
Income tax expense (2,458) (180) (336) (2,974)
PAT *4,572 456 281 13,290 18,599
*As originally stated £4,972,000 less acquisition fees £400,000

(2) Net assets of Taricco
At
On disposal acquisition
£'000 £'000
Retained earnings b/f 4,824 2,400
Profits to disposal (6 months) 456
Dividend paid 0
Total 7,280 4,400
(3) Goodwill
Taricco
£'000
Cost to parent
NCI at acquisition (25%) 15,000
Less net assets 1,100
Goodwill (4,400)
Impairment 11,700
Goodwill at disposal (2,500)
9,200
(4) Gain on sale of Taricco shares
£'000
Proceeds 19,800
FV of interest retained 8,200
NCI at disposal (W5) 1,820
29,820
NA at disposal (W2) (7,280)

Goodwill at disposal (W3) (9,200)
Gain on disposal 13,340
(5) NCI at disposal

£'000
At acquisition
Up to disposal (25% × (4,824 – 2,400)) + 114 (W9) 1,100
At disposal 720
1,820
(6) Share of profits of associate

Taricco
35% × PAT × 6/12 160

(7) Goodwill of Arismendi
01.01.X6 (Kr 6) 30.09.X6 (Kr 4)
Kr'000 £'000 £'000
Cost of investment 75,600 12,600 18,900
NCI at acquisition
12Kr × 5,000 shares × 20% 12,000 2,000 3,000
87,600 14,600 21,900
Net assets at Acquisition
Share capital 5,000
Three months to 1 January 20X6
3,670 × 3/12 918
Fair value adjustment
£2.4m × Kr 6 14,400
35,164 5,861 8,791
Goodwill 52,436 8,739 13,109
Increase to other comprehensive income 4,370
(8) Exchange difference arising in Arismendi

£'000 £'000
Net assets at acquisition
Kr 35,164 @ closing rate 4Kr : £1 8,791
Kr 35,164 @ acquisition rate 6Kr : £1 5,861
2,930
Nine months profit to 30.9.X6
Kr 3,670 per question × 9/12 = 2,753 – *1,350 = 1,403
@ closing rate Kr4:£1 350
Kr 3,670 per question × 9/12 = 2,753 – *1,350 = 1,403
@ average rate Kr5:£1 281
69
2,999
*depreciation on FV adjustment ((14,400/8 )  9/12)
(9) Non controlling interests
£'000
Taricco
456 × 25% 114
Arismendi
281 × 20% 56
Share of goodwill restatement for Arismendi
4,370 × 20% 874
Share of exchange difference
2,999 × 20% 600
1,644

(3) Bravo Ltd (Requirement 3)
Credit risk
Once the goods have been delivered, control has been transferred to the customer, and
under IFRS 15, Revenue from Contracts with Customers, revenue of £200,000 would be
recognised on the sale of the sports equipment and a trade receivable of £200,000 set up.
The trade receivable would be reviewed periodically for impairment, and the deteriorating
financial situation of the customer would be seen as an indicator of impairment. An
impairment of £20,000 would be recognised.
IFRS 9, Financial Instruments also takes account of the 5% risk that the customer would
default. This is not 5% of the revenue – if it were, a receivables expense of £10,000 would be
required – but a 5% risk that none of the revenue can be collected.
IFRS 9, Financial Instruments uses an expected credit loss method. In the case of trade
receivables such as this, that is trade receivables that do not have an IFRS 15 financing
element, IFRS 9 allows a simplified approach to the expected credit loss method. The loss
allowance is measured at the lifetime expected credit losses, from initial recognition.
The entries would be:
DEBIT Expected credit losses £10,000
CREDIT Allowance for receivables £10,000
Being expected credit loss: £200,000 × 5%
Interest of 4% will be recognised on this allowance of £10,000 during the year ended
30 September 20X6, which is the unwinding of the discount. This interest will be recognised
in profit or loss for the year, and will increase the loss allowance by the same amount:
DEBIT Profit or loss (4% × 10,000) £400
CREDIT Allowance for receivables £400
10 Inca Ltd
Scenario
This was the single silo corporate reporting question and included ethical issues. The scenario
was a company supplying plant and machinery to the oil drilling industry. At the beginning of the
year it acquired an 80% interest in an overseas subsidiary. The candidate was employed on a
temporary contract, reporting to the managing director. There was some concern about the
impact of the new subsidiary on the statement of financial position, and there were some
outstanding financial reporting issues, particularly with regard to deferred tax. The accountant
had identified five particular matters that needed to be resolved: accelerated capital allowances
on PPE; development costs; tax trading losses; a foreign currency loan which required correct
treatment by considering both IAS 21 and IFRS 9; and a loan to a director. Candidates were
provided with a draft statement of financial position for the parent and the overseas subsidiary.
Candidates were required firstly, to explain the correct financial reporting treatment for each of
the five issues identified; secondly, to prepare the consolidated statement of financial position;
thirdly to show the difference between the two permitted methods of calculating non-controlling
interest and fourthly as a separate requirement, to highlight any ethical concerns and actions
with respect to the email from the MD.

Marking guide
Marks
(a) An explanation of the appropriate financial reporting treatment for each of 12

the issues identified by the Excelsior accountant (Exhibit 3)
(b) The consolidated statement of financial position of Inca at 30 April 20X1, 7
assuming there are no adjustments to the individual company financial
statements other than those you have proposed
(c) A calculation of NCI at fair value 5
(d) Explain any ethical concerns that you have in relation to the MD's email, and 8
set out the potential actions you may take
Total marks 32
Maximum marks 30
Inca Ltd
To: Managing Director
From: Accountant
Subject: Excelsior – Outstanding issues
Deferred tax
Deferred tax is calculated on all temporary timing differences, and is based on the tax rates that
are expected to apply to the period when the asset is realised or liability is settled. The tax rates
are those that have been enacted or substantively enacted by the end of the reporting period. In
the absence of any other information to the contrary, therefore the current rate of 20% should be
used.
(1) Property, plant and equipment (PPE)
There is a temporary taxable timing difference of CU22 million (CU60m – CU38m) at 1 May
20X0. This agrees to the opening deferred tax liability of CU4.4m shown in Excelsior's
statement of financial position.
At 30 April 20X1 this has increased to CU28 million (CU64m – CU36m) and therefore the
deferred tax liability in respect of PPE increases to CU5.6 million.
Therefore a deferred tax charge on the increase in the difference of CU1.2 million is
required. This would be charged to the statement of profit or loss and other comprehensive
income of Excelsior.
(2) Development costs
There is a temporary taxable difference arising in respect of development costs because
they have a carrying amount of CU7 million at 30 April 20X1 in the statement of financial
position. However they have a zero tax base because they have been treated as an allowable
deduction in the company's tax computation at that date.
When the development costs are amortised in the statement of profit or loss and other
comprehensive income the timing difference will reverse.
This gives a deferred tax liability of CU1.4 million (20% × CU7m) and a charge to the profit or
loss.

(3) Tax losses
A deferred tax asset arises because the tax losses can be used to reduce future tax payments
when being offset against future taxable profits.
However, the amount of the deductible difference should be restricted to the extent that
future taxable profit will be available against which the losses can be used. This is an
application of the prudence principle.
As such, the deferred tax asset should be recognised on the budgeted profit of CU5 million
for the next two financial years only.
Therefore, the deferred tax asset would be CU2 million (20% × (CU5m × 2)). This will be a
credit to profit or loss.
Given the inexperience of the company accountant, the validity of these forecasts must be
considered and verified.
(4) American loan
The loan should initially be measured at the sum received of US$15 million, which at the
borrowing date is CU48.0 million.
Excelsior's accountant has incorrectly charged the repayment of ($800,000 × 2.8) CU2.2
million to profit or loss. This should be reversed and replaced with the interest calculated
using the amortised cost method. Therefore the interest charge for the year is US$1.6 million
(US$15m × 10.91%).
In Excelsior's own statement of profit or loss and other comprehensive income this could be
translated at either the average or the closing rate of exchange.
I have used the average rate in my figures and this gives an interest charge of CU4.8 million
(US$1.6m × 3 = CU4.8m). Therefore an adjustment to profit or loss of CU2.6 million
(4.8 million less 2.2 million) is required.
No deferred tax adjustment arises as only the interest paid is tax deductible and not the
discount or premium on redemption.
The loan constitutes a monetary liability, and therefore should be translated in the books of
Excelsior using the closing rate of exchange between the CU and the US dollar. The loan is
US$15.8 million which gives a figure of CU44.2 million ($15.8m × year end rate of 2.8). The
loan is currently stated after the above interest correction, at CU50.6 million (CU48 million
plus the adjustment for interest of CU4.8 million less interest paid of CU2.2 million) and has
not yet been translated by the accountant at the year-end rate. Therefore an exchange gain of
CU6.4 million arises, and this is taken to the statement of profit or loss and other
(5) Director's loan
Given the issues in terms of recoverability of the loan, it should be written off and removed
from receivables. This will also result in an expense in profit or loss.
As the loan is to a director, it is likely to be treated as a related party transaction, and as such
should be disclosed in the notes to the financial statements. The writing off of the loan
should also be disclosed.
There are likely to be current tax implications of this loan write off and the Ruritanian tax
treatment of this would need to be ascertained.

Consolidation of subsidiary
Goodwill
As Excelsior is a subsidiary, goodwill arises at the acquisition date, and is restated at
30 April 20X1 using the exchange rate at that date. The initial recognition of goodwill does not
in itself create a deferred tax consequence. This is because goodwill is only recognised in the
consolidated financial statements.
The assets and liabilities of Excelsior at 30 April 20X1, after any adjustments to align IFRS and
Ruritanian GAAP, should be translated using the closing rate of exchange in the consolidated
statement of financial position, and at the average rate in the consolidated statement of profit or
loss and other comprehensive income. Any gain or loss arising in respect of the movement in
exchange rates is taken to other comprehensive income.
Goodwill should be subject to an impairment review at the end of the first year of acquisition.
This is especially important because of the post acquisition losses generated by Excelsior.
Goodwill with non-controlling interest at fair value
If non-controlling interest in Excelsior is valued at its fair value of CU20 million, the goodwill is
CU2 million greater, at CU50 million, which is £11.1 million on translation. The exchange
difference on translation of the goodwill remains at £1.1 million (see W2).
Ethical issues
Director's loan
The loan to the director should be investigated to see if it is legal in accordance with Ruritanian
company law. It is advisable to seek expert advice on this issue.
On a separate issue it would be unethical to disregard the rules in relation to IAS 24 in respect of
related party transactions. I would expect that Excelsior's auditors will insist that the transaction
is disclosed in the notes to the financial statements.
The board's wish that the loan is not disclosed on the grounds of immateriality is irrelevant;
materiality is determined by nature in related party transactions rather than by value.
Potential permanent contract
The offer of a permanent contract in return for my 'silence' in respect of the preparation of the
working papers creates an improper working relationship and a threat to independent
judgement. This demonstrates a lack of integrity and professional behaviour on behalf of the
managing director.
Actions to be taken
Initially the issues I have should be discussed with the managing director, to make him aware of
the ethical responsibilities that a Chartered Accountant must abide by.
If those discussions are fruitless, then representations should be made to Inca's audit committee,
assuming that it has one.
If the above fails to resolve the issues with the managing director in a satisfactory manner then
the ICAEW ethical hotline, or legal counsel, should be sought. As a last resort resignation should
be considered.

Workings for adjustments to Excelsior financial statements for Exhibit 3
PPE CUm
Carrying amount 64.0
Tax base (36.0)
Temporary taxable difference 28.0
Tax rate 20%

Deferred tax 5.6
Provision at 1 May 20X0 4.4
Increase in provision 1.2
Development costs
Carrying amount 7.0
Tax base 0.0
Temporary taxable difference 7.0
Tax rate 20%
Tax losses
Deferred tax asset is restricted to the extent that probable taxable profit is available.
CUm
20X2 and 20X3 Expected profits 10.0
Tax rate 20%
American loan US$m Rate CUm
Borrowed 15.0 3.2 48.0
Interest for year to income statement (10.91%) 1.6 3.0 4.8
Interest paid (0.8) 2.8 (2.2)
Balance pre exchange adjustment 50.6
Balance at year end 15.8 2.8 44.2
Exchange gain on loan (6.4)
Statement of Financial Position of Excelsior
Adjustment to Excelsior's financial statements for issues in Exhibit 3
Dev Tax Interest/exchange Director's
Draft PPE Costs Loss adjustment loan Final
CUm CUm CUm CUm CUm CUm CUm
Non-current assets
PPE 64.0 64.0
Intangible assets 7.0 7.0
Total non-current 71.0 71.0
assets
Current assets
Accounts receivable 35.2 (2.0) 33.2
Cash 12.8 12.8
Total current assets 64.6 62.6
135.6 133.6

Dev Tax Interest/exchange Director's
Draft PPE Costs Loss adjustment loan Final
CUm CUm CUm CUm CUm CUm CUm
Equity and Liabilities
Share capital CU1 10.0 10.0
Share premium
account 16.0 16.0
Retained earnings at
acq'n 64.0 64.0
Net assets at
acquisition 90.0 90
Loss since acquisition (16.0) (1.2) (1.4) 2.0 (2.6) 6.4 (2.0) (14.8)
Deferred tax 4.4 1.2 1.4 (2.0) 5.0
Loans 48.0 2.6 (6.4) 44.2
Current liabilities 9.2 9.2
The subsidiary is translated at the closing rate for the assets and liabilities in the statement of
financial position and average rate for loss for the year.
Statement of financial position for Excelsior
CUm Rate £m
PPE 64 4.5 14.2
Intangible assets 7 4.5 1.6
Current assets
Inventories 16.6 4.5 3.7
Trade receivables 33.2 4.5 7.4
Cash 12.8 4.5 2.8
133.6 29.7
Share capital 10 5 2.0
Share premium 16 5 3.2
Retained earnings
Pre acquisition 64 5 12.8
Post acquisition (14.8) 4.8 (3.1)
Translation reserve (W1) 1.8
16.7
Non current liabilities: Deferred tax 5 4.5 1.1

Loans 44.2 4.5 9.8
Current liabilities 9.2 4.5 2.1
133.6 29.7
WORKINGS
(1) Translation reserve
Gain/(Loss)
£m £m
Opening net assets @ Closing rate 90 @ 4.5 20
Opening net assets @ Opening rate 90 @ 5 18 2.0
Loss for the year

@ Closing rate (14.8) @ 4.5 (3.3)
@ Average rate (14.8) @ 4.8 (3.1) (0.2)
Translation reserve for Excelsior 1.8

Inca group – Consolidated statement of financial position
£m
PPE (32.4 + 14.2) 46.6
Goodwill (W2) 10.7
Intangible (12.4 + 1.6) 14.0
71.3
Inventories (9.8 + 3 .7) 13.5

Trade receivables (17.4 + 7.4) 24.8
Cash (1.6 + 2.8) 4.4
114.0
Share capital 4.0

Share premium 12.0
Retained earnings (W2) 41.6
NCI (W2) 3.4

Deferred tax (12 + 1.1) 13.1
Loans (5.8 + 9.8) 15.6
Current liabilities (22.2 + 2.1) 24.3
114.0
(2) Consolidation of Excelsior

Goodwill on consolidation
CUm
Consideration 120
NCI @ acquisition (90 × 20%) 18
NA: 10 + 16 + 64 (90)
Goodwill 48
£m
48 @ Opening rate 5 9.6
48 @ Closing rate 4.5 10.7
Exchange difference on translation of goodwill 1.1
Goodwill on consolidation with NCI at fair value

CUm
Consideration 120
NCI @ FV 20
NA: 10 + 16 + 64 (90)
Goodwill 50
£m
50 @ Opening rate 5 10.0
50 @ Closing rate 4.5 11.1
Exchange difference on translation of goodwill 1.1

Consolidated retained earnings £m
Inca – Retained earnings 41.6
Excelsior (80% × 3.1) (2.5)
Exchange differences:
Translation of goodwill 1.1
Group's share of exchange difference on translation of Excelsior (1.8 × 80%) 1.4
41.6
Non-controlling interest (NCI) in consolidated statement of financial

position 20% × 16.7 3.4
11 Aytace plc
Scenario
The candidate is in the role of a financial controller for Aytace plc, the parent company of a
group that operates golf courses in Europe. The candidate is requested to explain the financial
reporting treatment of a number of outstanding matters which include revenue recognition,
defined benefit scheme, a holiday pay accrual, executive and employee incentive schemes and
the piecemeal acquisition of a subsidiary. The question requires the candidate to produce a
revised consolidated statement of profit or loss and other comprehensive income.
Marking guide
Marks
 Advice, with explanations and relevant calculations, on the appropriate 26

financial reporting treatment of the outstanding matters highlighted by
Meg in Exhibit 1.
 A revised consolidated statement of profit or loss and other
comprehensive income including the financial reporting adjustments you
have proposed. 6
Total marks 32
Maximum marks 30
To: Willem Zhang

From: Frank Brown
Subject: Financial Reporting Issues
(1) Golf tournament

(a) Tender costs
Tender costs should be expensed in the year in which they were incurred, and
therefore a further £1.05 million should be charged to profit or loss. This is because at
the tender date there was no probable inflow of economic benefits to Aytace and
therefore it would not be possible to capitalise the tender costs as an intangible asset
as it is highly unlikely to satisfy the recognition criteria as an internally generated asset
per IAS 38.
(b) TV revenues
Under IFRS 15, Revenue from Contracts with Customers, the broadcasting contract is a
contract in which performance obligations are satisfied over time. The performance
obligation in this case is the hosting of the golf tournament which the television
company will broadcast. IFRS 15 para 35 states that an entity transfers control of a

good or service over time and therefore satisfies a performance obligation and
recognises revenue over time if one of the following criteria is met:
 The customer simultaneously receives and consumes the benefits provided by the
entity's performance as the entity performs;
 The entity's performance creates or enhances an asset (eg, work in progress) that
the customer controls as the asset is created or enhanced; or
 The entity's performance does not create an asset with an alternative use to the
entity and the entity has an enforceable right to payment for performance
completed to date.
The first criterion will be met once the tournament starts in September 20X3. An
advance payment of £1 million was made on 1 May 20X3 and revenue recognised
from the date the contract was signed (1 February 20X3). £400,000 (£4.8m  4/48) is
recognised as revenue in profit or loss for the year ended 31 May 20X3. However, as at
31 May 20X3, the performance obligation has not been satisfied, as the tournament
has not started, so no revenue can be recognised under IFRS 15.
Therefore revenue should be reduced by £400,000 (£4.8m  4/12  ¼). The journal for
this would be:
DEBIT Revenue £400,000
CREDIT Contract liability £400,000
(2) Pension scheme
The pension expense in the statement of profit or loss and other comprehensive income
consists of a number of elements.
The service cost represents the extra pension liability arising in the year from employee
service in the year. It is charged to profit or loss in the year.
Pension assets are the equities, bonds and other investments in the fund, and the interest
income on these is credited to profit or loss.
Scheme liabilities are the pension obligations due to current and former employees, and
these are discounted by the market rate on high quality corporate bonds. The interest
charge on the liability is expensed to profit or loss.
The improvement in the pension benefit should be recognised by adding £400,000 should
be added to the liability immediately. Interest on this increased liability should therefore be
charged to profit or loss. As the liability is increased at 1 June 20X2, an interest charge is
made in relation to this increase of £24,000 (6% × £400,000).
Instead of the contributions paid into the scheme, the calculation should be as follows:
Defined benefit expense recognised in profit or loss
£'000
Current service cost 1,200
Net interest on net defined benefit liability (732 – (1,080 + 24)) 372
Total expense 1,972
IAS 19 is silent on how this expense should be charged, I have therefore charged it all to
operating costs, but some companies separate out the interest costs, and take these to
finance costs.
Therefore operating costs should be increased by the difference of £1,072,000 (£1,972,000
– £900,000) over the contributions paid into the scheme, which was the sum incorrectly
charged to the statement of profit or loss and other comprehensive income.

Pension scheme FV asset PV obligation
£'000 £'000
Opening balance 12,200 18,000
Interest on plan assets 732
Interest on obligation 1,080
Interest cost on past service cost 24
Contributions 900
Pensions paid (1,100) (1,100)
Current service cost 1,200
Expected closing balance 12,732 19,604
Difference on remeasurement through OCI 768 196
Actual closing balance 13,500 19,800
The net actuarial gain of £572,000 (768,000 – 196,000), should be recognised in other
The net pension obligation recognised in the statement of financial position is £6.3 million
(£19.8m – £13.5m).
(3) Holiday pay accrual
IAS 19, Employee Benefits requires that an accrual be made for holiday entitlement carried
forward to next year.
Number of days c/fwd: 900  3  95% = 2,565 days
Number of working days: 900  255 = 229,500
2,565
Accrual =  £19m = £0.21m
229,500
DEBIT Operating costs £0.21m

CREDIT Accruals £0.21m
(4) Investment in Xema
(a) Accounting method to be used
Xema should be treated as an associate only up to 1 September 20X2, when control is
achieved. Therefore the equity method should credit the statement of profit or loss and
other comprehensive income with only £102,000 (£1.02m × 3/12 × 40%).
For the remaining nine months of the year Xema should be consolidated using the
acquisition method, and income and expenditures included in the financial statements
on a line by line basis.
As Xema is 100% owned at the statement of financial position date there are no entries
in respect of non-controlling interests.
(b) Gain on increase in stake
At 1 September 20X2 the carrying amount of the stake held in Xema is £2.962 million,
calculated as follows:
Original cost 2,300
Share of profit to 31 May 20X2 560 (40% × (£4.8m – £3.4m))
Share of profit to 1 Sept 20X2 102 See above
2,962
At 1 September per IFRS 3 this should be restated to the fair value of the shares of
£3.8 million.
The gain of £838,000 is recognised in the profit or loss for the year. It would most likely
be shown as 'other operating income' or netted off against operating costs.

(c) Goodwill
Goodwill only arises when control is achieved, and is therefore calculated at
1 September 20X2.
The calculation should be as follows:
£'000
FV of original investment 3,800
Cost at 1 Sep 20X2 12,400
16,200
Less net assets at fair value (W) 6,055
Goodwill 10,145
WORKING:
Net assets at carrying amount/fair value:
Share capital 1,000
Retained earnings (at 31.05.20X2) 4,800
Retained earnings to 01.09.20X2 (1,020 × 3/12) 255
Net assets at carrying amount/FV 6,055
The goodwill figure should be reviewed for impairment at 31 May 20X3.

(5) Incentive schemes
(a) Executive scheme
This is an equity settled share based payment scheme. The vesting conditions are
market-based as they relate to a share price target and a non-market based condition
requiring the director to still hold office at 31 May 20X5.
Because the vesting condition relates to the market price of Aytace's shares, the
probability of achieving the target price by 31 May 20X5 is integrated into the fair value
calculation. Therefore your concerns about not achieving the share price rise can be
ignored when determining the charge to profit or loss. The non-market based
condition will impact on the number of options expected to vest and as it is anticipated
that one of the directors will leave by the vesting date this is taken into consideration
when calculating the charge.
Per IFRS 2 the fair value of the options is spread over the vesting period of three years
to 31 May 20X5.
The charge should therefore be £360,000 (£2.70 × 100,000 × 4 directors × 1/3), and
the same amount should be included in equity.
(b) Share appreciation rights
These are deemed to be cash settled share based rights because they do not involve
the issue of shares. The vesting conditions are not market based, because the scheme
only relates to continued employment.
Instead of recognising a credit in equity, a liability is created in the statement of
financial position. The fair value of the liability is remeasured at each reporting date,
and also takes into consideration the expected number of employees in the scheme at
the vesting date.
The charge is therefore £152,000 (£2.28 × 4,000 × 50 × 1/3), with an equal increase in
liability.

(6) Revised profit figures
After taking into consideration the above adjustments my revised profit is as follows:
Consolidated statement of profit or loss and other comprehensive income for year ended
31 May 20X3
Holiday Xema
Golf/TV Pension accrual Options 9 mths Total
£'000 £'000 £'000 £'000 £'000 £'000 £'000
Revenues 14,450 (400) 4,050 18,100
Operating costs (9,830) (1,050) (1,072)
(210) (360) (2,700)
(152) (15,374)
Other operating
income 838 838
Associate income 867 (765)* 102
Other investment
income 310 180 490
Finance charges (1,320) (540) (1,860)
Profit before taxation 4,477 2,296
(ignore tax as
instructed)
Other comprehensive
income
Net gain on
remeasurement
in year 572
Total comprehensive
income
for the year 2,868
WORKING:
Adjustment to income for associate
£'000
Xema's revenue 4,050
Costs (2,700)
Finance costs (540)
990
Tax for nine months (225)
(765)
12 Razak plc
Scenario
The candidate is in the role of a member of the financial reporting team at Razak plc. Razak has
increased its shareholding in the year in an investment, a company called Assulin. This mid-year
acquisition of shares results in a change in accounting treatment of the investment from a
financial asset to a subsidiary. The accounting is made further complex by a contingent payment
which is to be made provided that Razak's management team remain in post.
The candidate is also asked to explain the accounting adjustments needed in respect of a bond
purchased in Imposter plc. Imposter is now in financial difficulties. The candidate must also
explain the appropriate accounting for a proposed pension plan.

The chief executive of Razak is a director of, and a minority shareholder in Imposter. The
candidate is asked for the ethical implications of this scenario in the knowledge that the
purchase of the bond was not recorded in the Razak board minutes.
Marking guide
Marks
Provide explanations on how the increase in the stake in Assulin will be treated in 12
the financial statements of the Razak group.
Explain any adjustments needed to account for the purchase of the bond in 9
Imposter plc in Razak's group financial statements and evaluate any ethical issues
arising from this matter.
Prepare Razak's consolidated statement of financial position at 30 September 9
20X2 after making all relevant adjustments.
Explain how to account for the proposed pension plan. 9
Total marks 39
Maximum marks 30
To: Andrew Nezranah

From: Kay Norton
Subject: Razak plc, Group financial statements
Explanations of how the increase in the stake in Assulin will be treated in the financial
statements of Razak group.
Status as subsidiary
At 31 March 20X2 Assulin becomes a subsidiary because Razak now has a controlling stake
(80%). This means that goodwill arises on the transaction and a non-controlling interest will be
created in relation to the 20% of Assulin owned by minority shareholders.
Remeasurement of original investment
The gains on the equity investment of £750,000 previously taken to OCI are not reclassified to
profit or loss.
In addition the cost of the original stake is remeasured to the fair value of £20 each immediately
prior to acquisition. This gain of ((£20 – £16) × 75,000) = £300,000 is added to the cost of the
investment, and taken to other comprehensive income.
Intra group balance
The intra group loan of £800,000 is eliminated upon consolidation.
Contingent consideration
The contingent consideration should be measured at fair value (IFRS 3). A liability should be
recognised to pay £1.95 million (£6 × 325,000).
However as the payment is not due for two years from the acquisition date, it should be
discounted at the cost of capital of 9% to a present value of £1.641 million. This sum should be
added to consideration when calculating goodwill.
This discount should be unwound for six months to the SFP date, giving a charge of £73,845
(£1.641m × 9% × 6/12) to profit or loss, and increasing the liability by the same amount.

Fair value adjustment
The assets of Assulin should be remeasured to fair value at the acquisition date as a property
with a carrying amount of £1.2 million has an estimated fair value of £2.6 million, giving an
increase in PPE of £1.4 million. This sum should then be depreciated over the remaining useful
life of the property of five years, reducing both PPE and profits for the year by £140,000
(£1.4m × 1/5 × 6/12).
Goodwill
The consideration for goodwill takes into account the remeasurement of the fair value of the
original investment, plus the cost of the shares on 31 March 20X2, plus the fair value of the NCI.
The remeasured net assets of Assulin are then deducted from this total to give a goodwill total
of £8.826 million (W3).
Imposter bond
The bond was correctly classified and valued on initial recognition, but no adjustments have
been made to calculate the value at the year end, including the significant increase in the
present value of lifetime expected credit losses. This increase in allowance will be written off to
profit or loss (see W6).
Ethical issues
First of all, both Andrew and Kay are chartered accountants and are both therefore bound by the
ICAEW ethical code.
It is clear that there has been a significant deterioration in the credit quality of the Imposter
bond. If it was foreseeable that the bond would be so severely impaired, the chief executive
would be in breach of his fiduciary duty and potentially guilty of an illegal act. At worst this is a
case of fraud and at best a conflict of interest. We must first ascertain the facts.
As the chief executive is a shareholder and a director of Imposter there is potentially a self-
interest threat here and he may be seen to be behaving in the best interests of Imposter in
preference to the best interests of the shareholders of Razak. The question to be resolved is –
did the chief executive know of the financial position of Imposter at the time when the bond was
issued and was there evidence at that point that the bond would or could go bad? As a member
of the board this would appear highly likely.
Kay and Andrew should consider reporting the matter to the company's money laundering
compliance principal and possibly discussing their concerns with a non-executive director.
Advice from ICAEW can also be taken regarding their own positions considering they are both
chartered accountants.
Razak's consolidated statement of financial position at 30 September 20X2
Razak Assulin Adjustments Consolidated
£'000 £'000 £'000 £'000
Goodwill 8,826 8,826 W3
Non-current assets
FV
adjustment
Property, plant and equipment 6,000 3,460 1,400 – 140 10,720
Investment in Assulin 9,325 (9,325)
Loan to Assulin 800 (800)
Other financial assets 1,193 (503) (W6) 690 W6
17,318

Razak Assulin Adjustments Consolidated
£'000 £'000 £'000 £'000
Current assets
Inventories 1,255 610 1,865

Receivables 960 400 1,360
Bank 0 70 70
2,215 1,080 3,295
Total assets 19,533 4,540 (542) 23,531
Equity
£1 ordinary shares 2,800 500 (500) 2,800
Share premium account 7,400 7,400
(2,740)
Retained earnings 2,510 2,740 (529)(W5) 1,981 W5
Other components of equity 750 300 1,050 W5
NCI 2,012 2,012 W4
13,460
1,641 + 74
(unwinding
6/12
Contingent consideration 1,715 1,715 months)
Other 2,788 2,788
Loan from Razak 800 (800)
Current liabilities
Bank overdraft 1,220 1,220
Trade payables 865 290 1,155
Tax payable 1,200 210 1,410
3,285 500 3,785
Total equity and liabilities 19,533 4,540 (542) 23,531
Consolidated statement of financial position

£'000
Non-current assets
Goodwill 8,826
Other financial assets 690
Current assets
Inventories 1,865
Receivables 1,360
Bank 70
Total assets 23,531
Equity
£1 ordinary shares 2,800
Share premium account 7,400
Non-controlling interests 2,012
Contingent consideration 1,715
Other 2,788

£'000
Current liabilities
Bank overdraft 1,220
Trade payables 1,155
Tax payable 1,410
WORKINGS
(1) Group structure
Razak's shareholding has increased from 15% to 80% therefore the investment should now
be accounted for as a subsidiary.
(2) Net assets
SFP Acquisition
£'000 £'000
Share capital 500 500
Fair value adjustment 1,400 1,400
Depreciation (six months) (140)
Total 4,500 4,440
Since acquisition (4,500 – 4,440) 60
(3) Goodwill
£'000
Original cost of 15% shares in Assulin 450
Revalue 15% shareholding to £16 per share at 30 Sept
20X1 through OCI/OCE 750
Revalue 15% shareholding to £20 per share at 31 March
20X2 300
Cost of 325,000 shares at £25 per share 31 March 20X2 8,125
Contingent consideration (£6 × 325,000 DCF 9% 2 years) 1,641
NCI at acquisition 100,000 shares × £20 per share 2,000
Total 13,266
Less net assets at acquisition including FV adjustment (W2) (4,440)
Goodwill at acquisition 8,826
(4) Non-controlling interest

£'000
At acquisition 2,000
Profit share of Assulin since acquisition (60 × 20%) 12
Total 2,012

(5) Reserves
Other
Retained components
earnings of equity
£'000 £'000
Razak per draft 2,510 750
Revalue 15% shareholding in Assulin at
31 March 20X2 (W3) 300
Unwinding of contingent payment (74)
80% of Assulin's profit since acquisition (60 × 80%) 48 (529)
Imposter – net adjustments (503)
Total 1,981 1,050
(6) Imposter bond

Loan receivables (gross carrying amount)
£
At 1 October 20X1 1,200,000
Finance income (7.5%  1,200,000) 90,000
Cash received (–)
At 30 September 20X2 1,290,000
Allowance for credit losses

£
At 1 October 20X1 (Stage 1) (12-month expected credit losses) 7,000
Finance cost (unwind discount) (6%  7,000) 420
7,420
Finance cost (increase in allowance) 592,580
At 30 September 20X2 (Stage 2) (Lifetime expected credit losses) 600,000
Value of bond at 30 September 20X2, net of allowance: £(1,290,000 – 600,000) = £690,000

Therefore adjustment = £1,193,000 – £690,000 = £503,000.
Adjustments are required to retained earnings as follows:
£
Finance income (7.5%  1,200,000) 90,000
Finance cost (unwind discount) (6%  7,000) (420)
Finance cost (increase in allowance) (592,580)
Net (503,000)
Proposed pension plan

Razak wishes to account for its proposed pension plan as a defined contribution scheme,
probably because the accounting is more straightforward and the risk not reflected in the
figures in the financial statements. However, although the entity's proposed plan has some
features in common with a defined contribution plan, it needs to be considered whether this is
really the case.
With defined contribution plans, the employer (and possibly, as proposed here, current
employees too) pay regular contributions into the plan of a given or 'defined' amount each year.
The contributions are invested, and the size of the post-employment benefits paid to former
employees depends on how well or how badly the plan's investments perform. If the
investments perform well, the plan will be able to afford higher benefits than if the investments
performed less well.
With defined benefit plans, the size of the post-employment benefits is determined in advance
ie, the benefits are 'defined'. The employer (and possibly, as proposed here, current employees
too) pay contributions into the plan, and the contributions are invested. The size of the

contributions is set at an amount that is expected to earn enough investment returns to meet the
obligation to pay the post-employment benefits. If, however, it becomes apparent that the
assets in the fund are insufficient, the employer will be required to make additional contributions
into the plan to make up the expected shortfall. On the other hand, if the fund's assets appear to
be larger than they need to be, and in excess of what is required to pay the post-employment
benefits, the employer may be allowed to take a 'contribution holiday' (ie, stop paying in
contributions for a while).
The main difference between the two types of plans lies in who bears the risk: if the employer
bears the risk, even in a small way by guaranteeing or specifying the return, the plan is a defined
benefit plan. A defined contribution scheme must give a benefit formula based solely on the
amount of the contributions.
Razak's scheme, as currently proposed, would be a defined benefit plan. Razak, the employer,
would guarantee a pension based on the average pay of the employees in the scheme. The
entity's liability would not be limited to the amount of the contributions to the plan, but would
be supplemented by an insurance premium which the insurance company can increase if
required in order to fulfil the plan obligations. The trust fund which the insurance company
builds up, is in turn dependent on the yield on investments. If the insurer has insufficient funds to
pay the guaranteed pension, Razak has to make good the deficit. Indirectly, through insurance
premiums, the employer bears the investment risk. The employee's contribution, on the other
hand is fixed.
A further indication that Razak would bear the risk is the provision that if an employee leaves
Razak and transfers the pension to another fund, Razak would be liable for, or would be
refunded the difference between the benefits the employee is entitled to and the insurance
premiums paid. Razak would thus have a legal or constructive obligation to make good the
shortfall if the insurance company does not pay all future employee benefits relating to
employee service in the current and prior periods.
In conclusion, even though the insurance company would limit some of the risk, Razak, rather
than its employees, would bear the risk, so this would be a defined benefit plan.
13 Finney plc
Marking guide
(1) Review the information and 30 Apply the IFRS 9 impairment model to the
prepare a briefing note, loan stock investment.
including any relevant Calculate the impairment allowance.
calculations, that sets out the
financial reporting Recognise that when part of a gain or loss
consequences for the year on a financial liability relates to own
ended 30 September 20X2 of creditworthiness, that part must be treated
the issues contained in Exhibits separately from the rest of the gain or loss.
1 and 2. Recognise the opportunity to use hedge
accounting for the copper futures contract.
Conclude that the net effect of the futures
contract on profit or loss is the same,
whether hedge accounting is adopted or
not.

Recognise the gain on disposal of UK

investment.
Recognise that share appreciation rights are
cash-settled share-based payment.
Correctly calculate and apply the IFRS 2
treatment.
(2) Redraft financial statements to 7 Identify how the information affects the
take account of the financial financial statements and revise them
reporting issues. accurately.
Total marks available 37
Maximum marks 30
Briefing note
To: Simone Hammond
From: Marina Bujnowicz
Re: Financial Statements for year ended 30 September 20X2
Date: X-X-XX
In this briefing note I will set out the financial reporting consequences of each of the issues and
discuss any further financial reporting consequences which may arise in respect of these issues
in future financial reporting periods.
I also include re-drafted financial statements of Finney plc incorporating the necessary
adjustments as requested.
(a) Investment in loan stock
IFRS 9, Financial Instruments adopts an 'expected loss' model for impairment; in other
words, credit losses are recognised when expected rather than when incurred. On initial
recognition (1 October 20X1), Finney has correctly recognised 12-month expected credit
losses of 5%  £3,000,000 = £150,000, reflecting the 5% probability that the borrower
would default on the loan with a 100% loss.
An impairment loss on a financial asset at amortised cost was correctly recognised in profit
or loss, with a corresponding entry to an allowance account, which is offset against the
carrying amount of the financial asset in the statement of financial position.
1 October 20X1 £ £
DEBIT Profit or loss 150,000
CREDIT Impairment allowance 150,000
This will need to be adjusted for information available at the year end.
Finance income for the year needs to be recorded:
30 September 20X2 £ £
DEBIT Financial asset (10%  £3m) 300,000
CREDIT Profit or loss 300,000
The gross carrying amount of the financial asset (before the allowance for credit losses) is
therefore £3,300,000.

At 30 September 20X2, expected credit losses are re-assessed in accordance with IFRS 9,
using the 2% probability that the borrower will default on the loan. The impairment
allowance needed would be 2%  £3,000,000 = £60,000.
There is also a finance cost, being the unwinding of the discount on the allowance at initial
recognition, which is 8%  £150,000 = £12,000. The impairment allowance at
30 September 20X2 is therefore:
£'000
At 1 October 20X1 (Stage 1) (12-month expected credit losses) 150
Finance cost (unwind discount) 12
162
Finance income (decrease in allowance) (102)
At 30 September 20X2 60
The net carrying amount of the bond is therefore £3,300,000 – £60,000 = £3,240,000.
Net finance income (including interest income) is £300,000 + £102,000 – £12,000
= £390,000:
30 September 20X2 £ £
DEBIT Financial asset 390,000
(b) Financial liability
IFRS 9, Financial Instruments requires that financial liabilities which are designated as
measured at fair value through profit or loss are treated differently where part of a gain or
loss relates to an entity's own creditworthiness. In this case the gain or loss in a period must
be classified into:
 gain or loss resulting from credit risk; and
 other gain or loss.
This provision of IFRS 9 was in response to an anomaly regarding changes in the credit risk
of a financial liability.
Changes in a financial liability's credit risk affect the fair value of that financial liability. This
means that when an entity's creditworthiness deteriorates, the fair value of its issued debt
will decrease (and vice versa). IFRS 9 requires the gain or loss as a result of credit risk to be
recognised in other comprehensive income, unless it creates or enlarges an accounting
mismatch, in which case it is recognised in profit or loss. The other gain or loss (not the
result of credit risk) is recognised in profit or loss.
On derecognition any gains or losses recognised in other comprehensive income are not
transferred to profit or loss, although the cumulative gain or loss may be transferred within
equity.
This is a decrease in the fair value of the liability, which is a fair value gain in the books of
Finney. Finney should split the fair value decrease as follows:
Statement of profit or loss and other comprehensive income (extract) for the year ended
30 September 20X2
Profit or loss for the year
£m
Fair value gain not attributable to change in credit risk 8
Profit (loss) for the year 8
Other comprehensive income (not reclassified to profit or loss)

£m
Fair value gain on financial liability attributable to change in credit risk 2
Total comprehensive income 10

The journal entries are therefore:
DEBIT Financial liability £10m
CREDIT Profit or loss £8m
CREDIT Other comprehensive income £2m
(c) Copper inventories contract
This is potentially a fair value hedge as it relates to a change in the fair value of an existing
asset.
IFRS 9, Financial Instruments has an objective-based assessment for hedge effectiveness,
under which the following criteria must be met.
(1) There is an economic relationship between the hedged item and the hedging
instrument ie, the hedging instrument and the hedged item have values that generally
move in the opposite direction because of the same risk, which is the hedged risk.
(2) The effect of credit risk does not dominate the value changes that result from that
economic relationship ie, the gain or loss from credit risk does not frustrate the effect
of changes in the underlyings on the value of the hedging instrument or the hedged
item, even if those changes were significant.
(3) The hedge ratio of the hedging relationship (quantity of hedging instrument vs
quantity of hedged item) is the same as that resulting from the quantity of the hedged
item that the entity actually hedges and the quantity of the hedging instrument that the
entity actually uses to hedge that quantity of hedged item.
At the inception of the contract the hedge would be effective as it was designated by the
compliance department as satisfying the rules.
At 30 September 20X2 the inventories (the hedged item) have fallen in value by £1 million
(1,000 tonnes at (£9,200 – £8,200 a tonne)) and the futures contract (the hedging
instrument) has increased in value by £950,000. IFRS 9 does not specify in detail how hedge
values should be determined but in this case the two alternatives give the same answer (this
need not necessarily be the case due to transaction costs and market inefficiencies).
One way of considering the change in value of the hedge instrument is to consider changes
in the value of copper per tonne in the futures market measured by a futures contract
written at 30 September 20X2 for delivery of copper at 31 December 20X2. This is £8,250 a
tonne. On 1 July 20X2 the same contract cost £9,200 per tonne so the change in value of
copper on the futures market is £950 (ie, £9,200 – £8,250) per tonne.
Another way of considering the change in value of the hedge instrument is to consider
change in the value of the original futures contract itself (not the change in copper prices on
the futures market). The futures contract written on 1 July 20X2 requires the holder to sell
copper on 31 December for £9,200, whereas to write a contract for delivery on
30 September of copper would now only give a selling price of £8,250. The original
contract has increased in fair value from zero to £950 as the contract has value at
30 September by entitling the holder to sell at a higher price than prevailing market
conditions. (Note: Had copper prices increased – rather than decreased – the futures
contract would have negative value ie, would be a liability, as it would have tied the holder
into a sale at a price below the prevailing market price.)
Under either method of measurement, hedge effectiveness is therefore 95% (ie, the gain in
the value of futures contract of £950,000 divided by loss in value of inventories of £1 million)
and is therefore highly effective and so the IFRS hedge accounting rules can be applied.
If Finney invokes the hedge accounting rules then only the ineffective part of the hedge of
£50,000 net impacts upon profit in the statement of profit or loss and other comprehensive
income. A financial asset of £950,000 is recognised in the statement of financial position,
and the copper inventories are reduced in value by £1 million.

The double entry is therefore:
CREDIT Inventories £1 million
DEBIT Financial asset £950,000
DEBIT Profit or loss (hedging loss) £50,000
Had Finney not applied the hedging rules then the fall in the value of inventories of
£1 million would have been taken to profit or loss via an increase in cost of sales as a result
of the requirements of IAS 2 that inventory is shown at the lower of cost and NRV. The
increase in the fair value of the futures contract would also be recognised in profit or loss, as
it is a derivative and should be classified AFVTPL. The net effect on profit would therefore be
the same but the gross amounts of the gain and the loss would be disclosed separately.
The double entry would have been:
CREDIT Inventories £1 million
DEBIT Profit or loss (cost of sales) £1 million
And:
DEBIT Financial asset £950,000
CREDIT Profit or loss (gain on financial asset) £950,000
Tutorial note
For the purposes of redrafting the financial statements we have assumed that hedging has
been applied.
(d) UK investment – Coppery plc

These shares are held for trading and therefore correctly categorised as being at fair value
through profit or loss.
The acquisition of Coppery by Zoomla means that one financial asset should be
derecognised (the shares in Coppery), and replaced by another financial asset (the shares in
Zoomla).
As such, a gain on disposal in respect of the shares in Coppery should be recognised in
profit or loss.
This is calculated as:
£'000
Fair value of shares in Zoomla (£1.10  2  2m) 4,400
Fair value of cash receivable (2m  0.15)/1.1 273
Net proceeds 4,673
Carrying amount of Coppery shares (3,200 + 300) (3,500)
Gain on derecognition taken to profit or loss 1,173
A receivable should be recognised in the statement of financial position for the cash due
from Zoomla, after taking into consideration the change in the present value for six months.
0.5
Therefore a current asset receivable of £286,039 (£300,000/(1.1) ) is recognised in the
statement of financial position at 30 September 20X2. Finance income of £13,312 (£286,039
– £272,727) is credited to profit or loss.
Tutorial note
Alternatively the finance income could be calculated as (½  (300,000 – 300,000/1.1)) =
£13,636. The receivable at 30 September 20X2 would be £286,363 (£272,727 + £13,636).

Unless there is evidence to the contrary, the investment in Zoomla should be treated as an
equity investment at fair value through profit or loss, and restated to fair value at
30 September 20X2 of £4.8 million (4m  120 pence).
The increase in fair value of £400,000 should be recognised in profit or loss. This accounting
treatment would also apply to fair value movements in future accounting periods.
The journals are:
Acquisition of Coppery by Zoomla
£m £m
DEBIT Investment in Zoomla 4.4
DEBIT Receivable 0.273
CREDIT Investment in Coppery 3.5
CREDIT Gain on disposal 1.173
Gain on equity investment in the year
£m £m
DEBIT Investment in Zoomla 0.4
CREDIT Profit or loss 0.4
Finance income in the year
£m £m
DEBIT Receivable 0.013
CREDIT Finance income 0.013
Share appreciation rights
Share appreciation rights are cash-settled share-based payments. IFRS 2, Share-based
Payment requires that the entity should measure the goods or services acquired and the
liability incurred at the fair value of the liability. The fair value of the liability should be
measured at each reporting date until the liability is settled and at the date of settlement.
Any changes in fair value are recognised in profit or loss for the period.
£
1 October 20X1 liability b/f: (200 – 30 (managers))  300 SARS 
£14 (fair value)  2/2 (vested) 714,000
Cash paid on exercise: 40 managers  300 SARS  £21 (intrinsic value) (252,000)
Expense (balancing figure) 474,000
30 September 20X2 liability c/f: (200 – 30 – 40 (managers)) 
300 SARS  £24 (fair value) 936,000
The expense for the year is accounted for as follows:

DEBIT Expense (P/L) £474,000
CREDIT Cash £252,000
CREDIT Liability £222,000

(2) Statement of profit or loss and other comprehensive income for year ended
30 September 20X2
Share
Financial Copper appn.
Draft Loan stock liability contract Coppery Zoomla rights Revised
20X2 20X2
£m £m £m £m £m £m £m £m
Revenue 194 194.00
Cost of sales (111) (111.00)
Gross profit 83 83.00
Operating costs (31) (31.00)
Gain on
disposal – 1.17 1.17
Operating profit 52 53.17
Share-based
payment (0.5) (0.50)
Gain on IEI 0.4 0.40
Finance income 3 0.39 8 0.01 11.40
Hedging loss – (0.05) (0.05)
Interest payable (16) (16.00)
Profit before
taxation 39 48.42
Taxation (8) (8.00)
Profit for the
year 31 40.42
Other
comprehensive
income 7 2 9.00
Total
comprehensive
income for the
year 38 49.42

Statement of financial position as at 30 September 20X2
Share
Financial Copper appn.
Draft Loan stock liability contract Coppery Zoomla rights Revised
20X2 20X2
£m £m £m £m £m £m £m £m
Non-current
assets
Property,
plant and
equipment 84 84.00
Investment
in equity 4.4
instruments 36 (3.5) 0.4 37.30
Other
financial
assets 10 0.39 0.95 11.34
Inventories 66 (1) 65.00
Receivables 0.01
56 0.27 56.28
Total assets 252 253.92
Share
capital: £1
shares 75 75.00
Retained
earnings 97 0.39 8 (0.05) 1.18 0.4 (0.5) 106.42
Other
components
of equity 24 2 26.00
Non-current
liabilities 27 (10) 17.00
Current
liabilities
Trade and
other
payables 18 0.2 18.20
Overdraft 11 0.3 11.30
Total equity
and liabilities 252 253.92

14 Melton plc
Marking guide
Marks
(a) Up to 1 mark for each valid point 8

(b) Appropriate ratios and comparatives 9
Other points
(c) Up to 1 mark for each valid point 8
(d) Up to 1 mark for each valid point 9
Total marks 34
Maximum marks 30
Notes for meeting of investment team

(a) Diluted earnings per share
Information that helps users of financial statements make predictions of future earnings and
cash flows is very useful. The diluted EPS disclosure provides additional information
regarding the future of the basic EPS amount, in that it relates current earnings to a possible
future capital structure.
Where financial instruments have been issued by a company which will potentially lead to
the issue of further new equity shares, the earnings will be shared by more equity shares. In
some cases earnings themselves will be directly affected by the issue of the shares, in other
cases, they will not. The diluted EPS figure shows how the current earnings of the company,
as adjusted for any profit effect of the issue of the new shares, would be diluted, or shared
out amongst the future, potential new shares as well as the current shares. This gives the
current shareholders an idea of the effect that these dilutive financial instruments could
have on their shareholding in the future.
However, there are limitations to the use of these figures:
 The diluted EPS is based upon the current earnings figure, as adjusted for any profit
effect of the issue of the new shares. This earnings figure may not be relevant in future
years. What is more important is the level of earnings at the time conversion actually
takes place.
 Also, the calculation assumes a worst case scenario, that all potential diluting financial
instruments will be exercised. It may be that future events do not unfold like this. For
example, holders of convertible debt may choose to redeem rather than convert their
debt or share options issued may lapse if the holders leave the company or there are
adverse future movements in the share price.
The diluted EPS is therefore a 'warning' to existing shareholders about potential future
events. It is not a forecast of future earnings. Shareholders often find it helpful to calculate
the P/E ratio based on diluted EPS to show the potential valuation effects.

(b) Analysis of performance of Melton plc
Further ratios could be calculated. For example:
20X7 20X6
Performance ratios
Operating profit % (3,200 as % of 37,780) and (2,610 as %
of 29,170) 8.5% 8.9%
Gross profit – existing outlets (87 as % of 354) and (83 as
% of 343) 24.6% 24.2%
Gross profit – new outlets (69 as % of 256) 26.9% –
Administration expenses % (6,240 as % of 37,780) and
(4,480 as % of 29,170) 16.5% 15.4%
Depreciation and amortisation as % of (cost of sales +
administration expenses) – (3,060 as % of (28,340 +
6,240)) and (2,210 as % of (22,080 + 4,480)) 8.8% 8.3%
Cash flow and liquidity ratios
Interest cover (3,200/410) and (2,610/420) 7.8 times 6.2 times
Cash interest cover (6,450/410) and (4,950/440) 15.7 times 11.3 times
Cash generated from operations as % of operating profit
(6,450 as % of 3,200) and (4,950 as % of 2,610) 202% 190%
EBITDA/interest expense (6,260/410) and (4,820/420) 15.3 times 11.5 times
Investor ratios
P/E ratio (302/26.8) and (290/21.3) 11.3 times 13.6 times
P/E ratio (based on diluted EPS) (302/21.2) and (290/19.2) 14.2 times 15.1 times
(Credit will be given for other ratios; the basis of the calculation should be given.)
Introduction
A first look at the information indicates that the group has grown significantly during 20X7.
Revenues have increased by 29.5% ((37,780/29,170) – 1) and operating profits by 22.6%
((3,200/2,610) – 1). However, the additional information shows that there have been
structural changes in the business with a 35% ((30/(115 – 30)) – 1) increase in the number of
outlets that have opened. These structural changes will need to be considered in
determining the performance of the business.
A review of the statement of cash flows shows strong operating cash flows. However, these
cash flows are being reinvested in new outlet openings (through capital expenditure). The
group's objective is to limit its new debt financing but this may be hindering the availability
of distributions to investors.
Profitability
Revenue has grown by 29.5% during the year. For existing outlets (those open at
30 September 20X6) growth during the year has been 3.0% ((354/343) – 1). The real rate of
growth may be lower than this as some outlets may have only been open for part of the
previous year (ie, 20X7 is first full year of opening).
This rate of 'organic' growth is disappointing and below the sector average of 4.1%. It may
be that Melton only operates in a part of this sector which has a different growth rate that
management are concentrating on new outlets.
Gross profit margins have grown year on year from 24.3% to 25.0%. However, the
segmental analysis shows that gross margins from existing outlets have only improved
marginally to 24.6% and the new outlets have far better gross margins at 26.7%. This could
be due to:
 the locations of the new outlets in more profitable sites;
 strong promotional activities of new outlets in their initial phase;
 older outlets require refitting or advertising support; or
 management focusing on new outlets to the detriment of older ones.

Revenue per employee has grown from £37,900 to £41,100. This is an increase of 8.4%.
This is significant as wage costs will be a major cost for the business. It may be that new
working practices have reduced employee numbers or that staff numbers (eg, admin) do
not increase linearly with the number of outlet openings.
Administration costs as a percentage of revenue have increased significantly from 15.4% to
16.5%. These costs have increased by approximately £1.8 million. The list of key issues for
Melton did not mention operating costs and this may not have been the focus of
management's attention. Alternatively, investment in administration may have been made
with a view to further expansion.
Melton has a reputation for 'under depreciating' assets. Some support for this is indicated
by the losses on disposal in both years (see statement of cash flows). The depreciation rates
are inconsequential when considering the cash flow which is strong (see below).
Depreciation is 8.8% of the total of costs of sales and administrative expenses but it is
growing significantly (up from 8.3% and from £2.21 million to £3.06 million) and any future
change in estimates could significantly affect profit.
EBITDA has improved significantly, mainly because of better absolute profit figures due to
the continuing expansion. EBITDA is strong and confirms the strong cash flows (see below).
The return on capital employed (ROCE) has improved from 19.1% to 20.0% giving the
indication that the overall efficiency of management in employing the resources of the
group has improved. Operating cash flows are strong and net capital employed has only
increased by a small amount as the capital expenditure is almost covered by the operating
cash flow. Resources have been well managed. However, this should be viewed against the
fact that no dividend has been paid.
Non-current asset turnover supports the assertion that management have managed the
assets well. It has improved and the assets have been sweated harder.
Interest costs in the statement of profit or loss have reduced slightly (by £10,000) but the
statement of cash flows shows that net debt (new borrowings less cash increase) has
increased. This may be a result of the timing of the cash flows (in particular capital
expenditure and new outlet openings) during the year.
Cash flow (and changes in financial position)
The improvement in ROCE is supported by the increase in the cash return on capital
employed to 40.2%. As expected it is higher than traditional ROCE as that ratio takes into
account depreciation and amortisation. The cash return on capital employed suggests that
cash flow is strong and capital has been well managed. It appears that the objective of
funding growth from existing cash flows is being achieved and this is having a positive
effect on performance statistics.
This is supported by the interest cover (7.8 times), which demonstrates the strong financial
position and the possibility of further growth through borrowing if necessary.
Other measures of interest are also strong – cash interest cover is 15.7 times and
EBITDA/interest is 15.3 times. Both have improved as new outlet openings have improved
operating cash flows whilst net debt has not changed significantly.
The cash flows show that the quality of operating profits is strong. Cash generated from
operations as a percentage of profit from operations is over 200% and improving year on
year. The concerns about depreciation should only improve this ratio if depreciation
increased.
The current ratio is low at 0.56 times but this may not be unusual in an industry where
customers will pay cash for their products and cash flow will be almost immediate. However,
cash is high, and probably inventory, which may indicate a high payables balance.

The trade payable period has fallen but the absolute amount of trade payables has
increased. This will be due to the expansion of the business. Trade payables will be
principally for sourcing goods and possibly lease rentals. It may be due to changes in
payment patterns as the number of outlets expand.
Investor ratios
EPS has grown by 25.8% ((26.8/21.3) – 1) but diluted EPS has only increased by 10.4%
((21.2/19.2) – 1). This is potentially a concern. There appear to be some diluting instruments
in issue that are having a potential adverse effect on future earnings. This could affect the
future movements in market price.
The P/E ratio has fallen. This may be in line with general trends in share prices or may be as
a result of investor disappointment. The company is not paying a dividend and investors
may be unhappy about this. The policy of reinvestment of cash flows limits dividend
payments without taking on more debt.
Further matters for investigation
 Further analysis of revenue – is there true 'like for like' growth and what was the timing
of the outlet openings in the prior year?
 Locations of new outlet openings and product offerings to understand the higher
margins on new against older outlets.
 Non-current asset disclosure information – to determine the depreciation and
amortisation policies and quantify the potential effect of any differences from industry
averages.
 Analysis of capital expenditure between expenditure on existing and new outlets to
determine profile of ongoing replacement expenditure required by the business.
 Dividend policy – shareholders will undoubtedly demand a return on their investment.
The operating and financial review may indicate dividend and financing policy.
 Details of future outlet openings and planned levels of capital expenditure.
 An analysis of employee numbers by function and details of any changes in working
practices to understand the strong increase in revenue per employee.
 Details of administration costs changes – are there any non-recurring items disclosed in
the notes or any details of costs in the Operating & Financial Review/Management
Commentary?
 Details of the tax charge and the tax reconciliation should be reviewed in the notes to
the financial statements to understand why it is low (21.9% (610 as % of 2,790)) and the
year on year change.
 Receivables have increased significantly. As almost all sales will be for cash, this needs
investigation.
 Details of the potential diluting financial instruments (terms, timing etc) that may affect
future EPS.
(c) Payment of dividend
Distributable profits (the profits that are legally distributable to investors) are determined as
the accumulated realised profits less accumulated realised losses of an entity. Generally
they equate to the retained earnings of an entity.
However, the legality of a dividend distribution is determined by the distributable profits in
the separate financial statements (of a single company) rather than by the consolidated
retained earnings.
A company may have a debit balance on its consolidated retained earnings (for example
due to losses in subsidiaries) but it may have a credit balance on its own retained earnings
which would allow the payment of a dividend to the parent company's shareholders.

In addition, a public company may not make a distribution if this reduces its net assets
below the total of called-up share capital and undistributable reserves. In effect any net
unrealised accumulated losses must be deducted from the net realised accumulated
profits.
The colleague's comment is incorrect and further investigation is needed to determine why
no dividends have been paid or proposed.
(d) Proposed sale of stake in R.T. Café
The director proposes to sell 2,000 of Melton's 8,000 shares in R.T. Café, which has a share
capital of 10,000 shares, in January 20X8. In doing so it would be selling a 20%
shareholding and going from an 80% stake to a 60% stake. R.T. Café would remain a
subsidiary. In substance, under IFRS 3, Business Combinations there would be no disposal.
This is simply a transaction between group shareholders, with the parent (Melton) selling a
20% stake to the non-controlling interest.
The transaction would be dealt with by increasing the non-controlling interest in the
statement of financial position, which has effectively doubled from 20% to 40% and
recording an adjustment to the parent's equity.
The formula used to calculate the adjustment to equity at disposal is:
£'000
Consideration received X
Increase in NCI on disposal (X)
Adjustment to parent's equity (to be credited to group retained earnings) X
Since the adjustment is recognised in retained earnings rather than profit for the year, there
would be no impact on earnings per share.
15 Fly-Ayres
Marking guide

15.1 Review the information and 3 Explain the usefulness of industry average
prepare an analysis report, ratios.
making adjustments where 6 Explain, with supporting calculations, the
required and explain the correct treatment of the share options.
financial reporting issues.
6 Calculate and show the treatment of the
gain on the equity investment and related
7 deferred tax.
Redraft financial statements and make
5 appropriate adjustments to ratios.
Choose and calculate useful additional
5 ratios.
5 Comment on performance.
4 Comment on position.
1 Identify useful further information.

Communicate in an appropriate manner to
given audience.

15.2 Discuss any ethical implications 3 For Tom Briar, identify issues of professional
of the scenario for Tom Briar competence and conflict of interest.
and his assistant George. 2 For George, identify potential inappropriate
incentive and intimidation.
Total marks 47
Maximum marks 30
15.1 Report to the non-executive director

From: Financial Accountant
Date: X/XX/XXXX
Subject: Analysis of the financial statements to 31 October 20X8
Introduction
The purpose of this report is to analyse the performance and financial position of Fly-Ayres.
The report includes a brief explanation as to why we have used industry specific ratios for
comparison. It also explains an issue with regard to employee share options, which requires
the financial statements to be adjusted, with some consequences for ratios calculated. It
further calculates the figures for a disposal of an investment in equity instruments, and
adjusts the financial statements and ratios for the required treatment. Finally it sets out
some further information that might be useful to the analysis, indicating why there may be
problems with analysing these financial statements.
(a) Usefulness of industry specific ratios to users of financial statements
Many industries are assessed using specific performance measures that are useful
because they take into consideration the specific nature of the industry.
New and rapidly growing industries often use specific industry ratios as traditional ratio
analysis does not show the full extent of a company's operational status. They are well
understood in the industry and industry user groups will find great value from the
information. However, they may not be understood by those outside the industry.
Many users find them useful as they can focus on financial issues that are not affected
by accounting policies. However, they may be less reliable than data calculated from
financial statements where the basis of calculation (such as accounting policies) is fully
disclosed.
Industry ratios are not prepared to any published standards and management may
cherry pick those that they disclose. The full picture on financial performance may not
be disclosed by them and there may be a lack of consistency between companies.
(b) Treatment of share options
The finance director has stated that an advantage of an employee share option scheme
is that it is an incentive to employees without having a negative impact on profit. In the
past, this was true: if a company paid its employees in cash, an expense was
recognised in profit or loss, but if the payment was in share options, no expense was
recognised. However, this changed with the introduction of IFRS 2, Share-based
Payment. IFRS 2 requires an entity to reflect the effects of share-based payment
transactions in profit or loss and in its statement of financial position.
The share options constitute equity-settled share-based payment. The options are
generally charged to profit or loss on the basis of their fair value at the grant date
(IFRS 2: para 10). If the equity instruments are traded on an active market, market
prices must be used. Otherwise an option pricing model would be used.

The conditions attached to the shares state that the share options will vest in three
years' time provided that the employees remain in employment with the company.
Often there are other conditions such as growth in share price, but I am assuming that
here employment is the only condition.
The treatment is as follows:
 Determine the fair value of the options at grant date.
 Charge this fair value to profit or loss equally over the three-year vesting period,
making adjustments at each accounting date to reflect the best estimate of the
number of options that will eventually vest. This will depend on the estimated
percentage of employees leaving during the vesting period.
Sally followed the IFRS 2 treatment in the year ended 31 October 20X7, and this needs
to be followed in the year ended 31 October 20X8:
Y/e 31 October 20X7 £

Equity b/d 0
Profit or loss expense 510,000
Equity c/d ((500 – 75)  200  £18  1/3) 510,000
DEBIT Expenses (P/L) £510,000
Y/e 31 October 20X8 £

Equity b/d 510,000
Profit or loss expense 546,000
Equity c/d ((500 – 60)  200  £18  2/3) 1,056,000
DEBIT Expenses (P/L) £546,000
An adjustment will be required to show the 20X8 charge to profit or loss. IFRS 2,
Share-based Payment does not specify where, so 'other costs' has been adjusted as the
most appropriate caption.
The credit entry is to equity. IFRS 2 does not say which component of equity, and the
entry is usually to 'other components of equity' or 'other reserves'. Some UK
companies make the credit entry to retained earnings. The draft accounts as prepared
do not need to be adjusted as the caption 'Retained earnings and other reserves'
would cover both. Total equity is unaffected.

The financial statements will need to be redrafted and ratios will need to be adjusted as
follows:
Adjustments to statement of profit or loss and other comprehensive income for the
year ended 31 October 20X8
Investment in
Share equity 20X8
20X8 draft option adj instrument adj adjusted
£m £m £m £m
Revenue 158.4 158.4
Cost of sales (137.3) (137.3)
Other income 0.5 1 1.5
Other costs (7.6) (0.5) (8.1)
Profit from operations 14.0 14.5
Profit before taxation 3.6 4.1
Taxation (1.4) 0.1 (1.3)
Other comprehensive
income 30.0 30.0
Total comprehensive 32.2 32.8
income for the year
Adjustments to statement of financial position as at 31 October 20X8

Investment in
Share equity 20X8
£m £m £m £m
ASSETS
Non-current assets
Property, plant and 272.9 272.9
equipment
Financial asset 2.0 (2) –
Current assets
Trade and other 9.3 9.3
receivables
Cash and cash equivalents 11.2 3 14.2
20.5 23.5
Issued capital: £1 ordinary 25.0 25.0
shares
Revaluation surplus 30.0 30.0
Retained earnings and 54.3 (0.5) + 1 + 0.1 55.4
other reserves 0.5
Equity 109.3 110.4
Borrowings and 150.2 150.2
obligations under
finance leases
Maintenance provisions 5.2 5.2
Deferred tax liability 2.1 (0.1) 2.0
157.5 157.4

Investment in
Share equity 20X8
£m £m £m £m
Current liabilities
Trade and other payables 18.4 18.4
Taxation 1.6 0.1 1.7
Borrowings and 8.6 8.6
obligations under
finance leases
28.6 28.6
Adjustments to ratios calculated for the year ended 31 October 20X8

As calculated Draft Recalculated Corrected
20X8 20X8
Return on shareholders' 2.2/109.3 2.0% 2.8/110.4 2.5%
funds (ROSF)
Non-current asset 158.4/274.9 0.58 158.4/272.9 0.58
turnover
Gearing (150.2 + 8.6 – 135.0% (150.2 + 8.6 – 131.0%
(net debt/equity) 11.2)/109.3 14.2)/110.4
Passenger numbers (in 3,722 3,722
thousands)
Revenue per passenger (£) 42.56 42.56
Operating profit margin 14/158.4 8.8% 14.5/158.4 9.2%
WORKING: Profit on sale of investment in equity instrument

£m
Proceeds 3.0
Carrying value at 31 October 20X7 (2.0)
1.0
This figure (gross of tax) will be included in other income.
The current tax charge per question relating to the sale of the investment is on selling
price less cost, and therefore includes not only the tax on the £1 million gain on the
sale, but also the tax on the previous revaluation gain of £0.5 million. The tax on the
£0.5 million gain before 31 October 20X7 was previously recognised in profit or loss as
deferred tax and is included in the deferred tax liability brought forward.
The following correcting entry is therefore required to eliminate the deferred tax
liability b/d:
£m £m
DEBIT Deferred tax liability (0.5  20%) 0.1
CREDIT Income tax expense (deferred tax) (P/L) 0.1

(c) Fly-Ayres plc: Report on the financial statements for the year ended 31 October 20X8
Note: This report is based on the financial statements and ratios as adjusted for the
correct treatment of the share options and the disposal of the investment in equity
instruments. Further ratios could be calculated. For example:
20X8 20X7
Cost per passenger, excluding interest ((137.3 +
6.6)/3.722) and ((103.8 + 5.2)/3.163) £38.66 £34.46
Cost per passenger, excluding interest and fuel cost
((137.3 + 6.6 – 57.7)/3.722) and ((103.8 + 5.2 –
36.4)/3.163) £23.16 £22.95
Gross profit margin (21.1 as % of 158.4) and
(34.5 as % of 138.3) 13.3% 24.9%
Operating cost percentage ((137.3 + 6.6) as % of
158.4) and ((103.8 + 5.2) as % of 138.3) 90.8% 78.8%
Return on capital employed (14.5 as % of (110.4 +
150.2 + 8.6 – 14.2)) and (29.3 as % of (77.0 + 123.7 +
9.2 – 7.4)) 5.7% 14.5%
ROSF for 20X8 excluding effects of revaluation (2.8 as
% of (110.4 – 30.0)) 3.5%
Net asset turnover (158.4/(110.4 + 150.2 + 8.6 – 14.2))
and (138.3/(77.0 + 123.7 + 9.2 – 7.4)) 0.62x 0.68x
Trade receivables collection period ((9.3/158.4)  365)
and ((8.2/138.3)  365) 21.4 days 21.6 days
Trade payables payment period ((18.4/137.3)  365)
and ((17.3/103.8)  365) 48.9 60.8
days days
Financial position
Interest cover (14.5/10.4) and (29.3/10.0) 1.39x 2.93x
Current ratio (23.5:28.7) and (15.6:32.2) 0.82:1 0.48:1
Gearing for 20X8 excluding effects of revaluation
((150.2 + 8.6 – 14.2) as % of (110.4 – 30.0)) 179.9%
(Credit will be given for other ratios; the basis of the calculation should be given.)
Performance
There has been a healthy growth in passenger numbers (17.7% increase ((3,722/3,163)
– 1)) and revenue (14.5% increase ((158.4/138.3) – 1)) in 20X8, compared to 20X7.
Revenue per passenger has fallen slightly, which may reflect the keen competition in
the budget flight market, but it remains very similar to the average per passenger
figure generated by our listed competitors. As many of the competitors are no doubt
larger than Fly-Ayres, with brand names that have been established for longer, and are
able to take advantage of economies of scale not currently available to us, this is a very
impressive result.
Despite this growth, however, gross profit margin, operating profit margin and net
profitability (to 1.8% (2.8 as % of 158.4) from 10.2% (14.1 as % of 138.3)) have fallen
sharply in 20X8, as has the key return on shareholders' funds (ROSF) ratio. Most
elements of cost have remained well under control when measured as a percentage of
revenue, but fuel costs have increased by a very large margin (from 26.3% of revenue
to 36.4%). Further significant fuel increases after the year end date could erode
profitability completely, and all other things being equal, losses could be substantial in
the coming year.

The 20X8 ROSF figure of 2.5% is well below the industry average of 13.8%. However,
that figure is several months out of date and it is likely that other comparable
businesses have experienced similar reductions in key performance ratios as they are
exposed to fuel cost rises in the same way.
The revenue per passenger figure shows that Fly-Ayres has been unable to pass on the
increased fuel cost to passengers, presumably because of competitive pressures.
However, the fuel cost will have hit all airlines and if some of our competitors are forced
out of business because of it, price increases to passengers may become possible in
the short to medium-term.
Crew costs as a percentage of revenue have fallen, possibly because of increased
efficiencies in crew scheduling. More information would be required to confirm the
reason for the decrease.
Overall cost per passenger (before taking interest into account) has increased from
£34.46 to £38.66, a substantial amount, but once fuel cost is stripped out, the effects of
tight cost control can be appreciated: this cost per passenger has increased by a
negligible 21p (to £23.16 from £22.95).
The fall in ROSF, referred to above, has been exacerbated by the increase in
shareholders' funds arising from the revaluation of property, plant and equipment. The
adverse effect on ROSF is unfortunate, but it can be argued that the statement of
financial position now presents a more comprehensive picture of resources available to
the business. The additional strength in the statement of financial position could be
helpful if more borrowing is required.
Position
Borrowings from external parties (ie, excluding the £20 million loan from Bill Ayres)
have increased relatively little between the 20X7 and 20X8 reporting dates. Interest
cover has worsened from 2.93 to 1.39 because of the drop in profits, but it does
remain at above 1, and so, provided that conditions do not deteriorate further, it is not
a cause for immediate concern. Gearing has decreased, taking into account the
additional shareholders' funds in the form of revaluation surplus, but if this effect is
excluded it has worsened. In either case it is greatly in excess of the industry average.
However, it should be noted that the gearing calculation currently includes both
borrowings and obligations under finance leases. Excluding the latter would result in a
less alarming gearing percentage.
The cash position at the end of 20X8 has improved substantially compared to 20X7.
However, the business currently has a high rate of cash burn; Bill Ayres lent £20 million
in August 20X8, but by the year end, only a little over two months later, the cash
balance was only £14.2 million. It is very helpful to the business to have access to
substantial interest-free borrowings, especially in adverse circumstances. However, if
Bill Ayres were to require repayment, the borrowings would presumably have to be
replaced with a loan at a commercial rate of interest which would have a significant
impact on the business's profitability. Even at a modest rate of interest, say 5%, this
would mean an additional £1 million of finance costs per year.
The current ratio has improved between the two year-ends, although this is mostly
attributable to the additional cash injected via Bill Ayres' loan. The ratio remains well
below 1 at the year end, but much of the balance of trade and other payables probably
represents flights booked and paid for in advance by passengers. This balance does
not require a specific cash outflow for settlement in normal trading conditions.
In summary, the key problem emerging from the draft financial statements is that of
declining profitability because of large oil price increases that have not been passed
on to passengers (the increase in fuel cost as a percentage of revenue). Although the
business has grown in terms of increased revenue, growth has been achieved entirely

through volume increases, not through price increases. If, as Bill Ayres intends, a public
listing is achieved in 20X9, this could raise sufficient additional capital to fund the
expansion plans. If the public listing is not achieved, more borrowing may be required
soon, but the statement of financial position demonstrates sufficient strength to justify
it. The board and the company's stakeholders can gain comfort from the rapid and
significant increase in passenger revenue.
Further information that would be useful for the analysis
There is no information in the scenario about the nature of the revaluation of property,
plant and equipment that has taken place during the year ended 31 October 20X8. It
would be helpful to know the nature of the revalued assets and the effect on annual
depreciation charges.
It can be assumed that the business suffered a cash shortage during the summer of
20X8, and its rate of cash burn appears relatively high. Therefore a statement of cash
flows would be essential to the analysis.
A statement of changes in equity would also be useful. The statement of financial
position includes a line for 'Retained earnings and other reserves' showing a net
increase of £3.4 million between the 20X7 and 20X8 year-ends. Profit for the year is
only £2.8 million, and so there must be at least one other reserve to account for the
difference. Although a movement of £0.6 million is not significant in itself, it may be a
net figure and there may have been some significant movements during the year.
More information about the six listed budget airline companies would be helpful, in
order to assess the extent to which they are truly comparable. Also, this information is
many months out of date, in a year in which fuel price increases have had a very
damaging effect. It should be possible to access more up to date reports, including
interim financial statements, preliminary announcements and, possibly, profits
warnings.
In respect of Fly-Ayres's own information, further investigation of the reasons for the
relative fall in crew costs would be useful, as would be more detailed analysis of the
effects of leasing obligations on these financial statements.
Potential problems with the analysis
It has been noted above that obligations under finance leases could be excluded from
the gearing ratio, making it more favourable. In fact, there are several possible ways of
calculating gearing, for example tax and deferred tax may be included or excluded, or
gross debt or net debt (net of cash) may be used. The ratios may change considerably
when the financial statements are adjusted. When the adjustments are required to
correct mistakes or omissions, as here, that is justified, but they may also vary because
of selection of accounting policies where a choice still exists.
15.2 Ethical implications
Ethical implications for Tom Briar, the finance director
(a) On the evidence in the scenario, Tom Briar could fall short in respect of professional
competence and due care. His background is in the insurance industry, where he was
employed in sales rather than as an accountant. Also, he qualified a long time ago and
may not have kept abreast of technical developments.
(b) There appears to be a risk of familiarity threat. Tom is an old school friend of Bill Ayres,
and he has been appointed as finance director because of this relationship. His attitude
to Bill Ayres is, from the information presented, one of unquestioning loyalty, and it
seems unlikely that he would challenge any decision made by Bill Ayres.

Ethical implications for George, the assistant
Compliance with fundamental ethical principles could be threatened by the following
factors:
(a) Self-interest threat: Tom Briar has stated that if the company obtains a listing, all staff,
including those who have recently joined, will be entitled to a substantial holding of
shares. This gives George an incentive to ensure that the financial performance and
position are favourably presented in order to make flotation more likely. This could
happen not only because of self-interest but also because of familiarity; once George
has built up good relationships amongst other Fly-Ayres staff, he may become too
sympathetic to their desire to see the company floated so that they too can gain a
substantial holding of shares.
(b) Intimidation threat is a possibility: Bill Ayres appears to have a dominant personality. It
is unlikely that Tom Briar would act as an effective buffer if there was pressure to
present the financial statements in a favourable way.
16 Aroma
Marking guide
Marks
Financial performance discussion and ratios
Growth 7
Profitability 6
Efficiency 8
Financial position discussion and ratios
Liquidity 6
Working capital management 5
Solvency 5
Conclusion and recommendation 4
Total marks 41
Maximum marks 30
Report
To: Jo West
From: Lois Mortimer
Date: 31 August 20X1
Subject: Financial performance and position of Aroma
Introduction
The aim of this report is to analyse the financial performance and position of Aroma and
determine whether or not it would make a good investment.
Growth
Revenue has increased by an impressive 62% in the year. This is largely due to the newly
appointed sales director's actions:
(a) Setting up a new online store which has been trading for the last 14 months – even though
this is a new venture, it generated 18% of Aroma's total revenue in the year ended 30 June
20X1.

(b) Securing a lucrative deal with a boutique hotel chain to manufacture products for the hotel.
This new contract generated 15% of total revenue in the year ended 30 June 20X1, even
though it had only been in place for six months, and can therefore be expected to generate
twice as much revenue in future years. In addition, with the sales director's contacts, other
such deals could be won in the future, so generating further growth in revenue.
Profitability
Gross margin has improved slightly from 30% in the year ended 30 June 20X0 to 32% in the
year ended 30 June 20X1. An analysis of the margins of the three different business areas
reveals that the improvement is largely due to the strong margin of 43% on the new hotel
contract. This could be due to a mark-up on the sales price for the right of the hotel chain to use
its own name and logo on Aroma's products. Aroma needs to ensure that it does not lose its
own brand strength by allowing others to put their name to Aroma products.
Net margin has also improved from 8.3% to 9% despite the increase in finance costs due to
reliance on an overdraft in the current year and an increase in long-term borrowings. This is
largely due to the online store generating the strongest margin of 12.6%. The overheads
associated with running an online business are likely to be lower than those associated with
operating retail stores from expensive premises. Furthermore, set-up costs incurred by the
online part of the business would have been recognised in the year ending 30 June 20X0,
causing that year's net margin to be low.
The net margin of the hotel contract part of the business is 9.1% in the year ended 30 June
20X1. This contract is relatively new and initial legal and other costs will be included in this
segment's costs. This margin may be expected to improve in the future.
The online store and new hotel contract have been successful initiatives in terms of growing
revenue and increasing both absolute profit and margins.
Aroma could improve their overheads cost control though as administration expenses have
increased by 111% in the year. As discussed, this may be the result of the initial costs of the new
hotel contract, however a detailed breakdown of costs would be required in order to establish
whether this were, in fact, the case.
Distribution costs have increased by 30%; this is proportionately lower than the increase in
revenue. This may be because online customers are required to pay their own postage and
packing and therefore the increase in revenue associated with this part of the business does not
result in a corresponding increase in distribution costs.
Efficiency
Aroma's efficiency in using its assets to generate both revenue and profit has improved as
illustrated by asset turnover increasing from 1.91 to 2.84 and return on capital employed from
21.8% to 33.3%. This can be attributed to improved margins (see above).
Financial position
Liquidity
The current ratio has declined slightly from 4.05 to 3.98 – this is largely due to reliance on an
overdraft in the current year and reduced receivable and inventory days.
However, the quick ratio has increased from 0.93 to 1.06 largely due to paying suppliers more
quickly (32 days compared to 53 days).
Overall though, Aroma can easily afford to pay its current liabilities out of its current assets.
However, long-term reliance on an overdraft is both risky as the overdraft facility could be
withdrawn at any time (especially in light of the bank's recent rejection of Aroma's request for
additional funds) and expensive.

Working capital management
Inventory days have decreased from 166 days to 113 days indicating that Aroma is selling their
inventories more quickly. This could be to meet the increased demand from the new online
store and the new hotel contract, or it may be to release some cash since the overdraft has not
been extended.
Inventory days remain high though – presumably this is due to the nature of the products
(perfumes, lotions and candles) having a long shelf-life. If the development costs result in new
improved products, there is a risk of obsolescence amongst the existing products.
Receivable days are low as expected when the majority of the sales are from retail stores where
the customers pay in cash. Aroma is now only taking 28 days on average to collect cash from its
credit customers as opposed to 31 days in the prior year. It may be that favourable credit terms
have been negotiated with the hotel chain.
Interestingly, Aroma is paying its suppliers more quickly in 20X1 ie, taking on average 32 days as
opposed to 53 days in 20X0. This seems inadvisable given that a significant overdraft has arisen
in the current year. Aroma should take full advantage of the credit period offered by their
suppliers. It may be that they are sourcing from a new supplier with stricter credit terms to fulfil
the hotel contract.
Solvency
Even though the bank is refusing further funding, Aroma's gearing, despite a small increase in
the year, remains at a manageable level (38% in the current year). Furthermore, Aroma can
easily afford to pay the interest on its debt as illustrated by an interest cover of 13.6 in the
current year.
Conclusion
On initial analysis, there seems to be a strong case for investing in Aroma. The business is
growing and innovative having just expanded into two new areas with the online store and new
hotel contract due to the skills of the new sales director. It is also profitable and the profitability
is improving year on year. Perhaps the only concern is reliance on the overdraft but this can be
resolved by improving working capital management and ensuring that the full credit period of
suppliers is taken advantage of. With further new initiatives from the sales director such as new
contracts with other hotel chains and further growth of online sales, there is potential for even
more growth in the future.
One issue to raise, however, is whether the owner-managers are using a cash investment – and
have tried to increase the overdraft – in order to pay themselves excessive dividends. However
profitable the company, this needs clarification before any investment is made.
Appendix
20X1 20X0
Return on capital employed = 540+43 307+34
= 33.3% = 21.8%
PBIT/(Debt + Equity – Investments) 412+68+1,272 404 + 1,160
Asset turnover = Revenue/total assets 6,000 3,700

= 2.84 = 1.91
2,115 1,942
Gross margin = Gross profit/Revenue 1,917 1,110

= 32.0% = 30%
6,000 3,700
Gross margin of retail operations 1,200

= 30.0%
4,004

20X1 20X0
Gross margin of online store 330
= 30.1%
1,096
Gross margin of hotel contract 387

= 43%
900
Operating profit margin = PBIT/Revenue 540+43 307+34
= 9.7% = 9.2%
6,000 3,700
Net margin = PBT/Revenue 540 307

= 9% = 8.3%
6,000 3,700
Net margin of retail operations 320

= 8.0%
4,004
Net margin of online store 138

= 12.6%
1,096
Net margin of hotel contract 82

= 9.1%
900
Current ratio = Current assets/Current 1,715 1,532
= 3.98 = 4.05
liabilities 431 378
Quick ratio = (Current assets – 1,715 –1,260 1,532 –1,180
= 1.06 = 0.93
Inventories)/Current liabilities 431 378
Inventory days = (Inventories/Cost of sales)  1,260 1,180
×365 = 113 days ×365 = 166 days
365 4,083 2,590
Receivable days = (Receivables/Revenue)  455 310

×365 = 28 days ×365 = 31days
365 6,000 3,700
Payable days = (Payables/Cost of sales)  363 378

×365 = 32 days ×365 = 53 days
365 4,083 2,590
Gearing = Debt/Equity 412+68 404 – 42

= 38% = 31%
1,272 1,160
Interest cover = PBIT/Interest expense 540+43 307+34

= 13.6 = 10.0
43 34

17 Kenyon
Marking guide
Marks
Financial performance discussion and ratios
Profitability 7
Earnings per share 6
Contingent liability 3
Pension 3
Financial position discussion and ratios
Liquidity 6
Working capital management 5
Conclusion and recommendation
Contingent liability – impact on ratios 4
Contingent liability – further information 4
Total marks 38
Maximum marks 30
Report
To: Gary Watson
From: Investment Analyst
Date: X-XX-XXXX
Subject: Kenyon plc
(a) Analysis
Introduction:
This is an analysis of the financial performance and position of Kenyon plc (an operator of
bottling plants) for the year to 31 October 20X1 in the context of whether or not it would
make a good investment.
Financial performance:
Kenyon plc's revenue has grown in the year by 43%. This is due to a combination of
increased volume of sales to existing customers and a new contract secured at the start of
the year.
This increased volume has not been at the cost of profitability, which has improved in the
year with return on capital employed increasing from 26% to 48%. This is due to both
improved efficiency in using non-current assets to generate revenue (non-current asset
turnover has increased from 1.34 to 1.74) and improved margins (see below).
Kenyon plc's gross profit margin has improved from 32% to 40% implying an improvement
in how Kenyon management is running its core operations. This could well be due to a
higher selling price under the new contract compared to the existing contracts.
Alternatively there may have been some production efficiencies.
The operating profit margin has improved in line with the gross margin (32% in 20X1; 24%
in 20X0). However administration expenses have increased by more proportionately than
other expenses or revenue implying some cost control issues with overheads.
The investment in the associate partway through the year was a good investment,
generating a return of 12.5%, (7/56).
The investment income has declined significantly in the year in relation to the falling cash
balance. The fall in the cash balance is discussed below.

The earnings per share has improved from 31 pence to 58.7 pence in line with the
improved profitability above. However, although the share price has increased in absolute
terms from £2.80 to £4.90, the P/E ratio has deteriorated from 9.03 to 8.35. This implies
decreased market confidence in Kenyon plc despite its increased volume and profitability.
This is likely to be for two main reasons:
(1) There is a contingent liability relating to a court case pending against Kenyon plc as a
result of a chemical leak shortly before the year end. The lawyers believe that Kenyon
plc is likely to lose the case but the amount of potential damages cannot be reliably
estimated. The decline in P/E ratio indicates that the market is concerned about the
impact that the loss of this case could have on the future profitability of Kenyon plc. In a
worst case scenario, Kenyon plc's going concern could be called into doubt.
(2) The net pension liability which must relate to a defined benefit pension scheme has
increased from £5 million to £38 million indicating a serious deficit in the scheme. This
will undoubtedly result in increased contributions in the year ended 31 October 20X2,
however, the amount is unknown. This is another uncertainty likely to have an impact
on the share price.
A cash-seeking investor would have been happy with the £100 million dividend paid in
20X1 (57% of profit for the year).
Financial position:
There has been a significant decline in liquidity in the year as illustrated by the fall in the
quick ratio from 1.64 to 0.79 and the fall in the cash balance from £60 million to £3 million.
Arguably Kenyon plc were wrong to keep such a large balance of cash in 20X0 as better
returns could usually be earned elsewhere. This could be the reason for the investment in
the associate in 20X1 which is generating a healthy 12.5% return. Kenyon plc has also
invested in non-current assets in the year which will be good for future growth.
Working capital management has deteriorated slightly. Inventory days have nearly doubled
from 46 to 79 days. This could be deliberate in terms of building up inventory levels to meet
increased demand from existing and new contracts. However, Kenyon plc will be incurring
significant holding costs and there is a risk in light of bad publicity from the court case, that
Kenyon plc will be unable to sell all of the inventory, resulting in a write down.
Receivable days have seen a slight increase from 38 days to 40 days but it seems that
Kenyon plc's credit control function is working efficiently. If may be that longer than
standard credit terms were awarded under the new contract.
Payable days have increased from 76 to 88 days. Whilst it is advisable to take advantage of
free credit, Kenyon plc must be careful not to alienate their suppliers as it could ultimately
result in withdrawal of credit or even supplies.
Conclusion:
Kenyon plc's growth and profitability make it an attractive investment proposition. However,
there are two significant uncertainties making it a risky investment:
 A pending court case which Kenyon plc is likely to lose.
 A large pension deficit and future contributions to make good the deficit are uncertain.
It would be advisable to wait until the amount of likely damages from the court case and the
increase in contributions to the pension scheme are known before making a final decision
on whether or not to invest.
(b) (1) Best and worst case potential impact of the contingent liability
The lawyers have estimated the potential damages as being between £7 million and
£13 million. The amount cannot be measured reliably, as there is no information
available as to the likelihood of either outcome. However, it might be useful to
consider the best and worst case scenarios of the potential impact on selected key
ratios.

The results (see Appendix) can be summarised as follows:
Liability of
No liability Liability of £13m £7m
Ratio recognised recognised recognised
ROCE 48% 46% 47%
Operating margin 32% 30% 31%
EPS 58.7p 54.3p 56.3p
The potential effect on profitability ratios is only slight, with ROCE decreasing by 2% if
the liability is £13 million and only 1% if it is £7 million and the operating margins
showing the same variation. The fall in EPS is proportionally greater, but not such as to
deter an investor. The main concern is as yet unquantifiable, and relates to the bad
publicity that could arise from the negative outcome of the court case, and the
potential future effect on sales.
(2) Further information regarding the contingent liability
 The report resulting from the investigation into the potential environmental
damage from the chemical spill to try and ascertain the likelihood of Kenyon plc
losing the case and the possible damages they might have to pay.
 Whether the chemical leak caused damage to the buildings, machinery and
inventories and whether a write down was needed at the year end and if so, for
how much?
 How the incident has been reported in the press to ascertain the potential
damage to Kenyon plc's reputation and subsequent loss of business?
 Post year-end sales orders to ascertain potential loss of business as a knock-on
effect from the spill.
 Whether the plant has been repaired and is still in working order to ascertain
ability to keep operating at the same capacity in the future.
 Whether safeguards have been put in place to prevent it from happening again/in
other plants.
 Details of the length of the new contract, other contracts in place which expire
soon and future contracts under negotiation.
Appendix
Key ratios (excluding potential impact of contingent liability)
All workings in £m 20X1 20X0
PBIT 221–1–7 117– 6
ROCE = =48% =26%
Equity + Debt – Investments 465+38 – 56 423+5
Gross margin = Gross profit/Revenue 268/663 = 40% 148/463 = 32%

Operating margin = Operating profit/Revenue 221–1–7 117–6
=32% =24%
663 463
EPS = Profit for year/Weighted average no of 176/300 = 58.7p 93/300 = 31p
equity shares (Note: 50 pence shares)
P/E ratio = Price per share/EPS 490/58.7 = 8.35 280/31 = 9.03
Non-current asset turnover 663/381 = 1.74 463/346 = 1.34
= Revenue/Non-current assets
Quick ratio (161 – 86)/95 = 0.79 (148 – 40)/66 = 1.64
= (Current assets – Inventories)/Current
liabilities

All workings in £m 20X1 20X0
Inventory days = Inventory/Cost of sales  365 86/395  365 = 79 days 40/315  365 = 46 days
Receivable days = Receivables/Revenue  365 72/663  365 = 40 days 48/463  365 = 38 days
Payable days = Payables/Cost of sales  365 95/395  365 = 88 days 66/315  365 = 76 days
Selected key ratios (including potential impact of contingent liability)
All workings in £m Damages of £13m Damages of £7m
PBIT 221–1–7 – 13 221–1–7 – 7

ROCE = =46% =47%
Equity + Debt – Investments 465 – 13 +38 – 56 465 – 7 +38– 56
Operating margin = Operating profit/Revenue 221–1–7 – 13 221–1–7 – 7

=30% =31%
663 663
EPS
= Profit for year/Weighted average no of
equity shares 176 – 13/300 = 54.3p 176 – 7/300 = 56.3p
(Note. 50 pence shares)

Audit and integrated answers
18 Dormro
Marking guide
Marks
(a) Identifies and explains any known and potential issues which
you believe may give rise to material audit adjustments or
significant audit risks in the group financial statements. 20
Maximum 18
(b) Outlines, for each issue, the additional audit procedures, if
any, required to enable us to sign our audit opinion on the
group financial statements 10
Maximum 9
A revised consolidated statement of financial position as at
30 April 20X2, which includes the overseas subsidiary, Klip 14
Maximum 13
Total marks 44
Maximum marks 40
Scenario
The candidate has recently assumed responsibility for the audit of Dormro Ltd and its
consolidated financial statements. Dormro heads a group of companies which supply security
surveillance systems. An assistant has completed work on the parent company and
consolidation. The candidate is asked to brief the audit manager on the status of the audit work,
and potential issues arising and additional information required from the client. An overseas
subsidiary company has been acquired during the year, audited by another firm overseas which
raises technical audit issues regarding the audit approach and the application of ISA 600 (UK)
(Revised June 2016). In addition, the candidate is required to prepare a revised statement of
financial position incorporating the new subsidiary.
The candidate is required to review the junior assistant's work papers identifying potential audit
adjustments. The financial reporting requirement is therefore embedded within the exhibits. The
candidate must identify potential financial reporting errors, including the correction of an
accounting error (incorrect treatment of intragroup balances), incorrect application of a financial
reporting standard (treatment of loan under IFRS 9) and the identification of embedded
potential financial reporting adjustments arising from the scenario (understatement of provisions
for warranty and inventory). There is also the potential non-compliance with IFRS with respect to
the recognition of fair value adjustments on the acquisition of CAM. The candidate needs to
identify whether there is sufficient information to propose an adjustment or whether further
enquiries are required to determine the appropriate accounting treatment.
A successful candidate will understand fully the principles and mechanics of a consolidation and
be able to identify issues from the information provided. The scenario also tests the candidate's
ability to determine what is significant to a group (as opposed to an individual subsidiary) audit
and to consider wider implications across the group of issues identified at a particular
subsidiary.
ICAEW 2019 Audit and integrated answers 297

Work paper for the attention of audit engagement manager
Introduction
The purpose of this work paper is to identify and explain the issues which may give rise to an
adjustment or an indication of a significant audit risk in the group accounts and additional audit
procedures to enable FG to sign off the Dormro group accounts. The work paper also includes a
revised consolidated statement of financial position at Appendix, reflecting an adjustment for
the accounting treatment of the £8 million loan and the acquisition of Klip.
Investments (Notes 1 and 2)
Issues and potential adjustments
 The work of the audit senior is inadequate and this in itself presents a risk for the firm. The
insufficient audit procedures performed have a direct impact on the audit opinion.
Agreeing a £10 million investment to bank statement alone is clearly inadequate.
 The audit senior has failed to identify a subsidiary requiring consolidation and this will
require adjustment – see below.
 CAM appears to have an investment which has not been considered further. The amount is
immaterial (£15,000) but it should be determined whether this is a trade investment or an
investment in a subsidiary or associate whose results should be included in the group
accounts. Further information on the nature of this investment and a determination of
subsidiary/associate treatment are required so that the need for, and materiality of, any
adjustment can be fully assessed.
 The consolidation entries for the acquisition of CAM seem very simplistic and may not
comply with IFRS. No fair value exercise appears to have been carried out at the date of
acquisition and the difference between the net assets in CAM and the acquisition price has
been posted to goodwill. There may be elements which should be allocated to intangibles.
There may be consequential effects on performance for the year because of amortisation of
the identified intangibles.
 In addition, costs and revenues for CAM have been assumed to occur evenly throughout
the year which may not be the case, especially as CAM is clearly a growing company. Given
materiality of CAM's results and goodwill balance, adjustments here could clearly be
material. Further enquiries are required.
Additional audit procedures
Detailed reviews of the audit senior's work should be carried out by an appropriate member of
the audit team to ensure no further inadequacies in the senior's work.
The sale and purchase agreement for CAM and for Klip should be reviewed to ensure there is
no additional consideration payable, or adjustments required (for example, in respect of
inventories and warranties). Also evidence of ownership of shares through examination of share
certificates must be confirmed in particular it is important to check that ownership of CAM is
100% as has been assumed in consolidation entries.
Need to enquire as to how any costs related to the acquisition of CAM have been treated as
these do not appear to have been included within the investment value.
Audit work on the acquisition of CAM should be performed to substantiate that no fair value
adjustments are required and to identify separate intangible assets, if any. An expert valuer may
be required to assess this, unless an exercise was carried out at the time of the acquisition. Also,
consideration should be given to whether adjustments should be made at the acquisition date
for the application of group policies.
Need to obtain management accounts or other evidence which give a more precise analysis of
the split between pre and post-acquisition results. Likely to be significant additional work to do
in auditing this once this information is available.

Consolidation schedules are at summarised level. Work should be performed on the detailed
disclosures within group accounts.
Work done on consolidation adjustments comprises largely a description of the adjustment.
Need to ensure that the amounts of the adjustments and the accounts to which they have been
posted have been substantiated by agreement to individual company results or other
supporting documentation.
Need to confirm that Dormro has not issued any shares in year through reviewing Board
meeting minutes and documents filed at Companies House. Review of Board minutes and legal
correspondence for the holding company are important tests which do not appear to have been
performed/documented.
Intragroup balances and transactions (Note 3)
 There is a difference on the intragroup balances which has been written off to profit or loss.
Need to investigate further the difference on intragroup balances as the current treatment
may be incorrect.
 There does not appear to be any consolidation entries to eliminate intragroup sales and
purchases. Given that all group companies operate in similar sectors, it seems unlikely that
the only intragroup trading is management recharges so consolidation entries may well be
incomplete.
FG needs to enquire further into the nature of intragroup trading to ascertain whether further
adjustment to eliminate intragroup sales and purchases is required.
Also need to ensure that completeness of the consolidation entries has been considered by
comparison to prior year and our knowledge of the way the companies trade and interact.
Loan (Note 4)
No loan interest has been accrued on the long-term loan and the loan arrangement fee of
£200,000 appears to have been treated incorrectly as an administrative expense. Under IFRS 9 it
should instead have been deducted from the loan balance outstanding and charged over the
loan period in proportion to the outstanding balance on the loan. The adjustment proposed by
the junior to charge accrued interest of £480,000 to profit or loss is incorrect. Interest should be
calculated using the effective interest rate which would give a charge for the year of £521,040
not £480,000 as proposed. The accrued interest payable should be recognised in current
liabilities and deducted from the long term loan. The loan should also be split between current
liabilities, £1,000,000, and long term borrowings £6,841,040 as follows:
£8,000,000 – £200,000 = £7,800,000
Instalment Finance Interest
paid charge payable
£ £ £ £ £
Year 1 7,800,000 521,040 (480,000) 7,841,040
Year 2 7,841,040 (1,000,000) 456,981 (480,000) 6,818,021

Journals required
£'000 £'000
DEBIT Loan 200
CREDIT Admin expenses 200
DEBIT Loan 480
CREDIT Accrued interest 480
DEBIT Finance costs 521
CREDIT Loan 521
DEBIT Loan – long term borrowings 1,000
CREDIT Loan – current liabilities 1,000
Need to consider carefully cash flow forecasts and ability of Dormro to repay its debts as they fall
due. In addition, terms of the loan agreement need to be reviewed and covenant compliance
assessed both now and over the next year as any breach of covenant might render the entire
debt repayable immediately.
Outstanding audit work
 Going concern sign off is not required on each individual company for the sign off of group
accounts. However, the overall cash position of the group is relevant and this looks poor,
especially given that the first instalment of £1m on long-term debt was due on 1 May 20X2
and both Secure and CAM have very high trade payables. Although companies are
profitable, there are also signs that trading is difficult.
 The group policy on the obsolescence provision is potentially concerning. The potential
adjustment identified in CAM is not material but should be considered along with any other
unbooked adjustments at subsidiary or group level. An overall group adjustment schedule
should be maintained.
 If a similar error rate which is identified in CAM is applied to the provision in the other
group companies, then the total error could be material. The Klip auditors have not raised
this as an issue but that may be because their audit work has not gone beyond ensuring
compliance with group policies (see below). However, the same issue could apply to Klip,
particularly as a fair value adjustment on acquisition required a significant adjustment to
inventory.
 Warranty provision – Although the balance is not material, the key audit consideration here
will be whether it is complete. An understatement could be material.
 The tax position of Secure looks incorrect as no tax credit has been recognised at present.
This requires further investigation and explanation to ensure that tax losses have been
claimed appropriately.
 There is also no deferred tax balance separately identified on the SOFP of all three
companies and this needs to be followed up to ensure compliance with IFRS.
The bank letters should be obtained as these also provide details of any loan accounts and other
arrangements and are important audit evidence.
Confirmations of all intragroup balances are not required, providing the balances eliminate on
consolidation – there is in fact a difference and this is discussed above. The difference requires
further investigation and possible adjustment.
The nature of inventories in each entity should be considered and to evaluate further any
potential error which may arise.

In respect of the potential understatement of the inventory provision, discussion is required with
management and the other audit teams to determine the extent to which additional analysis is
required based on actual post year-end sales and sales forecasts rather than historic data.
The warranty provision should be assessed based on the number of months for which warranty
is given, historic experience of warranty claims and any known issues or problems with security
equipment supplied.
The tax position of Secure should be discussed with management to determine whether an
adjustment is appropriate. The tax computation should be reviewed and discussed with a tax
expert.
Overseas subsidiary – Klip
 Control is established when a parent owns more than 50% of the voting power of an entity.
A 90% shareholding in Klip would therefore signify that control exists unless Dormro
management can identify reasons why the ownership of the shares does not constitute
control. Therefore, an adjustment is required to include the results from the date of
acquisition and the assets and liabilities of Klip – see Appendix.
 No assessment appears to have been made at the planning stage of whether Klip is a
significant component.
 FG has placed reliance on other auditors to audit this entity. There appears to be no
evidence, however, that FG has obtained an understanding of the component auditor as
required by ISA 600 (UK) (Revised June 2016), or confirmed that the component auditor
meets the relevant independence requirements. Furthermore, confirmation appears to
have been addressed to Dormro FD and not to FG.
 The audit of Klip has been conducted under Harwanian Standards of Auditing, which may
not be equivalent to the ISA.
 Klip has prepared financial statements under group accounting policies supplied by group
financial controller. Local policies have been used where group policies are silent. There is
a risk that these are not compliant with IFRS or that they are incomplete.
To determine whether Klip is a significant component, FG will need to assess whether Klip has
financial significance, is significant by nature of its circumstances or due to its nature or
circumstances is likely to lead to a significant material risk of misstatement to the group. The
outcome of this assessment will determine the nature of the audit approach; full audit, audit of
specific balances, specified procedures based on specified risks.
ISA 600 (UK) (Revised June 2016) requires FG to evaluate the reliability of the component
auditor and the work performed. A formal confirmation of the independence of the Harwanian
auditors will be required as this is not covered in the clearance supplied. FG will need to assess
their competence by reviewing size, reputation, experience, client base of the firm.
FG will need to assess adequacy of the audit procedures performed by the Harwanian auditors.
This could be achieved by asking them to complete a questionnaire confirming their compliance
with the ethical and independence requirements of the group audit, their professional
competence, and the level of involvement the group auditor is able to have in the component
auditor's work.
If the component auditor does not meet the independence requirements, their work must not
be relied upon, and FG must perform additional risk assessment or further audit procedures on
the financial information of the component.

If there are less serious concerns about the component auditor's competency, FG should be
able to overcome the problems by being involved in the component auditor's work. In
particular, FG will need to conduct a very detailed review of completeness and appropriateness
of policies supplied. As Klip is in a different business (manufacturing) to the UK entities, there
may well be omissions and differences in the accounting policies adopted.
Appendix – Dormro: Revised consolidated statement of financial position
ASSETS Group
Non-current assets £'000
Property, plant and equipment (3,014 + 462) 3,476
Goodwill (6,251 + 52) 6,303
Investments 15
Current assets
Inventories (6,327 + 262) 6,589
Trade receivables (9,141 + 143) 9,284
Cash and cash equivalents (243 + 10) 253
Total assets 25,920
Equity
Share capital 200
Retained earnings (W4) 5,766
Foreign exchange reserve (W6 and W7) 52
Non-controlling interests 22
Long-term borrowings (6,841 (see above) + 333) 7,174
Current liabilities
Loan 1,000
Trade and other payables (10,252 + 329 + 480) 11,061
*Current tax payable 645
*Further adjustments may be required to taxation

WORKINGS
(1) Translation of the statement of financial position of Klip
H$'000 H$'000 Rate £'000
ASSETS
Non-current assets
Property, plant and equipment 1,940 4.2 CR 462
Current assets
Inventories 2,100
Less write down at acquisition 1,000 1,100 4.2 CR 262
Trade receivables 600 4.2 CR 143
Cash and cash equivalents 40 4.2 CR 10

Total assets 3,680 877
Equity
Share capital 200 5.4 HR 37
Pre-acquisition reserves 575 5.4 HR 107
Post-acquisition reserves (Including
exchange differences to date) 125 Balance 71
Long-term borrowings 1,400 4.2 CR 333
Current liabilities
Trade and other payables 1,380 4.2 CR 329
Total equity and liabilities 3,680 877
(2) Pre-acquisition reserves

H$'000
Balance at 30 April 20X2 1,700
Less earnings post acquisition 125
Reserves at 31 January 20X2 1,575
Less inventory write down 1,000
Pre-acquisition reserves 575
(3) Goodwill
H$'000
Non-controlling interest 775 × 10% 77

995
Less net assets of acquiree 775 £'000
Goodwill 220 HR 5.4 41
Exchange gain 11
Retranslated at closing rate 220 CR 4.2 52

(4) Consolidated retained earnings
£'000
Dormro (see below) 5,743
Adjustments
Share of Klip post-acquisition profits
3 months × 90% of Klip H$500,000 = 112.5 @AR 4.8 23
5,766
Retained earnings at 1 May 20X1 5,496
Add profit for the year 568
Add write back of arrangement fee on loan 200
Less finance charge on loan (521)
Revised retained earnings at 30 April 20X2 5,743
(5) Non-controlling interest

£'000
Closing net assets (37 + 107 + 71) 215,000 × 10% 22
(6) Exchange difference on retranslation of subsidiary
H$'000 £'000
Net assets at acquisition 775 HR 5.4 144
775 CR 4.2 185
Gain 41
Retained profits since acquisition

500 × 3/12 125 AV 4.8 26
125 CR 4.2 30
4
Total gain (41 + 4) 45
Group share 90% 41
(7) Foreign exchange reserve

£'000
Exchange gain on Goodwill 11
Exchange difference on retranslation of subsidiary 41
52
19 Johnson Telecom
Marking guide
Marks
(a) Treatments
Disposal of Cole 3
Hedge re International Energy 5
Acquisition of Routers 4
Loan note and swap 2
(b) Hedging
Explanation of hedging principles 4
Draft hedging documentation 3
Note independence issues 2

Marks
(c) Key risks and internal controls
1 mark for each risk/control identified and explained 9
(d) Audit evidence
1 mark for each piece of evidence, maximum of 9
Total marks 41
Maximum marks 40
MEMORANDUM
To: Annette Douglas
From: Poppy Posgen
Subject: Year-end reporting of financial instruments at Johnson Telecom
(a) Accounting treatment of financial instruments
(1) Disposal of equity investment in Cole plc
 50,000 shares initially recorded at cost of £163,000.
 The fair value (FV) at 31 December 20X6 was £230,000, hence £67,000 gains
accumulated in other components of equity.
 As the investment was classified as being at fair value through other
comprehensive income it was correct to adjust its carrying amount to fair value at
bid price at each reporting date.
 The journal correctly removed the FV of the investment from the statement of
financial position and recorded a profit on disposal of £12,000 (£242,000 –
£230,000).
The gains of £67,000 accumulated in other components of equity are not reclassified
to profit or loss on disposal of the investment, so the total profit or loss impact is
£12,000.
(2) Investment in Routers plc
8 November 20X7
 16,000 shares out of 50,000 shares were acquired, giving Johnson Telecom a
holding of 32%. Routers plc should therefore be treated as an investment, not as a
subsidiary.
 The investment in Routers plc has been recorded at the offer price of £5.83.
 Acquisition of 16,000 shares should have been initially recorded at bid price of
£5.80 per share, a cost of £92,800.
 The bid-offer spread of 3p reflects the transaction cost and as the investment is
classed as at fair value through profit or loss, this cost of £480 should have been
expensed to profit or loss for the year.
 The journal entry to adjust for the transaction cost is as follows:
£'000 £'000
DEBIT Profit or loss 0.48
CREDIT Investment 0.48
31 December 20X7
 In addition, as the investment is classed as at fair value through profit or loss, the
investment should have been re-measured to its fair value at the year end.
 The year-end bid price is £5.85. The fair value of the investment at the year end
should therefore be £93,600, with a gain of £800 being recorded in profit or loss.

£'000 £'000
DEBIT Investment 0.8
(3) Hedged investment in International Energy plc
Eligibility to apply special hedge accounting rules
In order to apply special hedge accounting rules, IFRS 9, Financial Instruments requires
that the hedge be designated and documented at inception, and the effectiveness of
the hedge to be tested at least every reporting date. As there is currently no
documentation to support the hedge, Johnson will not be permitted to apply hedge
accounting, because the hedge was not formally designated and documented at
inception. By implication, IFRS 9 does not permit documentation to be backdated, nor
for hedge accounting to be applied retrospectively.
It is therefore incorrect to apply hedge accounting rules.
Equity investment in International Energy
 IFRS 9 states that if a hedging instrument hedges an equity investment at fair value
through other comprehensive income, the gain or loss on the hedging instrument
is recognised in other comprehensive income (IFRS 9, para 6.5). Since hedge
accounting has been applied, the loss on revaluing the investment has been
charged to other comprehensive income, in accordance with the IFRS 9 treatment
of fair value hedges. Therefore no adjusting entries are required because the loss
would be recorded in other comprehensive income irrespective of the hedge
accounting rules.
 30,000 shares measured at FV at 31 December 20X6 are valued at £255,000
(£8.50 per share), and £228,000 at 31 December 20X7 based on bid price of
£7.60 per share.
 Without applying special hedge accounting rules, the loss of £27,000 is
recognised in the other components of equity, as follows:
£'000 £'000
DEBIT Other components of equity 27
CREDIT Investment 27
No adjustment is required to the investment to reverse the hedge accounting as the
investment is at fair value through other comprehensive income
Put options
 The put options are initially measured at cost and re-measured to fair value at
each reporting date.
 The original cost of the put options was £60,000 (30,000 @ £2.00). At the year end,
the fair value of the options is £72,000 (30,000 @ £2.40).
 Without hedge accounting, the £12,000 fair value gain is recorded in profit or
loss:
£'000 £'000
DEBIT Derivative asset 12
However, hedge accounting had been applied and the fair value gain recorded in
other comprehensive income/other components of equity:
£'000 £'000
DEBIT Derivative asset 12
CREDIT Other components of equity 12

Therefore the journal required to reverse the hedge accounting is:
£'000 £'000
(4) Investment in Spence & May bonds
Year-end disposal of 50% of holding
 The journal entry recording the disposal of the 50% holding neglected the gain
arising from the disposal. As the supporting workings correctly calculate, the
amortised cost of the debt investment sold was £72,227 (£144,454/2), giving a
gain of £10,773 to be taken to the profit or loss, as follows.
£'000 £'000
DEBIT Cash 83
CREDIT Debt investment 72.2
The journal entry to adjust for this error is as follows:
£'000 £'000
DEBIT Debt investment 10.8
(5) Loan note and interest rate swap
 The treatment of the interest rate swap appears to be correct. However, the
accounting note made no mention of the effectiveness of the swap, a factor upon
which the appropriateness of hedge accounting depends. (Please see Audit
evidence section below.)
(b) Hedge accounting rules and hedging principles
Hedging principles
 The fair value of the derivative is comprised of an intrinsic value (exercise price less
share price) and a time value, based on the period to expiry of the option.
 Where the share price is higher than the exercise price, the intrinsic value is zero as the
put option is out-of-the-money and will not be exercised.
 At acquisition, the share price was £9 (30,000 shares with a total cost of £270,000). The
exercise price of the put option was also £9. The intrinsic value is therefore zero.
 At the year end, the fair value of an option is £2.40 representing an intrinsic value of
£1.40 (£9 – £7.60) and a time value of £1.
 The share price has fallen by £1.40 since acquisition and this is exactly matched by the
increase in the intrinsic value of the options from zero to £1.40. Hence it can be seen
that the intrinsic element of the option provides a highly effective hedge for the
change in fair value of the share price below £9.00.
 It can be seen that the hedge constitutes a 'fair value hedge' as the option is protecting
against movements in the fair value of the recognised equity investments below £9.
Tutorial note
The company does not have to designate only the changes in the intrinsic value of the
option as the hedging instrument: it could in fact designate the changes in the total fair
value of the option as the hedging instrument instead. However, in this case the hedge
would not be effective.

Fair value hedge accounting
Without applying hedge accounting, a mismatch would arise: the gain on the options and the
loss on the associated investment are not recorded in the same financial statement. While the
gain on the options is recorded in profit or loss, the loss on the investment is charged to other
comprehensive income. Hedge accounting prevents such a mismatch.
 The £27,000 loss arising on the FV movement in the shares would be accounted for as per
the irrevocable election made on recognition, that is it would be recorded in other
comprehensive income and other components of equity.
 The gain on the derivative of £12,000 could be analysed as follows:
– Gain on the intrinsic value change of £27,000 (90p × 30,000)
– Loss on the time value change of £15,000 (50p × 30,000)
 The £27,000 loss arising on the FV movement in the shares would be hedged by the gain
arising on the increase in the intrinsic value of the options of £27,000.
 The IFRS 9 hedge accounting rules would require the loss on the shares to be matched in
OCI/OCE against the gain on the intrinsic element of the options, so this increase in the
intrinsic value of the options would be recorded in OCI rather than in profit or loss as is
usual.
 The net effect on profit or loss for the year would be to show a loss of £15,000, reflecting
the change in the time value of the options.
Hedge documentation: International Energy plc
As discussed above, the hedging documentation cannot be prepared retrospectively. The
following is therefore for reference only. We should make clear to the Directors that they must
use the documentation to support the hedge in question. As stated, hedge accounting should
not be applied in this case.
Hedge No. X
Date 7 February 20X8
Risk management objective and strategy:
The investment in the equity of International Energy plc is exposed to fluctuations in the market
value. To hedge exposure of a decline in share price, management has entered into a put option
over the entire holding.
Hedge type Fair value
Hedged risk Market risk that share price falls below £9.00
Hedged item
Investment in holding of 30,000 equity shares in International Energy plc.
Hedging instrument
Put option in 30,000 equity shares in International Energy plc at an exercise price of £9.00
exercisable until 31 December 20X8.
Hedge effectiveness
Monitor on a quarterly basis comparing change in intrinsic value of options to change in share
price where price falls below £9.00.
From an ethical perspective, the preparation of documents for financial reporting purposes on
behalf of the client would constitute a self-review threat. We should explain to the client that due
to our obligation to remain independent, we are unable to prepare supporting documentation
for the financial statements.

(c) Risks from derivatives trading:
Key risks
There are a number of concerns that we should address as auditors.
 Credit risk is the risk that a customer or counterparty will not settle an obligation for full
value. This risk will arise from the potential for a counterparty to default on its
contractual obligations and it is limited to the positive fair value of instruments that are
favourable to the company.
 Legal risk relates to losses resulting from a legal or regulatory action that invalidates or
otherwise precludes performance by the end user or its counterparty under the terms
of the contract or related netting agreements.
 Market risk relates to economic losses due to adverse changes in the fair value of the
derivative. These movements could be in the interest rates, the foreign exchange rates
or equity prices.
 Settlement risk relates to one side of a transaction settling without value being
received from the counterparty.
 Solvency risk is the risk that the entity would not have the funds to honour cash outflow
commitments as they fall due. It is sometimes referred to as liquidity risk. This risk may
be caused by market disruptions or a credit downgrade which may cause certain
sources of funding to dry up immediately.
Necessary general controls and application controls
Tutorial note
This answer assumes that a computer system is used in processing trades involving
derivatives.
General controls
A number of general controls may be relevant:
 For credit risk, general controls may include ensuring that off-market derivative
contracts are only entered into with counterparties from a specific list and establishing
credit limits for all customers.
 For legal risk, a general control may be to ensure that all transactions are reviewed by
properly qualified lawyers and regulation specialists.
 For market risk, a general control may be to set strict investment acceptance criteria
and ensure that these are adhered to.
 For settlement risk, a general control may be to set up a third party through whom
settlement takes place, ensuring that the third party is instructed not to give value until
value has been received.
 For solvency (liquidity) risk, general controls may include having diversified funding
sources, managing assets with liquidity in mind, monitoring liquidity positions, and
maintaining a healthy cash and cash equivalents balance.
Application controls
These include the following:
 A computer application may identify the credit risk. In this case an appropriate control
may be monitoring credit exposure, limiting transactions with an identified
counterparty and stopping any further risk-increasing transactions with that
counterparty.

 For legal risk, an application control may be for the system not to process a
transaction/trade until an authorised person has signed into the system to give the
authority. Such an authorised person may be different depending on the nature and
type of transaction. In some cases it may be the company specialist solicitor, or the
dealer's supervisor.
 For market risk, an application control may be to carry out mark-to-market activity
frequently and to produce timely exception management reports.
 For settlement risk, an application control may be a computer settlement system refusing
to release funds/assets until the counterparty's value has been received or an authorised
person has confirmed to the system that there is evidence that value will be received.
 For solvency risk, an application control may be that the system will produce a report for
management informing management that there needs to be a specific amount of funds
available on a given date to settle the trades coming in for settlement on that date.
In addition to the above, a fraud risk arises because the Financial Director – who has
maintained the accounting records for the derivatives almost single-handedly – also
appears to be the only person within the company familiar with the accounting treatment
for the financial instruments (including the derivatives). An effective system of internal
controls will go some way to mitigate the fraud risk, but an informed management with an
adequate understanding of derivatives and hedge accounting is crucial.
(d) Audit evidence:
The additional audit evidence that we will need to obtain with regards to the financial
instruments includes the following:
Equity investments
 Confirmations from management regarding the basis on which the year end valuation
of the equity investments were made.
 Information from third-party pricing sources regarding the fair value of the investments
(including details of valuation techniques, assumptions and inputs).
 Observable market prices at the year end for comparison.
 Supporting documentation (board meeting minutes, accounting notes produced by
the Treasury department) to support the classification of the investments in Cole plc
and International Energy plc as investments in equity instruments at FVTOCI.
 Details of controls that management has in place to assess the reliability of information
from third-party pricing sources.
 For the disposal of the investment in Cole plc, the sale agreement to support the
disposal value of £242,000 and bank statement to confirm the receipt of the
consideration.
 For the acquisition of the investment in Routers plc, documentation (sale agreement,
valuation documentation) to support the purchase price; bank statement and sale
documentation to confirm the payment of the consideration.
Hedged investment in International Energy plc
 Copy of the put option agreement, and back office report confirming the processing of
the put option.
 Statement from the clearing agents confirming the details of the options.
 Third-party pricing sources to support the fair value of the options.
(As discussed above, hedge accounting is not expected to be applied, as the hedge
documentation has been lost and the criteria for hedge accounting have therefore not
been met.)

Investment in Spence & May bonds
 Copy of the purchase agreement for the initial purchase of the bonds.
 Board meeting minutes or internal analysis confirming the suitability of measuring the bond
at amortised cost under IFRS 9.
 Sale agreement for the disposal of the bonds during the year.
 Bank statements supporting interest payments and disposal proceeds.
Loan note and interest rate swap
 Copy of the loan documentation.
 Copy of the interest rate swap agreement.
 Counterparty and broker confirmations agreeing the details of the interest rate swap.
 Copy of the hedging documentation for the files.
 Supporting workings analysing the effectiveness of the swap as a hedge, including an
explanation of the method used and any assumptions made.
 Bank statements showing the interest payments on the loan and the interest receipts from
the swap.
 Supporting documentation for the fair value of the swap at the year end (including details of
the methodology used, assumptions made, and report from independent experts where
relevant).
The exercise of professional scepticism will be particularly important around fair value
measurements. Where the audit evidence obtained is inconsistent or incomplete, we must seek
to perform further audit procedures. Further, where external experts have been consulted by the
entity, the degree of reliance that can be placed on the external experts also needs to be
considered.
20 Biltmore
Marking guide
Marks
(a) Treatments
General 2
Harmony Tower 3 3
Grove Place 3
Head office 3
Northwest Forward 2
Teesside 3
Essex Mall 2
Subone Head Office 3
Coventry Building 3
(b) Adjustments
1 mark for each journal entry, maximum of 8
(c) Impact on the auditor's report
Quantify the combined impact 4
Appropriate audit opinion and explanation, maximum of 4
Total marks 40

REPORT
To: David Williams, Audit Partner
From: Jane Smith, Audit Senior
Subject: Biltmore Group – Investment properties
Date: February 20X9
As requested, I report below on the issues raised by the Biltmore Group's investment properties.
(a) Proposed treatment
Broadly, the group has not met the requirements of IAS 40, Investment Property in most
cases. Each of those breaches has the effect of overstating profit and of overstating the
value attributed to investment properties in the statement of financial position.
Harmony Tower 3
We cannot accept the directors' claim that this property must remain at cost because there
is no reliable means of estimating its fair value. This is a standard office block in an area
where there is a thriving market for such properties. There are observable market prices. It
would be reasonable to expect this property to be valued at around £150 million because
there is good evidence of that being the current market valuation.
IAS 40 states that fair value must be measured in accordance with IFRS 13, Fair Value
Measurement, which defines fair value as:
"the price that would be received to sell an asset in an orderly transaction between market
participants at the measurement date."
IFRS 13 states that entities should maximise the use of relevant observable inputs and
minimise the use of unobservable inputs.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use
to measure fair value:
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that
the reporting entity can access at the measurement date.
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the
asset or liability, either directly or indirectly eg, quoted prices for similar assets in
active markets or for identical or similar assets in non-active markets or use of
quoted interest rates for valuation purposes.
Level 3 Unobservable inputs for the asset or liability ie, using the entity's own assumptions
about market exit value.
Harmony Tower may be valued using a Level 2 input, that is, prices that are directly
observable for identical buildings in an active market.
To obtain further evidence that a fair value of £150 million is appropriate, the use of
auditor's experts may be necessary.
Grove Place
The fair value of the property is £220 million. The £30 million spent during the year should
only have been capitalised in accordance with IAS 16 if it represented an improvement in
the asset – ie, increased the future economic benefits rather than maintaining the asset.
Evidence has shown that the refurbishment work has not created the future economic
benefits. Therefore, the £250 million carrying value must be written down to fair value at the
year end, being £220 million, with the refurbishment expense of £30 million charged to
profit or loss for the year.

This is not an investment property. Biltmore plc occupies and uses a significant part of the
building and the vacant part is not capable of being leased or sold separately. The whole
building will have to be treated as normal owner-occupied property.
Northwest development
Biltmore plc's use of this property is restricted to only a very small proportion, and the
complex cannot be sold separately. It is therefore acceptable, under IAS 40, to treat the
whole development as investment property.
The fair value should be decided in terms of market conditions as at the year end. Thus, the
company's proposed valuation of £150 million is correct providing that the downturn arose
after the year end. There may be an argument for treating this downturn as a non-adjusting
event after the reporting period and disclosing the change in the market value in a note to
the accounts.
Essex Mall
IAS 40 states that a property which is being developed for future sale cannot qualify as an
investment property. Thus, the building must be treated in accordance with IAS 2 until such
time as it is ready for disposal. Its initial recognition should be at cost, but it should be
written down to its net realisable value if this falls below cost.
Subone plc's head office
It is perfectly legitimate for Subtoo plc to treat this property as an investment property in its
individual company financial statements because it is occupied by a third party. However,
the Biltmore Group cannot treat the property as an investment property because it is
owned by one group member and occupied by another. There is nothing to prevent the
group from showing the property in its statement of financial position, but the revaluation
gain on consolidation cannot be recognised in profit or loss for the year and must instead
be recognised as other comprehensive income and accumulated in a revaluation reserve in
equity. As an item of PPE, the asset must be depreciated over the duration of the lease.
Coventry development
This property ceased to be an investment property when it was placed on the market. It
should have been transferred to inventory at that time at its deemed cost of £345 million
which is its fair value at the date of its change in use. It should be accounted for under the
requirements of IAS 2, Inventories. Any subsequent downward reassessment of the sales
value would cause the asset to be written down to the new net realisable value.
(b) Required adjustments
Harmony Tower 3
Recognise loss:
£m £m
DEBIT Gains on investment properties 50
CREDIT Investment properties 50
Grove Place
Treat costs incurred as revenue:
£m £m
DEBIT Repairs 30

Cancel gain recognised for year:
£m £m
Reclassify building as non-investment property:
£m £m
DEBIT Property, plant and equipment 80
Charge depreciation on additional non-investment property:
£m £m
DEBIT Depreciation expense 4
CREDIT Property, plant and equipment 4
Northwest development
No adjustment required.
No adjustment required.
Essex Mall
Cancel gain recognised for year:
£m £m
Reclassify development as non-investment property:
£m £m
DEBIT Property under construction 770
Subone plc's head office (consolidation adjustment only)
Reclassify building as non-investment property:
£m £m
Charge depreciation on additional non-investment property:
£m £m
DEBIT Depreciation expense 6
CREDIT Property, plant and equipment 6
(Book value throughout the year = £120m, divided by 20-year life = £6m.)
Transfer recognised gain to revaluation reserve:
£m £m
CREDIT Revaluation reserve 36
(The additional depreciation charged to profit or loss has to be added to the recognised
gain on revaluation and added back to property, plant and equipment at valuation less
depreciation.)

Coventry development
Cancel the revaluation gain recognised since property became part of inventory:
£m £m
Transfer property to inventory:
£m £m
DEBIT Inventory 345
(c) Impact on auditor's report
If Biltmore's directors refuse to put through the reclassifying adjustments in respect of
investment properties, several different accounts in the consolidated statement of financial
position will be misstated as follows:
Investment Current Property under

properties PPE assets construction Total
£m £m £m £m £m
Draft 2,360 57 6 0 2,423
Harmony Tower 3 (50) (50)
Grove Place (30) (30)
Head office (100) 76 (24)
Essex Mall (850) 770 (80)
Subone Head Office (150) 150 –
Coventry building (360) 345 (15)
Revised 820 283 351 770 2,224
In addition, the misclassification has resulted in profit being overstated by £235 million as a
result of associated adjustments, as follows:
£m
Harmony Tower 3 (fair value gain) 50
Grove Place (refurbishment costs) 30
Head office – upper floors (depreciation and fair value gain) 24
Essex Mall (fair value gain) 80
Subone plc's head office (depreciation and fair value gain) 36
Coventry (revaluation gain) 15
Total 235
The revaluation reserve is also understated by £36 million.

The materiality level for the financial statements as a whole is £24 million (total group assets
of £2,423m  1%). This shows clearly that the misstatements in each of the affected
accounts are material. Indeed, the overstatement in investment properties alone represents
64% of the group's total assets.
Besides materiality for the financial statements as a whole, ISA 320 (UK) (revised June 2016)
requires us to consider performance materiality. In particular, specific materiality levels may
be set for particular account balances that could have a particular influence on users'
decisions in the particular circumstances of the entity.

As Biltmore is a property business, and investment properties currently represent the
largest account balance in group's statement of financial position, the investment
properties account should be assigned a lower performance materiality. This makes the
level of misstatement in the investment properties account even less acceptable.
Arguably, inventory and properties under construction are equally significant to the users'
economic decisions. The difference between an inventory of less than £6 million (current
assets in the summary statement of financial position) and £345 million, and indeed
between properties under construction of £nil and £770 million, is highly important. Left
unadjusted, it could be very misleading to the users of the financial statements.
Finally, assuming the directors do agree to make the remaining adjustments listed above,
keeping the four properties in the investment properties account at their adjusted carrying
amount simply would not make any sense from an accounting point of view. As they
currently stand, the properties would not be accounted for in accordance with IAS 40.
I would recommend explaining the above to the directors, so that they understand that the
reclassification adjustments do have a material impact on the financial statements.
Should the directors still refuse to make the adjustments, an unmodified opinion cannot be
issued. Given that this misstatement represents a substantial proportion of the financial
statements, there is an argument for this being considered both material and pervasive,
which would lead to an adverse opinion; should this be considered material and not
pervasive though, a qualified opinion would be used.
As a separate point, given the directors' attitude, it may be necessary to consider adjusting
our materiality level, and to think about how this may impact other classes of transactions,
account balances and disclosures.
21 Button Bathrooms
Marking guide
Marks
(1) Financial reporting issues and key audit risks

(a) Revenue recognition – FR and audit issues 9
(b) Reorganisation – FR and audit issues 6
(c) Website development costs – FR and audit issues 5
(d) Pension 6
(2) E-commerce and service provider – audit risks 7
(3) Outsourcing of payables ledger 5
(4) Response re cyber attack 4
Total marks 42
Maximum marks 40

To: Carol Ying, Partner
From: A Senior
Date: 25 July 20X1
Subject: Button Bathrooms Audit
(1) Audit junior's points
(a) Revenue
Online sales
The timing of receipt of cash should not determine the timing of revenue recognition. In
accordance with IFRS 15, Revenue from Contracts with Customers, revenue should be
recognised for the sale of goods when the entity satisfies the relevant performance
obligation, which is when control is passed to the customer (IFRS 15: para 32). This would
normally occur on the passing of possession of the goods (ie, physical delivery).
The key audit risk is therefore that revenue is inflated as being recognised when cash is
received from SupportTech rather than when the goods are delivered which may be up to
four weeks later. This would in turn inflate profits.
A key audit risk is also incorrect cut off, as if revenue is recognised then the cost of sales
should also be recognised.
There is therefore a risk that profit is significantly inflated by overstating revenue and failing
to recognise any cost of sales on items paid for by customers in June. There needs to be an
appropriate system for recording the delivery date in order to have control over the timing
of revenue recognition and cut-off.
Similarly, there needs to be a system for recording the nature and timing of returns. If
returns are significant consideration could be given to making a provision or even deferring
revenue recognition until after the end of the returns period.
A key legal issue is with which party is the customer's contract. This could be SupportTech.
Alternatively it may be that the contract is with BB and SupportTech is merely an agent. This
could be significant in the case of default.
As goods are delivered to order there is no material issue with inventories in this respect.
Audit procedures will include the following:
 Examining the dates of delivery to customers of sales recognised in June 20X1
 Examining the dates of delivery to customers of sales recognised in July 20X1
 Tracing the receipt of cash recognised as revenue in June to delivery dates to ensure
that recognition is not according to the cash receipt date
 Reviewing returns post year end to ensure revenue has not been inflated
 Confirming the need for a returns provision by examining returns ratios over the period
on line sales have been in operation
Sales made on interest-free credit terms
The key issue here is that revenue would appear to be overstated as the full £520,000 has
been recognised as sales revenue. The revenue should be recognised at the fair value of
the consideration received. As an interest-free credit period has been given the revenue is
effectively made up of two elements:
 The fair value of the goods sold
 Finance income

These two elements should have been accounted for separately. In order to calculate the
fair value of the goods sold the future cash receipts are discounted to present value at an
imputed rate of interest. The imputed rate of interest reflects the credit status of customers
so in this case 10% should be used.
Revenue should be recognised as follows:
£
Sale of goods
Deposit (£520,000 × 10%) 52,000
Balance (468,000 × 1/1.12) 386,777
438,777
Finance income (386,777 × 10% × 6/12) 19,339
Sales revenue is currently overstated by £81,223 (520,000 – 438,777). This represents 8.9%
of net profit as per the draft management accounts.
The net impact on profit is £61,884 (81,223 – 19,339). This is approximately 6.8% of the net
profit as per the draft management accounts. In both cases the adjustment is likely to be
material.
A receivable would also be included in the statement of financial position of £406,116
(386,777 + 19,339).
Audit procedures
Audit procedures will include the following assuming that the adjustments above are made:
 Confirm total sales made on interest free credit.
 Inspect agreement details to confirm amount of deposit and interest free period.
 Agree deposits received to cash receipts and bank statements.
 Ascertain from management the basis on which the 10% interest rate reflecting the
credit status of customers has been calculated.
 Recalculate discounting of sale proceeds.
 Recalculate finance income and confirm disclosure as finance income (rather than sales
revenue).
 Confirm that receivable balance is included in current assets and discuss any
recoverability issues with management.
(b) Disposal of showrooms
Held-for-sale classification
IFRS 5 requires that a non-current asset, such as BB's unsold showroom, should be
classified as 'held for sale' when the company does not intend to utilise the asset as part of
its on-going business but instead intends to sell it. The showroom having been closed is
therefore potentially in this category. However to be classified as 'held for sale' the
showroom should be available for immediate sale.
The likelihood of a sale taking place should also be considered to be highly probable and
normally completed within one year of the date of its classification.
The intended sale date of the Bradford showroom is in September 20X1 and there is a
contract in place. This showroom is therefore within the category of held for sale. It would
therefore be reclassified as a current asset and measured at the lower of its carrying amount
and its fair value less costs to sell at the date that it is deemed as held for sale. The current
values will therefore need to be reassessed at this date but the sale price of £1.15 million
(less selling costs) would be a guideline. The revalued amount less depreciation up to the
time of the reclassification as held for sale should therefore be the amount recognised.

The Leeds showroom is more uncertain in terms of the disposal date and the level of
certainty. Audit procedures should therefore review the probability of sale up to the audit
completion date. In this respect, the showroom must be actively marketed for sale by BB at a
price that is reasonable in relation to its current fair value. For a sale to be considered as
highly probable there should be a committed plan and BB management should be actively
trying to find a buyer. The mere act of advertising may not be enough in this respect and
audit procedures need to obtain evidence of the likelihood of sale. If the conditions are only
met after the reporting date, there should be full disclosure in the notes to the financial
statements. Depreciation should cease when the held for sale criteria are satisfied.
It should be considered whether the Leeds showroom should be revalued as the company
has adopted the revaluation model. However, as it was acquired 'fairly recently' the scope
for revaluation is likely to be somewhat limited.
Conversely, given that trade is difficult the fair values may have fallen and the issue of
impairment arises according to IAS 36. This raises the question of obtaining audit evidence
in respect of whether the showrooms are cash generating units. This is the smallest
identifiable group of assets that generates cash inflows that are largely independent of the
cash inflows from other assets or groups of assets. Each showroom appears to meet the
criterion and should be reviewed for impairment on this basis. As the showrooms have been
closed they have no value in use hence the carrying amount should be compared to the fair
value less costs to sell.
Separate disclosure in the statement of profit or loss and other comprehensive income as
'discontinued operations' is also required when a company discontinues a 'component' of
its activities, which should have been a cash generating unit while held for use. The
definition of a discontinued operation is when it is classified as 'held for sale' or when it is
sold and according to IFRS 5 para 32:
(a) represents a separate major line of the business or geographical area of operations;
(b) is part of a single coordinated 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) may apply as the closure is part of the single coordinated
plan to withdraw from the showroom based accessories products market.
A component of an entity comprises operations and cash flows that can be clearly
distinguished operationally, and for financial reporting purposes, from the rest of the entity
and this seems likely to include each individual BB showroom given the policy of managing
performance on an individual showroom basis. The question of whether the closure is a
withdrawal from the market is however a question of judgment as accessories products are
now being sold online.
Revaluation
The revaluation reserve would become realised when the asset is sold but would not be
affected by being classified as held for sale. If there is an impairment charge that was a
reversal of this previous revaluation then it would be a write down in the revaluation reserve
rather than a charge to profit.
Audit procedures
 Confirm contract terms of the sale of the Bradford showroom.
 Inspect legal and other correspondence in respect of the sale of the Bradford
showroom.
 Obtain an independent valuation of Bradford and Leeds sites.

 Evaluate the probability of sale of the Leeds site up to the audit completion date.
 Inspect advertising and any correspondence in response of this.
 Inspect reorganisation plan for evidence of a coherent and coordinated plan.
 Confirm impairment procedures and calculations for compliance with IAS 36.
(c) Website development costs
Website development costs may be treated as an internally generated intangible asset
according to IAS 38 if the appropriate conditions are satisfied. SIC 32, Intangible Assets –
Web Site Costs, confirms that internal costs of the development stage of a web site are
subject to IAS 38.
Conditions about feasibility have been satisfied as the site is operational. Similarly, the costs
appear to be able to be measured reliably at £1 million. There may be some question over
whether there are future economic benefits as while BB has made a profit this year this is
only due to exceptional items. Clearly this is for the business as a whole and online sales are
not yet established, but there is doubt over the future profitability of online sales and
therefore whether the website development costs can be recovered and thus over whether
they should be capitalised.
According to SIC 32 internal costs incurred at the operating stage of a website (ie, once it is
completed), should be treated as an expense.
Audit procedures
 Given the possibility of future losses, the capitalised web site costs need to be
evaluated for impairment.
 Examine costs capitalised to ensure they are attributable to website development.
 Identify any overhead allocations in capitalised costs.
(d) Defined benefit pension plan
The key audit issue here is that the defined benefit plan does not seem to have been
accounted for in accordance with IAS 19, Employee Benefits.
The excess of liabilities over assets should be reported as a liability in the statement of
financial position. This is calculated as follows:
£'000
Present value of plan obligations 249.6
Less fair value of plan assets (240.0)
Plan deficit 9.6
Profit or loss for the year should include:

£'000
Net interest on net defined benefit liability
(38.4 – 19.2) 19.2
230.4
The charge recognised in profit or loss must therefore be increased by £38,400 (230.4 –
192). This represents 4.2% of the net profit based on the draft management accounts,
therefore may not be material. Materiality would need to be reassessed however on the
basis of other adjustments which may be required eg, online sales recognition. Also as it
relates to pensions (which affects employees) it may be judged material in qualitative terms.
The remeasurement gain of £28,800 is then recognised in other comprehensive income
(see below).

Remeasurement gain
PV of obligation Fair value of plan assets
£'000 £'000
B/f – –
Contributions paid 192.0
Interest on plan assets 19.2
Interest cost on obligation 38.4
Actuarial difference (bal. fig) – 28.8
C/f 249.6 240.0
Audit procedures
Ask the directors to reconcile the scheme assets valuation at the scheme year end date with
the fair value of the plan assets of £240,000 at 30 June 20X1.
Obtain direct confirmation of the scheme assets from the investment custodians.
Consider the extent to which it is appropriate to rely on the work of the actuary eg, ascertain
the qualifications and experience of the actuaries.
Through discussion with the directors and actuaries:
 obtain a general understanding of the assumptions made;
 consider whether they are unbiased and based on market expectations at the year
end; and
 consider whether assumptions are consistent with other information.
(2) E-commerce
(a) Audit risks arising from use of external service provider
A key risk to BB of the new e-commerce strategy is that it is using an outside service
provider.
ISA (UK) 402, Audit Considerations Relating to an Entity Using a Service Organisation
provides guidance on how auditors should carry out their responsibility to obtain sufficient
appropriate audit evidence when the audit client, which is a 'user entity', relies on such
services.
In the case of BB the online sales are clearly material to the business as they make up around
half of revenue, even though they have only been launched for half a year. The service is also
fundamental in being a key element of the internal control systems for BB.
ISA 402 requires the auditor to understand how the user entity uses the services of the
service organisation. In the case of BB, this most significantly requires an understanding of
the nature of the services provided by SupportTech; the degree of interaction between the
activities of BB and SupportTech; and the nature of the relationship between the two
companies, including the contractual terms.
When obtaining an understanding of internal control we should:
 evaluate the design and implementation of controls at BB that relate to the services
provided by SupportTech; and
 determine whether this gives sufficient understanding of the effect of SupportTech's
operations on BB's internal controls in order to provide a basis for the identification
and assessment of risks of material misstatement.
If not, then we should do one or more of the following:
 Obtain a report from SupportTech's auditors (either Type 1 or Type 2 depending on
their scope).

 Contact SupportTech, through BB, then visit SupportTech and perform audit
procedures that will provide information about the relevant controls.
 Use another auditor to perform procedures that will provide information about the
relevant controls at SupportTech.
If proposing to visit SupportTech we should first determine whether sufficient appropriate
audit evidence concerning the relevant assertions is available from records held at BB.
However given the extent of SupportTech's activities this seems unlikely.
We should therefore perform further procedures including tests of controls.
Substantive procedures will include inspecting documents and records held by SupportTech
(access to records held by SupportTech may be established as part of the contractual
arrangement with BB). This could include the use of CAATs, if permitted by SupportTech.
Substantive procedures will also include obtaining confirmation of balances and transactions
from the service organisation where the user entity maintains independent records of
balances and transactions. This will include the cash balance outstanding paid by customers.
We may also perform analytical procedures on the records maintained by BB and
SupportTech.
(b) E-commerce risks
Aside from the risks that arise because BB has used an external service provider there are
additional business risks that would arise from e-commerce even if it were operated
internally by BB. These include the following:
 Risk of non-compliance with taxation, legal and other regulatory issues
 Contractual issues arising: are legally binding agreements formed over the internet?
 Risk of technological failure (crashes) resulting in business interruption
 Impact of technology on going concern assumption, extent of risk of business failure
 Loss of transaction integrity, which may be compounded by the lack of sufficient audit
trail
 Security risks, such as virus attacks and the risk of frauds by customers and employees
 Improper accounting policies in respect of capitalisation of costs such as website
development costs, misunderstanding of complex contractual arrangements, title
transfer risks, translation of foreign currency, allowances for warranties and returns, and
revenue recognition issues
 Over-reliance on e-commerce when placing significant business systems on the Internet
An entity that uses e-commerce must address the business risks arising as a result by
implementing appropriate security infrastructure and related controls to ensure that the
identity of customers and suppliers can be verified, the integrity of transactions can be
ensured, agreement on terms of trade can be obtained, as well as payment from customers
is obtained and privacy and information protection protocols are established.
When auditing an entity that uses e-commerce, the auditor must consider in particular the
issues of security, transaction integrity and process alignment.
Therefore when examining the issue of security, we should carry out audit procedures to
address the following:
 The use of firewalls and virus protection software.
 The effective use of encryption.

 Controls over the development and implementation of systems used to support e-
commerce activities.
 Whether security controls already in place are as effective as new technologies become
available.
 Whether the control environment supports the control procedures implemented.
When considering transaction integrity, we need to consider the completeness, accuracy,
timeliness and authorisation of the information provided for recording and processing in the
financial records, by carrying out procedures to evaluate the reliability of the systems used
for capturing and processing the information.
Process alignment is the way the IT systems used by entities are integrated with one another
to operate effectively as one system. We need to assess the extent to which SupportTech's
systems are automatically integrated with the internal systems of BB and this may affect
issues such as the completeness and accuracy of transaction processing, the timing of
recognition of sales and receivables, and the identification and recording of disputed
transactions.
A more general business risk also exists in that e-commerce sales may merely be displacing
shop sales. This may be indicated for BB by the fact that total sales in the year are similar to
the previous year.
(3) Outsourcing of payables ledger accounts
Audit issues
Problems have been identified with controls in the past which increases audit risk in this
area. Details of these problems need to be clarified by reviewing the previous year's audit
file. The current year's procedures may have to be revised to address these.
Inherent risk is increased by the fact that the company has outsourced the payables ledger
part-way through the year. The transition may not have been well-managed. This risk is
increased by the historic in-house control issues as there may have been errors in the
information initially transferred to SupportTech.
There has been a high turnover in staff and staff continued to work for BB after redundancy
notices had been issued. Disgruntled and/or inexperienced staff increases the risk of error.
We need to understand how SupportTech is being used by BB. This will include:
 the contractual terms;
 the nature of the relationship and the service provided by SupportTech. The Finance
Director authorises all invoices before they are paid. This means that a key control is
maintained by BB, although SupportTech is responsible for processing the invoices;
and
 details of the information sent by BB to SupportTech and the level of detail in the
schedule sent back by SupportTech for approval by the Finance Director.
Other issues
Whilst purchase orders and delivery notes are maintained by BB, invoices are sent directly
to SupportTech. It is unlikely that sufficient evidence will be obtained from records
maintained by BB alone. However the fact that records were maintained in-house for 10
months of the year increases this possibility.
Effectiveness of controls over access to the portal. The system should operate such that the
Finance Director can view the payables accounts but not change them. If both SupportTech
and BB can update balances there is an increased risk of duplication.
Results of enquiries of management eg, whether management is aware of any issues eg,
uncorrected errors made by SupportTech.

(4) Points for inclusion in response to email
Consequences
 The consequences depend on the nature and extent of the breach.
 It is possible that the hackers have accessed data relating to BB's customers and
suppliers which could be used fraudulently.
 It would be advisable to obtain more information about this and assess the need to
contact and alert customers and/or suppliers where relevant so that they can take
action if necessary.
 BB could suffer reputational damage. For example customers may be more reluctant to
use the website to make purchases if they have concerns over security of personal
and/or banking details.
 There is the possibility that the portal between SupportTech and BB has allowed the
hackers to access BB's own system. This should be investigated as a matter of urgency.
Future action
 BB should implement a formal system for managing cyber-security risk within the
supply chain.
 Suppliers should be assessed using criteria relating to risk rather than spend ie, as
SupportTech has access to records and data there is a significant cyber-security risk
irrespective of the level of fees paid to SupportTech.
 BB should define who is responsible for supply chain cyber-security within the
organisation eg, IT department, operational department.
 Assurance should be obtained from suppliers when reviewing tenders for new
contracts (possibly through the use of questionnaires) but assurance should also be
requested throughout the period of the contract.
 Transparency regarding issues/breaches should be encouraged. (In this case it
appears that SupportTech has complied with this principle as BB has been notified of
the breach.)
22 Hillhire
Marking guide
Marks
Key audit risks and financial reporting treatment
General 5
Discontinuation
 Audit risk 3
 Financial reporting treatment 4
 Audit procedures 3
Acquisition 7
Swap
 Audit risk 3
 Financial reporting treatment 4
 Audit procedures 3
New system 4
Share options 5
Ethical 4
Total marks 45
Maximum marks 40

MEMO
To: Peter Lanning
From: A. Senior
Date: 12 April 20X8
Subject: Hillhire plc audit for the year ended 31 March 20X8
Audit risks
(1) General points
The profit for the year of £27,240,000, after taking into account the loss for the year from
discontinued operations, has decreased by 6.7%. Although this is not particularly serious in
itself, management might be concerned that the shareholders will react unfavourably. We
need to take particular care over any matters of accounting judgement that could have
distorted the results in order to improve matters. It may be that the profit according to the
draft statement of profit or loss and other comprehensive income has been overstated
already in order to mitigate the effects of this decline.
Continuing operations
More importantly we need to check that the profit from discontinued operations has been
correctly classified. Excluding the loss arising from discontinued operations, profit for the
year from continuing operations has shown an increase of 8.4%. The increase in revenue for
20X8 compared to 20X7 is 10%.
Cost of sales
In 20X8 cost of sales has increased by 11.5% over 20X7, compared with a 10% increase in
revenue.
Administrative expenses
In spite of the 10% increase in revenue, administrative expenses (excluding amortisation)
have increased by only 1.2%.
Gearing and borrowing costs
The company continues to be highly geared. Indeed, a great deal of additional borrowing
has been raised. There does not appear to be any particular concern about going concern
issues arising from this, but we should be sceptical about any accounting practices that
have the effect of smoothing profits, as well as any that have the effect of increasing
reported income.
Long-term borrowings have increased by £69,240,000 or 22% whereas finance costs have
increased by 11.56%. We need to look at the movement of interest rates in the period, look
into the company's other borrowings and request details of finance costs reflected in the
profit or loss and other comprehensive income, to establish these have been correctly
calculated and accounted for. We also need to ensure that the allocation of finance costs
has been correctly made and not inappropriately allocated to the discontinued operations.
It is possible that the figure for long-term borrowings could be even higher if the divested
depots have borrowings which have been netted off within assets held for sale. This
treatment would not be correct.
Are depots able to raise their own finance? If so their borrowings are included within total
borrowings in 20X7 but it is unclear how the liabilities of depots held for sale are treated in
the current year. Have they been incorrectly netted off within assets held for sale or are they
listed within total liabilities?
We should also establish when repayment of the long-term borrowings is due as it's a large
amount. The company's ability to repay any borrowings due in the near future needs to be
considered, as this could affect the going concern assumption.
In addition, perhaps the new borrowings were taken on mid-year so there's not a full year's
finance charge, which will have implications for the future.

Audit procedures
Evaluate any adjustments that are proposed to the draft accounts that have the effect of
increasing the reported profit and challenge directors over their suitability where
appropriate.
Perform analytical procedures on expenses to identify trends and confirm whether there is
any risk of material misstatement from continuing operations. As part of these analytical
procedures, we should be challenging any increases in costs which have not been reflected
in higher sale prices.
We also need to confirm that administrative expenses relating to continuing operations
have not been incorrectly allocated by analytical procedures.
Confirm the treatment of borrowing undertaken by depots held for sale by analysis of
liabilities.
(2) Discontinued operations risks
There is a risk that IFRS 5, Non-current Assets Held for Sale and Discontinued Operations
has not been complied with.
Professional scepticism would identify this as a risk here especially as the directors' bias in
the current year may well be to try to classify these depots as 'discontinued' as this allows
them to disclose the losses separately in the hope of downplaying their significance to
analysts assessing the company's future prospects.
In order to be treated as a discontinued operation, the Scottish depots would have to be a
component of Hillhire which either has been disposed of or is classified as held for sale,
and:
 represents a separate major line of business or geographical area of operations;
 is part of a single coordinated disposal plan; or
 is a subsidiary acquired exclusively with a view to resale and the disposal involves loss
of control.
IFRS 5 defines a component of an entity as 'operations and cash flows that can be clearly
distinguished operationally and for financial reporting purposes from the rest of the entity'.
As each depot is viewed as a cash-generating unit the group of Scottish depots represents
a component of Hillhire.
All of the depots are located in Scotland and the decision to sell is based on a strategic
decision to withdraw from this part of the country. This suggests that this is a separate
geographical area of operations. However further details would be required to determine
what proportion of the total number of depots held is represented by the 15 being sold to
assess whether this constitutes a major geographical area of operations.
The plan to dispose of the Scottish depots would appear to be a single coordinated
disposal plan based on the information provided.
Despite meeting two of the criteria to be classified as a discontinued operation, the Scottish
depots have not been disposed of by the reporting date and do not appear to meet the
definition of 'held for sale' at this date.
A disposal group is classified as held for sale only if its carrying amount will be recovered
primarily through a sales transaction rather than through continuing use. The following
criteria must be met in order for this to be the case:
 The depots must be available for immediate sale in their present condition. In this case
the depots are not available for immediate sale as they are still in use and no
alternative arrangements have been made to store the vehicles currently held at these
depots.

 The sale must be 'highly probable', that is:
– being actively marketed at a reasonable price;
– changes to the plan are unlikely;
– management must be committed to the sale;
– there must be an active programme to locate a buyer; and
– the sale must be expected to be completed within one year from the date of
classification.
From the information currently available, whilst management appear committed to the sale,
indicated by the recording of the decision in the board minutes, there is currently no active
programme to locate a buyer. Marketing of the properties is not due to start until May or
June of 20X8.
On this basis the Scottish depots should not be classified as either held for sale or
discontinued operations and the loss for the year in respect of this group of depots should
not be separated from the results of the continuing operations of the business in the
statement of profit or loss and other comprehensive income.
In the statement of financial position, the depots should not have been reclassified as held
for sale on 1 January 20X8 but should have been retained in property, plant and equipment
and depreciated for the remainder of the year.
From the draft financial statements we can see that on transfer to held for sale, the depots
have been measured at the lower of carrying amount and fair value less costs to sell.
Therefore, the following journals are required to reverse this transfer and record
depreciation for the three months to 31 March 20X8:
DEBIT Property, plant and equipment £44,520,000
CREDIT Profit or loss – discontinued operations £4,390,000
CREDIT Assets held for sale £40,130,000
and:
(44,520/25  3/12)
CREDIT Accumulated depreciation £445,200
The carrying value of the depots at 31 March 20X8 is therefore £44,074,800 (44,520 –
445.2).
An assessment should be made to determine whether the depots have suffered an
impairment. The depots are impaired if the carrying amount is in excess of the recoverable
amount, being the higher of fair value less costs to sell and value in use. The carrying
amount would appear to be in excess of fair value but further information is required in
order to calculate the value in use.
Audit procedures
Discuss the necessary adjustments with the directors to confirm that action will be taken.
Confirm the progress of the planned sale of the depots with directors.
Inspect board minutes and budgets and forecasts for evidence that management intend to
sell the depots.
Determine the proportion of depots which the sales of the 15 Scottish depots represent in
comparison to the business as a whole.
Confirm plans for moving vehicles currently held in the depots in Scotland.

Obtain details and inspect correspondence with agents for evidence that the marketing of
the depots is due to start in May/June only.
Ascertain how fair value was assessed and review any valuation reports prepared by
independent valuers.
Agree remaining useful lives of the Scottish depots with the company's stated depreciation
policy.
Discuss with the directors the extent of any impairment reviews performed by them and any
follow up on any steps identified but not yet taken.
Obtain details of the value in use for the Scottish depots and review the basis of these
calculations.
(3) Acquisition of Loucamion
The figure for intangibles (nearly £12 million) that appear to have been recognised on the
acquisition of Loucamion is high, and there is a risk that some of the intangibles, especially
any value allocated to customer relationships, may not meet the recognition criteria of
IFRS 3, Business Combinations and IAS 38, Intangible Assets. The overriding requirements
are that it is probable that future economic benefits will flow to the entity and that the cost
can be reliably measured.
In the case of an acquisition, the key issue to determine is whether other intangibles can be
identified separately from goodwill. IFRS 3, Business Combinations gives some illustrative
examples and these include customer lists and customer contracts and the related
customer relationships. For the customer lists of Loucamion to be recognised they must
meet the contractual-legal criterion or the separability criterion. Loucamion does not
appear to have any legal rights to protect or control the relationship it has with its
customers or their loyalty therefore the lists do not satisfy the contractual-legal criterion.
IFRS 3 states that a customer list acquired in a business combination does not meet the
separability criterion if the terms of confidentiality or other agreements prohibit the entity
from selling, leasing or otherwise exchanging information about its customers. This appears
to be the case with Loucamion's customer list. On this basis the customer list should not
have been recognised as a separable asset but should have been subsumed within
goodwill. This error should be corrected and the amortisation charged for the year reversed
as follows:
DEBIT Goodwill £4,000,000
CREDIT Intangible assets £3,600,000
CREDIT Profit or loss (4,000,000/10) £400,000
There may be unrecognised impairments of goodwill and other assets by the year-end.
The other newly acquired intangible assets may not be amortised over a realistic useful life.
It is essential we obtain details of the amortisation schedules and review these closely.
Audit procedures
Obtain a breakdown of the allocation of the purchase consideration and determine how
much has been allocated to the other intangibles. Confirm that items recognised in other
intangibles meet the criteria to be recognised separately.
Obtain details from the auditors of Loucamion about the nature of the customer
relationships to confirm that no legal relationships exist and that the confidentiality terms
are in place.
Ascertain how management have assessed the useful lives of the other intangibles for the
purpose of amortisation and consider whether this is reasonable.

Ascertain how the fair values of the assets and liabilities of Loucamion were assessed and
review any valuation reports prepared by independent valuers.
Obtain the consolidation schedules to review whether Loucamion has been correctly
consolidated, including only post-acquisition results.
Review the disclosures relating to the acquisition to ensure that all the requirements of
IFRS 3 have been met.
All relevant exchange rates should be recorded in the audit file so that we can ensure the
subsidiary's financial statements are translated from its functional currency to the
presentation currency of the group ie, £.
We need to consider the arrangements for the audit of Loucamion. It may not be cost-
effective for us to visit the company ourselves. We will need to ensure that we are satisfied
by the assurances provided by any local audit firm. Presumably this will not be too great a
problem because the company already has a range of operations throughout Europe.
We will also need to consider whether any issues relating to the valuation of goodwill and
intangibles require disclosure as Key Audit Matters.
(4) Interest rate swap
This appears to be the first time that Hillhire has used derivatives in this way, which
increases the risk that the treatment is incorrect. There is a risk that the swaps do not meet
the criteria for hedge accounting as set out in IFRS 9. We need to confirm that:
 the hedging relationship consists only of eligible hedging instruments and eligible
hedged items;
 at the inception of the hedging relationship there is formal designation and
documentation of the hedging relationship and the entity’s risk management objective
and strategy for undertaking the hedge; and
 the hedging relationship meets all of the hedge effectiveness requirements of IFRS 9,
namely (IFRS 9, para 6.4.1(c):
– there is an economic relationship between the hedged item and the hedging
instrument;
– the effect of credit risk does not dominate the value changes that result from that
economic relationship; and
– the hedge ratio of the hedging relationship is the same as that actually used in the
economic hedge.
The condition that the hedge should be highly effective appears to be met as the hedge is a
perfect match in terms of currency, maturity and nominal amount.
There is a risk that hedging may be applied from the wrong date. Whilst the interest-rate
swap was acquired on 1 April 20X7 it was only designated as a hedge on 1 May 20X7. In
accordance with IFRS 9 hedge accounting may only be applied prospectively, from the later
of the date of designation and the date that the formal documentation was prepared. We
would need to check the date of the documentation but based on information currently
available hedge accounting can be applied no earlier than 1 May 20X7.
These risks are exacerbated by the fact that the company is highly geared. The directors
have an obvious incentive to manipulate the manner in which this swap is accounted for so
as to minimise the volatility associated with any changes in interest rates or the values of any
assets or liabilities.
The change in fair value up to the year end should be recognised as other comprehensive
income and accumulated in equity.

Interest for the period 1 October 20X7 – 31 March 20X8 has not been accounted for.
The £9.5 million (£200m × 6/12 × (7.5% + 2%)) variable interest for the six months to
31 March 20X8 is charged to profit or loss and is accrued until payment is made.
The net settlement on the interest rate swap of £1.5 million (£200m × 6/12 × (9.5%-8%)
received from the swap bank as a cash settlement reduces the £9.5 million variable rate
interest expense to £8 million. This is equivalent to the fixed rate cost (£2m × 6/12 × 8%).
The following adjustments are required:
DEBIT Profit or loss – interest expense £9.5m
CREDIT Interest accrual/cash £9.5m
DEBIT Cash £1.5m

CREDIT Profit or loss – interest expense £1.5m
Audit procedures
 Review board minutes documenting the decision to enter into the swap and the
strategic reason for this ie, to confirm that there is formal designation of the hedge.
 Review and recalculate the effectiveness of the hedge.
 Check that documentation is adequate. This must include:
– identification of the hedging instrument ie, interest rate swap
– the hedged item or transaction ie, interest payments
– nature of the risk being hedged ie, changes in interest rates
– details of calculation of hedge effectiveness
– statement of entity's risk management objective and strategy
 Confirm date of preparation of the documentation to determine the date from which
hedge accounting should be applied.
 Check that adjustments already reflected in the draft financial statements have been
calculated from the correct date and that hedge accounting has not been applied
retrospectively.
 Seek specific assurances about the credit rating of the counterparty to the swap.
 Confirm basis on which the fair value of the hedge has been determined and assess
whether this complies with IFRS 9.
 Confirm that adjustments required for interest to 31 March 20X8 as outlined above
have been made.
(5) Controls review on new online ordering system
Risk
The new system has been piloted at quite a large number of depots during the current year.
There is a risk that any errors in the system will have affected the recording of transactions
during the year.
This is a highly sensitive system. It raises transactions involving payments from business
customers and credit card companies. It can instigate the transfer of vehicles between
branches. The whole point of piloting is the recognition that new systems frequently contain
errors.
Breakdowns in the system could have led to vehicles being transferred for fraudulent
purposes. It is unlikely that staff would steal a commercial vehicle, but it might have been
possible to 'lose' a vehicle in the system and hire it out for cash. Apart from the loss of
revenue, that could have led to exposure to claims if the unauthorised use meant that the
company's insurance policy did not cover any claims for damages in the event of an
accident.

Ideally, the pilot testing will have been controlled by a parallel run of the existing system at
the branches. In practice, it is unlikely that resources would permit this to happen.
It is worrying that the company has only engaged our IT specialists at this stage. That might
suggest that there was no independent, expert oversight of the piloting process or that the
consultant providing any such support has been sacked or has chosen to withdraw from the
engagement. At best, this suggests some recklessness in terms of the manner in which the
pilot process was managed. At worst, management may be planning to implement a system
that has been found to be defective.
Audit procedures
The new system needs to be documented and control risk assessed.
Management should be asked to provide detailed information about the errors that were
uncovered in the course of the pilot testing and the steps that have been taken to correct
them, both in terms of adjusting the system and correcting the underlying records that were
affected by the errors.
The proposal to roll the system out will also have implications for future audits. We will have
to take great care over the audit of the system testing phase and the implementation phase.
The transfer of standing data and the reconstruction of the vehicle register should both,
ideally, be checked clerically and the results retained for us to review.
(6) Share options
IFRS 2, Share-based Payment requires that the share options are reflected as an expense in
profit or loss.
We need to assess the assumption that 10% of senior employees will leave and therefore
forfeit the shares.
Assuming the forfeiture of 10% is accurate, the expenses reflected in each of the three years
from 20X8 should be as follows:
Cumulative
Year ending Expenses expenses
£ £
31 March 20X8 (50  100  90%  £10  1/3) 15,000 15,000
31 March 20X9 (50  100  90%  £10  2/3) – 15,000 15,000 30,000
31 March 20Y0 (50  100  90%  £10) – 30,000 15,000 45,000
The adjustment for 20X8 should be
£ £
CREDIT Equity 15,000
(7) Ethical points arising
The firm needs to consider whether the potential assurance assignment relating to the new
system may pose a threat to objectivity in respect of the audit.
There appear to be a number of threats:
Firstly, we need to remain vigilant to any increase in our evaluation of global inherent risk. If
the company's profitability and financial position are deteriorating then management might
be tempted to distort the financial statements. That will lead to an increased risk that we will
be blamed for some alleged audit failure. If we see any clear evidence that the financial
statements are being manipulated then we should consider resigning the appointment in
order to protect our reputation.
We would need to clarify the exact nature of the additional service to be provided by our IT
specialists. In accordance with Revised Ethical Standard June 2016 our firm would be

prohibited from designing and implementing information technology systems where the
systems concerned would be important to a significant part of the accounting system or to
the production of the financial statements (para 5.63). Even if the nature of the service is
such that the prohibition does not apply, we need to manage the perception that there
could be a self-interest threat. We might be accused of being prepared to compromise on
our audit opinion in order to win this consultancy business.
Looking ahead to future years' audits, if Barber and Kennedy provide assurance relating to
the controls over the system it could amount to both a self-review and management threat,
especially if in future years the firm was to place reliance on controls in gathering their audit
evidence.
23 Hopper Wholesale
Marking guide
Marks
(a) Inventory
Audit issues 5
Audit procedures 5
Audit issues 4
Audit procedures 4
(c) Receivable
Audit issues 3
Audit procedures 3
(d) Share option scheme
Audit issues 5
Audit procedures 4
(e) Sustainability issues (including ethics) 10
Total marks 43
Maximum marks 40
(a) Inventory
Audit issues
(1) Materiality
The option may be material to the statement of profit or loss and other comprehensive
income as the potential gain of £150,000 represents 5.5% of profit before tax.
(2) Risk
There is a risk that the option is incorrectly valued particularly as there is no directly
comparable instrument being traded on the open market at the period end and that
any change in value is incorrectly calculated.
If the underlying market price of flour has fallen as at 31 December 20X8 then the option's
intrinsic value will increase by 20,000 multiplied by the difference between the market price
of flour and the strike price of £140 per tonne.
The fair value of the option will have to be determined. From the information provided, it
does not necessarily sound as if the original contract was determined by reference to a
traded option that will have a standardised set of terms and conditions and that will have an
open-market, observable market value. The £400,000 offered by the counterparty to the
option will possibly constitute a reasonable estimate of the fair value as at the reporting

date, although the amount offered could be significantly different from fair value. Sweetcall
would have an incentive to offer less than the fair value in order to be released from this
potential commitment, but could just as easily offer more than the fair value in order to
resolve the significant uncertainty associated with the cost of having the option exercised
against it in June 20X9.
The option was recorded at cost of £250,000. If the £400,000 is regarded as a fair value
then the gain of £150,000 on the option would be recognised in profit or loss for the year
ended 31 December 20X8. If this is not deemed suitable as a fair value then the difference
between the carrying value and any assessed fair value should be included as the gain (or
loss – less likely).
There is a risk that the option may be incorrectly treated as a hedging instrument.
The directors might argue that the option is a hedging instrument because it was
purchased with the express intention of reducing risk arising from changes in the value of
the inventory. The hedge could be described either as a fair value hedge or as a cash flow
hedge. However, to account for the transaction as a hedge, the following requirements
must be met:
 the hedging relationship consists only of eligible hedging instruments and eligible
hedged items;
 at the inception of the hedging relationship there is formal designation and
and strategy for undertaking the hedge; and
 the hedging relationship meets all of the hedge effectiveness requirements of IFRS 9,
namely (IFRS 9 para 6.4.1(c):
instrument;
economic hedge
Based on the information available, it would appear not all these conditions are met,
specifically that the documentation is not in place, and that the purchase was arguably
opportunistic rather than a part of a coherently planned risk management strategy and so it
would be inappropriate to use hedge accounting.
There is a risk that the price of flour could change in such a way that the option lost much of
its value (market risk). Prices do seem to change dramatically, as evidenced by the fact that
the option was purchased substantially out-of-the-money and three months later it is
substantially in-the-money.
We need to consider the counterparty's ability to honour the commitment imposed by the
option (credit risk). This should have been investigated before paying for the option,
however even if this is the case Sweetcall's solvency will have to be reconsidered as at the
reporting date.
There is a risk that any errors in the drafting of the contract could result in the option lapsing
even if it would have been in Hopper's interests to exercise it (legal risk).
Disclosure may be inadequate. The option should be disclosed in accordance with IFRS 7
as a derivative financial asset.

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

Agree initial recognition at fair value to the transaction price eg, statements from
stockbrokers.
Obtain details of any transaction costs and confirm that these have not been included in fair
value but have been expensed.
Determine the means by which the period end fair values have been established. In this
case shares are listed therefore there should be a quoted market price and agree to
schedule.
Obtain details and review the way in which the investments are managed to determine that
they are not held for trading eg, enquire of management that it is not their intention to sell
in the short term corroborated by a review of events after the end of the reporting period.
Review other information eg, notes of board meetings and ensure that discussion of
investments is consistent with their classification as being held for the short-term.
Review the adequacy of the disclosure note in the financial statements and ensure that it is
in accordance with IFRS 7, Financial Instruments: Disclosures.
(c) Receivable
Audit issues
(1) Materiality
The receivable represents only 0.08% of total assets and is therefore not material on a
quantitative basis. However, it is material due to the nature of the transaction ie, on a
qualitative basis, because it is a director-related transaction.
(2) Risk
There is a risk of non-compliance with IAS 24, Related Party Disclosures due to the lack
of disclosure as this transaction constitutes a related party transaction. We have been
told that the receivable is due from a company which is under the control of Jack
Maddison, who is Hopper's managing director. Jack Maddison is in a position to
control or significantly influence both companies. The transaction may not be a normal
commercial transaction and may be subject to bias. A trade receivable with credit
terms of 12 months would be unusual. However, a loan with such terms would not.
Completeness is a high risk assertion. Whilst we are aware of this transaction and can
confirm the details there may be other similar transactions which we are not currently aware
of. Due to the nature of related party transactions they may be difficult to identify.
There is a risk that the receivable may be overstated. If there is any doubt about the
recoverability of the debt then an allowance may be required.
The classification of the debt also needs to be considered. We have been told that it will be
repaid within the next 12 months. If this is not genuinely the case then the asset should be
disclosed as an asset recoverable after more than one year, in other words, a non-current
asset.
Discuss the transaction with Jack Maddison to establish the nature and the purpose of the
transaction.
Review any documentary evidence of the transaction eg, invoice or loan agreement and
check the terms of the agreement, in particular the repayment terms and timing.
Review board minutes for authorisation of the transaction and any discussions regarding
the purpose of the transaction and its repayment. Also review the board minutes for
evidence of any other related party transactions.

Obtain evidence that Jack Maddison does control Bourne Ltd eg, review of Bourne Ltd
Review financial statements of Bourne Ltd to establish that it recognises that it has a liability
to Hopper and assess the ability of the company to repay the debt.
Obtain general representation from management confirming that they have disclosed all
related party transactions to us and that they are appropriately accounted for and
disclosed.
Obtain further specific written representations regarding the receivable due from Bourne
Ltd including details of the control which Jack Maddison has over Bourne Ltd, confirmation
that management believes the debt to be recoverable and the date on which it will be
repaid.
(d) Share options
Audit issues
(1) Materiality
Profits are understated by £430,000 (700 – 270). This represents 15.6% of profit before
tax and is therefore material. As the share options are transactions with employees the
transaction is likely to be material from a qualitative as well as from a quantitative
perspective.
(2) Risk
The key issue is that of inappropriate accounting treatment. In accordance with IFRS 2,
Hopper Wholesale Ltd is required to recognise the remuneration expense as the
services are received, based on the fair value of the share options granted.
In this case the fair value at the date the options were granted was £12. The calculation
performed by the entity currently uses the fair value at the end of the reporting period
of £14.
The full expense has been recognised in profit or loss in the year of issue. In
accordance with IFRS 2, the cost should be recognised over the vesting period (in this
case two years).
The calculation performed by Hopper Wholesale Ltd does not take into account the
number of options expected to vest but simply assumes that all will vest at the end of
the period. IFRS 2 requires that the amount recognised take into account estimates of
the number of employees expected to leave.
The credit entry has been recognised as a long-term liability. This should be
recognised as part of equity rather than as a liability.
The expense should have been recognised as £270,000 (100 × 500 × 90% × 12 × ½).
Agree other contractual terms to legal document ie, number of shares awarded to each
employee, vesting terms and length of vesting period.
Enquire of directors regarding the numbers of employees estimated to benefit and the
basis on which the 10% leaving rate has been estimated.
Compare staffing numbers to forecasts and numbers of leavers to prior years.
Confirm that £12 is the fair value at the grant date by reference to documentation
supporting the fair value calculation.

Enquire of the directors as to the model used to estimate fair value. Consider whether this is
in accordance with IFRS 2 (eg, Black-Scholes) and that it is appropriate in the circumstances.
(As the company is not listed it is unlikely that a market value for shares will be available.)
Consider whether expert advice is required on the valuation.
Obtain representations from management confirming that the assumptions used are
reasonable.
(e) Social and environmental report
Requirement to publish information
The Companies Act 2006 requires quoted companies to include information on
environmental, employment and social issues as part of its strategic report. Quoted
companies must also report on greenhouse gas emissions in their Directors' Report (from
1 October 2013). As Hopper is not a quoted company these requirements do not apply.
However, companies are encouraged to provide this information voluntarily therefore
increasingly its inclusion is being seen as best practice.
Assertion 1
This will be a difficult statement for us to verify for the following reasons:
 The statement is dependent on the integrity of others and we will not have access to
the records of the suppliers.
 There may be some flexibility in the definition of child labour eg, in terms of age and
potential hours worked.
Possible sources of evidence would include assertions by suppliers, inspection by auditors,
information available in the press.
Assertion 2
This assertion is more straightforward. The current minimum wage is set in law. A review of
payroll records should be performed targeting the lower paid workers in particular and
comparisons made with the minimum wage. A calculation would then be performed to
ensure that the additional pay rate does equate to at least 10% of the minimum wage.
Assertion 3
Again there should be evidence to support this assertion provided adequate payroll
records are maintained. Details of staff sickness rates for the current year and previous year
should be obtained from payroll records. A comparison should be made and a calculation
performed to confirm that rate of decrease.
Assertion 4
Our ability to verify this statement will depend on the records on waste disposal maintained
by the company. For example, if disposal is conducted by a contractor, invoices for the cost
of disposal would provide evidence of the volumes of waste sent to landfill. A comparison
with previous years could then be made. If this is not the case, we would need to establish
the basis on which the management have made this claim. Specific procedures would then
depend on the source information available.
Assertion 5
The company should maintain a log of all accidents which take place in the workplace.
Assuming that these records are available we should be able to compare the number of
recorded accidents which took place in the current year, compare this with the number
which took place in the previous year and recalculate the percentage change.
What will be more difficult to confirm is that the reduction is due to improved health and
safety procedures. We may not have the expertise to determine whether procedures have
improved (as opposed to simply being different) unless they have been made in response
to recommendations made by experts in the health and safety field. If this is the case we

would be able to confirm that procedures have been revised in accordance with those
recommendations.
Professional considerations
We have not been involved in this type of work before, therefore we need to ensure that we
have the relevant expertise and resources to complete this assignment. The scope of this
work is not set down in statute so we would need to clarify precisely our responsibilities in
an engagement letter. We also need to clarify the purpose of our report and consider issues
regarding any liability that we may have to third parties. This exercise would also constitute
the provision of other services, which is allowed under ethical guidance. We would need to
consider the fee that we will receive and ensure that we are not economically dependent on
this client.
In addition, the social and environmental report is expected to be included in the same
document that contains the audited financial statements. As such, it would form part of the
other information which we, as the statutory auditors, are required by ISA (UK) 720 (Revised
June 2016) to read to identify any material inconsistencies. If any of the proposed assertions
are found to be inconsistent with the audited financial statements and we conclude that
there is a material misstatement in the other information which management refuses to
correct, we would need to consider what impact this would have on the auditor's report,
and more generally, whether we should continue the audit engagement. In the Other
Information section of the auditor's report we would be required to provide a description of
the material misstatement.
24 Lyght plc
Marking guide
Marks
(a) Concerns of ethics partner 8

(b) New IT system 8
(c) Inventories 5
(d) Sale of tyres 6
(e) Leased buildings 6
(f) Asset treated as held for sale 7
(g) Receivables 7
Total marks 47
Maximum marks 40
To: Gary Orton

From: A Senior
Date: 11 May 20X8
Subject: Lyght plc – final and interim audit and ethical issues
(a) Concerns of ethics partner
(1) Tender and low audit fee
Obtaining an audit by tender does not, of itself, give rise to ethical concerns. Similarly, the
fact that the bid was at a low price and will generate a substantial under-recovery does not
constitute unethical conduct. However there are a number of other potential threats to
independence.

 Self-interest threat
One threat to independence is a 'self interest' threat. This may occur as a result of any
interest of professional accountants that may conflict with their duty to report
independently. In this case the threat is that the low bid may have been made in the
expectation of obtaining more profitable non-audit work. As the other work has not yet
been awarded, the client may pressurise us during the audit by threatening not to
award us the other work. If we are awarded the work, the client may threaten during
future audits to take it away from us. An alternative self-interest threat may be to
'reward' us with unduly high fees for other tax and advisory work in return for us
inappropriately attesting the financial statements.
There is also a potential self-interest threat from doing inadequate amounts of audit
procedures in order to reduce the under-recovery. The audit plan should clearly
require sufficient, relevant and reliable audit evidence to support the audit opinion,
irrespective of the fee.
 Self-review threat
If we are successful in gaining the other work there may also be a 'self review' threat.
This may occur when a judgement needs to be re-evaluated during the audit by the
professional accountant who originally made that judgement.
 Non-audit services
Revised Ethical Standard June 2016 sets out a clear general approach to non-audit and
additional services. Under the standard it would never be appropriate for the audit firm
to undertake a management role.
As Lyght is not a listed or public interest entity, tax work for Lyght would normally be
acceptable under the standard, but the materiality and risks involved in the work would
need to be considered on their merits.
The nature of other advisory work would also need to be considered on its merits (the
potential tender for the IT work is considered below). Where there is doubt, the
Revised Ethical Standard 2016 states that our firm should (para 5.16):
– Identify and assess the significance of any related threats to the integrity or
objectivity of the firm.
– Identify and assess the effectiveness of the available safeguards to counter any
threats (which may include resignation or refusal to accept appointment as auditor
or provider of the non-audit services).
– Consider whether it is probable that an objective, reasonable and informed third
party would conclude that the proposed service would not impair integrity or
objectivity.
The circumstances should also be communicated to those charged with governance
and the rationale behind the decisions taken should be documented.
According to the Revised Ethical Standard 2016 (para 4.56D & 4.57) audit staff should
not be assessed on, or have their pay related to, their ability to cross-sell the firm's
products. The suggestion that promotions may depend on selling the additional tax
and advisory services to Lyght is ethically inappropriate.
(2) Size of client
Lyght is a large client for a firm of our size. At the moment it appears the fees from Lyght (if
we gain the tax and advisory work) will make up about 8.8% (£0.5m/(£5.2m + £0.5m)) of our
firm's total fee income. This is within the bounds set by the Revised Ethical Standard 2016
(para 4.44) (15% of the firm's total fee income for non-listed client companies which are not
public interest entities). However if Lyght obtains a listing, our fee income would be likely to
increase (eg, from acting as reporting accountant) and the ethical limit according to the

Ethical Standard (para 4.42) would fall from 15% to 10%. We are therefore likely to breach
the limits at this stage.
According to the Revised Ethical Standard 2016 (paras. 4.47 and 4.51), where fees amount
to 5%–10% (for a public interest entity or other listed clients) or 10%–15% (for non-listed
clients that are not public interest entities) the fact needs to be disclosed to the ethics
partner and those charged with governance at the client and appropriate safeguards
adopted where necessary. This may include declining some of the work.
The fee percentage limits in the Revised Ethical Standard 2016 are not however rigid. They
are based on expected regular levels of fee income and relate to situations where a
'reasonable and informed third party' might consider the firm or the engagement partner's
objectivity to be impaired.
(b) New IT system
(1) Ethical issues
According to the Revised Ethical Standard 2016 (para 5.63), the firm should not undertake
work on computerised accounting systems on which the auditors would place significant
reliance. The threat to independence in this case is one of self-review, the auditors
performing services for an assurance client that directly affect the subject matter of the
assurance engagement.
Auditor involvement in the design and implementation of IT systems that generate
information forming part of a client's financial statements would therefore create a self-
review threat. Here Budd & Cherry would only be doing part of the work. It needs to be
clearly established how the work would impact upon the financial statements, as opposed
to producing management information that did not feed into financial statement
disclosures. (The briefing notes state that the new IT system is 'to monitor the flows of
goods across the globe and for management accounting purposes'.)
However, where the information provided by the new IT system is likely to have a significant
impact on Lyght's financial statements, then the self-review threat is likely to be too
significant to allow us to provide such services. Appropriate safeguards would certainly be
required, ensuring that Lyght does the following:
 Acknowledges its responsibility for establishing and monitoring the system of internal
controls
 Makes all management decisions with respect to the design and implementation
process
 Evaluates the adequacy and results of the design and implementation of the system
 Is responsible for the operation of the system (hardware or software) and the data used
or generated by the system
Additionally the non-assurance services should be provided only by personnel not involved
in the financial statement audit engagement and with different reporting lines within the
firm.
Nevertheless in spite of the safeguards, the self-review threat may still be considered to be
so great that we should not tender for this work.

(2) Audit issues
 Change of system
There are three key aspects that we will need to consider regarding the systems
changes implemented during the year.
– The operating effectiveness of the old system
As this is our first year as auditors we will need to document the old system and
gain an understanding of the way in which it operated including an understanding
of internal control. The fact that the system has been changed suggests that there
may have been particular problems with the old system which we should identify.
We should review systems files and interview IT personnel regarding specific
deficiencies in the old system that the introduction of the new system has
attempted to address.
– The development of the new system including the changeover
A key risk is the potential loss or corruption of financial information. We will need
to establish whether appropriate security for the previous systems was maintained
during the development and installation of the new systems. This might have
included for example appropriate access controls and confidentiality relating to
the new system developers and installers. We also need to obtain details of the
way in which data was transferred, details of the controls implemented over the
change-over and the extent and results of testing performed on the new system to
determine whether it is operating effectively.
– The operating effectiveness of the new system
Systems notes will need to be updated and we will need to ensure that we have an
good understanding of the way in which the new system operates including the
internal controls implemented by management. We will need to evaluate controls
to determine our detailed audit approach. However increased substantive testing
of payables and receivables is likely to be necessary due to the increased audit
risk resulting from the fact that it is the first year of the audit and systems changes
have taken place.
 Provision of other services
The proposed project commencing in July 20X8 does not affect the current audit but
does have implications for future audits. Even if our staff members are not involved in
development, as auditors we should be consulted during it and carry out the following
procedures:
– At the design stage, ascertain whether the systems specification appears to
include appropriate data security and authorisation processes.
– At the design stage, review plans to establish whether there are any obvious
problems with data collection, input, processing and output.
– Determine whether all aspects of the systems have been tested, and testing has
been carried out by users as well as developers.
– Either by carrying out procedures ourselves, or reviewing the results of internal
tests, confirm that controls over security and accuracy of data have been
satisfactorily tested.
– Ascertain whether there is a full information trail for the design and development
process.
– Confirm that new systems have been approved by management and users.
– Confirm that staff have been fully trained and user documentation is complete.

(3) Financial reporting issues
Hardware costs recognised as part of plant and equipment will include the purchase price
plus the costs directly attributable to bringing the assets to the location and condition
necessary to be capable of operating as intended. Installation costs would therefore be
capitalised. Related revenue expenditure eg, ongoing maintenance costs must not be
capitalised but must be recognised in profit or loss. The hardware should be depreciated
over its estimated useful economic life from the point that it is available for use.
The computer software should be recognised as an intangible non-current asset in
accordance with IAS 38, Intangible Assets. It is both identifiable as it is separable and under
the control of Lyght. As the software has been provided by an external contractor it should
also be possible to measure the software reliably based on the amounts invoiced and paid
by Lyght in respect of this. Capitalised costs may include the costs of testing the software
prior to use on the basis that these costs are directly attributable. The software should be
amortised over its useful economic life commencing when it is available for use.
(c) Inventories
(1) Audit issues
Inventories at around £20 million are clearly material both in their impact on profit and on
net assets. Verifying inventories is therefore clearly necessary. If we can obtain sufficient
evidence by alternative procedures, then we may be able to give an unmodified audit
report in spite of the fact that we have not attended year end inventory counts.
Alternative procedures may include the following:
 Attendance at physical inventory counts performed after the year-end with a review of
the 'roll-back' reconciliation performed by management.
 Assess the effectiveness of internal controls and other management controls over
inventory amounts and movements.
 Undertake analytical procedures to assess the reasonableness of inventory amounts
given the levels of sales and purchases prior to year-end. (This is most valid for sales of
large numbers of identical, small items – such as clothing and small appliances – where
patterns in sales may be more discernable than for large one-off sales.)
 Inspect purchase documentation and ultimate sales and receipt of cash documentation
for dates that straddle year-end. (This is most valid for sales of large items – such as
medical equipment and military vehicles – where there may be third-party documented
verification of dates.)
If we are unable to obtain sufficient appropriate evidence regarding the existence of
inventory we will need to consider issuing a modified audit opinion due to the limitation on
scope of the work we have been able to perform.
This issue of exchange rate volatility gives additional audit concerns. The dates of
transactions in foreign currencies need to be established in order to verify the amounts in
the functional and presentation currencies. The specific details are considered below under
financial reporting issues.
 Foreign currency
According to IAS 21, The Effects of Changes in Foreign Exchange Rates an entity is
required to translate foreign currency items and transactions into its functional
currency.
Lyght's functional currency 'is the currency of the primary economic environment in
which it operates'. The primary economic environment 'is normally the one in which it

primarily generates and expends cash'. It is assumed that Lyght's functional currency is
sterling as it operates from the UK.
Inventories are a non-monetary asset. Lyght therefore initially records both the
inventory and the associated liability at the exchange rate at the date of purchase
(perhaps the £/€ rate if acquired within the EU).
The inventory needs no further translating. Thus, while the exchange rates in
customers' countries may vary substantially, this will not directly affect inventory values
stated at cost. (Any outstanding liability is a monetary item and should be retranslated
at the reporting date. Exchange gains and losses should be recognised in profit or
loss.)
If however the exchange rate moves substantially post year-end, then the recoverable
amounts of inventories may fall in sterling terms, and thus an impairment review may
be required.
 Other issues
In accordance with IAS 2, Inventories, inventories must be valued at the lower of cost
and net realisable value. Net realisable value may be a particular issue here due to the
'pre-used' nature of the items sold. Audit procedures should include a review of after
date sales with a comparison to cost.
Revenue recognition may also be an issue. Further details are required regarding the
point at which revenue is recognised and therefore inventory derecognised,
particularly in respect of the high value items where there is an identified buyer prior to
the inventory being purchased.
(d) Sale of tyres
 The purchase
Lyght bought a batch of tyres from a depot managed by Leslie Moore's cousin. IAS 24,
Related Party Disclosures identifies key management personnel which includes
directors, and 'close family members' of key management personnel as related parties
of an entity. Cousins are not specifically identified in IAS 24 as 'close family members'
but the depot manager may fall within the more general description of 'those family
members who may be expected to influence, or be influenced by, that individual in
their dealings with the company'. The provision of gifts to the depot manager could be
a factor which indicates that the depot manager is influenced by Leslie Moore or vice
versa. Whether the purchase of the tyres represents a related party transaction requires
further investigation. If it is a related party transaction disclosure will be required in the
 The sale
As an associate company of VenRisk Lyght is a related party of VenRisk. Hott is also an
associate of VenRisk and therefore they are related parties, however, Hott is unlikely to
be a related party of Lyght, as the possibility of exercising significant influence, or
having significant influence exercised upon it, by another associate of VenRisk seems
unlikely. More information on governance structures and contractual rights would
clarify this situation. The sale of the tyres is thus not a related party transaction.
(2) Audit issues
 Related party transactions
Establishment of whether related party relationships exist is a key issue. Given that the
directors do not appear to have made all relevant information available in the first
instance there may be a high risk of further undisclosed transactions. Audit procedures

need to be designed in this context. The under-disclosure may be due to a lack of
knowledge/awareness of the transactions' nature or it may be deliberate concealment.
Audit procedures need to establish and evaluate the controls that exist to identify and
approve such transactions.
Audit procedures that may indicate the effectiveness of controls and reveal RPTs
include the following:
– Review the board minutes for transactions with other parties and evidence of
influence.
– Review disclosures in previous year's financial statements.
– Review RPT disclosures in the financial statements of entities suspected of being
related parties.
– Review large transactions, particularly loans and other financial transactions, for
evidence that they may not be on an arm's length basis.
– Review legal correspondence for guarantees and other undertakings where no
monetary amount has been transferred.
– Examine shareholder records of group entities and, where possible, of entities
suspected of being related parties.
– Enquire of the directors the nature of the controls to identify and record RPTs.
 Unethical behaviour
There may have been fraudulent behaviour by Lyght and Leslie Moore. There is a risk
that the purchase of tyres by Lyght may be at a price significantly below their fair value.
This may be either as a favour to a cousin, or in return for a financial inducement from
Lyght. Alternatively, it may be that the purchase price is legitimate. The army may have
wished to dispose of the tyres even at a nominal price as it had no other means of
distribution. As bulky items, the purchase cost may have been small by comparison to
the transport costs to be incurred, making the eventual sale price reasonable. An
explanation should however be obtained from Leslie Moore.
The invoice of £3,487 also requires further investigation. The gifts and entertainment
may have been provided in order to secure a reduced purchase price. Not only would
this represent unethical behaviour but could also be seen as a payment of a bribe in
contravention of the Bribery Act. This would be an offence for both the giver and
receiver of the bribe. Reasonable and proportionate hospitality would not be
considered a bribe, however the ethical guidance on gifts and hospitality would also
need to be taken into account. Further information is required to determine whether
illegal acts may have taken place which we, as auditors, may be permitted or required
to disclose.
If unethical or illegal behaviour has taken place this also has implications for our
assessment of the integrity of management and may affect the extent to which we rely
on responses provided by them to other issues.
(e) Leased building
On the basis of the information regarding the length of the lease term, the lease appears to
have been misclassified as a finance lease when it should have been classified as an
operating lease. If the lease is an operating lease, in accordance with IAS 17, Leases the
asset and corresponding liability would not be recognised and the payments under the
lease would be recognised in profit or loss on a straight line basis. The classification of the
lease for accounting purposes depends on its economic substance rather than legal
ownership. Therefore where the risks and rewards of ownership are transferred to the

lessee, a lease is classified as a finance lease. More information is required to determine the
appropriate treatment.
The lease was initially capitalised at £1.1 million, which is material in the context of the
statement of financial position. However the misclassification has not led to profits being
materially misstated. The annual lease payment of £150,000 is 1.25% of pre-tax profits of
£12 million, which would not normally be regarded as material. In addition the impact of
not charging the £150,000 lease payments is mitigated by the fact that £110,000
depreciation (£1.1m/10) will be recognised in profit or loss.
(2) Audit issues
We would carry out the following audit procedures in connection with the lease:
 Review the lease agreement and assess whether the terms appear to show that the
risks and rewards have been transferred to Lyght (for example is Lyght allowed to
sublet the office space?).
 Assess the significance of arrangements at the end of the finance lease (in particular
whether legal title transfers to Lyght or whether Lyght has been granted an option to
extend the lease so that it could occupy the premises for all or a substantial part of its
economic life).
 Examine invoices and other documents related to maintenance, insurance and other
office costs to assess the economic substance of the lease terms.
 Inspect the premises to confirm their existence and that they are used by Lyght.
If we conclude that the treatment as a finance lease is correct, the following procedures
would be required:
 Recalculate the present value of lease payments, confirming that the calculation is
taken from the start of the lease date, and that the finance cost is being spread over the
lease term in a method that accords with IAS 17.
 Agree payment figures and implicit interest rate used to lease agreement.
 Recalculate the depreciation charge and agree the calculation basis to the accounting
policy note.
 Check that disclosures of liabilities under the lease are in accordance with IAS 17.
If we decide that the lease has been misclassified we would discuss the matter with
management. If management were to refuse to revise the financial statements a qualified
audit opinion would be given on the grounds of material misstatement (disagreement) in
respect of non-compliance with IAS 17.
(3) Under IFRS 16, Leases, the distinction between operating and finance leases is no longer
relevant to lessees. With the exception of leases for less than 12 months or leases of low-
value assets, all leases must be recognised in the statement of financial position. A lease
liability is recognised, together with a right-of-use asset, being the lease liability plus the
first payment in advance.
(f) Asset treated as held for sale
Lyght has classified its head office as held for sale from 1 January 20X8 on the basis that
management made the decision to dispose of this asset on that date. However, in
accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued Operations
certain conditions must be met in order for this classification to be made.

These are as follows:
 The asset must be available for immediate sale in its present condition.
 Its sale must be highly probable.
For the sale to be highly probable:
 Management must be committed to the plan.
 There must be an active programme to locate a buyer.
 The asset must be marketed for sale at a price that is reasonable in relation to its
current fair value.
 The sale should be expected to take place within one year from the date of
classification.
 It is unlikely that any significant changes to the plan will be made or that the plan will
be withdrawn.
On the basis that Lyght is not planning to market the property until May 20X8 and there is
no current active programme to locate a buyer, all of the above conditions are not met. The
asset should not therefore be classified as held for resale but should be retained within
property, plant and equipment and should be depreciated for the remainder of the year.
This would result in an additional depreciation charge of approximately £33,000
(2,000,000/20 × 4/12).
On the basis that Lyght has treated the asset as held for sale the following adjustments
would have been reflected in the draft financial statements:
£'000 £'000
DEBIT Assets held for sale (1,600 – 20) 1,580
DEBIT Profit or loss 20
DEBIT Revaluation surplus 400
CREDIT Property, plant and equipment 2,000
These entries should be reversed on the basis that the treatment of the asset as held for
sale is not in accordance with IFRS 5.
Impairment of the asset should also be considered if its recoverable amount is less than the
carrying amount. See audit issues below.
(2) Audit issues
 Confirm with management that marketing is only going to commence on 1 May 20X8
ie, the asset does not qualify as held for sale at the period end.
 Consider materiality. The treatment of the property as held for sale has resulted in a
reduction in net assets of 1.2% (420/36,000). However if the property is deemed to
have suffered an impairment the difference in the financial effect of the two treatments
may be negligible. Further investigation is required. In this instance materiality also
needs to be considered from the qualitative aspect as well as the quantitative aspect.
The classification adopted in the draft financial statements results in the property being
removed from non-current assets and being disclosed separately immediately below
current assets. This impacts on the perception of the company's liquidity.
 Confirm that the asset has been included in property, plant and equipment and that it
has been depreciated for the full year. The net impact of correcting the treatment of
£13,000 (33,000 additional depreciation – 20,000 estimated costs of disposal) is
unlikely to be material however the additional depreciation is consistent with
continued recognition of the asset as part of property, plant and equipment.

 Confirm whether the property has suffered an impairment. Its fair value is currently
below its carrying value. An assessment of the value in use of the asset should be made
to determine whether an adjustment is required. If the recoverable amount (higher of
fair value less costs of disposal and value in use in accordance with IAS 36) is less than
the carrying amount the asset will be impaired and should be written down to its
recoverable amount. Any loss would initially be treated as a revaluation decrease.
(g) Receivables
 The requirements of IFRS 9, Financial Instruments apply.
 Interest on the trade receivable is £2,577,000 × 8% = £206,160.
 A loss allowance for the trade receivable should be recognised at an amount equal to
12 months' expected credit losses.
 Although IFRS 9 offers an option for the loss allowance for trade receivables with a
financing component to always be measured at the lifetime expected losses, Lyght has
chosen instead to follow the three stage approach of IFRS 9.
 The 12-month expected credit losses are calculated by multiplying the probability of
default in the next 12 months by the lifetime expected credit losses that would result
from the default. Here this amounts to £376,440 (£1,505,760 × 25%).
 Because this allowance is recognised at 1 May 20X7, the discount must be unwound by
one year: £376,440 × 8% = £30,115.
Overall adjustment:
DEBIT Finance costs (impairment of receivable)

(376,440 + 30,115) £406,555
CREDIT Loss allowance £406,555
(2) Audit issues
We would carry out the following audit procedures in connection with the allowance:
 Review correspondence with Cristina and assess whether its commitment appears
legally binding.
 Obtain representations from the management of Lyght which confirm the decision to
adopt IFRS 9 and the three-stage approach (this could be confirmed via board
minutes).
 Review a sample of similar receivables to determine whether any further loss
allowances should be recognised.
 Evaluate the probability of external factors occurring which may result in the monies
owed by Cristina not being paid, such as a likely change of government in the next
year.
 Recalculate the loss allowance using information obtained during the course of the
audit.
 Confirm with management the basis on which the 8% interest rate and the 25% default
rate have been used to reflect the risks of Cristina.
 Review any significant changes in circumstances occurring between the interim audit
and the final audit.

25 Maykem
Marking guide
(a)(1) Review of assistant's 11 Write in a clear and concise style appropriate to a

work: key weaknesses file review.
Identify weaknesses in assistant's work.
Link large number of invoices with low GRNI
provision.
Identify there is insufficient evidence on the audit
file to determine the work performed on GRNI and
other accruals.
Identify that the financial controller is not the best
source of audit evidence (eg, for confirmation of
legal provision).
Identify potential creative accounting – window
dressing re invoices in transit.
(2) Additional audit 8 Identify practical solutions in terms of additional
procedures audit work to address the identified weaknesses.
(b) Financial reporting Write in a clear and concise style appropriate to a
issues file review.
(1) Derivatives 3 Identify the financial reporting issues relating to
derivatives and possible treatments.
(2) Claim from MegaCo 2 Assimilate facts relating to likelihood of claim and
plc outline potential treatments.
(3) Contract liability 3 Link change in revenue policy with potential for
warranty provision.
Identify inappropriate revenue recognition
treatment.
(4) Disposal 3 Highlight potential irrecoverable receivables from
the disposal of the business.
Identify potential need for dilapidations.
(c)(1) Accounting treatment 7 Adjustment required to proposed treatment.
of pension scheme
Calculation of amounts to be presented in the
statement of financial position and of profit or loss
(2) Audit issues 3 Evaluate the key issues including the impact of the
departure of the responsible accountant and
materiality.
(d) Ethics 5 Evaluate the issue with reference to ICAEW Code.
Total marks 45

Maximum marks part (a)(1) 9

Maximum marks part (a)(2) 7
Maximum marks part (b)(1) 3
Maximum marks part (c)(1) 6
Maximum marks part (c)(2) 2
Maximum marks part (d) 5
Maximum marks 40
Review points on procedures performed

Trade payables
Explanation for decrease in payables seems odd as comments on commission imply high
trading in last month of year. Are we sure there is no cut-off error here?
Debit balances within trade payables ledger – what are these? What have we done to ensure
that they are recoverable? How do we know it is appropriate to classify them as trade
receivables?
How were balances chosen for supplier statement reconciliation? Should select based on
throughput rather than year-end balance as key risk is understatement.
Work on invoices in transit is not adequate. Need to determine when goods were received
rather than when invoice was posted. If goods were received pre year end then should have an
accrual within goods received not invoiced (GRNI). This needs to be checked.
Large number of invoices in transit and significant balance in GRNI accrual suggest a risk of a
cut-off error so need to do careful work here.
May be other balances denominated in foreign currency – where are FX rates used to translate
these considered?
Not clear what procedures if any have been done on GRNI accrual – would expect it to be tied
into detailed listing which has been reviewed for unusual items, debit balances, old items etc.
Also needs to be tested for completeness by reference to procedures on supplier statements,
cut-off, accruals etc.
Review for any intra-group balances that may need to be disclosed as related party transactions
or may not be at arm's length. (Consolidation schedules may also later require identification of
such balances in group financial statements.)
Accruals
Exceptionally high May sales increase risk of cut-off errors and fraud. Need to ensure adequate
procedures performed on sales cut-off.
Procedures performed on bonus are inadequate – need to understand basis on which accrual
made and bonuses to which staff are contractually entitled. Also need to determine what
authorisation is required from parent company for element payable to directors. May need to
wait and see amounts actually paid/authorised.

Procedures on general and admin accruals are not adequately documented – need analysis on
file so can see exactly what vouching was done.
In addition, the direction of testing does not address risk that accruals are incomplete. We need
to look at post year end payments and invoices and ensure that all items relating to pre year end
purchases have been accrued in year end financial statements.
The financial controller is not the right person to discuss the legal claim with – need to talk to
whoever has been handling discussions and also seek direct input from the legal firm involved
through circularisation.
Need to examine and file copies of all relevant correspondence.
May also need expert input re validity or otherwise of patent claim from a technological point of
view.
Should also consider whether legal firm was qualified to give an opinion in such a specialised
area – fees seem quite low for expert advice against a large corporation which may have far
more in-house expertise and expert lawyers.
See also points re related financial reporting issue below.
PAYE/NI
No procedures documented – what has been done on this?
Would expect agreement to payroll and post year end payment. Also important to discuss the
outcome of any PAYE/NI inspections and whether any additional amounts of penalties are likely
to be payable.
Contract liabilities
Cross reference to work carried out on revenues in audit file.
See comments below re change in allocation between product and revenue.
Given that there is a one year warranty period – seems odd that there is no warranty provision in
current liabilities.
Surplus property provision
Again seem to rely on discussion with financial controller – not appropriate as she did not
calculate provision.
Need to determine what advice was taken in determining two year period for provision – would
expect them to have taken advice from estate agents etc.
See also issues identified below.
General
No taxation payable shown – where are such balances and what work has been done on them?
No balances due to other group companies?
Potential financial reporting issues and adjustments identified
Accounting for derivatives
Comment on Metallo balance makes it clear that there is a derivative in the form of a forward
exchange contract. Accounting for this needs to be in line with IAS 32/39. Will need to look
carefully at whether it qualifies for hedge accounting. Fair value of derivatives should be shown
within statement of financial position. If qualify for hedge accounting then gain/loss on the
hedging instrument will be taken to profit or loss in same period as item which was hedged. This
will depend on when inventory from Metallo is used. If does not qualify for hedge accounting
then gain/loss should go to profit or loss. In either case, balance with Metallo should be
translated at year end rate.

We can only use fair value hedge accounting if there was appropriate documentation in place at
inception of the contract. Could also use cash flow hedge as either FV or CF hedges are
permissible under IFRS 9 for foreign currency.
MegaCo claim
MegaCo royalty claim – position taken in the accounts is very different to that taken in the prior
year and we need to understand what has actually changed to justify the different treatment.
Any claim like this represents a contingent liability where the probability of a payment being
made needs to be assessed. Only if it is remote is there no provision or disclosure in the financial
statements. If it is not remote but not more likely than not then a disclosure must be made and if
possible quantified – quantification is clearly possible here as there must have been some basis
for prior year provision.
Letter was only sent to MegaCo a few months ago and the fact they have not yet responded is
not adequate evidence that claim has been dropped, particularly given their acknowledgement
letter – more likely that they are using the time to build a stronger case and possibly even a
larger claim.
Contract liability
Revenue recognition change is inappropriate and contravenes IFRS 15, Revenue from Contracts
with Customers. Two performance obligations can be identified: the supply of a refrigeration
unit and the three-year maintenance contract. Per IFRS 15, transaction price is allocated to each
performance obligation in proportion to the relative stand-alone selling price of the goods or
services provided within each performance obligation.
Since Maykem do sell products separately, they have evidence of stand-alone selling price of
product by reference to what a customer will pay for it. The same is true of the additional
amount a customer chooses to pay for maintenance contract. To split on any other basis would
not be permitted.
Changing allocation retrospectively in this way has resulted in a large release of revenue and
additional profit which has materially distorted the results for the year. At the very least it will
require disclosure and might be regarded as a change in policy (if valid at all).
There is no requirement that all elements of a multi-element sale should give same margin –
what matters is appropriate stand-alone proportions allocated to revenue.
Revenue from the sale of the refrigeration unit should be recognised on delivery of the unit
(performance obligation satisfied at a point in time).
The maintenance contract is a performance obligation satisfied over time. Time elapsed (an
input method) is an appropriate way to measure progress towards satisfaction of the
performance obligation, so spread evenly over the period of the contracts.
The revenue received in advance for the maintenance contract is a contract liability
(consideration received or due before a performance obligation is satisfied). As maintenance
contracts are for three years, surely part of the contract liability should be in payables falling due
after more than one year.
Disposal of business
Seem to have considered only some of the costs. One might expect:
 What about dilapidations for property as in bad state?
 Do plant and machinery or leasehold improvements have a NBV which is impaired and
should be written down or even written off completely? What proceeds, if any, are
expected for such items?

 What has happened to any receivables balances relating to domestic customers? Have
these all been collected or is collectability in doubt given sale of business?
 Does Maykem have any ongoing warranty or other obligations under terms of deal which
should be provided for?
Need also to consider whether domestic market is a separate business segment and therefore
should be disclosed as a discontinued operation within the accounts.
May also be assets held for sale which should be reclassified.
Need to ensure gain or loss is properly described within statement of profit or loss and other
comprehensive income as should probably be regarded as an exceptional item.
Does sale of inventory suggest that other inventory provisions within Maykem might be
inadequate? Need to understand more fully what profit or loss was made on sale of inventory.
Should consider discounting in calculating surplus property provision.
Pension scheme
The directors are not correct. The contributions to the scheme are not recognised in profit or
loss but are treated as a debit to plan assets. The accounting entries relating to the contributions
should be:
DEBIT Plan assets £306,000
According to IAS 19, Employee Benefits (revised 2011), gains or losses on remeasurement of the
net defined benefit asset/liability (actuarial gains or losses) must be recognised in other
comprehensive income in the year in which they arise.
The full accounting treatment is as follows:
Amounts recognised in the statement of financial position
31 May 20X8 31 May 20X7
£'000 £'000
Present value of obligation 4,320 3,600
Fair value of plan assets (4,050) (3,420)
Net liability 270 180
Expense recognised in profit or loss for the year ended 31 May 20X8
£'000
Net interest on the net defined benefit obligation:
(5%  3,600) – (5%  3,420) 9
Net expense 369
Loss recognised in other comprehensive income for the year ended 31 May 20X8
£'000
Actuarial loss on obligation (522)
Return on plan assets (excluding amounts in net interest) 495
Net actuarial loss (27)
Change in the present value of the obligation

£'000
Present value of obligation at 1 June 20X7 3,600
Interest cost on obligation (5%  3,600) 180
Benefits paid (342)
Loss on remeasurement through other comprehensive income (residual) 522
Present value of obligation at 31 May 20X8 4,320

Change in the fair value of plan assets
£'000
Fair value of plan assets at 1 June 20X7 3,420
Interest on plan assets (5%  3,420) 171
Contributions 306
Benefits paid (342)
Gain on remeasurement through other comprehensive income (residual) 495
Fair value of plan assets at 31 May 20X8 4,050
Audit issues
 We need to determine where the information in Exhibit 2 has been obtained from in order
to evaluate the integrity of the data. This is a particular issue as the accountant normally
responsible for pensions has left.
 We need to consider the implications for the audit of the involvement of experts ie,
actuaries.
 We need to ask why the accountant responsible for pensions has left and assess the
consequences of this on our risk assessment and on other areas of our audit.
 Materiality must be evaluated. The net effect on profit or loss is a reduction of profit of
£63,000 (369 – 306). This in itself is not material (based on the materiality level of £250,000)
but there are also consequences of the revised treatment in the statement of financial
position and in other comprehensive income. The proposed treatment would also be
inconsistent with the previous year therefore we should request that the financial
statements are revised so that they are in accordance with IAS 19.
Ethics: Sophie's investment
We have a responsibility to consider any possible or actual conflicts of interest.
In this case, there is a threat of self-interest arising, as a member of the audit team (Sophie) has
an indirect financial interest in the client's parent company. The fact that the parent is listed on
Euronext rather than the London Stock Exchange does not reduce the risk.
The relevant factors are as follows:
 The interest is unlikely to be material to the client or to Sophie, as the investment is in a
tracker fund rather than shares and, therefore, the value of Maykem will only have a small
influence on the value of Sophie's total investment.
 Sophie is a junior member of the audit team and so her role is not significant in the sense
that she will not be making audit conclusions or be substantially involved in areas of high
audit risk.
 The investment is in ParisMet, the parent, rather than in Maykem itself.
The risk that arises to the independence of the audit here is not considered to be significant.
It would be inappropriate to require Sophie to dispose of her investment. It is also unnecessary
to remove Sophie from the assignment.

26 Sunnidaze
Marking guide
Marks
(a) Prepare a memorandum setting out and explaining the additional audit 21
adjustments and unresolved audit matters identified at our follow up visit
together with a brief summary of any additional audit procedures required
Drafting of revised financial statements
(b) Your comments on any more general concerns including ethical issues you 11
have in relation to the audit as a whole and what our audit response to these
concerns should be
(c) Brief notes setting out an explanation of the form of audit opinion we should 8
give
(d) Explanation of treatment of sale and leaseback transaction 6
Total marks 46
Maximum marks 40
(a) Memorandum
To: Audit manager
From: Jamie Spencer
Additional audit adjustments and unresolved audit matters, together with additional
procedures required
Credit note adjustment not posted
Although the final Jacuzzi was not delivered until after the reporting date, it must have been
clear at the year end that 10 were to be delivered and that a discount would therefore be
given. We need to check that the discount arose from a commitment pre year end rather
than a post year end decision but, assuming this to be the case, an adjustment to account
for the discount on nine items should be posted:
CREDIT Receivables £9,000
This amount is not by itself material but the client's unwillingness to book it is a little
concerning. We will need to reassess this along with any other unrecognised adjustments at
the end of the audit.
Late adjustments made by client – health club receivable
Clearly it is appropriate to make provision for the health club receivable, because the
specialist nature of the product (luxury hot tubs) means that, as per IFRS 15, revenue should
not have been booked until the installation was complete (the performance obligation
satisfied). However, not so clear that this should be recorded as an exceptional item. The
amount must be reversed from revenue.
Hence:
CREDIT Exceptional item £42,000

In addition, we need to consider the entry for inventory that is expected to be returned. We
can only record this at the lower of cost and net realisable value and will need to take into
account the cost of bringing the inventory back to the warehouse. Hence, we can only
determine the precise entry with more information.
Assuming appropriate to record at cost and average margin made, likely entry is:
DEBIT Inventory £22,260
(Assumes margin of approx 47% as per statement of
profit or loss and other comprehensive income)
CREDIT Cost of sales £22,260
However also it is likely some provision is required against the inventory as this will not be in
pristine condition, and therefore the net realisable value is likely to fall below cost.
Tutorial note
Reasonable estimates of this were accepted.
Late adjustments made by client – broader implications of delay in installation

Concerning the goods which were delivered to the health club in June but not installed
until some months later – this together with delays in the payment of year end receivables
suggests that revenue may be being recognised too early. We will need further audit
procedures to consider:
 Extent of revenue recognised for goods delivered pre year end but installed
afterwards.
 Whether installation is optional or required for all sales in which case it could be
argued that the installation cannot be separated from the supply of goods and no
revenue should be recognised until installation is complete.
 Whether there is a separate charge for installation and if so, when is that element
invoiced.
 Does some installation revenue need to be deferred at year end or is a cost accrual
more appropriate. Has such an accrual been made?
 Whether customers actually required the goods to be delivered pre year end. Possible
that revenue has been artificially accelerated into the prior year especially as post year
end sales are quite low. Need to look at customer order information re required date
of delivery and consider circularising customers. Particular attention should also be
given to invoices still not paid or paid some time after year end.
Bonus accrual
The entry seems reasonable as the bonus clearly relates to performance for the financial
year which draft accounts show has met the target.
It is unclear whether the related social security taxes have been accrued – we need to check
this.
In addition, adjustments may mean that the target operating profit has not in fact been met,
in which case the bonus would need to be reversed.
Dividend
This should not be accrued unless actually declared pre year end which seems unlikely.
There may well have been a similar error in prior year as brought forward retained earnings
were nil so will need to check this.

Intangible assets
Intangible assets do not seem to have been amortised since their acquisition which is an
error. Total amortisation to the reporting date should be £250,000 on a straight line basis of
which £200,000 should have been booked in prior years (see consideration under general
matters below of potential implications of this). Hence adjustment required:
DEBIT Operating expenses £50,000
DEBIT Retained earnings at 30 June 20X5 £200,000
CREDIT Intangible asset £250,000
We need to consider whether the remaining balance of £250,000 is impaired, given
reducing sales of the DupaSpa product. If sales are expected to continue at the 20X6 level
then the asset is probably not impaired as £400,000 @ 47% = £188,000 of margin
generated in one year. However we need to look in more detail at forecast sales for the
DupaSpa product and the cash flows arising and perform sensitivity analysis.
Cash after date – recoverability of receivables
We are now four months after the year end so we would expect all balances outstanding at
the reporting date to have paid. It seems unlikely that a nil provision against the £186,000
outstanding is adequate, especially as some debts are due from local builders who may be
experiencing financial difficulty. Again much more analysis is required to determine the
level of allowance required – we need to look at each customer in turn and analyse the
reasons for non-payment.
We should also consider days sales outstanding (DSO) at the year end and on average
when considering whether receipts have been received within the anticipated time period
or whether there is any indication of extended payment terms being offered.
Bank loan
The instalment of £400,000 due on 31 December 20X6 should be classified within current
liabilities not long term creditors.
It is not clear how loan arrangement fee has been treated – it may have been expensed, or
recognised within other current assets. It should be deducted from the liability (£2,000,000
– £40,000) on initial recognition. An effective interest rate would then need to be calculated
to incorporate the 5% interest and the £40,000 transaction costs. In order to perform the
required adjustment, enquiries need to be made about how this was treated in the first
place.
For year ended 30 June 20X6, a crucial measure for the covenant is an operating profit of
no lower than £280,000.
Draft financial statements show £467,000, adjusted to £388,000 (467 – 9 – 42 + 22 – 50) by
the above adjustments. However there are also potentially significant adjustments re loan
fee, bad debts, intangible impairment and revenue recognition which could reduce this
below £280,000. In this case the bonus accrual might also be reversed. Hence finalisation of
accounts is crucial in determining whether there has been any breach.
It seems odd that there are no restrictions in respect of dividends and major transactions
(including sale of shares) in the agreement – there needs to be a review by more senior
personnel to ensure that all relevant factors have been summarised and taken into account.
In addition need to check whether there is any obligation for the auditor to report direct to
bank as this would require a separate engagement.
Review of post year end results
The key issue to be considered here is going concern. Results are not in line with budget
and operating profits at this level are insufficient to meet the covenant going forward (which
requires £280,000 profit for the year). The inability to comply with loan agreements is a key
factor which may cast doubt on the use of the going concern basis of accounting. The cash

balance will be seriously depleted once the loan repayment and dividend paid, although
movement for the post year end period is not out of line with operating profit.
It is important that management takes responsibility for the conclusion about whether the
entity is a going concern and produces forecasts and arguments to support this, which are
then audited. We will need detailed cash flow forecasts for at least a 12-month period (from
date of approval) to consider going concern and these should include modelling to ensure
that covenants will be met. The budget should be used as a starting point but will need a
critical review and sensitivity analysis, as there is an indication that it may be far too
optimistic – we need to make sure specifically that factors such as declining sales are taken
into account. In addition, ongoing changes to accounting policies in respect of revenue
recognition and intangible amortisation need to be taken into account when modelling the
covenant compliance as these may affect operating profit in future.
Another factor to consider is the willingness and ability of shareholders to put in more
capital. This seems unlikely as they are actually planning to sell. However they are already at
risk over bank borrowing and finding a buyer may be difficult.
Maisie's view of forecasts must be considered when planning our work.
Revised summary financial information
Per draft
financial Revised
statements Adjustments balances
£'000 £'000 £'000
(9) (42) (50 amortisation)
Operating profit 467 22 388
Exceptional items (42) 42 –
Interest payable (100) (100)
Profit before taxation 325 288
Taxation (125) (125)
Profit after taxation 200 163
Assets
Intangible assets 500 (250) 250
Inventories 1,392 (22) 1,414
Trade receivables 1,587 (9) 1,578
Other current assets 40 40
4,466 4,229

Retained earnings (from P/L) 200 (37) 163
Long-term borrowings 2,000 (400) 1,600
Loan 400 400
Tax payable 125 125
4,466 4,229
(b) Comments on more general concerns

Ethical considerations and fraud risk
Knowledge of Maisie's view of the forecasts needs further consideration. There is no duty to
disclose this to any party outside the client despite concern that wildly optimistic forecasts
may be being used to attract investors, unless there is the possibility that there is
misconduct by a member of the Institute or reportable fraud.

Discussion of concerns with the directors is possible but would need to be done sensitively
and without quoting Maisie's view. The most appropriate way to address this is to plan very
rigorous work on the forecasts as part of the going concern review, challenging
assumptions and subjecting them to sensitivity analysis.
If this work identified any deliberate attempt to deceive potential investors then that might
be fraud and reportable under money laundering regulations – we would need to consult
the firm's Money Laundering Compliance Principal (MLCP).
We might also want, at that point, to reconsider whether we wanted to continue to act as
auditors.
Potential investment has raised the risk associated with audit conclusions and it may be
necessary to revisit risk considerations and/or allocate additional reviews.
Fraud risk
All three directors have a strong incentive to ensure that operating profit is stated at a
certain level either because of bonus arrangements or personal guarantees and a desire to
sell the company at the best price.
Inappropriate classification of the adjustment to the allowance for receivables and some
indication that revenue has been accelerated may suggest that they are prepared to
manipulate the results to meet this target as might the high level of unrecognised liabilities
identified by our earlier work and their unwillingness to agree to and recognise one of the
audit adjustments.
Arnold has potentially been involved in the determination of provisions and other
judgmental areas. We need to apply enhanced levels of professional scepticism to ensure
that our procedures throughout the audit take into account this risk of fraud and that we
revisit any areas where we have relied on written representations from management. We
may also enlist the use of a specialist to assist the audit team.
Time-scales and need for appropriate focus on audit completion
The financial statements need to be delivered to the bank before the end of November so
time is tight. A meeting with the bank is also clearly very important and it is crucial that
directors understand fully the status of the audit, further work that is required and final
review processes necessary to close down the audit completely. Time must be allowed for
audit completion and necessary quality control procedures.
Opening balances
Prior year accounts were unaudited and work on intangibles and dividends suggests that
they may include a number of misstatements. We need to ensure that sufficient work has
been performed on all opening balances. Areas of particular focus might include:
 revenue recognition and cut-off
 purchases
 capitalisation policy and existence of property, plant and equipment
 adequacy of provisions
 classification of items within the financial statements
If there is any indication of accounting irregularity or a deliberate intention to mislead tax
authorities or bank in the past, then we should reconsider whether we want to act for this
client at all. It may, however, just be due to ignorance about accounting standards or lack of
clarity about the GAAP being followed.
We have full responsibility for comparative figures in the accounts even though no opinion
is given on them.

Materiality
Materiality was initially set at £30,000 based on a profit before tax of £551,000. This in itself
may be a little high as it is slightly above normal benchmarks, especially given that this is a
first year audit.
Profit is likely to be much lower and headroom compared to the bank covenant could be
very tight. We need to revisit this level of materiality and consider if it should be lower which
might well require additional audit procedures.
Another factor relevant to this is the very high level of adjustments identified to date – this
far exceeds materiality and presumably estimation of likely mis-statements. Again this could
require some re-assessment of performance materiality as applied to each balance tested
and to the sample sizes used during our audit procedures. Again additional work may well
be necessary.
(c) Consideration of form of audit opinion
Key factors for consideration here are:
 Whether client will agree to additional audit adjustments – if not then there may be a
qualified audit opinion and basis for qualified opinion section setting out the matters
that we believe are materially misstated. Such a paragraph would depend entirely on
the reasons for the disagreement and the nature of the items involved. Opinion might
even be adverse if matters are of such significance that this is justified.
 Whether we believe we can gain sufficient audit evidence to give an opinion. There is
no indication that we cannot in this case, although reliance on written representations
from management could become an issue if further work uncovers evidence of fraud.
 Seems unlikely that things are so bad that the going concern basis of accounting will
be inappropriate although this could be the case if the bank calls in the loan. However,
there may well be material uncertainty over the entity's ability to continue as a going
concern or possible insufficient disclosure by the directors of the relevant factors.
Assuming disclosures are sufficient, we would not modify our opinion but would
include a Material Uncertainty Related to Going Concern section drawing attention to
the uncertainty and the key factors underlying it. In this case, it would be continued
compliance with the covenant and cash flows sufficient to repay the loan and interest
as they fall due while meeting all other obligations. If disclosures are not adequate
then there would be a qualified or adverse opinion. If management will not provide an
adequate review for a long enough period there might possibly be a need to modify
the opinion due to inadequate audit evidence. (If the directors have not considered a
year from the date of approval of the financial statements and have not disclosed that
fact this must be disclosed in the auditor's report.)
We will also need a reference in the auditor's report to the effect that prior year
comparatives are unaudited, although we still have responsibility to perform appropriate
procedures in respect of opening balances and to ensure that adequate disclosures are
made.
We should also consider the use of the Bannerman clause in respect of duty of care.
(d) Sale and leaseback transaction
 IAS 17 states that if the land element of the land and buildings is immaterial the land
and buildings may be treated as a single unit for the purpose of lease classification.
This is the case here.
 The treatment of the lease depends on the terms of the lease.

 In accordance with IAS 17 there are five factors which would normally indicate that a
lease is a finance lease:
– The lease transfers ownership of the asset at the end of the lease term.
– The lessee has the option to purchase the asset at a price sufficiently below fair
value at the option exercise date, that it is reasonably certain the option will be
exercised.
– The lease term is for the major part of the asset's economic life even if title is not
transferred.
– Present value of the minimum lease payments amounts to substantially all of the
asset's fair value at inception.
– The leased asset is so specialised that it could only be used by the lessee without
major modifications being made.
 More details are required regarding the terms of the lease but based on the
information provided:
– The lease term of 20 years is inconclusive as the asset is a building (buildings may
have a useful life well in excess of 20 years).
– The present value of the minimum lease payments does appear to amount to
substantially all of the asset's fair value at inception. The present value of the
minimum lease payments in respect of the warehouse building is £272,435
(32,000 × 8.5136). This is 97.3% of the fair value of the warehouse building
£272,435 ÷ £280,000. On this basis it is likely that the lease will be treated as a
finance lease.
 Assuming the lease of the property is a finance lease, any profit on the initial disposal
would be deferred and amortised over the lease term.
 The asset and finance lease liability will initially be recognised as £272,435 (see
above). This is the lower of the present value of the minimum lease payments and the
fair value of £280,000.
27 Tydaway
Marking guide
Marks
(a) Follow up work from inventory count 12

(b) Audit work arising from concerns and need to address 13
financial statement assertions
(c) Financial reporting effects of four hedging options 10
(d) Explanation and comparison of the alternative financial 4
reporting treatments
(e) Documentation required for audit purposes 4
Total marks 43
Maximum marks 40

(a) Questions and follow up work on inventory count attendance notes
Counting procedures
It appears that counters had access to the quantities shown on the system as they counted.
This is not best practice and can lead to a tendency to 'count' what should be there, as
possibly illustrated in the mezzanine area discrepancies.
You need to determine whether this was in fact the case and then to evaluate whether we
can still rely on the count. If they did have access to quantities then you will need to raise a
management letter point in this area.
In addition, investigating only differences greater than 10% tolerance level may be
insufficient given the level of materiality and significance of the inventory balances.
Overall count difference
No mention in your notes of what the overall count difference was – important to know this
both to evaluate accuracy of count and to assess what work is necessary on roll-forward of
count quantities to year end.
Audit sample count sizes
How were audit sample sizes for both raw materials and WIP determined? Important to
know this so we can assess adequacy of work done and also understand how to evaluate the
potential impact of errors identified. If errors are to be extrapolated into the population as a
whole then we need to make sure a representative sample has been chosen.
Whether this is the case is not clear from documentation at present. WIP sample size is very low
at only five and unlikely to be representative unless number of WIP items is very low. You need
to find out and clarify this.
Weigh counting method for WIP
What value of total inventory was counted using weigh counting? 5% error rate is only
acceptable if this is clearly immaterial when applied to the whole relevant population.
You need to clarify whether weigh counting differences noted all went in one direction or
whether there were unders and overs as would be expected. 5% error rate does seem quite
high unless value of items involved is clearly immaterial.
Inventory controller – discussion on paint and chemicals
We cannot rely on discussion with controller to evaluate whether the approach taken on
paint and chemicals is reasonable. Again you need to determine the total value of such
items and to estimate what total possible mis-statement could be from the approach taken.
If potentially significant then additional work and analysis will be necessary at the year end.
Errors in mezzanine area – need for additional year end procedures
Although specific differences noted in the mezzanine area have been corrected, the fact that
two differences were noted in the same area may be indicative that counters in that area
were not accurate enough. You should ideally have performed additional counts in the areas
that team had counted to determine whether errors were indeed isolated or whether the
whole area should be checked and recounted. However you cannot now do that but,
depending on the significance of inventory counted by that team, we will need to consider
additional procedures at year end, possibly including a year-end inventory count.
It is important to understand fully the nature of the errors and inventory items on which they
arose as it may be possible to isolate the risk of similar errors to part of the population and
thus either determine that any misstatement cannot be material or limit additional
procedures to the relevant part of the overall population. As the errors went in both
directions this suggests that there is both overstatement and understatement risk. You need
to determine the nature of the errors and the inventory items which were miscounted.

No work on finished goods
No work appears to have been performed on finished goods quantities – were there any at
inventory count date? We might have expected some from the management accounts
analysis which showed goods made for Swishman.
Old or damaged inventory
Was any old or clearly damaged inventory noted during the count? We need details of this
to ensure adequately provided at year end.
Consignment inventory
Do you have any further details of how inventory sent on consignment to subcontractors is
accounted for? We would expect it to remain within inventory records but notes from count
imply that it is booked out and then booked back in again when it is received back. This
might result in under-recognition of inventory and a grossing up of revenue and cost of sales
entries.
You need to understand and document fully the arrangements with the subcontractors and
to review all accounting entries. There may also be more inventory at the subcontractor
which we need to consider. In addition there is a question as to how inventory received back
should be accounted for – as raw materials or as WIP. It is also important to understand and
document where subcontractor costs are recorded in profit or loss so appropriate amount is
inventorised but there is no double counting.
Cut-off at count date
There is no evidence that you have tested the accuracy of cut-off entries at the inventory
count date. You need to do this so that the comparison of book to physical quantities is
accurate as books have been updated for all physical transactions before the count and post
count transactions are not included.
(b) Financial statement assertions – concerns or issues and key audit procedures
Introduction
Inventory is a material debit balance and audit work would be expected therefore to focus
on the assertions of existence, accuracy, valuation and allocation, and rights and obligations
(ownership). Each of these is considered below.
Within the statement of profit or loss and other comprehensive income the inventory balance
is a credit element of cost of sales and so it is also important to ensure that it is not
understated.
Work on existence of inventory
Roll forward – work on book inventory
The count at the South London factory was on 30 June, one month before year end; we will
need to perform work on inventory movements over the last month to ensure that the year-
end inventory at that factory exists and has been accurately recorded. This might include test
counts and cut off work at year end or detailed work on completeness and accuracy of
movements recorded within the book stock records.
Also need to make sure that the count data tested at the inventory count has been tied into
the system and that the physical inventory count (including any book to physical adjustment)
has been recorded accurately in the accounting records.
Woodtydy – not included in count?
Inventory at Woodtydy does not appear to have been included in the 30 June count – we will
need to make arrangements to attend a count at this site and to perform appropriate audit
tests of the accuracy and completeness of this count. If the count is not at year end then we

will also need to roll-forward procedures as above. Will also need to address risk of incorrect
cut-off on inventory transferred between the two sites.
Work on accuracy, valuation and allocation of inventory
The fact that differing methods are used to value inventory at the two sites is not necessarily
an issue, providing both result in a reasonable approximation to actual cost of inventory
held. However the different approaches mean that there will be two separate populations for
audit testing and that the testing will need to be tailored for each site.
Purchase price variance
Tydaway's inventory is valued at standard cost which has proved to be a reasonable
approximation to actual cost in the past. However purchase price variances are much higher
in the 10 months to 31 May 20X1 than in the equivalent prior year period and might well
need to be taken into account in determining the actual cost of inventory held at year end.
 Audit work should include testing a sample of individual raw material costs, comparing
the actual cost to the standard cost and ensuring that the difference has been posted
accurately to the purchase price variance account.
 Purchase price variances (PPV) should then be reviewed for any significant one-off items
such as that already identified in the commentary on the management accounts. Such
items should be excluded from any adjustment made to inventory if, like the £25,000 in
the commentary, they relate to purchases of inventory which has been sold prior to year
end.
 We will then need to determine whether any adjustment has been made by
management to include a proportion of PPV in inventory and thus adjust the raw
material inventory valuation to a closer approximation to actual cost. An independent
assessment of the reasonableness of this adjustment should then be made.
Calculations to assess the appropriateness of the PPV add back could include:
– extrapolating the difference between actual and standard costs noted in the
sample testing and comparing this to the add back made;
– calculating the ratio of PPV to raw material purchases (excluding in both cases the
one off items identified above);
– applying this percentage to the raw material element of inventory; and
– considering PPV over the period of average inventory turn and ensuring after
adjustment for one off items that the amount added back is equivalent to PPV over
the period in which inventory was acquired.
The change between old and new standard costs may have been posted to PPV when
standard costs were changed on the first day of the financial year. If it was, then this would
need to be excluded from the PPV add back calculation.
No PPV add back should be applied to £60,000 of components which were purchased in the
previous year. However, we will need to look at whether the standard cost for these was
increased at the beginning of year and to reverse that entry as the correct cost is cost
components that were actually purchased in prior year.
Freight costs
Freight is added to standard cost at 1.5% whereas actual costs are running at around 3.2% of
raw materials (£77,000/£2,431,000). It is not clear where the variance has been accounted
for. It may have been taken into account in variances already considered. In any case the
amounts which might potentially be included in inventory are not material so are not
considered further. However should note that % in 20X0 was 1.4% so may be exceptionally
high costs in 20X1 which should not be included within inventory valuation.

Overheads
Overheads included in inventory need consideration as these are based on May figures and
could well be material. You should obtain client calculation of the amount to be included in
year-end inventory and perform the following procedures:
 Consider whether the assumption that WIP is on average 50% complete is reasonable –
this may involve an inspection of the WIP on site at year end.
 Verify accuracy of calculations and agree amounts to expenses tested in statement of
profit or loss and other comprehensive income testing or other supporting evidence.
 Agree overheads included are all items that can be included within inventory valuations.
As they appear to include delivery costs this may well not be the case as such costs are
selling costs and should not be inventorised.
 Consider whether levels of activity through the factory have been normal as it would be
inappropriate to include in inventory excess levels of overhead arising from idle time or
inefficient production. There are some indications that this may have arisen as sales are
at around 75% of prior year level and direct production costs are also lower (despite
higher unit costs for materials) but overheads have remained at around the same level.
 Ensure both finished goods and WIP are included in the calculation.
Woodtydy's inventory
Work will also be necessary on Woodtydy's inventory valuation. In designing this work we
will need to consider the extent to which audit work has been completed in the past as
Woodtydy was only a division. Work may also be required on opening balances.
 In addition, the description of the inventory records implies that they may be manual in
which case additional work may be needed to ensure internal consistency and clerical
accuracy.
 Raw materials are valued at the latest invoice price and the accuracy of this can be
tested by taking a sample and agreeing the value to an invoice for the last transaction.
 We also need to consider whether latest invoice price is appropriate as this may result in
inventory which was purchased earlier in the year being included in inventory at a price
which is higher or lower than actual cost. If differences are significant then additional
testing may be necessary to determine error over whole population. It would normally
be more appropriate to use FIFO pricing and although latest invoice can be an estimate
of this, it is not always an accurate one.
 To test overheads we will need to look at actual hourly rates and compare to the £30
rate used to include overhead in inventory. Also we need to ensure that hours included
on each job card appear reasonable and are consistent between similar jobs.
Information available to test this is not clear at present so further investigation will be
necessary. As for Tydaway we need to look at the nature of costs included and whether
overheads are for normal level of production.
 No obvious freight costs are included in the value at Woodtydy so we need to discuss
whether freight and other purchasing costs are included and if not, whether the effect
could be material.
 Woodtydy's inventory is also likely to include components purchased from Tydaway as
there are sales between the factories. We will need to ensure that any interdivisional
profit is eliminated in the company accounts.
 To the extent that any issues are noted with valuation of Woodtydy inventory, we will
need to consider whether there is any impact on fair values recorded at the time of
Woodtydy acquisition. In addition, we need to consider any pre-existing supply contract
between Tydaway and Woodtydy and assess whether the fair value of this needs to be
taken into account.

Provisions
We will need to do work on inventory provisions at both sites. The provision at Tydaway
appears not to have been reassessed since the last year end and looks very low compared
to the level of inventory, the slower stock turn and the provision made by Woodtydy which is
in a similar business.
It seems likely that a specific provision will be required against the finished goods made for
Swishman as the margin (11%) possible on any sales is unlikely to cover the rework costs and
may also only be able to sell repainted units at a lower price.
We also need to consider whether any contingent asset should be recognised re claim
against Swishman. Swishman has agreed to pay an immaterial amount £6,000, which prima
facie can be shown as an asset – however financial position of Swishman means it is unlikely
to be able to pay. The same consideration applies to any further amounts claimed from
Swishman and we would need to be virtually certain that the additional claim would be
upheld to meet the criteria for recognition of a contingent asset.
 We need to consider whether there is any risk of further order cancellations from other
customers.
 Old components still in stock but purchased in a prior year may also need a provision as
they are clearly very slow moving. Need to discuss this with management.
 Work done should include understanding and assessing the appropriateness of the
provisions that have been made but also considering whether the provisions are
complete. This will mean following up on potentially obsolete items noted at stock
count; considering data available which will allow us to identify slow moving items; and
looking at the margins made on individual product sales (including post year-end sales
of WIP held at year end) to determine whether there are low margin items or items sold
at a loss where a provision may be necessary.
Overhead costs which are not included in standard costs at Tydaway, selling costs and any
rework costs should all be considered in this analysis. In addition a sample of high value
items should be reviewed to ensure that there are no NRV issues, that the items are being
used in current production and that there is no excess inventory.
Work on rights and obligations (ownership) of inventory
 Testing of value will ensure agreement to valid purchase invoices. However, testing is
also required around cut-off to ensure that inventory is only included where either it has
been paid for or a creditor recorded and where the delivery was received before the
year end.
This will involve testing the last few deliveries before year end to ensure both inventory and
creditor included and the first few post year end to ensure that goods not delivered until
after year end have not been booked into year-end inventory.
 We will also need to test sales cut-off to ensure that goods shipped to a customer
before the year end are not also included in inventory. This will involve detailed testing
but also enquiry as to any goods held at year end on behalf of customers.
Consignment stock sent to subcontractors will need more consideration as highlighted
under stock count queries as this may well be owned stock not included at present.
Understatement of inventory
Much of the work outlined above will be two directional – for example the detailed sample
testing of valuation. In addition, cut-off testing will test for understatement as well as
overstatement, as will stock count work.

Work on PPV add back and freight will involve an expectation/calculation which is also
two-directional. Work on provisions will need to be extended to ensure that provisions
made are on a valid basis and not overstated.
(c) Impact of Chinese transaction on the financial statements
No hedging
In the absence of hedging there is no recognition of the purchase of the metal in the
financial statements for the year ending 31 July 20X1 as there has been no physical delivery
of the inventory, so it is unlikely that control has passed from the seller to Tydaway. The firm
commitment would not therefore be recognised.
On 15 December 20X1, the purchase takes place and the transaction would be recognised
at the exchange rate on that day at a value of £354,409 ($500,000/1.4108) as follows:
This cost of inventory (which is £44,004 greater than at the time the contract was made)
would then be recognised in cost of sales and impact on profit in the year ending 31 July
20X2.
Hedging with forward contract – but no hedge accounting
At 31 July 20X1:
DEBIT Forward contract – financial asset £20,544
To recognise the increase in the fair value of the forward contract (ie, a derivative financial
asset) and to recognise the gain on the forward contract in profit or loss.
At 15 December 20X1:
To recognise the further increase in the fair value of the forward contract (ie, a derivative
financial asset) and to recognise the gain on the forward contract in profit or loss.
DEBIT Cash £43,994
CREDIT Forward contract £43,994
To recognise the settlement of the forward contract by receipt of cash from the
counterparty.
Being the settlement of the firm commitment (ie, the purchase of inventory) at the
contracted at the spot rate on 15 December 20X1 ($500,000/1.4108).
Fair value hedge
A hedge of a foreign currency firm commitment may be accounted for as a fair value hedge
or as a cash flow hedge (IFRS 9 para 6.5.4) at the choice of the entity.
If the hedged risk is identified as the forward exchange rate, rather than the spot rate, then
it could be assumed to be perfectly effective.
The value of the transactions are as follows:
At 15 July 20X1
$500,000/1.6108 = £310,405

At 31 July 20X1
$500,000/1.5108 = £330,950
Difference = £20,545 is almost identical to the movement in the fair value of the forward at
£20,544 and is clearly therefore highly effective:
Similarly, at 15 December 20X1
$500,000/1.4108 = £354,409
Difference = £23,459 which is almost identical to the movement in the fair value of the
forward at £23,450 and therefore remains highly effective.
At 15 July 20X1:
No entries are required at this date as the firm commitment is unrecognised. The forward
contract is potentially recognised, but it has a zero fair value and there is no related cash
transaction to record.
However, the existence of the contract and associated risk would be disclosed from this
date in accordance with IFRS 7.
At 31 July 20X1:
To recognise the increase in the fair value of the hedging instrument (which is the forward
contract, being a derivative financial asset) and to recognise the gain on the forward
contract in profit or loss.
CREDIT Firm commitment £20,545
To recognise the increase in fair value of the hedged item liability (ie, the previously
unrecognised firm commitment) in relation to changes in forward exchange rates and to
recognise a debit entry in profit or loss, which offsets the profit previously recognised in
respect of the gain on the derivative financial asset (IFRS 9).
To recognise the increase in the fair value of the hedging instrument (which is the forward
contract, being a derivative financial asset) and to recognise the gain on the forward
contract in profit or loss.
CREDIT Firm commitment £23,459
To recognise the increase in the fair value of the hedged item liability (ie, the firm
commitment) and to recognise a debit entry in profit or loss, which offsets the profit
previously recognised in respect of the gain on the derivative financial asset (IFRS 9 para
6.5.13).
DEBIT Cash £43,994
To recognise the settlement of the forward contract by receipt of cash from the
counterparty.

Being the settlement of the firm commitment (ie, the purchase of inventory) at the
contracted price of $500,000 at the spot rate on 15 December 20X1 ($500,000/1.4108).
DEBIT Firm commitment £44,004
CREDIT Inventory £44,004
To remove the firm commitment from the statement of financial position and adjust the
carrying amount of the inventory resulting from the firm commitment.
Cash flow hedge
At 15 July 20X1:
No entries are required at this date as the firm commitment is unrecognised. The forward
contract is potentially recognised, but it has a zero fair value and there is no related cash
transaction to record.
At 31 July 20X1:
The increase in the fair value of the future cash flows (the hedged item) of £20,545 is not
recognised in the financial statements. However, as it exceeds the change in the fair value
of the forward (the hedge instrument) it is fully effective.
To recognise the increase in the fair value of the forward contract (ie, a derivative financial
asset) and to recognise the gain on the forward contract in other comprehensive income.
To recognise the increase in the fair value of the forward contract financial asset and to
recognise the gain on the forward contract in other comprehensive income. It is recognised
in its entirety in other comprehensive income (ie, no part is recognised in profit or loss) as
there is no ineffectiveness as the increase in the fair value of the forward contract (the
hedging instrument) is less than the change in the fair value of the future cash flows (the
hedged item) (IFRS 9 para 6.5.8).
DEBIT Cash £43,994
To recognise the settlement of the forward contract at its fair value by receipt of cash from
the counterparty.
DEBIT Purchases £354,409
Being the settlement of the firm commitment (inventory purchase) at the contracted price of
$500,000 at the spot rate on 15 December 20X1 ($500,000/1.4108).
DEBIT Other comprehensive income £43,994
CREDIT Purchases £43,994
To remove the firm commitment from other comprehensive income and adjust the carrying
amount of the inventory resulting from the hedged transaction.

(d) Discussion of financial reporting differences
Year ending 31 July 20X1
No hedge Fair value Cash flow
No hedge accounting hedge hedge
£ £ £ £
SPLOCI
Profit or loss – 20,544 20,544 –
(20,545)
Other comprehensive income – – – 20,544
SOFP
Financial asset – 20,544 20,544 20,544
Inventory – – – –
Cash – – – –
Retained earnings – 20,544 – –
Hedging reserve – – – 20,544
Firm commitment – – 20,545 –
Year ending 31 July 20X2
No hedge Fair value Cash flow
No hedge accounting hedge hedge
£ £ £ £
SPLOCI
Profit or loss – 23,450 23,450 –
(23,459)
Other comprehensive income – – – Note (2)
SOFP
Financial asset – Note (1) Note (1) Note (1)
Inventory 354,409 354,409 354,409 354,409
(44,004) (43,994)
Cash (354,409) (354,409) (354,409) (354,409)
43,994 43,994 43,994
Retained earnings – 43,994 – –
Hedging reserve – – – Note (2)
Firm commitment – – 44,004 –
(44,004)
Notes
1 The financial asset increases to £43,994 before being settled for cash.
2 Other comprehensive income and the hedging reserve each increase to £43,994
before being recycled into inventory.
Tutorial notes
The notes below are more detailed than would be expected from even the best candidates.
The purpose of hedging is to enter into a transaction (eg, buying a derivative) where the
derivative's cash flows or fair value (the hedging instrument) are expected to move wholly
or partly, in an inverse direction to the cash flows or fair value of the position being hedged
(the hedged item). The two elements of the hedge (the hedged item and the hedging
instrument) are therefore matched and are interrelated with each other in economic terms.
Overall, the impact of hedge accounting is to reflect this underlying intention of the
matched nature of the hedge agreement in the financial statements. Hedge accounting
therefore aims that the two elements of the hedge should be treated symmetrically and
offsetting gains and losses (of the hedge item and the hedging instrument) are reported in
profit or loss in the same periods. Normal accounting treatment rules of recognition and

measurement may not achieve this and hence may result in an accounting mismatch and
earnings volatility, which would not reflect the underlying commercial intention or effects of
linking the two hedge elements which offset and mitigate risks. For example, typically,
derivatives are measured at fair value through profit or loss; whereas the items they hedge
are measured at cost or are not measured at all (eg, a firm commitment in the case of the
Chinese contract).
Hedge accounting rules are therefore required, subject to satisfying hedge accounting
conditions.
In the case of the Chinese contract, the forward rate hedge attempts to lock Tydaway into
the contractual price of £310,405 ($500,000/1.6108). This reflects the US$ price at the
exchange rate at the time of the contract at the spot rate at the original contract date.
In the absence of hedging, the inventory cost would be higher at £354,409
($500,000/1.4108) reflecting the movement in the spot rate by the settlement date
(according to the scenario in the working assumptions). This would be reflected in a higher
cost of sales in the year ended 31 July 20X2 and therefore lower reported profit, due to the
exchange loss, than would have been the case with hedging.
With hedging, but without hedge accounting, the inventory would still be recognised at
£354,409, but there would now be a gain on the forward contract derivative. This overall
gain of £43,994 would be recognised through profit or loss entirely separately from the
inventory purchase contract without trying to match the two elements of the hedge
transaction in the same period. The gain on the derivative is split between the two
accounting periods according to when the gain arose (£20,544 in the year ending
31 July 20X1; and £23,450 in the year ending 31 July 20X2). The earnings therefore would
be inflated in the year ended 31 July 20X1 by the £20,544 gain. Earnings would be deflated
in the year ended 31 July 20X2 as the higher inventory cost of £44,004 in cost of sales
would only be partially offset by the derivative gain of £23,450, resulting in earnings
volatility.
Fair value hedge accounting attempts to reflect the use of the forward rate derivative (the
hedging instrument) to hedge against fair value movements in inventories arising from
foreign exchange movements (the hedged item). To do this, movements in the derivative,
in the year ending 31 July 20X1, go through profit or loss and are recognised in the
statement of financial position as a financial asset. The treatment of the firm commitment
(the hedged item), in order to match the treatment of the hedging instrument, is also
recognised through profit or loss and as a liability in the SOFP in order to avoid a mismatch.
(A firm commitment would not, in the absence of hedge accounting, satisfy normal
recognition criteria and so would not normally be recognised.) The small ineffective
element for Tydaway represents the net difference in the movements of the fair values of
the hedged item and the hedging instrument and is recognised through profit or loss in
accordance with IFRS 9 para 6.5.8. On settlement, the firm commitment is offset against the
inventory cost to reflect the inventory price that the futures contract originally tried to lock
in.
Cash flow hedge accounting attempts to reflect the use of the forward rate derivative to
hedge against future cash flow movements from inventory purchases arising from foreign
exchange movements. To do this, movements in the derivative, in the year ending 31 July
20X1, which would normally go through profit or loss, are recognised in other
comprehensive income. The other comprehensive income balance (including further
movements in 20X2 in the forward exchange derivative) is recycled to profit or loss in the
same period in which the hedged firm commitment (the Chinese contract) affects profit or
loss. (This may be regarded as superior to fair value hedge accounting as it avoids the need
to recognise a firm commitment, which would not be recognised in any other
circumstances.) In this case, this is in the year ending 31 July 20X2 when the contract is
settled and the hedging gain is recognised as part of the inventory assets (basis adjustment)

which in turn affects cost of sales and profit in the period. The offset against the carrying
amount of the inventory resulting from the hedged transaction is to reflect the inventory
price and ultimate cash flows that the futures contract originally tried to lock into.
Note that under cash flow hedge accounting, the increase in the fair value of the future cash
flows (the hedged item) of £20,545 is not recognised in the financial statements. However,
as it exceeds the change in the fair value of the forward (the hedging instrument) it is fully
effective (IFRS 9 para 6.5.11). This is because the separate component of equity associated
with the hedged item is limited to the lesser of: the gain/loss on the hedging instrument;
and the change in fair value of the hedged item (IFRS 9 para 6.5.11).
(e) Documentation
For audit purposes and to meet the requirements of IFRS 9, we would expect the following
documentation to be available:
 Details of the risk management objectives and the strategy for undertaking the hedge
 Identification and description of the hedging instrument (forward contract)
 Details of the hedged item or transaction (payable settled in $)
 Nature of the risk being hedged (exchange rate changes £:$)
 Description of how Tydaway will assess the hedging instrument's effectiveness
28 Wadi Investments
Marking guide
Marks
Report describing, explaining and quantifying required accounting treatment of:

Acquisition of Strobosch 7
Additional audit procedures 5
Change of use of asset 6
Audit procedures 5
Points for instruction letter 8
Loan to Strobosch 4
Hedging of net investment 8
Total marks 43
Maximum marks 40
Report
To: T Flode
From: A Perdan
Date: 30 July 20X9
Subject: Audit of Wadi Investment Group
(1) Audit of parent company
(a) Acquisition of Strobosch
We need to consider whether Strobosch is a subsidiary. The acquisition of an 80% stake in
the equity of Strobosch strongly suggests that Wadi has control of the entity, and provided
there are no indications to the contrary as listed in IFRS 10, Consolidated Financial
Statements the investment should be treated as a subsidiary. On this basis the purchase
consideration will be accounted for in accordance with IFRS 3, Business Combinations.

(b) Cost of investment in the books of Wadi
The cost of the investment does not appear to have been calculated correctly. IFRS 3
requires that the initial investment in the subsidiary is recorded in Wadi's statement of
financial position at the fair value of the consideration transferred.
 Under IFRS 3 costs relating to the acquisition must be recognised as an expense at the
time of the acquisition. They are not regarded as an asset. The RR23 million legal costs
and the £2 million internal costs incurred by Wadi's M&A team must therefore both be
expensed. The RR23 million should be translated at the rate ruling at the date of
acquisition.
 IFRS 3 requires that costs of issuing debt or equity are to be accounted for under the
rules of IFRS 9, Financial Instruments. The £6 million transaction costs associated with
the issue of the debentures must therefore be written off against the carrying amount
of the debentures and expensed over the life of the debentures using the IRR%.
Based on the above the investment should initially have been accounted for as follows:
£m £m
DEBIT Consideration transferred (675 + 360) 1,035
DEBIT Profit or loss for the year (2 + (23 × 0.45)) 12
CREDIT Cash (675 + 2 + 6 + (23  0.45)) 693
CREDIT Non-current liability: Debentures (360 – 6) 354
The following journal is therefore required to correct the investment:
£m £m
DEBIT Profit or loss for the year 12
DEBIT Non-current liability: Debentures 6
CREDIT Investment in Strobosch 18
At the year end, the debentures must be measured at amortised cost (W1).
 The interest expense of £16 million, determined by the IRR of 4.42%, should be
charged to profit or loss for the year.
 The coupon of 4% for the six-month period is the amount actually paid.
 The debenture is therefore recognised at £356 million.
The following adjustment is required:
£m £m
DEBIT Interest expense 16
CREDIT Cash 14
CREDIT Debenture 2
(c) Audit procedures
The following additional procedures are required:
 Details of the consideration paid for the investment should be agreed to the purchase
agreement.
 The purchase agreement should also be reviewed to determine that there is no
additional consideration to be paid.
 The number of shares purchased should be agreed to the sale agreement to confirm
the 80% holding and the details should be reviewed to determine that Wadi does have
control of Strobosch.
 Ownership of the shares should be confirmed by examination of share certificates.
 Confirm the nature of costs detailed as issue costs of the debenture to ensure that they
should not be written off to profit or loss.

 Confirm where the IRR of 4.42% has been obtained from and the basis on which it has
been calculated.
 Discuss with management the way in which the costs of the internal team have been
allocated to the acquisition to agree appropriate treatment is applied.
 Agree legal costs to invoices.
 Discuss adjustments required to the investment and the debenture with management
to determine whether they will be made.
(d) Change of use of non-current asset
IAS 40, Investment Property requires that property that is held to earn rental or capital
appreciation or both, rather than for ordinary use by the business, must be recognised as
investment property. Hence the head office in London must be reclassified from Property,
plant and equipment to Investment property in the statement of financial position.
The asset must be accounted for under IAS 16, Property, Plant and Equipment up to the
date of change in use, and any difference between its carrying amount and its fair value at
this date must be dealt with as a revaluation in accordance with this same standard.
The carrying amount of the asset at 15 March 20X9, the date of change in use, was
£108 million (W2a), hence the £16 million uplift to its fair value of £124 million at this date
should have been recognised in OCI and as a revaluation surplus.
The accounting treatment of the asset from this date is governed by IAS 40 and, as the
company applies a fair value policy to its investment property, no further depreciation
should have been charged on this asset from 15 March 20X9. At the year end, the
£4 million uplift to the new fair value of £128 million (W2a) should have been credited to
profit or loss for the year.
By continuing to record the asset in Property, plant and equipment, the asset has continued
to be depreciated and hence excess depreciation of £1 million (W2b) must be added back
to the group's profits. The revaluation surplus of £21 million (128m – 107m, W2b) has been
recognised in the revaluation reserve, meaning that profit for the year is understated by
£5 million (21m – 16m). A further adjustment must be made to recognise the gain on
remeasurement of £4 million.
(e) Audit procedures
 Agree original cost and confirm depreciation policy.
 Check that fair values have been calculated in accordance with IFRS 13.
 Check basis on which the fair values have been calculated. Current prices in an active
market should be available for this type of asset.
 Agree valuations to valuer's certificates.
 Confirm the date that the office was vacated.
 Review details of the rental agreement to confirm terms ie, occupier is not a company
connected to Wadi and rent has been negotiated at arm's length.
 Reperform calculations to confirm the net book value at the date of change of use.
 Discuss adjustments required to remove the asset from property, plant and equipment
with management to determine whether management is willing to make these.
 Confirm that disclosure is adequate ie, disclosure of the policy and a reconciliation of
the carrying amount of the investment property at the beginning and end of the
period.

(2) Audit of the consolidation
(a) Points to be included in the letter of instruction
The following points should be included:
Matters that are relevant to the planning of the work of Kale & Co:
 A request that the component auditor will cooperate with our firm.
 Timetable for completing the audit.
 Dates of planned visits by group management and our team, and dates of planned
meetings with Strobosch's management and Kale & Co.
 The work to be performed by Kale & Co, the use to be made of that work and
arrangements for coordinating efforts.
 Ethical requirements relevant to the group audit, particularly regarding independence.
 Component materiality and the threshold above which misstatements cannot be
regarded as clearly trivial.
 A list of related parties.
 Work to be performed on intra-group transactions and balances.
 Guidance on other statutory reporting responsibilities.
Matters relevant to the conduct of the work of Kale & Co:
 The findings of our tests of control of a processing system that is common for all
components, and tests of controls to be performed by Kale & Co.
 Identified risks of material misstatement of the group financial statements, due to fraud
or error, that are relevant to Kale & Co's work, and a request that Kale & Co
communicates on a timely basis any other significant risks of material misstatement of
the group financial statements, due to fraud or error, identified in Strobosch and Kale &
Co's response to such risks.
 The findings of internal audit.
 A request for timely communication of audit evidence obtained from performing work
on the financial information of Strobosch that contradicts the audit evidence on which
the team originally based the risk assessment performed at group level.
 A request for a written representation on Strobosch's management's compliance with
the applicable financial reporting framework.
 Matters to be documented by Kale & Co.
Other matters:
 A request that the following be communicated on a timely basis:
– Significant accounting, financial reporting and auditing matters
– Matters relating to going concern
– Matters relating to litigation and claims
– Significant deficiencies in internal control and information that indicates the
existence of fraud
We should also request that Kale & Co communicate matters relevant to our conclusion
with regard to the group audit when they have completed their work on Strobosch.

(b) Loan to Strobosch
The loan to Strobosch represents an intra-group item. On consolidation the non-current
liability must be cancelled against the matching financial asset of Wadi. The intra-group
loan of £200 million must be translated into RR at the spot rate. It has been recorded as a
non-current liability in the books of Strobosch at RR444 million (£200m/0.45). As a
monetary liability, retranslation to the closing rate at the year end is required to give a
liability of RR426 million (£200m/0.47) and an exchange gain in the books of Strobosch of
RR18 million.
We must confirm that the financial statements of Strobosch included in the consolidation
schedule reflect the adjustments above. We should confirm that the intra-group balances
agree and that the cancellation has been reflected in the adjustments column of the
consolidation schedule.
(c) Hedging of net investment
There is a risk that hedging provisions have been adopted inappropriately. IFRS 9, Financial
Instruments states that the use of a foreign currency loan to hedge an overseas investment
can only be used where strict conditions are met:
 The hedging relationship consists only of eligible hedging instruments and eligible
hedged items – we could seek the services of a suitably qualified expert in this field to
ensure this condition has been met.
 At the inception of the hedging relationship there is formal designation and
and strategy for undertaking the hedge.
We would need to confirm that the hedge has been formally designated as such and
check that the following have been documented:
– Identification of the hedging instrument ie, the loans.
– The hedged item ie, the net investment in Strobosch.
– Details of how hedge effectiveness is to be determined.
– Statement of the entity's risk management objective and strategy for undertaking
the hedge.
 The hedging relationship meets all of the hedge effectiveness requirements of IFRS 9,
namely (IFRS 9 para 6.4.1(c)):
instrument;
economic hedge.
Based on the information there does appear to be an economic relationship.
– The gain on the translation of the net investment in Strobosch is 80% × 41m =
£33 million (W3).
– The exchange loss on the hedging loans is £36 million.
Hence the hedge is effective and hedge accounting rules may be applied provided
that the other conditions have also been met.

Assuming the conditions have been met we must confirm that the following accounting
treatment has been adopted:
 The portion of loss on the loans that is determined to be an effective hedge,
£33 million, should be recognised directly in equity to offset the gain on the translation
of the subsidiary.
 The ineffective portion of the exchange difference on the loans, a loss of £3 million,
should be recognised in profit or loss for the year.
If we conclude that the hedging provisions of IFRS 9 have not been met an audit adjustment
will be required. The exchange loss on the loans would be charged to profit or loss for the
year and the gain on the subsidiary to the foreign currency reserve.
WORKINGS
(1) Debenture
£m
Initial measurement (360 – 6) 354
Interest for 6 months @ 4.42% 16
Coupon paid (8% × 360 × 6/12) (14)
Year end balance 356
(2) Correction of investment property

(a) Correct treatment
Date £m
3 April 20X6 Initial measurement 90
30 June 20X7 Depreciation (90 × 15/600) (2.250)
30 June 20X7 Carrying amount 87.750
Revaluation to FV 112
30 June 20X8 Depreciation (112 × 12/585) (2.297)
15 March 20X9 Depreciation (112 × 8/585) (1.532)
15 March 20X9 Carrying amount 108.171
Gain on revaluation (OCI and revaluation surplus) 15.829
15 March 20X9 Revaluation to FV 124
Gain on remeasurement (profit or loss) 4
30 June 20X9 Revaluation to FV 128
(b) Current treatment
Date £m
15 March 20X9 Carrying amount 108
30 June 20X9 Depreciation (112 × 4/585) (1)
30 June 20X9 Carrying amount 107
Gain on revaluation (to revaluation reserve) 21
30 June 20X9 Revaluation to FV 128
(3) Foreign currency reserve
£m
Opening net assets: RR1,865m @ Closing rate 0.47 877
@ Opening rate 0.45 839
38
Retained earnings:
280 + gain on loan 18 = RR298m @ Closing rate 0.47 140

@ Average rate 0.46 137
3
Gain on retranslation of Strobosch 41

29 Jupiter
Marking guide
(a) Accounting 11 Consider how each development project meets IAS 38

treatment of criteria for deferral.
development costs
Identify the inter-relationship of the two projects and
how a successful outcome of the engine project could
shorten the useful life of the fuel converter.
Calculate the impairment loss on the conversion device
development costs based on the cash flow forecast.
Identify the implications of the competitor's
development activity for the useful life and carrying
value of Jupiter's intangibles.
Identify the risk of the bank foreclosing on its funding
and how this may result in the write off of all
development costs.
Highlight how the combination of factors may bring
Jupiter's going concern into doubt.
(b) Audit issues 11 Identify practical lines of inquiry to discuss with
directors.
Demonstrate professional scepticism towards directors'
assertions.
Assess the possibility of mitigating factors such as the
existence of patents or other legal rights.
Identify how the work of internal audit could be
relevant, and discuss the procedures required to
evaluate whether the procedures of internal audit can
be used.
Demonstrate how the risks relating to going concern
should be explored.
Assimilate information that indicates an overall risk of
creative accounting.
(c) Professional and 4 Identify ethical and legal implications of industrial
ethical implications espionage to the company.
Demonstrate awareness of how the lack of integrity of
directors affects the auditor's position.

(d) Audit of trade 12 Identify practical alternative forms of evidence in face

payables of the inability to obtain confirmation or statements
from Myton.
Recognise the risk of dependence on Myton as a
supplier.
Identify the potential implications of the retention of
title clause.
Identify the risks arising from the non-replacement of
the clerk.
Demonstrate understanding of the risks relating to
overseas suppliers.
Identify practical level of testing for the other balances.
Recognise the implication of debit balances and the
increasing level of goods received not invoiced.
Total marks 38
Maximum marks part (a) 10
Maximum marks part (b) 9
Maximum marks part (c) 3
Maximum marks part (d) 8
Maximum marks 30
MEMORANDUM
To: Jane Clarke, audit manager
From: Audit senior
Re: Jupiter Ltd – Development costs
Date: 15 January 20X9
I set out below my analysis of the position on the ongoing capitalisation of development costs.
There are also some associated professional and ethical issues which we will need to consider.
These have implications for our evaluation of inherent risk at the global level as well as at the
level of development costs. We may have to consider our position with respect to the
continuation of this appointment.
(a) Treatment of development costs
The key audit issue is the risk of overstatement of intangibles due to the inappropriate
recognition of development costs in the statement of financial position. There are two
issues for Jupiter Ltd concerning accounting for development costs.
(1) The device to convert vegetable oil to diesel was launched in 20X7. The development
costs were capitalised and are being amortised on a straight line basis over eight years.
There is a carrying amount of £3 million in the statement of financial position.
(2) A car engine, which runs on unconverted vegetable oil, is under development. Costs of
£6 million were capitalised in 20X7 and further costs of £2 million that were incurred in
20X8 have been capitalised.

Costs relating to internally developed intangible assets can only be capitalised when they
are incurred during the development phase of the project. According to IAS 38, the
development phase of a project occurs when the entity can demonstrate all of the
following:
 Technical feasibility of completing the asset so it will be available for use or sale
 Intention to complete the intangible asset and use or sell it
 Ability to use or sell the intangible asset
 How the intangible asset will generate probable future economic benefit
 Availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset
 Ability to measure reliably the expenditure attributable to the intangible asset
Research phase costs must be expensed, as should development costs which do not
comply with the above criteria.
The vegetable oil conversion device
Even ignoring the threat posed by the competitor's new car engine, Jupiter's plan to launch
its own new engine is, in itself, a threat to the estimated commercial lifespan and viability of
the conversion device.
IAS 36, Impairment of Assets requires assets to be carried in the financial statements at no
more than their recoverable amount, which is the higher of their fair value less costs to sell
and their value in use. If there is any indication that the asset may be impaired, the
recoverable amount should be calculated. Should the recoverable amount of the asset be
lower than the carrying amount, the carrying amount must be written down to the
recoverable amount. The impairment loss should be recognised immediately in profit or
loss.
In the case of the conversion device technology, it is not possible to calculate the fair value
less costs to sell. However, the internal auditors' forecast provides a basis for determining
the likely amount of impairment loss. It should be noted that the additional threat posed by
the competitor has not been taken into account here. We will also need to consider
whether the work of the internal auditors can indeed be relied upon (see 'Professional and
ethical implications' section below).
Discounted future
Year Future cash flows PV factor at 15% cash flows
£'000 £'000
1 770 0.86957 670
2 700 0.75614 529
3 520 0.65752 342
4 350 0.57175 200
5 330 0.49718 164
1,905
The cash flow from the sixth year has not been taken into account. IAS 36 requires a
maximum of five years to be covered when calculating value in use, unless a longer period
can be justified.
Based on this working, the recoverable amount for the asset is £1.9 million, lower than its
carrying amount of £3 million. This suggests that the capitalised development costs related
to the conversion device should be written down, and an impairment loss of £1.1 million
recorded. It is worth noting that a larger impairment loss may be required, as the
competitor's new engine may further reduce the market for the conversion device.

In addition to the impairment, the launch of the car engine may have the effect of reducing
the expected useful life of the asset. Any change in the estimated useful life of the device to
convert the oil should be accounted for as a change in accounting estimate in accordance
with IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. For example, if
the development costs are determined to have a shorter useful life after the introduction of
the alternative car engine, the carrying amount should be written off over the current and
remaining years. This will result in a revised amortisation charge for the period, over and
above the impairment charge.
The vegetable oil burning engine
If the rival company does launch its new engine, then it is possible that Jupiter's engine will
be unsuccessful. Jupiter might decide not to keep developing their product and, even if
they do continue, demand could be lower than expected.
This raises the risk that the capitalised car engine development costs may be carried at
greater than the recoverable amount, and that an impairment should be reflected in the
financial statements. The capitalised development costs may need to be written down if the
demand for the product is expected to be lower than planned.
Alternatively, if Jupiter decides to discontinue the development of the engine, the
£8 million will need to be written off and expensed to profit or loss. This would likely be the
case if the launch of the competitor's product makes the new car engine no longer
commercially viable.
A full write-off would also be required if Jupiter no longer have funds available to continue
with the development. For example, given the level of Jupiter's borrowings and the bank
covenant in place, the bank may withdraw its funding. That would mean that there would no
longer be adequate resources to complete the development of the engine.
Conclusion
Further audit procedures will need to be performed before we can reliably quantify the
amount of adjustment required to the financial statements.
The writing down of the conversion device development costs due to impairment is almost
certainly required, unless management can provide reliable evidence otherwise. The
impairment or full write-off of the car engine development costs needs to be determined.
At this stage, it would seem that the adjustment required in relation to the value of the
capitalised development costs is between £1.1 million (impairment to the conversion
device costs only) and £11 million (full write-off of all development costs). Even if only the
conversion device costs require writing down, this is likely to be material to the financial
statements.
We will also need to consider whether the company is in fact a going concern, given the
gearing-based bank covenant in place.
(b) Audit issues and evidence
The prospects for both projects must be discussed with management. It may be that they
have a valid reason to believe that the diesel device project has not been impaired and that
the expenditure on the new engine still meets the criteria for a development project.
Diesel conversion device
We will need to make enquiries of management to understand:
 their assessment of the viability and expected useful life of the conversion device, in
the light of the threat posed by the competitor's new engine; and
 their rationale for not writing down the capitalised development costs in spite of the
evidence of impairment provided by the cash flow forecast produced by the internal
auditors.

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

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

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

(5) Going concern indicators
We will need to remain alert to the issue of going concern throughout the audit. The
company has borrowed heavily to finance the development projects and it is possible
that Jupiter will be in default of the bank loan covenant. Trade payables have increased
by 25% which may be indicative of problems with cash flow. A major supplier has
introduced a reservation of title clause which may indicate a lack of confidence in
Jupiter's ability to settle liabilities.
30 Poe, Whitman and Co

Commedia Group
Background comments
The scenario in this question considers an independent television production company. At the
beginning of the period the company had two subsidiaries but it disposed of its majority
shareholding in one of these companies during the current year for an amount which included a
contingent consideration element. Other issues raised include: taking over from the previous
auditor who had resigned late into the relevant accounting period; changes in the funding basis
for commissioned productions; a provision in the company which is the subject of the partial
disposal; and possible impairment in the other subsidiary.
Candidates were required to identify audit risks and draft the audit procedures to mitigate these
events. They were also required to advise on financial reporting matters raised by a director.
The solution below provides significant detail, but it is sufficient for a good quality answer, that
would obtain a clear pass mark, to provide concise explanations of the following:
 Clear identification of the ethical issues of taking over from a resigning auditor and the
practical issues of late appointment, including the possible inability to obtain sufficient
appropriate audit evidence (limitation of scope) that may arise as a consequence of not
being in office for the entire accounting period.
 Identification of the risk and implications of the shift from a 'funded commission' to a
'licensed commission' basis and an explanation of the associated audit work.
 Regarding the Scherzo subsidiary, there should be a clear identification of the valuation and
financial reporting risks associated with partial disposal. There should be particular
emphasis on the incentives given to directors to creatively account given the nature of the
contingent consideration contractual terms. The risks arising from the provision should also
be identified and explained together with the associated audit work.
 Regarding the Riso subsidiary, the key issue of impairment should be identified, quantified
and explained. This should include the appropriate financial reporting treatment.
Client: Commedia Group

(a) Practical and ethical issues arising from late appointment
The unexpected resignation of the previous auditor could be as a result of an ethical or
other professional issue identified by that auditor. We must have already ensured that there
were no such issues preventing us from accepting the appointment as we have already
been appointed.
We must have checked, prior to accepting the appointment, that adequate professional
clearance has been obtained from the previous auditor and that there are no matters of
which we should be aware.

We need to discuss the late resignation with the directors of Commedia to ensure there are
no matters such as a disagreement with the auditors that would have adverse implications
for our firm's audit.
Before carrying out any work for Commedia we must ensure that satisfactory client
identification procedures have been performed (money laundering regulations).
We were not appointed as auditor until after the year end. Therefore, we may not be able to
assess adequately the stage of completion of the various commissions at 28 February 20X7
and the value of work in progress at that date. If there are no other audit procedures that we
can carry out to gain sufficient audit evidence as to the value of work in progress at the year
end, we may conclude that the audit opinion will have to be modified. If the possible errors
are considered to be material, this may result in a qualified opinion ('except for'). If the
potential effect is pervasive, we may have to issue a 'disclaimer' of opinion.
As the auditors of Scherzo, we will have access to confidential information which would be
of use to Commedia in assessing the probability of contingent consideration. This presents
us with a conflict of interest. We need to ensure that there are adequate procedures in
place within our firm to ensure that confidential information cannot be passed from one
company to the other. Staffing a separate team for the Scherzo audit is probably not
feasible as we remain responsible for the Commedia group audit and Scherzo probably
remains as an associate company. The potential conflict of interest must be disclosed to
Commedia's audit committee. It may be necessary to arrange independent partner reviews
of the Commedia group and Scherzo audit files.
(b) Auditor's responsibilities for initial engagements
The auditor must obtain sufficient appropriate audit evidence that the opening balances do
not contain misstatements that materially affect the current period's financial statements.
The auditor must obtain evidence that the prior period's closing balances have been
brought forward correctly to the current period or have been restated, if appropriate. The
auditor should also obtain sufficient appropriate audit evidence that appropriate
accounting policies are consistently applied or changes in accounting policies have been
properly accounted for and adequately disclosed.
If this evidence cannot be obtained, the auditor's report should include a modified opinion
(inability to obtain sufficient appropriate audit evidence) or a disclaimer of opinion.
If the opening balances contain misstatements that could materially affect the current
period's financial statements the auditor must perform additional procedures to determine
whether this is the case. If the auditor then concludes that misstatements do exist in the
current period's financial statements, the auditor should inform the appropriate level of
management and those charged with governance (ISA 510.7). The auditor should also
request that the predecessor auditor be informed (ISA 710.18). If the effect of the
misstatement is not properly accounted for and disclosed, a qualified or adverse opinion
will be expressed.
If the current period's accounting policies have not been consistently applied to the
opening balances and the change not accounted for properly and disclosed, a qualified or
adverse opinion will be expressed.
If the prior period's auditor's report was modified, the auditor should consider the effect of
this on the current period's accounts. If the modification remains relevant and material to
the current period's accounts then the current period's auditor's opinion should also be
modified.
The auditor must obtain sufficient appropriate audit evidence that the comparative
information meets the requirements of the applicable financial reporting framework.
Auditors must assess whether:

 the accounting policies used for the comparative information are consistent with those
of the current period or whether appropriate adjustments and/or disclosures have
been made; and
 the comparative information agrees with the amounts and other disclosures presented
in the prior period or whether appropriate adjustments and/or disclosures have been
made. In the UK this will include checking whether related opening balances in the
accounting records were brought forward correctly.
If the auditor becomes aware of a possible material misstatement in the comparative
information while performing the current period audit, then additional audit procedures
should be performed to obtain sufficient appropriate audit evidence to determine whether
a material misstatement exists.
An Other Matter paragraph should be included in the auditor's report in the case of the
prior period financial statements not having been audited at all, or having been audited by
another auditor. This is irrespective of whether or not they are materially misstated, and
does not relieve the auditor of the need to obtain sufficient appropriate audit evidence on
opening balances.
(c) Audit risks arising from specific events during the year
(1) Commedia Limited
Changes from a funded to a licensed basis
During the year ended 28 February 20X7 a number of the company's commissions
changed from a funded to a licensed basis. This has the following implications for our
audit:
 A funded commission entitled Commedia to invoice their customer in instalments
as the production progressed. Under the terms of a licensed commission,
Commedia must wait until the programme is delivered before they can invoice.
This may cause cash flow shortages for the company which, if not addressed
through the securing of alternative funding, may cause going concern issues.
Licensed commissions generally attract a lower fee from the commissioning
broadcaster (due to the smaller bundle of rights attached to them). The costs of
making the programmes are, however, likely to remain the same, which again will
have a probable negative impact on company cash flow and profitability in the
short term.
 The cost of making a licensed commission sometimes exceeds the value of the
invoice to the broadcaster. Where the cost of making the programme exceeds the
value of the licensed commission payment, the difference is carried forward as an
intangible asset. The estimation of future revenues from residual rights is an area
of uncertainty with which Commedia's management may not be familiar.
 We will need to examine work in progress carefully as this is likely to be a material
area. We will need to examine the contracts with broadcasters to ensure the
correct treatment. However, under IFRS 15, Revenue from Contracts with
Customers, costs incurred in relation to satisfied or partially satisfied performance
obligations (ie, costs related to past performance) must be expensed as they are
incurred. Therefore, once a performance obligation starts being performed, the
costs will be written off to the income statement as they are incurred
(IFRS 15 para 98).

Audit procedures
With respect to licensed commissions, where the costs exceed the initial fee from the
originating broadcaster we should consider the following:
 Examine a sample of the new licensed commission contracts to ensure the
company is accounting for them in accordance with their terms.
 Discuss with management the rationale for carrying costs forward where they
exceed the value of the broadcaster's payment under the terms of the licensed
commission as they may need to be expensed instead.
 We need to examine management's estimates of future revenues for a sample of
such contracts to ensure these exceed the costs carried forward.
 We should obtain documentation supporting the estimates of future income
where possible. This will include sales programmes.
– Any sales contracts for the exploitation of the rights to the programmes made
to other broadcasters.
– Agreements to make sales or the progress of negotiations to sell
programmes.
– Any evidence of the popularity of the programme with the originating
broadcaster.
Reviews of these factors should continue up to the date the financial statements are
authorised for issue.
We should review Commedia's cash flow forecasts to identify the new funding
requirements, if any, arising from the change from funded to licensed commissions.
This change in production funding should be discussed with management to assess
their view on its impact on the company's cash flow. Where gaps in funding are
identified, discuss with management to assess what steps they have taken to fill them.
We also need to ensure management have considered the going concern status of the
company for the foreseeable future.
Disposal of Scherzo
The disposal by Commedia of part of its investment in Scherzo during the year also has
audit risk implications. The sales proceeds should include any contingent
consideration payable even if, at the date of acquisition, it is not deemed probable that
it will be paid. Bob Kerouac of Commedia has requested advice on the accounting
treatment of the disposal in the financial statements. This shows he is unfamiliar with
such items and so increases the audit risk as this may have been accounted for
incorrectly. We need to examine the sale and purchase agreement for the disposal of
the shares in Scherzo to ensure that the disposal has been accounted for in accordance
with its specific terms, particularly to ensure that the transaction results in a loss of
control. We should also:
 reperform management's calculation of the profit or loss on disposal of the shares
to ensure it is accurate;
 review Scherzo forecasts as prepared prior to sale to support contingent
consideration element;
 review management's calculation of the fair value of the remaining investment in
Scherzo and check that any revaluation gain is included in the calculation of the
gain or loss on disposal;
 review Scherzo year end financial statements (as provided by Commedia only and
not as obtained in our capacity as auditor of Scherzo) and assess whether the
amount of contingent consideration recognised is appropriate;

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

Specific areas where management may seek to manipulate profits are as follows:
Collapsed stage
Provisions in connection with the collapsed stage. This is likely to be treated as an
exceptional item and therefore excluded from the calculation of pre-tax profit for these
purposes. However, management have an incentive to:
 classify some of the costs associated with the incident as 'normal' operating
expenses and so suppress the pre-tax profit figure used in the calculation of
contingent consideration; and
 overstate any elements of the provision which are not to be classified as
exceptional or understate any that would be classified as exceptional.
Aside from the issue of the contingent consideration, the issue of the collapsed stage
itself represents an audit risk in that the provision for costs associated with the incident
may be misstated at the year end, particularly the provision for any potential litigation
from members of the crew and general public. If the company is found to have been
negligent, this may result in criminal implications for the company which may have
going concern implications for the financial statements. The incident will have no
doubt caused adverse publicity for the company which may adversely affect
attendance at future events staged by the company.
A key issue is the role of Highstand to whom Scherzo subcontracted the erection of the
stage. There may be a contingent asset in respect of Scherzo taking litigation against
Highstand. This would, however, be an issue of disclosure rather than recognition.
There should be no set-off between the potential provision and the contingent asset.
The question of the probability of success of the litigation against Scherzo needs to be
considered. If it is possible, rather than probable, then this needs to be disclosed as a
contingent liability rather than recognised as a provision. This is a question of fact but
also some legal judgement may be needed.
No provision can be made in respect of anticipated future operating losses arising
from the reputational effects of the accident.
Audit procedures
 Request management provide you with a reconciliation of costs incurred on this
exceptional item, reconciling the charge in profit or loss with the closing provision
in the statement of financial position. This will enable you to ensure all costs have
been appropriately recognised and measured.
 Review legal documentation for the claims being made and the possibility of a
counter claim against Highstand.
 Inspect insurance documentation to assess the extent that any liability may be
covered by insurance.
 Evaluate any correspondence with insurers over whether any claims would be fully
covered.
 Inspect any correspondence with the injured parties directly regarding any
evidence of the fact, nature and amount of any claims. Examine the level of
complaints from customers and request to see any additional undisclosed
correspondence threatening litigation.
 Inspect any correspondence with Highstand directly regarding any evidence of
the fact, nature and amount of any claims and the ability of Highstand to pay any
claim (eg, whether they have insurance cover).
 Consider speaking or corresponding directly with the company lawyers to assess
the extent, and the probability of success, of legal proceedings.

 Obtain written representations from management on the level of claims included
within the financial statements and review any payments made in respect of the
incident both before and after the year end.
 Assess impact on company's reputation from a review of reports in the media.
Directors' emoluments
Directors' emoluments exceeding £350,000 are to be excluded from the calculation.
Management may seek to report a lower emoluments figure by excluding benefits in
kind or use share based payments according to IFRS 2. Only those emoluments over
£350,000 are to be excluded, therefore management may defer payment of a portion
of their salary below this figure until the following year in order to reduce pre-tax profit.
Similarly, any bonuses to which the directors are entitled may not be provided for by
management, or may be deferred or waived for this year.
Audit procedures
The major issue with respect to the directors' emoluments is their impact on the
contingent consideration. The key risk therefore is the extent to which directors'
emoluments are understated below the benchmark of £350,000 in year to
28 February 20X7. Audit tests should therefore focus on this shortfall risk and may
 Assess whether there is a clear definition of 'directors' emoluments' in the
contingent consideration contract. Areas of doubt may be the following:
– whether they are determined for the purposes of the contract on a normal
IAS 19 accruals basis;
– whether bonuses are included;
– whether share-based payments are included and if so whether they are
measured for the purposes of the contract on an IFRS 2 basis;
– assess the treatment under the contract of any other payments to directors
(eg, pension payments); and
– whether any actions by the new Scherzo directors are forbidden under the
contract (eg, waiving or deferring emoluments).
 Obtain a list of all directors and verify that both executive and non-executive
directors are included in the contract.
 Ascertain from the contract that all directors are included (ie, anyone who was a
director at any time during the year).
 Attest all payments made and owing to directors at any time during the year.
 Confirm that payments to the directors in the pre disposal period are included.
 Review the contract for any other terms relevant to the determination of directors'
emoluments for the purposes of determining the contingent consideration.
 Compare the level of emoluments with prior years to review whether they are
likely to be understated, particularly benefits in kind.
 Examine directors' service contracts to ensure emoluments are in line with these
and that any bonus entitlements have been provided appropriately.
Other audit procedures
We need to pay particular attention to revenue and purchases cut-off in Scherzo to
ensure profits are not understated. Any new provisions should be examined in detail to
ensure they are fairly stated and presented. Similar tests should be carried out with
respect to impairments.

The purchase by management is likely to have been funded by external debt or equity
coming into Scherzo. If they are made available to us, examine the agreements for any
such funding to ensure appropriate treatment in the financial statements. We need to
assess the ability of management to fund any contingent consideration element, as any
issues here could have implications for Scherzo's future activities. The debt element of
any external funding introduced into Scherzo will need to be serviced. This will place a
cash flow strain upon the company and therefore we need to assess both short and
medium term serviceability of this debt (eg, from review of cash flow forecasts) to
ensure there are no adverse going concern implications for the company.
(3) Riso Limited
The company has lost a major customer accounting for approximately 35% of its
revenue. It has not as yet been able to find a suitable replacement customer for this
lost studio time. This is partly due to a surplus of studio space within the UK which is
likely to make it harder for Riso to fill the spare capacity within the studio. This gives
rise to a going concern risk for Riso if its losses continue.
The loss during the year ended 28 February 20X7 and forecast cash outflows for the
next two years indicate that the value of the television production equipment may be
impaired at 28 February 20X7. Its carrying amount at that date was £5.6 million (£8m –
(£8m – £2m) × 4/10) which was well in excess of its fair value at that date of £4 million. It
is therefore necessary to carry out an impairment review to determine whether the
value of the equipment needs to be written down. If this is not adequately done, there
is a risk of overstatement of non-current assets in the financial statements.
Audit procedures
Given the loss of a major customer during the year, we should assess the
reasonableness of the preparation of the financial statements on a going concern
basis. This will include discussions with management, review of profit and cash flow
forecasts, and examination of new contracts to ascertain whether the surplus capacity
in the studio has been filled post year end.
We need to carry out a review of the client's impairment review on the television studio
equipment. This will include the following procedures:
 Obtain a copy of the recent valuation of equipment and agree to the review.
 Evaluate the estimate of future cash flows prepared by management, ensuring
they are based upon reasonable assumptions.
 Evaluate the calculations of the possible impairment, including an assessment of
whether the pre-tax discount factor used is reasonable.
 Confirm any impairment identified is appropriately accounted for and disclosed in
the financial statements.
Notes in response to Bob Kerouac's email
Disposal of shares in Scherzo Limited
On disposal the assets and liabilities of Scherzo (including the goodwill) should be
derecognised and the fair value of the consideration recorded. The remaining
investment in Scherzo should be recognised at its fair value on the date the control was
lost (30 April 20X6). Where there are any assets held at fair value with movements as
part of other comprehensive income then these other comprehensive income amounts
need to be transferred to retained earnings or profit or loss. Any resulting difference is
recorded in profit or loss and would be likely to be recognised as an exceptional item.
After the disposal, Scherzo is no longer a subsidiary but rather an associate company
of Commedia. It will need to be accounted for in the consolidated financial statements

under the equity method of accounting. This involves including the fair value of the
30% retained interest in Scherzo on the date control was lost plus 30% of its retained
earnings since that date in the group's consolidated statement of financial position.
Television production equipment in Riso Limited
The company's loss in the year ended 28 February 20X7 and anticipated future losses
indicate that the television production equipment may be impaired under IAS 36. An
impairment review therefore needs to be carried out. This involves a comparison of the
carrying amount of the television production equipment in the financial statements (net
book value) at 28 February 20X7 with its recoverable amount. For these purposes,
recoverable amount is defined as the higher of (1) the fair value less costs to sell and
(2) the value in use. The fair value less costs to sell is (per IFRS 13) the price that would
be received to sell the equipment and other net assets (£4 million plus £0.25 million) in
an orderly transaction between market participants at the measurement date, and
value in use equals the present value of expected future cash flows from the cash
generating unit ('CGU') where the impaired assets exist. These cash flows should be
discounted at a rate the market would expect for an equally risky investment. If the
carrying amount is higher than the recoverable amount, the difference should be
written off in profit or loss for the year.
Because Riso's sole activity is the operation of the television studio, it can be
considered a CGU in itself. From the information given to us by management the
calculation will be as follows:
At 28 February 20X7:
Carrying amount of net assets – Equipment £5.6m (£8m cost less £2m estimated
disposal proceeds = £6m. Depreciation for four
years is therefore £2.4m on the depreciable
amount of £6m)
– Other net assets £0.25m
– Total £5.85m
Fair value less costs to sell – Equipment £4.0m
– Other net assets (assumed) £0.25m
– Total £4.25m
Value in use – cash flows Before discount £m After discount £m
Year 1 (0.1) (0.091)
Year 2 (0.05) (0.041)
Year 3 0.9 0.676
Year 4 1.375 0.939
Year 5 1.495 0.928
Year 6 2+1.695 2.086
Total discounted value in use 4.497
It is assumed all cash flows occur at year ends.

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

31 Precision Garage Access
Marking guide
Marks
Carry out revised analytical procedures identifying any unusual patterns 18

and trends in the data which may require further investigation.
Outline the audit risks that arise from the patterns and trends identified in 8
the analytical procedures and set out the audit procedures you would
carry out.
Set out the financial reporting issues that arise from the above audit work. 8
Outline impact on profit of share option schemes and explain reasons for 8
differences.
Total marks 42
Maximum marks 30
To: Gary Megg, Audit Manager

From: A. Senior
Date: 26 July 20X6
Subject: PGA audit
(1) Analytical procedures
(a) Statement of profit or loss and other comprehensive income (in £'000)
9m to 9m to
30.06.20X6 30.06.20X5
Revenue: Note 1
Monty 7,500 9,600
Gold 14,000 28,800
Cost of sales: Note 2
Monty (6,700) (7,800)
Gold (15,500) (23,400)
Gross (loss)/profit (700) 7,200
Fixed administrative and distribution costs (1,200) (1,200)

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

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

Monty
9,000 units × £840 = £7.56m
The actual revenue for sales of Monty is £7.5 million which is extremely close to the
predicted level and therefore provides some assurance.
Gold
6,000 units × £2,520 = £15.12m
The actual revenue for sales of Gold is £14 million which is a difference of 7% and may
represent a risk of material understatement of sales (eg, through significant and
inappropriate discounting of sales, or errors in recording of sales).
Audit work
 Confirm the accuracy of the source data provided by Claire which was used to
make the predictions in the analytical procedures.
 Agree standard prices to price lists and time of price change.
 Test standard prices against sample of invoices.
 Compare inventory records with inventory count information or continuous
inventory records.
 Enquire whether significant discounts have been given which may explain the
shortfall. Determine conditions for discounting and relevant authorisation
enquiries from invoice sample.
 70% of sales are overseas and denominated in euro. The standard price is fixed in
euro at the beginning of the year as equivalent to the pound, but exchange rate
movements during the year may have caused a change. As a consequence, the
actual revenue may have moved out of line with the predicted revenue based in
pounds. Review exchange rate movements and confirm whether the translation is
at the actual or average £/€ exchange rate. (This test also applies to each category
of cost.)
2 Cost of sales
Cost of sales of the Monty declined by 14%.
Cost of sales of the Gold declined by 34%.
Using the quantity data provided by Claire, a significant fall in cost of sales would have
been anticipated due to reductions in total variable costs. The reduction in cost of sales
would however be expected to be smaller in percentage terms than the reduction in
revenues as this is a manufacturing company and hence some costs are fixed. This
fixed element of costs does not change despite the fall in volumes.
The predicted values of cost of sales are:
Monty
(£4m × 9/12) + (9,000 units × £840 × 50%) = £6.78m
The actual cost of sales of Monty is £6.7 million which is extremely close to the
predicted level and therefore provides some assurance.
Gold
(£12m × 9/12) + (6,000 units × £2,520 × 50%) = £16.56m
The actual cost of sales of Gold is £15.5 million which is a difference of 6.4% and may
represent a risk of material understatement of cost of sales if the understatement is due
to errors and omissions. It is not clear from the data whether the cost saving arises from
lower variable cost per unit or fixed costs savings but this requires further investigation.

Audit work
While the percentage difference is smaller for cost of sales than for revenue it may be
more concerning as exchange rates do not appear to be an explanatory factor as
manufacturing is in the UK. However, installation costs and the sales network are
incurred in euro so the exchange rate effect is not entirely to be ignored. As cost of
sales and revenues are both lower than anticipated this may be a consistent
explanation.
 Agree the total fixed costs being incurred against budget assumptions.
 Review the method of allocation of fixed production costs as given the seasonal
nature of the business then if the allocation is on a time basis, rather than a normal
usage basis, this may distort the costs allocated to cost of sales and inventory.
 Similarly, the large fall in volumes compared to previous years may not represent a
normal usage basis in allocating fixed production costs to units of output.
 An alternative explanation for the difference in costs may be that there are fewer
economies of scale arising from the smaller production runs from the lower
volumes. Variable cost per unit may therefore have risen.
 As we are relying on budget data, review of the budgeting process and its historic
accuracy.
A key audit concern is that the analysis implies there is a risk that revenue and cost of
sales of the Gold may both be materially understated.
Gold based on results for nine months to 30 June 20X6
£'000
Actual gross loss (1,500)
Revenue difference 1,120
COS difference (1,060)
Imputed loss from analysis (1,440)
Overall the possible indicated misstatement in overall profit or loss is quite small at
£60,000 as the two differences are largely compensatory. Nevertheless individually
they are of concern and need investigating.
Summary analysis
There has been a 25% reduction in sales volumes of Monty and a 50% reduction in
sales volumes of Gold compared to the nine month period last year. Given the high
fixed costs, the cost of sales has not fallen in line with revenues and a gross loss has
been made.
As the business is seasonal, further losses are anticipated in the fourth quarter as
revenues will be low and fixed costs will be high, being recognised on a time basis.
3 Staff bonus
The full year bonus is potentially £600,000. An accrual of 9/12 of this amount (ie,
£450,000) appears to have been made for the three quarters interim accounts.
However this is not appropriate as the business is seasonal as: "sales volumes in the
final quarter of the year ending 30 September 20X6 are expected to be the same as
the final quarter of the year ended 30 September 20X5."

On this basis revenue will be:
£'000
Y/e 30 Sept 20X5 (10,400 + 31,200) 41,600
9 months to 30 June 20X5 (9,600 + 28,800) (38,400)
Final quarter y/e 30 Sept 20X5 3,200
Final quarter revenue adjusted for 5% price increase 3,360

9 months to 30 June 20X6 21,500
Projected revenue y/e 30 Sept 20X6 24,860
This is lower than the £26 million threshold thus the bonus should not be recognised.
(See financial reporting below.)
Tutorial note
The forecast revenue for the final quarter to 30 Sept 20X6 can also be calculated as
follows:
Sales volumes expected in the quarter to 30 September 20X6 (in units)
Monty (13,000 – 12,000) 1,000
Gold (13,000 – 12,000) 1,000
Total revenue expected in the final quarter = (1,000  £840) + (1,000  £2,520) =
£3,360,000
Audit work
Review the sales budgets for the final quarter up to the year end to evaluate whether
the threshold level of sales to trigger the bonus has been achieved. For the final audit
this figure will be known but for the purpose of reviewing the interim financial
statements a combination of the latest actuals and the budget would be needed.
Inspect the terms of the bonus agreement and of any announcement or other
undertakings with staff to determine the possible payment of the bonus.
(b) Statement of financial position
 Receivables
9 months to 30 June 20X6
Receivables days = (2,400/21,500) × 270 days
= 30 days
= 30 days
Y/e 30 September 20X5
= 8.7 days
Superficially it may seem that receivables have fallen substantially from June 20X5 to
June 20X6, from £4.3 million to £2.4 million. On closer inspection however the
reduction is in line with the fall in sales and the receivables days are more or less the
same.
Conversely, it may seem that receivables at 30 September 20X5 are very low using the
calculation of 8.7 days. However receivables reflect sales in the most recent month(s)
before the statement of financial position is drawn up, rather than the average for the
year. Given the seasonality of PGA, the final quarter sales are low and therefore the
year end receivables are expected to be low.

 Inventories
Superficially it may seem there has been little movement in inventories and thus it is
low risk. However, the inventory days show significant movement:
Inventories days = (3,500/22,200) × 270 days
= 43 days
Inventories days = (3,500/31,200) × 270 days
= 30 days
The significant increase in inventory days shows that inventory remained constant but
the expectation was that it should have fallen as the cost of sales has reduced through
a lower level of commercial activity.
Audit work
Analytical procedures show a low level of risk for receivables as the receivables days
(30 days) is consistent both with the previous period and with the credit terms
extended.
Inventories are more concerning as we would have expected them to fall and they
have not. The key tests are to look at older inventory to see if there is a problem with
quality, settlement or ability to sell.
It may also be worth looking at whether there has been a large increase in finished
goods (eg, cancelled orders). If this is the case, then a write-down of such inventories
should be considered.
Financial reporting issues
Revenue
There is a risk from the revenue recognition policy as it may not be appropriate to
record the sale of garage doors until the installation is complete unless the two
elements are separable.
Foreign currency translation
According to IAS 21 sales should be translated at the date of the transaction (or the
average rate as an approximation). Given that sales are seasonal in the full year then
there is a risk that the average rate may not be at an appropriate rate.
Staff bonus
The bonus should only be recognised according to IAS 37 and 34 when there is a
constructive or legal obligation to make a payment. In this case, the full year's revenue
on which the bonus is based is expected to fall below £26 million in the full year (see
note 3 above) thus no bonus should be recognised in the interim or the final full year
Impairments of PPE
The Gold product looks to be performing poorly in making losses and the estimate is
that "sales of Gold doors are not expected to increase in the foreseeable future".
Gold doors production seems likely to be a cash generating unit as the assets to make
the Gold doors are separately identifiable from the Monty assets. Similarly, the revenue
streams are also separately identifiable.
As a consequence the value in use of the PPE used on the Gold production line (and
other PPE specifically associated with the Gold product) seems likely to be low.

Also the fair value less costs of disposal also seem to be low as the "production
equipment is specialised and highly specific to each of the separate production
processes".
In such circumstances the sharp downturn in Gold sales could represent an impairment
event and therefore an impairment review of the Gold assets should be carried out.
Receivables
The amount for receivables is a monetary asset and so should be translated at the year
end exchange rate.
If bad debts are increasing then an impairment charge should be considered.
(2) Response to David May's request
Proposal A – equity settled
Equity
Scheme Computation of annual expense for each Expense impact
commencing scheme each year each year
£ £
01.10.20X6 600  £8  1/3  (80 – [3  10]) 80,000 80,000
01.10.20X7 600  £10  1/3  50 100,000 100,000
01.10.20X8 600  £12  1/3  50 120,000 120,000
Year Year Year

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

Scheme commencing 01.10.20X6
Year ending
30 September Expense Liability
£ £
20X7 (600  £10  1/3  50) 100,000 100,000
20X8 (600  £12  2/3  50) – £100,000 140,000 240,000
20X9 (600  £14.4  3/3  50) – £240,000 192,000 432,000
Year ending
£ £
20X8 (600  £12  1/3  50) 120,000 120,000
20X9 (600  £14.4  2/3  50) – £120,000 168,000 288,000
Year ending
£ £
20X9 (600  £14.4  1/3  50) 144,000 144,000

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

Year Year Year
30.09.20X7 30.09.20X8 30.09.20X9
£ £ £
Proposal A 80,000 180,000 300,000
Proposal B 100,000 260,000 504,000
Variation in profit
With the equity settled proposal the charge for each yearly tranche is constant over its life,
as the fair value is determined at the grant date and then apportioned evenly over the life of
the scheme.
The total charge to profit or loss does however increase over the period with the equity
settled proposal for two reasons:
 The share price is projected to increase so the annual cost of later schemes is greater
than earlier schemes.
 There is a cumulative effect as in 20X7 there is only one scheme in operation, in 20X8
there are two schemes and in 20X9 there are three schemes. In 20Y0 and beyond the
cost will not however continue to increase due to this cumulative effect, as there will
only ever be three schemes in operation in steady state.
The annual expense under the cash settled proposal will also increase due to the above
effects but, in addition, there is an annual increase for each individual scheme as the liability
is recalculated each year. Thus, as share prices rise, the charge will increase for this
proposal and will include the cumulative shortfall from previous years in respect of the
increase. As a consequence, with rising share prices the cash settled proposal will result in a
higher charge to profit or loss than an equivalent equity settled scheme.
In both cases there will, in reality, be volatility in the charge to profit or loss due to the actual
number of managers who leave and join in each year. This factor is not evident above due
to the simplifying assumption that 10 managers leave and join in each year. In addition the
actual share prices at the time of granting the cash settled items could vary significantly and
this would be a further cause of volatility.

32 Tawkcom
Marking guide
Marks
(a) Explanation of financial reporting and auditing issues arising from Jo's work. 16
(b) Identification of additional steps required to complete audit procedures and 9
to support opinion on financial statements.
(c) Summarise where group audit team may provide useful information. 5
(d) Description of Key Audit Matters. 5
Total marks 35
Maximum marks 30
(a) Explanation of financial reporting and auditing issues

Prior year adjustment for repairs and maintenance costs
 Need to understand whether prior period audit adjustment of £1.3 million has been
recognised through pack in current year. If not then will give rise to an adjustment
which, whilst not material, is above the scope and should be reported to group.
 Also need to consider whether there are similar items which have been wrongly
capitalised in the current year. Procedures performed on additions to network assets
are probably insufficient to identify such items at present.
Sample sizes
 Unclear from work sent for review whether sample sizes for detailed testing have been
calculated correctly. Documentation on additions states that Jo has used group
materiality rather than performance materiality for PPE. Hence need to consider
carefully whether adequate samples tested for all areas.
Head office lease
 Although presumably tested in prior years, may be a question over whether lease of
head office building is really an operating lease, given length of term. Cannot tell
without further information. Need to start with prior year work papers/manager's own
knowledge. When IFRS 16, Leases comes into force it will definitely need to be
recognised in the statement of financial position.
Leasehold improvements
 Given that lease of head office expires in 20Z5, should be depreciating leasehold
improvements over remaining 16/17 years. The depreciation charge for the year
seems low and work on depreciation and figures suggests that a life of 20 years is still
being used even for additions in the year. Unlikely to be material for group but is a
clear error and could well be above reporting scope, depending on timing of
additions. Hence this needs to be evaluated and posted to the schedule of
adjustments. In addition, need to make sure that improvements are being depreciated
over no longer than their actual useful life, which may be shorter than lease term.
 Given major refurbishment of building, would expect much more significant disposals
of improvements capitalised in previous years (or perhaps significant expensing of
expenditure if it is not a true improvement).

Network asset additions
Appears from comments on additions that certain of the network assets are specific to
particular customers. If this is the case need to consider carefully the terms under which
customers use them and whether they are in substance leased to customer and, if so, how
that lease should be accounted for. Even if correct to continue to include the assets in PPE,
the depreciation periods should not exceed the expected life of the relationship with the
particular customer which may well be less than the 22-year depreciation period. Cannot at
present evaluate the extent of this potential issue but could be material given the size of the
network assets.
Appears that rates used to capitalise labour and overhead may be inconsistent with prior
year, include an element of profit (as they are based on day rates for external customers)
and were increased at the request of group management. Effect is material and will affect
both PPE and statement of profit or loss and other comprehensive income.
Disposal of computer and office equipment
 Disposals of fixtures and equipment include a disposal of office equipment to a
company owned by friends of the FD. Whilst not a RPT for FR purposes, this transaction
is large and clearly raises questions of propriety, especially as the equipment was
relatively new (since low accumulated depreciation) and no proceeds were received.
Need also to check on whether authority limits for disposals followed.
Sale and leaseback
 Sale and leaseback transaction has been accounted for as a disposal of Glasgow House
and a profit of £1.295 million recognised. This is only the correct treatment if the lease
is an operating lease and the disposal proceeds represent fair value. Option to extend
lease to up to 50 years and fact that the lessor is a finance company and not a property
company are both indications that the lease may be a finance lease. However further
details are required. Transaction was also concluded very close to year-end which may
be indicative of window dressing. Transaction increases cash (ie, reduces net
borrowings) and decreases PPE so may have had an effect on critical ratio for
covenants.
Sale of land
 It appears that the sale of land has been treated as an adjusting event after the
reporting period. Sale and profit have been recognised despite the fact that the sale
was not completed at 30 September 20X9. This treatment is not correct in accordance
with IAS 10, Events After the Reporting Period as the sale in October does not provide
evidence of circumstances which existed at the reporting date as the contract was still
conditional at that time. The profit on disposal should therefore be reversed and the
cost of land added back to PPE. If considered material to the users the transaction
could be disclosed as a non-adjusting event after the reporting period.
 Consideration should be given as to whether the land meets the criteria to be classed
as 'held for sale' in accordance with IFRS 5, Non-current Assets Held for Sale and
Discontinued Operations. If this were the case the asset would be measured at the
lower of its carrying amount and its fair value less costs to sell at 30 September 20X9. In
this case the valuation would be at carrying amount.
Valuation of freehold property
Last valuation of freehold properties was at 30 September 20X7. Given recent movements
in property market, that may be out of date. The client appears to have provided no
documentation to support keeping the valuation unchanged. Even if they can support the
valuation remaining unchanged, a depreciation charge should be made to profit or loss
and a revaluation recognised separately. The way they have accounted for it at present

overstates profit which may affect bonus. Revaluation entries should also result in reversal of
accumulated depreciation. Amount is not material to group but is above level which should
be reported and is a clear error.
Investment property
 Investment property has been shown within PPE which is incorrect as it should be
shown in a separate asset category (as should related revaluation reserve). In addition,
need to determine group policy for investment properties and whether using cost or
fair value model. Neither applied at present as property is held at an out of date
valuation. Given that sale fell through and company has decided to postpone sale,
seems likely that current market value has fallen and reduction in value may be
necessary.
 Also question as to whether the property is really an investment property at all as
Tawkcom is offering services as well as accommodation to the lessees. This would
preclude classification as an investment property unless such services are insignificant
to the arrangement as a whole which seems unlikely in the case of serviced offices. If
classification is incorrect then depreciation should be charged. However depreciation
amount unlikely to be above scope for reporting to group. Classification question and
impairment question potentially more significant.
Useful life increase
 Increase in useful life by two years does not explain fully the very low depreciation
charge for network assets. A charge of around £7–8 million would have been expected
based on a rough calculation. It appears that an error has been made, perhaps by
adjusting prior years' depreciation through the current year charge. This is incorrect as
any change in useful life should be accounted for prospectively and the carrying value
at the time of the change simply depreciated over the remaining revised useful life.
Initial indicators are that effect is material and an adjustment will be required even if
longer life can be justified.
 Will need input from head office team to determine whether longer useful life is
reasonable for core network assets. In addition, may well need input from auditor's
expert/specialist audit team to consider evidence for the longer useful life and whether
it is representative of reality.
(b) Additional steps required to complete audit procedures
Group scope not entity level procedures performed
 Indication from additions testing in particular that procedures to date have been
completed to group scope only – procedures will need to be updated to take into
account materiality for individual statutory entity.
Procedures on impairment
 At present there is no consideration as to whether there are indications of impairment.
Carrying value of network assets in particular continues to grow and is very material to
both group and company figures. There will need to be consideration of whether
impairment indicators exist before we sign off to group. (Important to consider each
asset separately for impairment). Likely to be the case given the general economic
climate. If indicators do exist then the recoverable amount of the assets will need to be
considered and evidence of external value or cash flow projections obtained as
necessary. As network supports all of company's business, overall cash flow projections
obtained for going concern purposes will also be relevant here. However, this work
may not yet have been completed as typically left until the statutory accounts for the
subsidiary are signed off. Given that Tawkcom is a significant trading subsidiary of the
group, procedures performed on going concern at group level may be relevant.

Procedures on brought forward position
 No procedures appear to have been performed to verify the existence/ownership of
brought forward PPE balances and so test the completeness of disposals. Need to
determine what work the company/internal audit have done on this and to consider
the extent to which such work can be relied on as audit evidence. Will also need to do
own testing. This is an important step given the materiality of the balances involved.
Physical verification
 Physical verification of property should be possible, as should agreement to deeds or
land registry.
 Physical verification of fixtures and equipment should be possible although might be
possible to leave this for statutory work as balance (excluding additions in year which
have been tested) is not material for group purposes.
 Physical existence vouching should be possible for leasehold improvements although
potential issue has already been raised above. Therefore important that procedures
done in this area reflect the high risk of unrecorded disposals and consider specifically
whether any previous improvements have been disposed of or rendered redundant as
a result of the work done in the last two years.
 Physical existence procedures for network assets much more challenging as already
highlighted by procedures on additions. Need to look for evidence that network is still
being used – perhaps by review of sales/operational data; discuss with personnel
outside of accounts whether there are stretches of cabling which are redundant/little
used or superseded by alternative routing; consider whether additional cabling laid in
year has rendered any existing cabling redundant. May well need to involve a
specialist. This review should consider additions in the year as well as brought forward
assets as work on additions has not been completed. Additional review of customer
specific assets also relevant – see below.
Capital/revenue?
 Need to look much more critically at nature of additions to network assets and consider
carefully whether there is evidence that any of the capitalised projects represent
expense items such as repairs and maintenance. This can be done through discussion
of the nature of the projects with the project managers or other personnel outside
accounts. Also need to review procedures performed on repairs and maintenance
expense in the consolidated statement of profit or loss to ensure that there is no
evidence that this is lower than would be expected and therefore potentially
incomplete.
 Need to evaluate extent to which network assets relate to particular customers and
compare depreciation period to the life of the relevant customer relationship.
 Need to understand in much more detail the costs and any mark up included within the
day rates used to capitalise labour and overhead incurred on the creation of network
assets. Important that only the direct cost of bringing assets to working condition
should be capitalised and this should not include an allocation of administrative cost or
a profit element. Costs should be vouched and the hours/days incurred tied in to time
reports (nature of projects already covered in proposed work above). Material
elements of additions should be vouched in the normal way – not clear that this has
been done.

Disposal to AR Hughes
 Need to understand rationale for disposal of assets to AR Hughes – ie, were assets
surplus to requirements? Why was their useful life so much shorter than that assumed
in setting the depreciation rate? Were other potential buyers considered? What was
market value of similar assets at time of sale?
Glasgow property
 Obtain evidence of fair value of Glasgow property at time of sale and leaseback
transaction, having liaised first with group audit team to see what procedures can be
done/have already been done at group level. Review leaseback agreement and
conclude as to whether it is a finance or operating lease.
 Need to obtain further support from client to support valuations of freehold property
and investment property at year end. This might include external valuations, or use of
indices which show how values for similar properties have moved since last formal
valuation on 30 September 20X7.
 Obtain details of terms of rental agreement to tenants of the investment property to
determine whether services offered are significant to the overall arrangement.
Sale of land
 Confirm details of the sale agreement to determine whether classification as held for
sale is appropriate.
(c) Areas where group audit team may provide useful evidence
 Understanding extent to which procedures performed on going concern or
impairment of investments at group level may assist Tawkcom team in assessing
impairment of PPE.
 Enquire as to procedures done on day rates for capitalisation of employees' time as
this has been driven by a head office project. Would be useful to understand fully
group policy and the procedures performed at head office to validate the way in which
rates are calculated.
 Discuss with group FD the disposal of assets to AR Hughes and his rationale for
approving this.
 Obtain further information re Glasgow House transaction and consider fully the impact
of this transaction on compliance with the bank covenant.
 Understanding of group policy for investment properties.
 Background to and support for the group decision to increase the useful life for
network assets.
(d) Key audit matters
Key audit matters are defined as 'those matters that, in the auditor's professional judgment,
were of most significance in the audit of the financial statements of the current period. Key
audit matters are selected from matters communicated with those charged with
governance' (ISA (UK) 701.8).
When determining key audit matters the auditor needs to take the following into account:
 Areas of higher assessed risk of material misstatement
 Significant auditor judgments relating to areas in the financial statements that involved
significant management judgment
 The effect on the audit of significant events or transactions that occurred during the
period (ISA (UK) 701.9)

These should be communicated in a separate section of the auditor's report under the
heading Key Audit Matters. They should not be used as a substitute for expressing a
modified opinion.
However, the scope of the standard needs to be taken into account. ISA (UK) 701 applies to
audits of complete sets of general purpose financial statements of listed entities. It can be
applied in other circumstances where the auditor decides that it is necessary. In the UK the
ISA (UK) also applies to the audits of other public interest entities and entities that are
required, and those that choose voluntarily, to report on how they have applied the UK
Corporate Governance Code (ISA (UK) 701.5). Tawkcom is not a listed entity and assuming
that it does not meet the other criteria stated above a Key Audit Matters section would not
be required in the auditor's report. As the parent company, Colltawk plc is a listed entity,
the parent company auditors would need to apply ISA (UK) 701. The description of each
key audit matter would need to address:
 why the matter was considered to be one of most significance in the audit; and
 how the matter was addressed in the audit together with a reference to any related
disclosures.
In the UK in describing each of the key audit matters Colltawk's auditor's report would also
need to include:
 a description of the most significant assessed risks of material misstatement;
 a summary of the auditor's response to those risks; and
 where relevant, key observations arising in respect to those risks (ISA (UK) 701.13R-1).
33 Expando Ltd
Marking guide
Marks
Explain FR treatment and audit procedures for the outstanding issues
Revaluation 5
Debenture loan 5
Acquisition of Minnisculio 4
Disposal of premises 5
Acquisition of Titch 3
Comment on procedures performed by the auditors of Titch 3
Provision of temporary staff 4
Complete the draft statement of profit or loss and other
comprehensive income, statement of changes in
equity and statement of financial position 7
Total marks 36
Maximum marks 30
Revaluation of land
Accounting treatment
The basic treatment of the land adopted in the draft financial statements is correct. In
accordance with IAS 16, Property, Plant and Equipment there is no requirement to depreciate
land. In addition, the revaluation has been correctly recognised in the revaluation surplus and as
other comprehensive income. This gain is recognised but not realised therefore it will not be
distributable.

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

 Recalculate the effective interest rate ie, it should be the rate that exactly discounts
estimated future cash payments or receipts through the expected life of the debenture to
the net carrying amount of the financial liability.
 Confirm the change in the accounting treatment of the interest charge and the liability in
the statement of financial position with the client.
 Confirm the financial liability is adequately presented and disclosed in accordance with
IAS 32, Financial Instruments: Presentation and IFRS 7 Financial Instruments: Disclosures eg,
qualitative and quantitative disclosures about exposure to risk, carrying amount of the
liability by IFRS 9 category, interest recognised in profit or loss.
Acquisition of Minnisculio
The purchase of the trade and assets of Minnisculio is currently represented as an investment at
cost of £250,000. This should be shown in the statement of financial position as inventories of
£20,000 and an intangible asset of goodwill £230,000 as it is these assets which have been
purchased as a result of the business combination. In accordance with IFRS 3, Business
Combinations the goodwill should not be amortised, but should be subject to an impairment
review. Whilst the basic provision of IAS 36, Impairment of Assets is that an impairment review
only needs to be conducted where there is an indication that an asset may be impaired,
goodwill acquired in a business combination is an exception to this rule. In this instance IAS 36
requires an annual test for impairment irrespective of whether there is any indication of
impairment therefore the management of Expando must address this. Provided that we are
satisfied with the impairment review subsequently performed no further adjustment will be
required.
Audit procedures
 Confirm the purchase price of Minnisculio to the purchase documentation.
 Establish the basis on which the value of £20,000 has been attributed to the inventories
(and therefore the £230,000 to goodwill).
 Confirm that goodwill does not include any non-purchased goodwill or any identifiable
intangible assets.
 Discuss with the directors the need to perform an impairment review.
Assuming this is carried out determine the means by which the goodwill impairment review has
been conducted eg, in accordance with IAS 36 has goodwill been allocated to the cash-
generating units expected to benefit from the synergies of the combination?
Disposal of premises
The premises would appear to be an asset held for sale in accordance with IFRS 5, Non-current
Assets Held for Sale and Discontinued Operations as its carrying amount is to be recovered
principally through a sale transaction rather than through continuing use. For this to be the case
the asset must be available for immediate sale in its present condition and the sale must be
highly probable. For the sale to be highly probable the following conditions must be met:
 Management must be committed to the plan.
 An active programme to locate a buyer and complete the plan must have been initiated.
 The asset must be actively marketed for sale at a price that is reasonable in relation to its
current fair value.
 Management should expect the sale to be completed within one year from the date of
classification.
 It should be unlikely that significant changes will be made to the plan or that the plan will be
withdrawn.

Assuming that these conditions are satisfied the asset should be classified as held for sale and
disclosed separately, in the statement of financial position. It should be measured at the lower of
its carrying amount and fair value less costs to sell. An impairment loss should be recognised
where fair value less costs to sell is lower than the carrying amount. Until the date of
reclassification the asset should be depreciated as normal. An additional charge of £3,125
(£125,000/20 × 6/12) is therefore required. The asset would no longer be depreciated from the
date of reclassification even if the asset remained in use.
Assuming that the asset does meet the criteria to be classified as held for sale the following
adjustment would be required:
£
Carrying amount at date of reclassification (125,000 – 125,000/20 × 6/12) 121,875
Fair value less costs to sell 115,000
Impairment 6,875
Audit procedures
Confirm that the asset is held for sale by ensuring that the IFRS 5 conditions above are satisfied:
 Discuss with management their plans for the sale and marketing of the asset.
 Obtain evidence of management commitment eg, proposed sale should be minuted.
 Obtain evidence of an active programme for sale eg, property agents being appointed.
 Assess the market to determine the likelihood of the sale being completed within the one
year time frame.
 Recalculate current book value of the asset.
 Assess the means by which the fair value of the asset has been established and determine
whether this is reasonable.
 Obtain information about costs to sell to assess whether they relate directly to the disposal
of the asset.
 Confirm that separate disclosure of the asset has been made in accordance with IFRS 5.
Acquisition of 25% of Titch
Assuming that the 25% owned by Expando allows it to exert significant influence Titch will be
treated as an associate. As such the investment will be equity accounted as follows:
In the statement of profit or loss and other comprehensive income the group's share of
profit/loss after tax is added to consolidated profit. This is normally achieved by adding the
group share of the associate's profit/loss before tax and the group's share of tax. In this case the
tax has already been dealt with. Therefore the adjustment required is as follows:
Share of loss of associate (350,000 × 9/12 × 25%) = £65,625
The group's share of any other comprehensive income would also be included if relevant.
In the statement of financial position the group share of net assets is shown as a single item. This
is represented by the initial cost of the investment increased or decreased each year by the
amount of the group's share of the associated company's profit or loss for the year less any
impairments in the investment to date. In this case, the 'Investment in associates' will be
£334,000 (£400,000 – £66,000) to the nearest thousand.
Audit procedures
The audit of the financial statements of Titch is the responsibility of the auditors of Titch. We do
not have any direct responsibility for this. However, we are responsible for the audit opinion of
Expando even though the results will include information not directly audited by us. The amount

of work we will need to do depends on the extent to which we can rely on the component
auditors and whether Titch represents a significant component. At the planning stage we will
have assessed the competence of the component auditors and will have requested a summary
of the audit procedures conducted. Therefore the following additional work needs to be
performed:
 Review the summary of the audit procedures and assess whether the work is
comprehensive enough for our purposes.
 Identify any areas requiring special consideration and/or additional procedures.
 Consider the impact of any significant findings made by the component auditors.
If the component is not significant, analytical procedures at the group level may be sufficient for
the purposes of the group audit.
Once we have sufficient confidence in the individual financial statements of the associated
company audit work will be concentrated on the mechanics of the equity accounting as follows:
 Confirm the date of acquisition and that the shareholding is 25%.
 Inspect the shareholder agreement to verify that the relationship with Titch is that of
'significant influence' – it could also be an interest in a joint arrangement, in which case we
would see evidence of 'joint control' as defined in IFRS 11, Joint Arrangements.
 Confirm the purchase cost of the investment to the purchase documentation.
 Recalculate the group's share of the loss of the associate ensuring that only post acquisition
losses have been consolidated.
 Recalculate the statement of financial position balance to confirm that the cost has been
reduced by the appropriate share of losses.
 Confirm that any intra-group transactions have been identified and dealt with appropriately.
Provision of temporary staff
As Expando is a private company Revised Ethical Standard 2016 does allow the provision of
'loan staff' provided that the agreement is for a short period of time and does not involve the
employee in providing a service which is prohibited elsewhere in the standard (s 2.39). Again as
Expando is a private company Revised Ethical Standard 2016 (s 5.155 & s 5.161) does allow the
provision of accounting services by the audit firm. However, this is on the basis that:
 the services do not involve us undertaking part of the role of management; and
 the services do not involve us initiating transactions or taking management decisions and
are of a technical, mechanical or an informative nature.
The duration of the role, the specific nature of the role and the accounting work to be performed
by the individual would have to be assessed.
In addition, steps would have to be taken to reduce the potential self-review threat to an
acceptable level. The individual involved should not take part in any future audits and steps
should be taken to ensure that other members of the audit team do not place too much reliance
on the work performed by their colleague.
There are also practical issues to consider including whether we have sufficient staff available
who can be seconded and whether they have the relevant experience and expertise. There is a
potential for our reputation to be damaged if an unsuitable individual is sent.

Revised draft financial statements
Year ended 30.06.20X7 30.06.20X6
(draft) (audited)
£'000 £'000
Revenue 4,430 3,660
Less operating expenses (3,620 + 3) (3,623) (2,990)
Operating profit 807 670
Interest payable (260 + 70) (330) (200)
Impairment loss on reclassification of non-current asset as held for
sale (7) –
Share of loss of associate (66) –
Taxation (91) (141)
Gain on property revaluation 1,000 –
Total comprehensive income for the year 1,313 329
Statement of changes in equity 30 June 20X7 (extract)

Retained Revaluation
earnings surplus
£'000 £'000
Balance at 1 July 20X6 713 –
Total comprehensive income for the year 313 1,000
Balance at 30 June 20X7 1,026 1,000

Period end date 30.06.20X7 30.06.20X6
(draft) (audited)
£'000 £'000
Non-current assets
Land 5,000 4,000
Plant and machinery 2 2
Intangible assets: goodwill 230 –
Investment in Titch (400 – 66) 334 –
Current assets (2,155 + 20) 2,175 520
Asset held for sale 115 –
Current liabilities
Taxation (91) (141)
Other (300) (149)
6% bank loan (3,333) (3,333)
3% debenture (1,850 – 60 + 130) (1,920) –
2,212 899
Share capital 86 86
Share premium 100 100
Revaluation surplus 1,000 –
Retained earnings 1,026 713
2,212 899

34 NetusUK Ltd
Marking guide
Marks
(1) FR advice 5
(2) Summary of proposed audit work 12
(3) Other comments – ethical issues 4
(4) Explanation of data analytics and use in risk assessment 10
Total marks 31
Maximum marks 30
(1) FR advice
Pension should be accounted for in accordance with IAS 19, Employee Benefits. This means
that the net surplus/deficit on the pension plan will be recognised in the financial
statements.
Harry needs to obtain details of the scheme assets and liabilities from the actuary and to
record entries in the financial statements:
 Record the opening balance on the scheme as shown in the prior year statutory
accounts (gross of deferred tax).
 Using details provided by the actuary, analyse the movement in assets and liabilities in
the year into the following and make the entries indicated below:
– Current service cost (as calculated by actuary). Will need to split between
departments and allocate between various statement of profit or loss and other
comprehensive income captions. Charge to operating profit.
– Interest on obligation (as calculated by the actuary). Forms part of finance cost in
– Interest on plan assets (as calculated by the actuary). Forms part of finance
cost/income in statement of profit or loss and other comprehensive income. It is
netted off against the interest on obligation to show 'net interest on net defined
benefit asset/liability'.
– Contributions paid – this will be the contributions paid in the year by employer
and employee. Employee contributions reduce current service cost (unless
already netted off). Employer contributions are what have already been charged
to profit or loss. That entry needs to be reversed so that profit or loss charge is
only as specified above and amounts paid form part of movement on deficit within
statement of financial position.
– Remeasurement gains and losses (actuarial gains and losses) should be
recognised immediately in other comprehensive income.
 Closing deficit should then agree to amount advised by the actuary.

(2) Schedule of audit procedures
Substantive analytical procedures are likely to be the most efficient and effective way to
audit the main payroll balances as headcount figures and details of pay increases are
available. Such procedures can also be used for commission as that would be expected to
move in line with revenue. Procedures for the first nine months should be as follows:
 Expectations for annual figures should be calculated and compared to actual. Any
significant variations should be investigated. Pension contributions can also be audited
this way as the relationship to main payroll cost is known.
 Sample of temporary staff costs should be agreed to invoices, timesheets and contracts
for rates of pay. Position re tax status of temporary staff should be considered, to
address risk of underpayment of income tax and NI via PAYE. Creditor balance should
be discussed and basis for calculation reviewed as creditor for temporary staff looks
very low.
 Sample of employee expenses should be vouched to receipts/other documentation.
Analytical procedures should be performed for completeness of expense claims.
 Procedures should be performed to ensure that it is possible to audit year end pension
figures on a timely basis. We will need to ensure client understands entries to make
and has made arrangements with actuary/investment managers to get information in
time (this may be challenging given deadline). Discussions should have been held with
the actuary at interim and assumptions to be used in valuation of liabilities should have
been reviewed at this stage and discussed with management's experts as appropriate.
Circularisation letters can be sent to investment managers and actuaries, backed up by
discussions on how quickly information can be provided. We must ensure Harry
understands the entries he must make and where the information can be sourced from.
Entries to record correct opening position in the statement of financial position should
be determined.
 Obtain summary of pension balances to be included in the accounts from the actuary.
Ensure assumptions used to calculate actuarial liabilities are in line with those
discussed at interim and there are no market conditions which would make amended
assumptions re discount rates etc more appropriate. Ensure contributions shown by
actuary agree to those in the accounting records and tie in investment values to
investment manager returns. Consider procedures required on any other assets and
liabilities within scheme and ensure that balances owed by company to scheme are
correctly eliminated when scheme deficit is included in the accounts.
 Liaise with auditors of parent company with respect to opening balances relating to
pensions.
 Basis for bonus provision should be discussed, rules of bonus scheme reviewed and
expectation established for year-end accrual.
 Discuss with client why there is no holiday pay provision as would be expected. If
provision is recognised as a result of our query obtain support for the calculation and
compare with expectations.
 Perform work to check all payroll disclosures including those for pension scheme and
directors' remuneration.

(3) Other comments
 Level of temporary staff used in admin area may indicate issues with staffing and
controls over the course of the year – needs further investigation.
 Management's attitude to controls is concerning – the tone at the top is a crucial
element of entity level control and it is difficult to rely on controls if this is not
appropriate. Deficiencies in controls have been an ongoing problem, and whilst
management seem to be addressing the issue we would want to see positive steps
being taken in this respect as there is a poor track record of dealing with our concerns.
 Full compliance with IFRS is required this year whereas some items were handled
centrally last year – may be other areas where this applies – need to consider more
generally.
 Help in calculating entries for pensions – need to ensure that the threat of self-review –
ie, auditor auditing their own work is safeguarded. May do this by using people from
outside the audit team to assist, suggesting that parent company staff rather than audit
firm provide assistance, ensuring that CFO and his team take full managerial
responsibility for all assumptions made, including in particular judgmental assumptions
for actuarial calculations and volatility assumptions etc in share option valuation
models. It is very important that these are not suggested by the audit firm.
 CFO's general lack of expertise is concerning for such a large subsidiary. We need to
be alert for other more complex areas where he may not have the necessary financial
accounting knowledge.
(4) Data analytics
Data analytics involves the manipulation of complete sets of data eg, 100% of the
transactions in a population, thereby enabling conclusions to be drawn on the basis of the
results. Results are usually presented in a format which is easy to understand. The analysis is
often presented visually eg, in the form of graphs or pie charts. This allows data to be
analysed to a greater degree of detail such that the auditor can drill down into further detail
at a granular level for specifically targeted areas.
Journals dashboard: use in risk assessment
 Journals exceed materiality threshold in total therefore would require investigation
 Manual journals compared to automated journals seem high both in volume terms but
particularly in value terms
 Manual journals in relative terms are greater than automated journals (£16,500 on
average compared to £3,670 for automated journals, see Working)
 These should be compared to data for the previous year to determine whether this is
an anomaly or whether this is the norm for this business
 We need to further investigate how the system operates to determine the basis on
which journals are automated as opposed to those which are manually entered
 The high level of manual journals could indicate that the system is not being operated
effectively ie, journals are being manually input which the system is capable of
generating
 Alternatively it could be an indication of fraud ie, the controls are being overridden to
create fictitious journals

A number of issues can be identified from the analysis of the users as follows:
 Two individuals posting journals are from the sales department. Further investigation
regarding what these relate to would be required.
 23 journals have been posted by Wong but the value in total is only £50,000. On
average these journals are for relatively small amounts but this could indicate a
deliberate policy for individual journals to fall below the point at which journals must
be authorised. This is particularly relevant as this user may be an 'unexpected' user.
 Similarly although only one journal has been posted by Lyndon this seems unusual and
may indicate that controls are being over-ridden. This is of particular concern in the
light of our previous issues with control deficiencies and the management's attitude
towards controls.
 Journals posted by Dalton are comparatively high, being £53,000 on average. This is
significantly more than other users including the FD, Thomas. We should clarify the
nature of these and in particular whether they have been authorised in accordance with
company policy.
 It is notable that journals posted by Dalton exceed those posted by Thomas. It is
possible that as the financial controller he has been authorised by the FD to process
significant journals on his behalf. We need to obtain information regarding the
authorisation process and authorisation limits.
Further analysis
The following further analysis could be performed by the data analytics tool:
 Analysis of accounts to which journals have been posted both in terms of volume and
value
 Monthly analysis of volume/value of journals to identify trends (eg, year end journals)
and in particular unexpected peak months
 Analysis of unexpected journals ie, highlighting unusual double entries. If significant
these could then be investigated further.
WORKING:
75%×£3,874,000
Average value of manual journal = = £16,500 (rounded)
40% ×440
25% ×£3,874,000
Average value of automated journal = = £3,670 (rounded)
60%×440
35 Verloc Group
Marking guide
Marks
(a) Identify financial reporting issues, explain the correct accounting treatment
and describe audit response. 18
Identify audit issues and describe the actions required. 10
(b) Draft revised consolidated statement of profit or loss and OCI. 18
Total marks 46
Maximum marks 30

(a) Financial reporting issues
Based on the draft consolidated statement of profit or loss and OCI and the information
provided thus far, financial reporting issues can be identified as follows.
Part disposal of Stevie
Verloc Group has disposed of 40,000 shares in Stevie nine months into the year, which
reduces its shareholding from 75% to 35%. Assuming that the Group retains no special
voting rights, its control of Stevie has been lost. Stevie should therefore be accounted for as
an associate instead of a subsidiary for the last three months of the year.
The draft consolidated statement of profit or loss and OCI continues to treat Stevie as a
subsidiary, consolidating the full amount of Stevie's revenue and expenses throughout the
year. As a result, the profit after tax generated by the group is currently overstated by
£171,000 (£684k  3 months/12 months), as well as a corresponding (as yet unquantified)
overstatement in the consolidated statement of financial position. This amount is both
material in terms of its size, and also in terms of its impact on the users' understanding of
the financial statements. We should therefore raise this issue at our meeting with the
Finance Director, and ask that the consolidated financial statements be adjusted.
The revised consolidated statement of profit or loss, reflecting Stevie's status as a subsidiary
for the first nine months of the year and as an associate for the last three months, is
attached.
Other issues to consider during the audit:
 Confirm with the Finance Director the reason why Stevie has continued to be
accounted for as a subsidiary at the end of the year.
 If Stevie's accounting treatment is due to an error, consider the technical competence
of the financial controller and assess whether this has any implications for the rest of
the audit. Audit risk may be deemed to be higher than previously assessed, and
materiality may then need to be adjusted accordingly.
 Inspect the contract for the disposal of the shares, to agree the proceeds from the
disposal and for any evidence that Verloc Group may have maintained a controlling
interest in some form.
 Discuss with management and review supporting evidence for the determination of
the value of Verloc's remaining shareholding. As Stevie is not listed, it would be
important to understand how the fair value has been determined and evaluate the
appropriateness of the method used. This will also affect the valuation of
non-controlling interests at the time of the disposal.
Investment property
Issues to consider in relation to the property:
 The property is classified as investment property, and has been owned by Winnie for
10 years. To understand whether the property has been correctly classified in
accordance with IAS 40, we will need to find out what the property is, and its current
and future intended use (for example, whether it is leased on an operating lease).
 We will need to review evidence of the property's uplift in value, by inspecting due
diligence reports or purchase documentation.
 The appropriateness of the assumption of 50 years useful life must also be considered
– by inspecting due diligence reports and asking group management to explain future
plans relating to the property.

Gains on investments in equity instruments
Under IFRS 9, Financial Instruments, all equity investments in the scope of IFRS 9 are
measured at fair value in the statement of financial position. Generally gains or losses
arising on the subsequent measurement of investments in equity instruments are
recognised in profit or loss.
If an equity investment is not held for trading, an entity can make an irrevocable election at
initial recognition to measure it at fair value through other comprehensive income with only
dividend income recognised in profit or loss. The amounts recognised in other comprehensive
income are not re-classified to profit or loss on disposal of the investment although they may
be reclassified in equity.
However, the gains in question are on equity investments already held, and there is no
evidence that an irrevocable election to measure them at fair value through other
comprehensive income has been made. Therefore the default recognition rule applies.
The £46,000 gain on the investments in equity instruments should therefore be recorded in
profit or loss in the consolidated statement of profit or loss and other comprehensive
income. As this has not been done, the total consolidated profit or loss and therefore total
comprehensive income for the year is understated by £46,000. This is not material in itself,
but needs to be added to the summary of uncorrected misstatements which, in aggregate,
may amount to a material difference. We should therefore still request that an adjustment is
made.
A separate issue is that some of the equity investments are unquoted equity. Under IFRS 9,
unquoted equity investments must also be measured at fair value. (This is a change from
IFRS 9's predecessor, IAS 39, which allowed them to be measured at cost.) IFRS 13, Fair
Value Measurement should be applied, for example the market approach, using prices and
other relevant information that have been generated by market transactions that involve
identical or comparable assets (IFRS 13 para B5).
Other issues to consider:
 Determine what other financial assets and liabilities are held by Verloc, and by the
group, and evaluate their current accounting treatment. The fact that the financial
controller is unsure how to account for the subsequent gain arising on the investments
in equity instruments indicates a higher risk of material misstatement in this area.
 Inspect the purchase contracts for the investments in equity instruments as well as
other financial assets, and discuss with management in order to understand the nature
of the investment held. Evaluate whether the financial assets have been classified
correctly.
 For investments traded on an active market, obtain the quoted prices at the year end
to verify their fair value.
 For any investments not traded on an active market, assess the need for impairment by
reviewing the present value of the estimated future cash flows and comparing this to
the investments' carrying amount.
Loan from Inver Bank
Under IFRS 9, Financial Instruments, an entity should derecognise a financial liability when it
is extinguished ie, when the obligation specified in the contract is discharged or cancelled
or expires. An entity discharges its obligation by paying in cash, other financial assets or by
delivering other goods or services to the counterparty.
When a liability is extinguished, the difference between its carrying amount and the
consideration paid including any non-cash assets transferred and any new liabilities
assumed is recognised in profit or loss.

As a result of the transfer, Verloc should extinguish the liability but it should also recognise
a gain of £30,000 in profit or loss, arising from the difference between the carrying amount
of the liability (£800,000) and the value of the retail outlet (£770,000) that was transferred to
the bank.
Other issues to consider:
 Confirm the existence of the arrangement with Inver Bank and the agreement to settle
the debt by transfer of the retail outlet to relevant documentation (such as legal
correspondence, board minutes, signed contracts etc).
 Review the draft financial statements to confirm the correct accounting treatment once
completed by the financial controller (as described above) within loans, non-current
assets and profit or loss, including any suitable disclosures.
 Recalculate the gain in profit or loss to ensure it matches the amounts specified in the
documentation from Inver Bank.
 Obtain representations from management and the company's legal team that there are
no subsequent liabilities regarding the retail outlet (such as rent, rates, employment
commitments etc).
Audit issues
Time pressure
An unrealistically tight timescale increases detection risk. Procedures are likely to be
rushed, resulting in a lack of professional scepticism and misstatements going undetected.
Good audit planning, informed by meaningful risk assessment, will be essential here. The
purpose of the audit plan is not only to direct audit work to appropriate areas of the
financial statements, but also to decide on the resources and deadlines necessary to
complete the audit satisfactorily.
At this stage, it is unclear whether risk assessment has been carried out adequately. Before
determining the audit strategy and audit plan, it is very important that robust risk
assessment procedures, including an evaluation of the group's system of internal controls,
have been performed and documented. We might be able to roll forward some prior year
documentation following confirmation with the client, provided that adequate
documentation had been maintained in prior years. Even so, detailed risk assessment
would still be required in relation to Winnie, which represents a material acquisition during
the year.
The tight timescale, and the heightened detection risk that this entails, means that
appropriately experienced staff need to be allocated to the engagement. We may need to
consider whether additional staff need to be brought on to the audit engagement team, to
ensure that audit quality is not compromised by the short turnaround.
The consolidated statement of financial position and statement of changes in equity have
not yet been provided. If the Finance Director does not supply them at the meeting as
promised, we will need to make very clear to him that the group audit cannot commence
until a full set of draft financial statements has been prepared. Any delays in providing
supporting documentation to us will also cause the audit completion date to be pushed
back, as our audit opinion must be based on sufficient appropriate audit evidence.
If, after considering the audit risk and resource allocation, it is determined that the audit
requires more time, we should request Verloc's directors to push back the sign-off date. We
need to explain to the directors that without this, we would not be able to fulfil our
responsibility as Verloc's auditor and perform the audit in accordance with the ISAs.

Group audit arrangements
It is currently unclear who the auditor of Winnie is, or whether we will continue to act as
auditor of Stevie. The arrangements for this year, as well as for future years, need to be
discussed with management.
However, whether or not we act as statutory auditors of Winnie and Stevie, we remain the
group auditor of Verloc Group. The audit opinion on the group consolidated financial
statements – incorporating the results of Winnie and Stevie, insofar as they are consolidated
in the group financial statements this year – is therefore our responsibility.
From the information provided, Winnie is likely to constitute a significant component by
virtue of its size. On this basis, if we do not audit Winnie's individual financial statements, we
need to identify who the component auditor is and evaluate the extent to which we can be
involved in the component auditor's work.
To do so, we must first gain an understanding of the component auditor, taking into
account the component auditor's level of professional competence, and whether they are
independent from the company.
Based on our understanding of the component auditor, and the assessment of material
misstatement in the group financial statements, the following will be required:
 Meeting with the component management or the component auditors to obtain an
understanding of Winnie and its environment, including:
– Winnie's business activities that are significant to the group;
– the susceptibility of Winnie to material misstatement of the financial information
due to fraud or error; and
– identified significant risks of material misstatements. (This may take the form of
review of a memorandum containing the conclusions drawn by the component
auditors.)
 Reviewing the component auditor's overall audit strategy and audit plan.
 Performing risk assessment procedures to identify and assess risks of material
misstatement at the component level. These may be performed with the component
auditor or by the group auditor.
It will be crucial to maintain communication with the component auditor of Winnie on a
timely basis. ISA (UK) 600 (Revised June 2016), Special Considerations – Audits of Group
Financial Statements (Including the Work of Component Auditors) requires us to set out for
the component auditor the work to be performed, the use we will make of the work and the
form and content of the component auditor's communication with us (ISA (UK) 600.46).
Related party transactions
The audit manager described these as low risk, but they are material by nature. Not only are
they subject to specific disclosure requirements, they carry a high risk of manipulation.
There will also be additional reporting requirements should the company list on the stock
exchange during the coming year, which only increases the risk to the auditor.
Related party transactions should be considered at the risk assessment stage, with the
following audit procedures being performed:
 Discussion among the audit team of the risk of fraud-related misstatements
 Inquiries of management regarding related parties and associated transactions
 Obtaining an understanding of the controls in place to identify such related party
transactions

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

Going concern
Going concern is a difficult area to audit as it usually involves making judgements about a
business's future prospects, which requires substantial experience. Juniors are very unlikely
to be able to do this and so should not have been assigned to audit going concern.
A more senior member of the audit team should have been assigned going concern, such
as the audit manager or partner.
Taken together with trade payables, this reveals a disturbing failure of direction on the
audit, which is a key quality control.
Planned listing – events after the reporting period
Should Verloc Group become listed before the signing of the financial statements, the
listing will constitute a non-adjusting event. Although the financial statements for the year
ended 20X9 (including share capital) will not be adjusted, the transaction will affect the
decisions and evaluations taken by the users of the financial statements, and therefore
should be disclosed.
The audit team will need to review the disclosure and assess whether it is appropriate, and
consistent with the knowledge obtained by the audit team during the audit. It will be
necessary to consider the inclusion of an Emphasis of Matter paragraph in the auditor's
report, to draw the users' attention to the relevant disclosure of a significant uncertainty (not
related to going concern).
Materiality
Last year's materiality for the financial statements as a whole is relatively high, representing
1.6% of revenue, 9.5% of profit before tax and 1.8% of gross assets. While this might have
been appropriate in the previous year, the group has gained in complexity this year, with
the acquisition and disposal of subsidiaries. The planned listing also increases the level of
reliance that will be placed on the financial statements going forward. There is therefore an
argument for assigning a lower level of materiality this year.
Subject to risk assessment procedures, lower performance materiality levels should also be
set for accounts at a higher risk of material misstatement. These should include accounts
affected by the acquisition and disposal of subsidiaries (investment in subsidiaries and
associates, goodwill, non-controlling interest) but should also cover investments in equity
instruments, property, plant and equipment and pension.

(b) Attachment
Verloc group
Consolidated statement of profit or loss and other comprehensive income for the year
ended 30 September 20X9
£'000 £'000
Revenue (6,720 + (6,240  5/12) + (5,280  9/12)) 13,280
Cost of sales (3,600 + (3,360  5/12) + (2,880  9/12)) (7,160)
Gross profit 6,120
Administrative expenses (760 + (740  5/12) + (650  9/12) + 23 (W3)
+ 10 (W5) – 30 (gain on liability extinguished (W9)) – 46 (gains on
equity inv. (W10)) (1,513)
Distribution costs (800 + (700  5/12) + (550  9/12)) (1,504)
Gain on disposal of investment in Stevie (W6) 163
Finance costs (360 + (240  5/12) + (216  9/12)) (622)
Share of profit of associate (684  3/12  35%) 60
Income tax expense (400 + (360  5/12) + (300  9/12)) (775)

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

1,929
Total comprehensive income for the year attributable to:

2,030
WORKINGS
(1) Group structure and timeline
Verloc
1.11.X6 Buy 75/100 = 75%
1.5.X9 160/200 = 80% 1.7.X9 Sell 40/100 = (40%)
Have left 35%
Winnie Stevie

Timeline
1.10.X8 1.5.X9 1.7.X9 30.9.X9
Winnie
Subsidiary – consolidate
5/12
Acquired
160,000 shares
= 80% of
Winnie
Stevie
Subsidiary – 9/12 Associate –
Held 75,000 Sells 40,000 shares Equity

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

PFY TCI
£'000 £'000
Winnie
Per Q (840  5/12) 350
Additional depreciation on fair value adjustment (W5) (10)
340
NCI share (NCI in TCI is the same as Winnie has no OCI)  20%
= 68 = 68
Stevie
Per Q (684  9/12)/(709  9/12) 513 532
 25%  25%
= 128 = 133
Total NCI 196 201
(3) Goodwill (Winnie) (to calculate impairment loss for year)

£'000 £'000
Less net assets at acquisition:
Share capital 200
Reserves 2,050
Fair value uplift on PPE (W5) 960
(3,210)
Goodwill 232
Impairment (10%) 23

(4) Goodwill (Stevie) (to calculate group profit on disposal)
£'000 £'000
Less net assets acquired:
Share capital 100
Reserves 1,020
(1,120)
140
(5) Fair value adjustments (Winnie)

At acq'n At year end
1.5.X9 Movement 30.9.X9
£'000 £'000 £'000
PPE 960 (10) * 950
* 960/40  5/12 = 10
Note: 50 year total useful life but had owned for 10 years at acquisition so 40 years
remaining
(6) Group profit on part disposal of Stevie
£'000 £'000 £'000
Fair value of consideration received 960
Fair value of 35% investment retained 792
Less share of consolidated carrying amount when
control lost
Net assets
Share capital 100
Reserves b/f 1,300
TCI to 1.7.X9 (709  9 )
12 532
1,932
Goodwill (W4) 140
Less non-controlling interests (W7) (483)
(1,589)
163
(7) Non-controlling interests (SOFP)

£'000
NCI at acquisition (W4) 280
NCI share of post acquisition reserves to disposal
(25% × [(W6) (1,300 + 532) – 1,020]) 203
NCI at disposal 483
Decrease in NCI on loss of control (483)
0
(8) Intragroup dividend

Intragroup dividend income from Winnie = £100,000 × 80% group share = £80,000
→eliminate from 'investment income' bringing balance to zero.
(9) Loan from Inver Bank
Verloc recognises gain of £30,000 in profit or loss on extinguishing the loan to Inver
Bank.

(10) Gain on equity investments
IFRS 9 requires that £46,000 gain arising on subsequent measurement of investments
in equity instruments is taken to profit or loss. The draft revised consolidated financial
statements assume that this is calculated correctly based on IFRS 9. This is subject to
further review.
36 KK
Marking guide
(a) For each of the issues in

Exhibit 2:
 describe the
appropriate financial
reporting treatment in
the KK consolidated
Explain and justify
whether or not
disclosure of any
related party
transactions needs to
be made in the
individual financial
statements of the
companies concerned
for the year ended
30 June 20X4; and
 explain the key audit
issues and the audit
procedures to be
performed.
(1) Seal sold £12 million of 13 Assimilate information to evaluate the relationship
goods to Crag between KK and Crag.
Apply technical knowledge of IFRS 10 to the
scenario to determine that Crag is a subsidiary of KK.
Identify that related party transaction exists if Crag is
a subsidiary.
Apply professional scepticism to the assertion of fair
value of the Crag shares.
Determine that Seal (KK associate) and Crag (KK
subsidiary) are related parties.
Explain the disclosure required according to IAS 24.
Identify audit issue and provide appropriate
procedures.

(2) Sale of goods from 7 Apply technical knowledge of IFRS 10 to the
Seal to Moose scenario to determine that Moose is an associate of
KK.
Determine that no related party relationship exists
between Seal and Moose as they are associates of
KK.
Apply scepticism to the nature of the transaction to
consider that a related party transaction may be
required to be disclosed.
procedures.
(3) Purchase of a company 5 Explain that director is related party and requires
asset by a director disclosure.
Identify audit issues in relation to conflict of interest
and duty of directors.
Set out relevant audit procedures to address audit
issues.
(4) Loan from Yissan 3 Explain related party transaction exists even though
loan repaid.
Identify audit issue and relevant procedures.
(5) Sale of goods from 7 Determine that the sale of goods from Crag to KK is
Crag to KK an intragroup transaction with unrealised profit.
Explain the consolidation adjustment required in the
Explain the disclosure required in the individual
financial statements according to IAS 24.
procedures.
(b) Identify and explain the key 5 Identify and explain the key audit issues surrounding
audit issues which arise the acquisition of a controlling interest in Crag
from the acquisition by KK during the year.
of shares and options in
Crag.
(c) Explain the ethical 5 Identify the issue as an advocacy threat arising from
implications for WJ of the provision of non-audit services.
Mike's suggestion that WJ Assimilate information to identify intimidation and
carry out review work in self-review threats.
respect of the due diligence
assignment performed by Provide a recommendation of appropriate action.
TE.
Total marks available 45
Maximum marks 30

Tutorial note
It may be helpful to draw a diagram of the group structure before answering this question.
(a) (1) Sales of goods by Seal to Crag

Financial reporting treatment
Determining the relationship between KK and Crag is crucial to determining whether
this is a related party transaction in the KK group financial statements.
Seal appears to be an associate of KK as there is a 40% direct shareholding and
significant influence. If Crag is a subsidiary of KK, then it is purchasing parts from a
related party (per IAS 24 (revised) (a) (vii) (Seal)).
If, however, Crag is an associate of KK, then Seal and Crag are not considered
members of the same group for related party purposes as they are only subject to
significant influence from the same investor.
Establishing the relationship between KK and Crag
A subsidiary is defined by IFRS 10, Consolidated Financial Statements as "an entity that
is controlled by another entity".
In accordance with IFRS 10, an investor controls an investee when "the investor is
exposed, or has rights, to variable returns from its involvement with the investee and
has the ability to affect those returns through its power over the investee".
Through its shareholding in Crag, it is clear that KK is exposed to variable returns
dependent on the performance of Crag. The key question is whether KK has the power
to affect those returns, rather than just influence decisions.
At the acquisition date and at the year end, KK can only vote with 45% of the ordinary
shares. If it were to exercise its options it would be able to vote with 60% of the
ordinary shares and exercise control.
IFRS 10 paragraph 12 states that "an investor with the current ability to direct the
relevant activities has power, even if its rights have yet to be exercised". IFRS 10
paragraph B47 also requires an investor to consider potential voting rights in
considering whether it has control over another entity. The potential voting rights are
considered only if they are substantive ie, if the holder has the practical ability to
exercise the right.
Based on the information provided, the options appear to be 'in the money' as fair
value per share has risen by 13% since acquisition compared to a required exercise
premium of 10% per share over the price per share for the 45% shareholding.
Consequently, the options seem likely to be exercised and KK does have a 'current'
ability to direct the activities of Crag, as it only requires the options to be exercised
(which it can do at any time up to the exercise date, it does not need to wait for the end
of the exercise period) to take control through a majority shareholding.
Consequently, Crag should be accounted for as a subsidiary of KK in the consolidated
Regardless of whether there have been transactions between a parent and a
subsidiary, IAS 24 requires an entity to disclose the name of its parent and, if different,
the ultimate controlling party. Crag must therefore disclose the fact that KK is now its
parent in its financial statements.

Treatment and disclosure of the goods sold to Crag by Seal
KK has significant influence over Seal and it is therefore a related party of KK. In
accordance with IAS 24, Related Party Disclosures, disclosure of the aggregate amount
of the transactions occurring between Crag and Seal between 1 August 20X3 and
30 June 20X4 is required in the consolidated financial statements of the KK group as
they are related parties. (Crag is a subsidiary of KK and Seal an associate of KK.)
Disclosure is also required in the individual company financial statements of Seal and
Crag. No disclosure is required in KK's individual company financial statements (even
though Seal and Crag are both related parties of KK) as the transaction does not
impact on its individual company financial statements.
Transactions before the acquisition date do not require separate disclosure in any
company's financial statements as the parties were not related during this period.
Any outstanding balances and any bad or doubtful debts must also be disclosed in
accordance with IAS 24.
Audit issue
The key audit issue is the nature of the relationship between KK and Crag which
determines whether related party disclosures are required or not.
KK appears to have transactions with a number of related parties. Related party
transactions are particularly difficult to audit, not least because they depend upon
management providing the auditor with complete and correct information. This is an
area that the audit team will need to focus on, both to ensure that appropriate
disclosure has been made in the financial statements, and as part of considering the
risk of fraud.
The auditors must remain alert for circumstances which might indicate the existence of
related party relationships or transactions. Where transactions outside the entity's
normal course of business are identified the auditors must discuss them with
management, in particular inquiring about the nature of the transactions, whether
related parties are involved and the business rationale (or lack of) of those transactions.
Audit procedures
Sales transactions
 Agree the total of post-acquisition transactions to supporting sales and purchases
records of the two companies.
 Inspect a sample of delivery notes around acquisition date for cut-off to ensure
consistency of treatment between the two companies.
 Confirm amounts of intra group goods held in inventory at year end against
inventory count records.
Related parties
 Confirm shareholdings by inspecting share certificates and rights attaching to
them.
 Inspect the contract for the options to verify the rights to exercise options.
 Review the assertion that fair value has increased by 13% since acquisition. Crag is
a private company so appropriate professional scepticism needs to be applied
and management should present evidence that the increase in sales represents an
increase in the fair value of the shares (eg, KK may have overpaid for the shares; or
the sales increase may have been anticipated at acquisition and already
discounted into the price paid by KK at acquisition).

 Review the related party disclosure notes in Crag's financial statements, to verify
whether KK is identified as Crag's parent.
 Agree appropriate disclosure of each related party transaction in accordance with
IAS 24. This should include the following disclosures:
– Nature of transactions
– Amounts involved
– Amounts due to or from the related party
– Bad debt write offs to or from the related party
Tutorial note
The above answer depends upon the student correctly identifying that Crag is a subsidiary
of KK. If the student identifies Crag, instead, as an associate of KK, the answer would be
marked on an own answer basis, with follow-up marks being awarded for relevant
discussion.
(2) Sale of goods – Seal to Moose

KK has a total (direct and indirect) shareholding of 54.5% in Moose. KK has a 35%
direct holding in Moose and also a 30% shareholding in Finkle which, in turn, has a
65% shareholding in Moose.
Through its shareholding in Finkle, it is thus clear that KK is exposed to variable returns,
dependent on the performance of Finkle. The key question here is whether KK has "the
current ability to direct the relevant activities" and in particular to direct the way Finkle
exercises its shareholder voting power with respect to Moose.
Given that one unrelated individual owns the other 70% of Finkle's ordinary shares, it
seems unlikely that KK can exercise any more than significant influence over Finkle. As
a consequence KK can only exercise significant influence over Moose through its 35%
direct shareholding, making Moose an associate of KK rather than a subsidiary.
As Moose is an associate of KK and Seal is also an associate of KK, then in accordance
with IAS 24, Seal and Moose are not considered members of the same group for
related party purposes so they are not related parties. No separate disclosure of this
transaction is therefore required.
Audit issue
If KK (or another related party of KK) actually influences the transaction then it could be
regarded as a related party transaction and therefore the audit issue is whether the
disclosure of the related party is not correct.
Audit procedures
 Confirm shareholdings by inspecting share certificates and rights attaching to
them.
 Enquire of the directors whether actual influence existed which would require the
transaction to be disclosed as a related party transaction.
(3) Purchase of a company asset by a director
Financial reporting
A director is regarded as key personnel in accordance with IAS 24. Separate disclosure
is therefore required even if this transaction is not material to the company. This is
because the transaction is likely to be material to the director and therefore capable of
influencing his decisions. The disclosure will include the profit on disposal and the fair
value attributed.

Audit issue
The audit issue in this case is that there is a potential conflict of interest between a
director and the body of shareholders in that a director may be benefiting from a
transaction which is not at arm's length.
Directors have a fiduciary duty to act in the interests of all shareholders. Directors must
not place themselves in a position where there is a conflict of interest between their
personal interests and their duty to the company (Regal (Hastings) Ltd v Gulliver). In
certain circumstances the company may void such contracts. In statute law the duty to
avoid conflict of interest has also been codified in CA2006 – s175.
More specifically, the audit issue in this case is that the price of £300,000 for the
machine seems not to be at an arm's length compared to the fair value. Mike might
therefore be exploiting his position as director to gain personal advantage.
The Companies Act 2006 imposes restrictions on the dealings of directors with
companies in order to prevent directors taking advantage of their position. This applies
even where the directors are shareholders, but particularly where the interests of
non-controlling shareholders such as Yissan may be damaged.
If there has not been knowledge and approval of the transaction by the board then
there may be an issue of false accounting by Mike.
Audit procedures
 Inspect provisions in Articles of Association and any shareholder agreement
regarding directors' contracts with the company to determine whether there has
been any wrongdoing.
 Examine the terms of the contract(s) ascertaining whether there is any clause
relating to purchase of assets by directors.
 Ascertain whether any similar transactions have taken place in the past (review
board minutes) and at what prices (see evidence of such agreements where
appropriate). The risk here is that directors may be approving each other's
bargain purchases. Also, as Janet is Mike's wife she is also a de facto beneficiary of
such a transaction and may have voted in favour.
 Ascertain whether the other directors were aware of the nature and extent of the
sales contract (eg, review correspondence; discuss with other directors) if they
have approved it.
 Review board minutes to see if the contract has been considered and formally
approved by the board.
 Confirm the amounts to the underlying contract for sale of the machine to Mike.
 Confirm carrying amount from accounting records.
 Reconcile fair value to third party evidence (eg, trade guides if there is an active
second hand market).
 Determine whether the difference between fair value and price paid should be
treated as a benefit in kind for disclosed remuneration (also tax treatment to be
considered later).
 Make enquiries to determine why Mike wanted an industrial machine. There is a
risk he may be acting in competition with KK which may be contrary to any
exclusivity clause in directors' service contracts. Alternatively he may have sold it at
a profit thereby making a personal gain from company assets.

 Obtain written representations from management and, where appropriate, those
charged with governance that all matters related to this related party transaction
have been disclosed to them and have been appropriately accounted for and
disclosed.
 Confirm the recognition of the excess of the payment over the carrying amount as
a profit on sale of PPE.
(4) Repayment of loan from Yissan
Financial reporting
KK is an associate of Yissan and therefore they are related parties.
Separate disclosure is required in accordance with IAS 24. This should include the
existence and repayment of the loan during the current period. Even though the loan is
no longer outstanding at the year end, it is a related party transaction during the
reporting period, as is any interest charge on the loan, even though no cash interest
has been paid.
The nature and treatment of the loan would also be disclosed ie, the loan would be
held at fair value (discounted at a market interest rate with the PV unwinding over time.
The unwinding of the discount element is the related party benefit).
Disclosure of the trading between KK and Yissan should also be made.
Audit issue
As the loan is no longer outstanding the related party transaction could be missed.
Audit procedures
 Agree brought forward balance on the loan.
 Perform supporting calculations of implicit interest on the loan and confirm
unwinding of the discount is charged to profit or loss.
 Reconcile repayment to supporting documentation and accounting records.
(5) Sale of goods by Crag to KK
Financial reporting
As we have seen above, Crag is a subsidiary of KK. The sale of goods by Crag to KK for
a profit of £500,000 is therefore an intragroup transaction. While the revenue and cost
of sales in Crag and KK respectively cancel out, unsold inventory remains in KK at the
year end.
As discussed above, effectively 40% of Crag is owned by Woodland plc. 40% of the
unrealised profit from this inventory therefore belongs to Woodland, the non-
controlling interest, and cannot therefore be consolidated into the group financial
statements.
The adjustment for the unrealised profit is calculated as (£1,500,000 – 1,000,000)  ¼ =
£125,000. On consolidation, Crag's post-acquisition retained earnings must be
adjusted. 60% of Crag's post-acquisition retained earnings (including £75,000 of the
£125,000 unrealised profit) will be consolidated on the face of the group statement of
financial position as part of the group's retained earnings. The remaining 40% must be
presented as pertaining to non-controlling interests. An adjustment of £50,000 must
also be made to the profit attributable to non-controlling interests line in the
consolidated statement of profit or loss and other comprehensive income.
The details of the transaction must be disclosed in the individual financial statements of
both KK and Crag.

Audit issue
Subject to confirming that the relationship between KK and Crag is indeed that of a
parent and its subsidiary, the main audit issue here is ensuring the correct
consolidation of Crag's financial results into the group financial statements. It is
important to determine whether any non-controlling interest has been correctly
accounted for.
Audit procedures
 Reconcile the cost of the goods sold to KK to Crag's inventory records.
 Confirm the consideration paid for the goods to both Crag's sales ledger and KK's
purchase ledger.
 Agree KK and Crag's underlying records relating to the transaction to the
consolidation schedule.
 Review the consolidation schedule to confirm whether the unrealised profit
adjustment has been calculated and recorded correctly.
 Agree Crag's pre-acquisition retained earnings to the company's management
accounts for the period up to KK's acquisition of Crag's shares.
Tutorial note
The above answer depends upon the student correctly identifying that Crag is a subsidiary
of KK. If the student identifies Crag, instead, as an associate of KK, the answer would be
marked on an own answer basis, with follow-up marks being awarded for relevant
discussion.
(b) Acquisition of Crag

As discussed above, Crag was effectively acquired on 1 August 20X3, when KK bought 45%
of Crag's shares with an option to purchase an additional 15% at a future date. It is essential
to confirm whether the acquisition of a controlling interest in Crag is accounted for in
accordance with IFRS. The numbers and the disclosures relating to the acquisition are
material, both from a quantitative and a qualitative point of view.
 Valuation of assets and liabilities: These should be valued at fair value at the date of
acquisition in accordance with IFRS 13.
 Valuation of consideration: This should be at fair value and will include the option to
acquire further shares as a contingent consideration. KK should measure the
contingent consideration at its acquisition date fair value.
 Goodwill: This must be calculated and accounted for in accordance with IFRS 3. The
amount of contingent consideration should be included as part of the consideration
transferred in the goodwill working.
 Date of control: Crag's results should only be consolidated from the date of
acquisition, 1 August 20X3.
 Accounting policies/reporting periods: Accounting policies and reporting periods
should be consistent across the group.
 Consolidation adjustments: The KK group must have systems which enable the
identification of intra-group balances and accounts.
 Accounting policies: Accounting policies must be consistent across the group.

(c) Ethics
The FRC's Revised Ethical Standard (2016) addresses the issue of providing non-audit
services to audit clients in section 5.
In this case there is a potential advocacy threat in acting for an audit client in a legal dispute.
A potential advocacy threat arises where the assurance firm is in a position of taking the
client's part in a dispute or somehow acting as their advocate.
While in principle the provision of other services is allowed, a threat of self-review must also
be considered, particularly where the matter in question will be material to the financial
statements. WJ acts as auditors covering the date of the acquisition so we have
responsibility for that transaction which may materially affect the financial statements for the
year ended 30 June 20X4. In providing a review of TE's procedures there may therefore be
conflict with WJ's role in the audit engagement.
In addition, there may be a potential intimidation threat arising from Mike's suggestion that
a review contract may only be awarded to WJ if he is happy with the audit. Mike himself is
one of the key risks identified in the interim audit (purchase of company asset). The
suggestion that if there are no audit issues raised about this, and other matters, there may
be more work assigned to WJ is both an intimidation threat and a self-interest threat since
relating the outcome of the review to the continuance as auditor has clear financial
implications for WJ.
Also, it is the board rather than Mike alone who would determine whether we would be
offered the review work. The shareholders would decide whether we continue as statutory
auditors.
The appropriate response is to complete the audit work as we see fit, ignoring the
possibility of further review work. It does not seem appropriate to accept the additional
work given the advocacy threat, the threat of intimidation and self-interest threat. At the
completion of the audit, we need to consider whether we should accept reappointment as
auditors if offered this position.
37 UHN (July 2014) (amended)

Scenario
In this scenario the candidate is in the role of an audit manager being asked to take over in the
final stages of an audit of UHN. UHN is a manufacturing company which has survived the
recession but is still reliant on bank support who monitor performance against gearing and
interest cover ratios calculated on the year-end audited financial statements. The company is
easily meeting these ratios provided that the accounting policy choices of the directors are
appropriate and the accounting treatment of certain financial reporting issues is correct.
These financial reporting issues have been identified by the audit senior as areas which he
believes the board has exercised significant judgement in the choice of accounting policies.
Issue 1 involves a sale and leaseback arrangement – the leaseback is on the cusp of being
treated as either an operating leaseback or a finance lease and therefore a matter on which the
directors have exercised judgement. Issue 2 involves an impairment charge on an overseas asset
where the accounting rules have been applied incorrectly. Issue 3, a hedge for delivery of
titanium where the directors have chosen (incorrectly) not to apply hedge accounting despite
satisfying the conditions; and Issue 4 where a liability has been treated incorrectly as a provision.
The impact of the adjustments for these issues is that the interest cover ratio is still met but the
gearing covenant would be breached.
The candidate is required to propose appropriate financial reporting treatments, adjust the
financial statements in order to recalculate the covenant ratios based upon their
recommendations and to identify the key audit risks arising from the review of the senior's notes.

The candidate is required to exercise scepticism in their recommendations to distinguish
accounting errors from areas where judgement has been applied. In particular the candidate is
required to recognise that although there is potentially judgement to be exercised by the board,
this is acceptable if the accounting policy choices are within the substance of the relevant IFRS.
In addition the board is in disagreement about the business approach to cyber security. The
responsibility chain appears to end before board level and it appears to be a severe breach in
risk management and control. The operations director has suggested that a cyber-attack would
be catastrophic and there appears to be little board level discussion and agreement about this
risk. The issue creates audit risk, potential going concern risk and undisclosed liabilities.
The firm has been asked to tender for a one-off assignment, on this matter. The candidate is
asked for a report on the ethical implications of this tender for the firm.
Marking guide
Marks
(a) Set out and explain the implications of the financial reporting issues in
Greg's handover notes. Make recommendations on the appropriate
financial reporting treatment where relevant. 20
(b) Using your recommendations above, evaluate and explain the impact of
your adjustments on the gearing ratio and the interest cover ratio in
accordance with the bank's loan covenants (Exhibit 1). 6
(c) Outline the key audit risks we need to address before signing our audit
opinion on the financial statements. I do not need the detailed audit
procedures, just concentrate on the key risks. 9
(d) Explain the responsibility and accountability of the UHN board for cyber
security and make appropriate recommendations 5
(e) Prepare a file note explaining the ethical implications for our firm if we
decide to tender for and, if successful, accept this one-off assurance
assignment. 5
Working Paper – Prepared by Audit Manager

For the attention of Petra Chainey
I have examined the issues identified by the audit senior as follows:
Issue 1 – Sale and leaseback
The directors' justification for the treatment of the lease on the property as an operating lease is
not correct. IAS 17 identifies five factors which would lead to the conclusion that a lease should
be classified as a finance lease. There is limited information regarding two of these situations
and more information would be required (ie, whether there is an option to purchase, and
whether the asset is so specialised that it could only be used by the lessee without major
modification).
However there is information to assess the application of the two factors; the lease term and the
relationship of the PV of the MLP and the fair value of the asset at the inception of the lease.
The asset was purchased in 20W4 and had a useful life at that date of 30 years. Therefore at
31 March 20X4 at the inception of the lease, the 20-year lease term is for the entirety of the
asset's remaining useful life. This is strong evidence that the company has entered a finance
lease for the factory. We would need to consider if the assessment of useful life has changed but
if not, this is reasonably strong evidence that the lease term is for the entire useful life of the
factory.

The present value of discounted future rentals relating to the factory is £611,120 × 20-year
annuity discount factor @ 8% ie, £611,120 × 9.818 = £6m. The fair value of the factory at the
inception of the lease is £6 million. This is strong evidence that the leaseback of the factory is a
finance lease.
Therefore as regards the freehold factory, from the information provided, it would appear that
UHN has entered into a sale and finance leaseback and this would significantly change the
picture presented in both the statement of profit or loss and the statement of financial position.
If the factory leaseback is a finance lease, the transaction is a means whereby the lessor provides
finance to the lessee, with the asset as security. The excess of fair value (where fair value equals
proceeds) over the carrying amount (£3.040 million) should be deferred and amortised over the
term of the lease. As the lease was taken out at the year end, no profit should be recognised on
the leaseback of the factory.
The finance lease is then recorded in the normal way, with the asset and corresponding liability
both initially recognised at £6 million which is the lower of the fair value and the present value of
minimum lease payments.
Correcting journals:
£'000 £'000
DEBIT Exceptional item 3,040
CREDIT Contract liabilities more than 1 year (£3.04m  19/20) 2,888
CREDIT Contract liabilities less than 1 year (£3.040m /20 years) 152
DEBIT PPE 6,000
CREDIT Finance lease creditor – long term liabilities see working below 6,000
CREDIT Current liabilities 130
DEBIT Finance lease creditor – long term liabilities 130
Finance lease creditor
Lease payment
due on Finance charge
b/f 31.3.20X5 8% in arrears c/f Due > 1 year Due < 1 year
£m £m £m £m £m £m
6.00 5.87 0.13
6.0 (0.61) 0.48 5.87
The directors correctly state that the treatment of sale and leaseback will change under IFRS 16.
Accounting for sale and leaseback transactions depends on whether in substance a sale has
occurred (ie, a performance obligation satisfied) in accordance with IFRS 15, Revenue from
Contracts with Customers.
If the transfer is in substance a sale, the seller-lessee derecognises the asset sold, recognises a
right-of-use asset and lease liability relating to the right of use retained and a gain/loss in
relation to the rights transferred.
Where the transfer is in substance not a sale, the seller-lessee accounts for the proceeds as a
financial liability (in accordance with IFRS 9).
Issue 2 – Impairment of service centre
The restrictions imposed by the government would indicate impairment and the directors have
correctly carried out an impairment review.
RUB
Cost 266
Depreciation 44
Carrying amount 222

Expressed in RUB, the asset is impaired because the recoverable amount, which is the fair value
less costs to sell of RUB204 million, is less than the carrying amount of RUB222 million.
However for the purpose of testing for impairment the carrying amount should be measured at
the normal historic exchange rate, but the recoverable amount should be determined at the
closing exchange rate.
Thus the carrying amount in £s is 222/53 = £4.189m
The recoverable amount in £s is 204/48 = £4.25m
Therefore no impairment charge is required.
£'000 £'000
DEBIT PPE 375
CREDIT Cost of sales 375
This is an error and must be adjusted.
Issue 3 – Hedge
The directors have not applied hedge accounting correctly and therefore an adjustment is
required to reflect the profit on the movement of the price of titanium held in inventory at
31 March 20X4. The directors have already taken the loss to operating profit. However as
hedging is applied a gain must be recognised in profit or loss to reflect the movement in the
value of the inventory.
£'000 £'000
DEBIT Inventory 2,000
680,000 kg  £15 = £10.2m – Cost £8.2m
CREDIT Income statement – Gain on inventory 2,000
The net gain recognised in profit or loss is £232,000.

Issue 4 – Provision for claim for damages
The provision should now be classified as a liability as the timing and amount are no longer
uncertain. It would therefore form part of the long-term borrowings of the company and be
taken into consideration when applying the bank gearing covenant. The provision stands at
£9.26 million at 31.3.20X4 (£10m  0.926 = £9.26m).
The liability has been agreed to be £9.1 million. 25% will be payable within the next 12 months =
£2.275 million. The balance will be due after more than 1 year and should be discounted for
1 year.
Short term Long term Total
£'000 £'000 £'000
Provision 740 8,520 9,260
Actual liability 2,275 6,825  0.926 = 6,320 8,595
(1,535) 2,200 (665)
Provisions should be reclassified to liabilities and then
£'000 £'000
DEBIT Long term liabilities 2,200
CREDIT Profit and loss 665
CREDIT Short term liabilities 1,535

Recalculation of the gearing ratio and the interest cover ratio in accordance with the covenant
with the bank (Exhibit 1).
Year ended 31 March 20X4 Statement of profit or loss
Before Issue 1 Issue 1 Issue 2 Issue 3 Issue 4 After
£'000 £'000 £'000 £'000 £'000 £'000 £'000
Revenue (56,900) (56,900)
Operating costs 49,893 (375) (2,000) (665) 46,853
Exceptional item (Issue 1) (3,040) 3,040 –

Operating profit (10,047) (10,047)
Finance costs 2,200 2,200
Profit before tax (7,847) (7,847)

ASSETS
Non-current assets
Property, plant and
equipment (Issue 2) 20,040 6,000 375 26,415
Current assets
Inventories (Issue 3) 21,960 2,000 23,960
Trade receivables 15,982 15,982

Equity
Share capital – ordinary £1
shares (1,000) (1,000)
Share premium (15,000) (15,000)
Retained earnings – deficit 500 500
Total equity (15,500) (15,500)
Loans (20,000) (20,000)
Long-term liability – (Issue 4) (8,520) 2,200 (6,320)
Finance lease creditor and
deferred income (2,888) (5,870) (8,758)
Deferred tax liability (1,000) (1,000)
Total non-current liabilities (29,520) (36,078)
Current liabilities
Trade and other payables (12,350) (12,350)
Short-term provision –
(Issue 4) (740) (1,535) (2,275)
deferred income (152) (130) (282)
Total current liabilities (13,090) (14,907)
Total equity and liabilities (58,110) – – – – – (66,485)
Conclusion
Therefore although the covenant in respect of the interest cover ratio is still satisfied, the impact
on the gearing ratio changes significantly and it is now breached.

Interest cover ratios
Before and after
10,047/2,200 = 4.57 times
Gearing ratio
Net debt defined as:
Long - term borrowings and long - term payables (excluding provisions)
Equity (Share capital and reserves)
After
Loans 20,000
Long-term liability 6,320
deferred income 8,758
35,078
= 226%
Equity 15,500
Before
Loans 20,000
= 129%
Equity 15,500
The key audit risks to be addressed before signing our audit opinion on the financial
statements
Inappropriate accounting treatments
The directors are under pressure to meet covenant requirements and although clearly the
interest cover ratio can be easily met, the gearing ratio covenant is encouraging the directors to
be creative in their judgements. This represents a key risk for the audit firm and would require
the exercise of professional scepticism in areas of judgement made by management. For
example other areas of judgement in this type of industry would be inventory, bad debt
provisions and warranty provisions.
Correction of accounting errors
Whereas there is judgement involved in the treatment of the sale and leaseback (issue 1), and
further discussion will be required with the directors over this matter, issue 2 the impairment of
the service centre and issue 4 the incorrect categorisation of the provision are less subjective
and adjustments should be proposed for correction of this accounting treatment. The outcome
of these issues would result in the gearing covenant being breached. Clearly with covenants in
place, any adjustment exceeds the materiality of £100,000. The materiality level should therefore
be revisited and other areas of the audit re-examined in the light of a recalculated materiality
level.
Going concern
A key audit risk is therefore going concern. If the covenant is breached UHN will need to show
the loan as short term whether or not they are able to reschedule and the company does not
have sufficient cash to repay the loan if it is recalled immediately.
Consideration should be given to whether the going concern is affected by the breaching of the
gearing covenant. Initially we should discuss with management their relationship with the bank
and the probability of funding being withdrawn and their contingency plans to obtain an
alternative funding arrangement.
The effect of UHN being unable to meet its covenant does not necessarily mean that the entity is
not a going concern if the financial risk of this event can be counterbalanced by management's
plans to reschedule its loan capital.

The directors are required to report that the business is a going concern with assumptions or
qualifications if necessary as part of their responsibilities under the UK Corporate Governance
Code. The listing rules also require auditors to review the annual statement by the directors that
the business is a going concern. As part of the audit we will have performed audit procedures to
examine the directors' review of going concern to establish whether the use of this assumption
is appropriate. ISA (UK) 570 requires auditors to consider the same period used by
management: therefore in the first instance we will need to discuss with management their
assessment of going concern. We should ensure that management's assessment considers the
financial risk of the withdrawal of the loan funding.
If there is adequate disclosure in the financial statements by the directors regarding the
uncertainties about going concern then an unmodified audit opinion with a 'Material Uncertainty
Related to Going Concern' section in the auditor's report is likely to be sufficient. If the directors
do not disclose going concern uncertainties appropriately, however, it may be necessary to
modify the audit opinion.
Audit quality
There is also a risk arising from the use of inexperienced audit staff on the assignment –
additional review procedures will be required to mitigate this risk.
Cyber security
There is an allegation that UHN's systems were hacked causing the navigation system in a
customer's cargo plane to fail. Although UHN strenuously denied the claim, the board appears
not to be in control of the issues relating to cyber security and the reporting chain and budget
responsibility lies with the IT manager who is not a board member. The risk of a cyber-attack
could present a going concern issue for Hartner to consider and also there may be further
undisclosed liabilities to record.
Responsibility and accountability of the UHN board for cyber security and make appropriate
recommendations
It is clear that the board does not understand the risks of cyber security and have not linked up
IT and information risks with the management of business risks.
It is also apparent that the technical function of managing risk is separate from the business
function. There is no implication that the level of security and the handling of the risk of a cyber-
attack is not managed appropriately by the IT manager, however as the board is not involved or
aware of the processes, it is demonstrating lack of accountability and is indicative of poor
corporate governance. The FRC risk guidance states that directors are responsible for
appropriate risk management and internal control; that they should also agree how principal
risks should be managed or mitigated. Cyber security should be seen as part of that
responsibility which is currently being delegated to sub board level management.
Recommendations for the board:
 Cyber security should become the responsibility of a board member – preferably part of the
responsibilities of a chief risk officer.
 Clear lines of responsibility and accountability for cyber security should be embedded in
day-to-day operational responsibilities and subject to board oversight.
 Develop a road map which defines critical business data and associated risks.
 Consider UHN's participation in networks to share intelligence about attacks and attackers
within the industry.
 If in-house professionals are not available, the board should appoint external professionals
to communicate and articulate risk management and advise on the value of security
spending.

 Ensure that non-executive directors and audit committee members have appropriate
knowledge and training to hold management to account in a meaningful way regarding
cyber risks.
 Explore and determine the board's tolerance to cyber security such as risk tolerance and
risk appetite.
 Improve the understanding between board members and IT specialists.
 Instil the ethos of reporting early breaches without penalty in staff and where security is
seen as an enabler of digitally based business rather than a compliance process.
File Note – the ethical implications for our firm tendering and, if successful, accepting the one-
off assurance assignment
Petra suggests that the fee for this work would be lower as we could use some of our findings as
part of the audit work. The Revised Ethical Standard 2016 (para 5.5) specifically prohibits other
work undertaken by the engagement team from being categorised as part of the audit. This is
because the nature of the work is not to gather evidence to support the audit opinion and the
nature and extent of the assignment will not be determined by the auditor but by the terms of
the engagement agreed with the client.
This assignment would therefore be called a 'non-audit related service'. The firm should identify
any threats to independence and objectivity. If a low fee for the work is agreed as suggested in
the email, then this would clearly be a threat to independence. We would need to consider the
relative size of the engagement fee in relation to the audit fee and discuss with the ethics
partner.
Other considerations here are the nature of the proposed work and whether it breaches rules
and principles of The Revised Ethical Standard 2016 – if this is of an advisory nature there is a risk
that the firm would be auditing its own work when assessing the arrangement for audit
purposes. There is also a hint here that the firm is being pressurised by the client with the threat
that it might lose the audit and this in itself would be a threat which should be carefully
considered.
The firm should not undertake work for which it does not have expertise. There is a basic
requirement that ICAEW Chartered Accountants act in accordance with professional
competence and behaviour. Doing work which is beyond their knowledge would be a breach of
the ICAEW ethical code.
38 Couvert (November 2014)

Scenario
In this scenario the candidate is in the role of a recently-qualified ICAEW Chartered Accountant
assigned to the audit of Couvert plc. Couvert has made two acquisitions during the year: a 55%
shareholding in Ectal, an overseas subsidiary; and a 100% shareholding in a UK subsidiary,
Bexway, acquired partway through the year. The skills required to answer this question
successfully are: financial statement analysis in conducting relevant analytical review
procedures; application of technical knowledge to identify appropriate actions; assimilation and
structuring skills eg, in linking poor corporate governance with the financial reporting question
over control of Ectal; and communication skills to different audiences.
The candidate is first asked to perform analytical procedures on Ectal's financial information
which has been provided to Couvert only very recently and close to the reporting date. The
candidate should identify that the information is incomplete (SOCIE and cash flow is missing, no
tax charge) and perform financial statement analysis in preparing eg, profitability ratios. The
candidate should identify that Ectal has performed significantly worse than in 20X3 and against
budget expectations, which raises the possibility of earnings management prior to the

acquisition to enhance the acquisition price. Linking the finance costs in the statement of profit
or loss with the SOFP suggests a return of 10% on a loan from a director. The candidate should
express scepticism over the amount of interest and question whether it is reasonable in the
context of the overseas jurisdiction. The candidate should select relevant financial ratios and
determine that the financial position has declined in 20X4 and in particular inventory ratios
indicate a slow-down in the inventory turnover.
The candidate is then asked to discuss the governance structure at Ectal and identify that control
is effectively retained by the vendor of the 55% shareholding. Linking this to the financial
reporting treatment of the investment is an embedded point requiring higher level skills.
The candidate is asked to explain the financial reporting treatment and again there is an
embedded point to be identified concerning the impairment of assets in the statement of profit
or loss which has implications for the value of goodwill at acquisition.
The candidate is then asked to recommend appropriate audit actions arising from the
investment and is required to apply technical knowledge therefore of ISA 600.
Finally the candidate is required to explain the appropriate financial statement adjustments in
respect of a pension issue and a put option which arise in the financial statements of Bexway, the
100% newly-acquired subsidiary.
Marking guide
Marks
(a) Analyse and explain, using analytical procedures, the financial performance
and position of Ectal for the year ended 31 August 20X4 (Exhibit 2). Include
enquiries that will need to be made of Ectal's management and its auditor
Stepalia arising from these analytical procedures. 15
(b) Identify and explain your concerns about the corporate governance
arrangements at Ectal and the impact of these on the financial reporting of the
investment in Ectal in Couvert's consolidated financial statements for the year
ended 31 August 20X4. 9
(c) Explain in respect of the audit of Ectal by Stepalia:

 the actions to be taken by PG; and
 the potential implications for the group auditor's report. 8
(d) Explain the appropriate financial reporting treatment for the two issues
identified by Couvert's finance director (Exhibit 3). 8
Total marks 40
(a) Report on analytical procedures of Ectal's financial information for the year ended
31 August 20X4
Prepared by Anton Lee, Audit Senior
Introduction
It is clear that Ectal's performance has declined significantly; the business produced a
substantial loss in 20X4, compared to budgeted and prior year profit. This loss in 20X4
arose primarily because of the highly significant impairment of property, plant and
equipment.

General comments
The financial statements, on which the analytical review is based, are incomplete. There is
no statement of cash flows, no explanatory notes, no statement of changes in equity and the
performance statement also appears to be incomplete. The movement in retained earnings
for the year is a reduction of C$70.2 million, but only C$50.2 million has been accounted for
as loss in the year. Therefore there is, presumably, a further C$20 million of loss/expense
accounted for in other comprehensive income. If this is accounted for by a dividend paid in
the year it would be expected that 55% of it will have been received by Couvert. But it could
be something else and we need to find out what this difference relates to.
Ectal's performance
Ectal classifies expenses by nature, rather than by function. The budgetary information for
the year ended 31 August 20X4 provides a set of expectations against which actual
performance can be judged, and a comparison against the prior year results is also
possible. Analysis of the principal profit or loss items shows the following:
Actual 20X4 as a Actual 20X4 as a
% of budget % of 20X3
Revenue 85.2% 87.2%
Raw materials (RM) and consumables used,
adjusted for changes in inventories and WIP* 87.3% 87.9%
Employee expenses 101.9% 125.2%
Depreciation expense 86.2% 88.2%
Other expenses 141.4% 140.1%
*Consumption of raw materials and consumables adjusted for inventory change (C$m):
20X4 Actual 20X4 Budget 20X3 Actual
Inventory change 5.9 (8.3) (18.6)
RM and WIP used (192.8) (205.7) (194.1)
(186.9) (214.0) (212.7)
Revenue for 20X4 is very much lower than both prior year and budget figures, which may
suggest a downturn in trade. However, it is also possible that cut-off at the beginning of the
year was incorrect, and that revenue was recognised too early in order to manipulate profits
immediately prior to takeover and to improve the price paid for the acquisition. This factor
could have affected many of the figures in both the performance and position statements,
and if so, the consequences for the audit and for the client would be very significant. It
would be helpful to undertake some trend analysis of Ectal's results, going back over three
or four years, and also to look at the extent to which their budgeting has deviated from
actual results in the past. We should be able to obtain this information from the due
diligence files.
Employee expenses are higher than budget, and much higher than in the previous year.
The increase appears to have been expected in that the 20X4 budget figure is substantially
increased compared to 20X3 actual figures. It may indicate a significant planned pay
increase for staff, but it is difficult to tell without further information. Other expenses have
increased even more, both against budget and prior year. Again, more information would
be required. It is possible that expenses have been misallocated, and that the totals that we
are currently examining are not accurate comparators.
Depreciation, on the other hand, is much lower than planned, and much lower than in the
prior year. However, the C$60 million impairment, which is material, has had a significant
impact on the PPE balance. More information would be required about the timing of this
impairment. If it occurred and was recognised at the year end, as seems likely, then it does
not explain the drop in depreciation which should have been recognised in full before the
amount of the impairment was calculated. It is impossible to reconcile the movement in
property, plant and equipment without further information on acquisitions and disposals.

The carrying amount of PPE at 31 August 20X3 was C$603.7 million, which reduced to
C$551.3 million at 31 August 20X4. The difference between the two figures is
C$52.4 million, exactly the amount of the depreciation charge for the year ended 31 August
20X4. It appears, therefore, that net acquisitions amounted to exactly C$60 million,
balancing the amount of the impairment. The note to the financial statements on PPE and
the cash flow statement would help in providing explanations.
Profitability
Because of the classification of expenses by nature, no figure for gross profit is disclosed.
However, gross profit can be estimated by deducting change in inventory, RM and WIP
used, employee expenses and depreciation expenses from revenue, as follows:
20X4 Actual: 305.4 + 5.9 – 192.8 – 26.3 – 52.4 = 39.8 (ie, excluding impairment)
20X4 Budget: 358.6 – 8.3 – 205.7 – 25.8 – 60.8 = 58.0
20X3 Actual: 350.4 – 18.6 – 194.1 – 21.0 – 59.4 = 57.3
Margins can then be calculated as follows:
Gross profit margin 13.0% 16.2% 16.4%
Operating profit margin
(operating profit = (loss)/profit
before tax + finance costs) (14.8%) 10.3% 10.3%
Net pre-tax margin (16.4%) 8.9% 8.9%
Note: All calculations exclude other income, which was not budgeted. There is no
indication of what this might be, but audit work will be required on this figure.
Gross margin has suffered a significant decline. This may possibly be the result of a change
in sales mix, but the decline requires further explanation.
Finance costs
Linking finance costs to the statement of financial position, the principal liability at the 20X4
and 20X3 year ends was the loan from director. It appears that the director is earning
approximately 10% pa from this loan. Whether or not this is a reasonable return depends to
some extent upon interest rates in Celonia, but the interest rate may be excessive.
Other issues
Return on capital employed (7.7%) 5.6% 5.6%
Return on capital employed is negative in 20X4. Budgeted and 20X3 actual ROCE are both
relatively modest figures. It could be helpful to compare these and other performance
ratios with industry averages, both within Celonia and globally.
There is no tax charge or credit for 20X4. We need to know more about tax relief available
for losses in Celonia, but on the face of it, a figure appears to have been omitted in this
respect. Depending upon loss relief available, the bottom line loss for 20X4 may be
reduced.
Financial position
A selection of relevant accounting ratios is presented in the table below:
Non-current asset turnover 0.55 0.58 0.58
Inventory turnover (days)* 134.7 days 109.3 days 114.7 days
Receivables turnover (days) 60.6 days 56.0 days 59.4 days
Current ratio 1.48:1 1.51:1 1.46:1
Quick ratio 0.51:1 0.66:1 0.62:1
Payables turnover (days)** 148.3 days 134.4 days 142.3 days

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

Financial reporting implications for Couvert's consolidated financial statements for the
year ended 31 August 20X4
The implications of the analysis above are as follows:
(1) Ectal's financial reports for the year ended 31 August 20X4 are incomplete, and appear
to require a lot of additional work. This may have the effect of delaying the
consolidation and thus placing the group's preliminary reporting deadline at risk.
(2) Goodwill on consolidation in respect of the Ectal investment may be misstated, and
any misstatement could be highly material. The material impairment loss in respect of
property, plant and equipment could indicate that PPE was overstated at acquisition,
and that goodwill was therefore understated. However, if the financial statements for
the year ended 31 August 20X3 (the opening position for this year) were manipulated
to show an improved performance and position, it is likely that Couvert paid too much
for the investment, and goodwill may require impairment. If the loss for the year ended
31 August 20X4 is, on the other hand, genuine (and not affected by the misstatement
of the opening position) goodwill may still require impairment.
(3) The extent to which Couvert actually controls Ectal requires careful examination from a
financial reporting perspective. Couvert has the majority shareholding which would
normally indicate control. However, IFRS 10, Consolidated Financial Statements states
that an investor controls an investee if and only if it has all of the following:
 Power over the investee;
 Exposure, or rights, to variable returns from its involvement with the investee; and
 The ability to use its power over the investee to affect the amount of the investor's
returns.
Couvert apparently has power over the investee as it owns 55% of the share capital.
The fact that the Couvert board members have not exercised control is not a
determining factor in deciding whether Couvert has control over Ectal. However
further information would be required regarding the rights of the shareholders to
appoint board members. If Ygor has further rights to appoint more members of his
family it could be that Couvert does not have control over Ectal.
If Couvert does not control Ectal under IFRS 10, then the investment cannot be
recognised in the consolidated financial statements as a subsidiary and would be
recognised instead as an associate.
(c) Actions to be taken by PG, and potential implications for the group auditor's report arising
from the audit of Ectal by Stepalia
Reassessment of audit risk
We may need to reassess audit risk in respect of the investment in Ectal. Audit risk was
originally assessed as moderate. There appear to be some good reasons for reassessing
the risk as high:
(1) There are now questions over the effectiveness of Ectal's corporate governance and,
especially, over the extent of Couvert's involvement in Ectal's governance.
(2) There is now an apparent risk that Ectal's opening figures were misstated and that due
diligence was compromised.
(3) There is a continuing lack of communication from Stepalia (see below).
If the due diligence engagement was not conducted thoroughly, PG's relationship with
Couvert may be damaged, and engagement risk may increase.

Poor performance by Ectal's auditors, Stepalia in respect of the audit for the year ended
31 August 20X4
As at today's date, no returns or information have been received from Stepalia. ISA (UK) 600
(Revised June 2016), Special Considerations – Audits of Group Financial Statements
(Including the Work of Component Auditors) requires that group auditors should evaluate
the work of the component auditor but currently it is not possible to do this.
We should take the following actions immediately:
 Seek a meeting with the Couvert finance director to explain that our group audit
cannot be concluded satisfactorily unless full information is received about the Ectal
audit from Stepalia.
 Attempt further direct communication with the Stepalia audit team via phone or email.
 Plan attendance at key audit meetings between Stepalia and Ectal's management. This
is likely to involve a visit to Celonia before our audit completion deadline.
If we do not receive full information from the component auditors before our reporting
deadline, the implication for our audit report is that modification may be necessary. This is
likely to be on the basis that we have not obtained sufficient appropriate audit evidence (a
limitation on scope opinion), which is material but not pervasive. The appropriate form of
audit report would state a true and fair opinion (assuming no other audit modification was
necessary in respect of Couvert and other parts of the group) except in respect of the audit
of Ectal where insufficient information was received from the component auditors. We
would also need to consider any Key Audit Matters as Couvert is a listed company.
(d) Financial Reporting queries received by email from Couvert's finance director
Issue 1 – Accounting for retirement benefits
The following working shows the movement in the six-month period in respect of pension
plan assets and obligations:
Assets Obligations
£'000 £'000
Fair value/present value at 1 March 20X4 8,062 8,667
Interest for six months to 31 August 20X4
(£8,062,000  3%) (£8,667,000  3%) 242 260
Past service costs 500
Contributions paid into plan 842
Benefits paid (662) (662)
Gain on plan assets (balancing figure – OCI) 146
Gain on remeasurement (balancing figure – OCI) (312)
Fair value/present value at 31 August 20X4 8,630 9,057
The present value of obligations at 31 August 20X4 has been adjusted upwards to take
account of the additional £500,000 in plan liabilities in respect of the plan amendment. The
increase in benefits has been announced and is therefore properly recognised as a liability.

Journal entries to reflect these transactions are as follows:
Debit Credit
£'000 £'000
Staff costs (in respect of service costs) 1,104
Plan obligations 1,104
Finance costs 260
Plan obligations 260
Finance costs 242
Plan assets 242
Plan assets – contributions to the scheme 842
Staff costs 842
Pension plan assets – gain on plan assets 146
Pension plan liabilities – gain on plan liabilities 312
OCI actuarial gain 458
2,906 2,906
The total gain on pension assets and liabilities is recognised in other comprehensive
income. The six-month discount rate of 3% is applied to opening plan assets and liabilities,
and the amounts calculated are added to plan assets and liabilities and credited/debited to
finance costs in profit or loss.
Issue 2 – Financial asset
The put option appears to fulfil the definition of a derivative: its value changes in response
to the changing price of an underlying security, its initial investment is small relative to the
underlying value of the security, and it is settled at a future date. This being the case, the
correct IFRS 9 classification for the option is as a derivative at fair value through profit or
loss. The initial recognition of the financial asset was therefore incorrect, and the following
correcting journal is required:
Debit Credit
£ £
Financial assets at fair value through profit or loss 63,000
Investment in equity instruments 63,000
The share price has fallen below the put option price of £6.00 and the option is therefore
in-the-money. A gain can be expected on the option, measured at the year-end date of
31 August 20X4 as the increase in the fair value of the option of £32,000 (£95,000 –
£63,000).
The required journal entry is:
Debit Credit
£ £
Financial assets at fair value through profit or loss 32,000
Profit or loss 32,000
Examiner's comments
Financial statement analysis
Most candidates made a reasonable attempt at the first part of the question which required
analysis and explanation of Ectal's incomplete financial statements, plus queries for Ectal's
management and its auditor. There were few really impressive answers, but most candidates
managed to achieve at least half marks for this section.
Few candidates identified the risk that the prior year figures may have been manipulated to
improve the price paid to acquire the subsidiary. The fact that the statement of profit or loss
analysed expenses by nature rather than function was rarely commented on therefore caused
problems in the calculation of standard ratios such as gross profit margin. Although some
candidates commented on the loan from a director, it was very rare to see the loan related to the
level of interest and the possibility that the interest being paid was excessive. Finally,

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

39 ERE (November 2014)
Scenario
The candidate in this scenario is asked to review the audit procedures performed by a junior
member of staff on payables and deferred tax. To answer this question the candidate needs to
identify weaknesses and missing procedures and to recommend further audit procedures to
enable a conclusion to be determined on the audit of ERE. There are also errors in financial
reporting which the candidate needs to assimilate in order to recommend adjustments. A
summary of uncorrected errors needs to be prepared from which the candidate should
determine a reasonable course of action to enable the firm to arrive at an audit opinion on the
financial statements of ERE.
Finally the candidate must identify the ethical issues arising from the scenario which relate to the
potential weakness in the firm's quality procedures and a potential fraud at the client.
Marking guide
Marks
(a) Explain the key weaknesses in the audit procedures performed by Chris.
Identify the audit risks arising in respect of ERE's payables and deferred tax
liability and the audit procedures that should be completed in order to
address each risk. 10
(b) Identify and explain the financial reporting issues. Recommend appropriate
adjustments. 12
(c) Summarise on a schedule of uncorrected misstatements the adjustments that
you have recommended. Explain the further action that we should take in
respect of the uncorrected misstatements. 6
(d) Identify and explain any ethical issues for HH, and recommend any actions
for HH arising from these issues. 6
Total marks 34
(a) General weaknesses

(1) The working paper prepared by Chris does not adequately document the work he has
performed.
(2) There are no references to how he has calculated his sample size and how he has used
the materiality level.
(3) There is no evidence that he has carried out analytical procedures.
(4) ISA (UK) 500 requires that audit evidence should be 'sufficient' and 'appropriate'.
Appropriateness relates to the quality of evidence which should be relevant and
reliable:
 In terms of relevance, there is no reference to relevant audit assertions for each
class of balance being tested. Nor has he identified which audit assertions are
more relevant dependent upon the nature of each balance.
 With respect to reliability, he has relied heavily on the client for oral evidence
which is not an independent source. In so far as he has examined supplier
statements this provides third party evidence but he has allowed the client to
select the sample which reduces the quality of such evidence.

Specific weaknesses in work performed by Chris
Trade payables
(1) It appears that the client chose the balances for the supplier statement reconciliation
test on the basis of the largest balances at the year end. The client should not have
selected the sample. Also it should have been selected based on throughput rather
than year-end balance as the key risks are both understatement and overstatement.
(2) Chris has also underestimated the amount of coverage of the sample selected since he
has based the percentage coverage on the supplier balance not on the ledger
balance. His sample represents 53% of the unadjusted purchase ledger balance.
(3) The work performed on the cash in transit is inadequate and needs to be followed up –
there is evidence here of window dressing and this point needs to be raised with the
board. There is at least £1.2 million which has reduced the payables and cash balances
at the year end and I have recorded £1.2 million on the schedule below. However,
there may be more and the amount should be quantified and raised at the audit
completion meeting.
(4) The work on invoices in transit is not adequate. Chris should have determined when
the goods were received rather than just when invoice was posted. If the goods were
received pre year end, Chris should have agreed the amount to an accrual within
goods received not invoiced and ensured that the goods were either in inventory or
sold at the year end. Further audit procedures are required to provide assurance that
payables are not understated by sampling goods received notes immediately prior to
the year end and ensuring they are recognised in payables, particularly where they
have not been invoiced at the year end.
(5) The large number of invoices in transit on two suppliers may suggest a cut-off error so
further emphasises that there is a need to do careful work here.
(6) The explanation of the invoices on 'hold' is inadequate and should be taken forward to
be discussed with those charged with governance. Potentially this is indicative of a
fraud at a supplier company and has ethical implications and reputational risks for the
firm and for ERE as there may be collusion with ERE staff – see below.
(7) The calculation of the KH exchange gain is incorrect – see below financial reporting
issues. The work performed by Chris is again inadequate. He should have enquired
about other currency denominated creditors and how these have been treated at the
year end.
(8) Chris should also have asked whether there are any hedging arrangements in place for
such large forex balances as there may be unrecognised derivatives at the year end.
(9) The legal claim and Medex disputed invoices should be raised for discussion with the
board and further audit procedures are required in terms of direct confirmation with
the legal advisers and potentially an auditors' expert.
(10) The adjustment to credit purchases is large – £850,000, and in excess of materiality,
and there is no evidence that Medex has accepted liability and intend to issue credit
notes for this amount. I have highlighted this on the schedule below.
(11) The work on debit balances is inadequate – Chris should have investigated how and
why such balances have arisen this year and whether they are recoverable.

Other payables
(12) The provision for restructuring and the lease have been calculated incorrectly – see
below under financial reporting issues. In terms of the audit procedures performed this
is also limited. The division has now closed and Chris should have confirmed the
restructuring costs to payments after the year end. There are also potentially further
costs for impairments of non-current assets and receivables and no audit procedures
appear to have been carried out to identify these.
(13) No work has been performed on other accruals which has increased from last year
even after taking account of legal costs, and exceeds the materiality level.
(14) Deferred tax work is clearly inadequate – I have therefore summarised the risks and
audit procedures in the following schedule:
Audit risks and procedures:
Audit risks Procedures
 Risk of both over and understatement of  Re-perform a sample of supplier

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

Foreign exchange
 There is a clear risk that there may be  Review the list of trade payables for other
other misstatements of Forex balances. currency balances and reperform
calculations of exchange gains and losses.
 Inventory may be overstated if the goods  Confirm with other team members that
purchased in other currencies are still in adequate testing has been performed on
inventory at year end. NRV for inventory.
 There may also be missing balances in  Enquire whether there have been any
respect of derivatives. forward contracts undertaken in the year.
Enquiries should be made of the finance
director as this is unlikely to be an area
which is the responsibility of the financial
controller.
Other payables
 Other payables may not be fairly stated.  Obtain a list of other payables, compare
to previous year and supporting
documentation. Verify to third party
evidence and re-performing calculations
as appropriate.
Provisions
 There is a risk that there may be other  Review accruals schedule for other
similar balances that required discounting accruals which may need discounting and
which may cumulatively be material. quantify the impact of such an adjustment.
 There is a risk that impairments of assets  Confirm with other audit team members
in the factory have not been correctly that adequate testing has been
assessed therefore non-current assets will performed on impairments of receivables
be overstated. and non-current assets.
 Receivables relating to the division may  Review payments after date and ensure
also not be correctly stated. that the provision is fairly stated. Agree to
supporting third party documentation.
 There could be additional liabilities which
have arisen which were not originally in
the budget.

Legal claim
 The financial statements may not be fairly  Make appropriate enquiries of those
stated if the legal claim is not disclosed. charged with governance including
obtaining representations.
 Review board minutes and
correspondence with ERE's legal advisers.
 Ask for permission from those charged
with governance to communicate directly
with ERE's lawyer by means of a letter of
enquiry with the reply sent direct to HH.
 Consider all matters pertaining to the
legal case up to the date of signing the
auditor's report.
Deferred tax
 There is a risk that the client lacks the  Review the current tax computation for
appropriate financial reporting any temporary differences not accounted
knowledge to prepare accurate deferred for as a deferred tax adjustment.
tax computations resulting in a
 Obtain a reconciliation of profit per the
misstatement of the financial statements.
financial statements to taxable profit and
ensure that deferred taxation has been
appropriately provided for temporary
differences only.
 Verify that the tax rate at which the
liabilities and asset unwind is in line with
tax legislation enacted.
 Agree the opening position of the
deferred tax liability to the prior year
 Consider whether it is appropriate for the
company to recognise deferred tax assets
and liabilities given future forecasts of
taxable profits.
(b) Identify and explain the financial reporting issues. Recommend appropriate adjustments.
Issue 1 – Forex gain on KH balance.
The purchase has been recorded correctly at the rate of exchange on 1 October 20X3.
£'000 £'000
DEBIT Purchases 3,478
CREDIT Trade payables 3,478
On 1 April 20X4 ERE paid €2,000,000 to settle half of the trade payable (£1,739,130). This
cost €2,000,000/€1.20:£1 = £1,666,667 and the company therefore made an exchange
gain of £72,463, which (assuming the credit has gone to profit or loss) has been correctly
recorded as:
£'000 £'000
DEBIT Trade payables 72
CREDIT Exchange gains: profit or loss 72

However on 31 July 20X4, the year-end date, the liability should be recalculated using the
year-end balance: €2,000,000/€1.27:£1 = £1,574,803 which gives rise to a further gain of
£1,739,130 – £1,574,803 = £164,327
Further adjustment required:
£'000 £'000
Issue 2 – Legal claim made by hospital
The issue here is whether the legal claim should give rise to a provision or a contingent
liability requiring disclosure and, if possible, quantification; or if remote no disclosure. It
appears likely that this issue represents a contingent liability and further audit procedures
are required to determine and quantify the level of disclosure. There may also be an
offsetting claim against Medex and an assessment must also be made of whether any
disclosure can be made in respect of a contingent asset. At the moment there is insufficient
information to determine the adjustment for this claim.
The legal fees have been correctly accrued. Given the size of the balance, discounting is
unlikely to be material but should be quantified for the schedule of uncorrected
misstatements below. I have used an annual discount rate of 5% for two years (1/1.052) to
calculate the following adjustment:
100,000  0.907 = £90,700
However the interest rate should be confirmed as appropriate to this type of liability and
level of risk.
Issue 3 – Provision for restructuring
The provision for restructuring has been overstated and should not include the one-off
payment nor the removal costs of the plant and machinery. An adjustment is required as
follows:
£'000 £'000
DEBIT Other payables 450
CREDIT Restructuring costs: profit or loss 450
Further adjustments will be required on completing of audit work in this area.
Issue 4 – Lease cost
The signing of the lease is a past event which creates a legal obligation to pay for the
property under the terms of the contract and is an obligating event. ERE has correctly
created a provision for the onerous contract. This is calculated as the excess of unavoidable
costs of the contract over the economic benefit to be received from it. The unavoidable cost
is the lower of the cost of fulfilling the contract and the penalty arising from failing to fulfil it.
If the effect of the time value of money is material it should be taken into consideration in
calculating the provision.
The present value of the sublease arrangement is:
(£240,000 – £60,000)  5.076 = £913,680
This is lower than the immediate payment of £1.1 million and therefore an adjustment is
proposed of:
£'000 £'000
CREDIT Lease costs: profit or loss 186
This assumes that the 5% discount rate is correct. It should be confirmed that it is
appropriate to this type of provision and level of risk.

In accordance with IFRS 16, Leases a lease liability and a right-of-use asset should have
been recognised in the statement of financial position. The potential fall in rental income
indicates that the right-of-use asset is impaired, because it is underperforming. An
impairment test must be carried out and an impairment loss recognised for the right-of-use
asset.
Issue 5 – Deferred tax
The offsetting of deferred tax assets and liabilities is permitted by IAS 12 provided that the
entity has a legally enforceable right to offset current tax assets against current tax liabilities
– this appears to be the case but further audit procedures should be carried out to confirm
this.
A temporary difference arises with the upward revaluation of the head office building. This
should be provided for in full and therefore the following adjustment is proposed:
£'000 £'000
DEBIT Other comprehensive income 200
CREDIT Deferred tax liability 200
Unused tax credits carried forward against taxable profits will give rise to a deferred tax
asset to the extent that profits will exist against which they can be utilised.
The existence of unused tax losses, however, is strong evidence that future taxable profits
may not be available. The deferred tax asset should be limited to the likely future profits –
£1,250,000  20% = £250,000
£'000 £'000
DEBIT Deferred tax: profit or loss 150
Therefore the total deferred tax liability at year end is £790,000.
(c) Summarise any proposed adjustments you have identified on a schedule of uncorrected
misstatements and determine what further action we should take.
Statement of profit Statement of financial
or loss position
£'000 £'000 £'000 £'000
(1) Window dressing – cash in transit
DEBIT Cash 1,200
CREDIT Payables 1,200
(2) Medex disputed invoices
DEBIT Purchases 850
CREDIT Trade payables 850
(3) Exchange gain on KH balance
(4) Discount on legal fees
DEBIT Accruals 10
CREDIT Legal costs 10
(5) Provision for restructuring
CREDIT Restructuring costs: profit or loss 450
(6) Lease costs
CREDIT Lease costs: profit or loss 186

Statement of profit Statement of financial
or loss position
£'000 £'000 £'000 £'000
(7) Deferred tax on office building
(8) Deferred tax asset
DEBIT Deferred tax: profit or loss 150
Further action
Clearly some of these adjustments are material and will therefore be required so that the
financial statements are fairly stated. However, the audit work to date would appear to be
inadequate therefore I propose the following actions:
 Completion of audit work as proposed above.
 Review of the entire audit file and quantification of adjustments by an appropriately
qualified member of staff.
 The schedule of uncorrected misstatements should also include any brought forward
errors which impact on the current year's results and SOFP.
 Arrange a meeting with those charged with governance to discuss the adjustments.
 Refusal to adjust or refusal to permit HH to obtain necessary explanations and
confirmations may result in limitation on scope of audit work and a modification of the
audit opinion may be required.
 In accordance with ISA (UK) 530, Audit Sampling, HH is required to project
misstatements found in the sample onto the population. If the projected misstatement
(plus anomalous misstatement if any) exceeds the tolerable misstatement the sample
does not provide a reasonable basis for conclusions about the population. HH may
then (1) request management to investigate actual and potential misstatements, or (2)
perform further audit procedures.
(d) Identify and explain any ethical issues for HH, and recommend any actions you believe we
should take.
 For HH there is a professional ethical concern in respect of the quality of the work
being performed. HH are not acting in accordance with the FRC and ICAEW ethical
codes in respect of professional competence and due care.
 A junior member of staff appears to have been inadequately supervised and
performed inadequate audit work to date. Although this has been identified on a
timely basis on this assignment there may be quality issues with other assignments.
 Although there is no breach of the ethical code in respect of Josi's appointment at ERE
(as she had not completed her training contract she would have held a junior position
within the audit team), clearly relying on the work she is producing represents a threat
to audit independence which needs to be addressed in the planning of audit
procedures.
 There is evidence of poor training, lack of professional competence and maybe also
lack of policies in HH for addressing problems when staff members leave for
employment with a client.

 There is potentially a fraud being perpetrated at an ERE supplier company, Mesmet.
HH needs to determine whether there is collusion with ERE staff and whether there is a
risk of material misstatement in the ERE financial statements. This is an ethical issue for
HH if the client has unaddressed ethical issues as this increases engagement risk for
HH.
 HH should adopt an attitude of professional scepticism and obtain relevant audit
evidence of this impact which should be documented including tests performed,
discussions with audit team members and detailed enquiries made at the appropriate
level of management and their responses.
 If fraud is suspected, HH should report to those responsible for governance at the
appropriate level – as potentially the finance director is involved then this should be
given careful consideration.
 There may also be responsibilities under the money laundering legislation and
therefore we should consult the firm's money laundering compliance principal (MLCP).
Examiner's comments
Comment on candidates' performance
A significant minority of candidates' attempts at this question were perfunctory and partial.
Some candidates omitted answering this question which makes being successful at the paper
very difficult.
However, there were some excellent answers demonstrating a very high level of analysis skills
and knowledge of auditing and financial reporting.
Key weaknesses, risks and procedures
The first requirement was an explanation of key weaknesses in the audit procedures carried out
on payables by a junior member of the audit staff. There were many relevant points that could
be identified in this respect and well-prepared candidates appeared to find little difficulty in
scoring the maximum marks for this part of the question. Even weaker candidates were often
able to score relatively highly on this, although their efforts were often marred by repetitious and
sometimes irrelevant answers.
Candidates produced comprehensive answers that clearly identified the weaknesses in the work
done as well as identifying risks and suggesting procedures. Most answers were in a logical
format with candidates working their way methodically through the information given. The most
common weakness was with regard to further procedures which were sometimes vague –
'discuss with management' or inappropriate – suggesting contacting a supplier directly without
first obtaining the client's permission.
Financial reporting treatments and appropriate adjustments
The second requirement was to identify and explain the financial reporting issues. This was
generally less well-handled. Despite lengthy calculations and explanations, many candidates
were unable to calculate an exchange gain. Weaker candidates were unsure about how, or if, to
recognise a contingent liability, and relatively few identified the point about the need to
discount the liability for legal fees. A significant number of candidates completely omitted any
reference to the provision for restructuring. Of those that did address the provision for
restructuring, few candidates realised that relocation and costs of removing plant and machinery
should not be included. Well-prepared candidates were able in most cases to produce a correct
calculation for the present value of the sublease arrangement, and the consequent correcting
journal. Weaker candidates tended to omit any reference to this issue. Most candidates who got
this far were able to calculate the deferred tax asset and deferred tax liability correctly, although
some omitted to recommend adjustments.

Other common errors included:
 Mis-calculating the foreign currency gain at the year-end by ignoring or dealing incorrectly
with the impact of the part payment made/occasionally treating it as a loss rather than a
gain.
 Suggesting a provision should be set up even where the solicitors had advised that it was
only possible the claim would succeed.
 Failing to reverse out the adjustment for credit notes that had not been agreed with the
supplier.
 Identifying that there was an onerous lease but making errors in calculating the discounted
future cash flows/failing to recognise that the provision should be at the lower of this figure
and the termination cost/adjusting for the entire amount rather than just correcting the
provision already made.
 Recognising the entire amount for the deferred tax asset re trading losses rather than
calculating the adjustment to the asset currently recognised.
Schedule of uncorrected misstatements
The third part of the question required candidates to summarise their adjustments on a
schedule of uncorrected misstatements. This requirement was often omitted. Missing out
sections of questions is not advisable. Those candidates who did attempt it tended to produce
just a list of journals, without any attempt to separate the profit or loss effects from the statement
of financial position effects.
Those who did attempt to explain further action often achieved good marks for simple points
such as discussing the errors with the client and considering the potential impact on the audit
report.
Ethical issues
Finally, candidates were required to identify and explain any ethical issues in the scenario. Most
candidates were able to gain a mark or two, at least, on this section and some did very well.
Most candidates made a reasonable attempt at identifying the ethical issues but the most
common weakness was to focus almost entirely on the issue of a previous member of the audit
team joining an audit client.
Other issues such as the quality of work performed by the junior member of the team, the
potential fraud at a supplier and the motive to manipulate caused by the potential AIM listing
were then often overlooked limiting the marks that could be awarded.

40 Congloma
Scenario
The candidate is an audit senior working on the audit planning for a group audit. They receive
details of a number of transactions and is required to determine the appropriate financial
reporting treatment of these transactions and also their implications for the group audit.
To answer this question, a good understanding of accounting for acquisitions and disposals
(including step acquisitions and part disposals) was essential. The scenario required the
candidate to link information concerning the group transactions from different sources and to
assimilate the information to determine the correct financial reporting treatment. The candidate
was then required to summarise adjustments against the consolidated profit before taxation.
The audit element required the candidate to set out the additional audit procedures not only
procedures for the individual transactions but also at group level to assess the impact on the
group audit scoping.
Marking guide

(a) Draft a response to Jazz's email 20  Identify the implications of control
(Exhibit 2) and its attachment threshold not being crossed in
(Exhibit 3). In your response you respect of the acquisition of Oldone
should: shares.
(1) Set out and explain, for each of  Apply technical knowledge to
the transactions she identifies, determine the split of equity and
the correct financial reporting liability in respect of the bond.
treatment in Congloma's  Apply IFRS 10 to determine whether
consolidated financial control exists in respect of the
statements for the year ending Neida investment.
31 August 20X4. Recommend
and include appropriate  Explain the implication of
adjustments and calculations. unidentified intangibles in Neida on
consolidation.
 Describe the impact on the control
threshold arising from the sale of
Tabtop and the implications for the
consolidation.
 Determine the allocation of
goodwill between parent and NCI in
respect of the Shinwork disposal.
 Identify potential omissions
regarding fair values and other
costs and provisions in respect of
the Shinwork disposal.

(2) Calculate the consolidated profit 5  Assimilate information on
before taxation for the year adjustments and prepare a revised
ending 31 August 20X4, taking profit before taxation.
into account the adjustments
you have identified.
(b) Set out in a working paper the 15  Determine relevant audit
additional audit procedures that we procedures to the transactions
will need to perform as a result of the identified.
transactions Jazz has identified.  Identify the potential to manipulate
Include an explanation of the impact profits in arising from the sale of the
that the transactions will have on the Oldone CEO's shares – link relevant
scope of our audit procedures and procedures to this risk.
the components that we consider to
 Apply concept of materiality to
be significant.
determine that Neida is potentially
not material to the group and
therefore that subsidiary level
procedures may not be required.
 Link the changes in group structure
to the assessment of work required
on the identification of significant
components and hence the level of
audit procedures required at
associates and subsidiaries.
(a) (1) Financial reporting treatment of the matters raised in the finance director's email
Oldone
As Oldone has been recognised as a subsidiary for some time, the acquisition of a
further 20% does not 'cross an accounting boundary' nor result in any change in
control. As a result, no gain or loss will be recorded. The proposed fair valuation
exercise is therefore not required.
The accounting entries required in the consolidated financial statements will be as
follows:
DEBIT Non-controlling interest £2.8m
DEBIT Shareholders equity (balancing figure) £1.2m
CREDIT Cash (or elimination of investment in holding
company) £4.0m
Convertible bond issue
The bond issue should be accounted for as a compound financial instrument with a
liability element and an equity element.
The liability element of the gross proceeds is calculated as the net present value of the
maximum cash flows at the rate of interest for a similar bond without conversion rights,
8%:
Cash flow Discount factor PV
Year £'000 8% £'000
1 500 0.926 463
2 500 0.857 429
3 10,500 0.794 8,337
9,229
ICAEW 2019 July 2015 answers 459

Hence of the £10 million gross proceeds, £9.229 million should be shown as a liability
payable (on issue). The split between the short and long term elements will need to be
redetermined at the year end of 31 August. The remaining balance of £771,000 should
be shown as equity. The effect on profit before taxation will be a charge of three
months' interest on the bond. This will be £9,229 @ 8%  3/12 = £185,000.
Neida
IFRS 10 para 12 states that "An investor with the current ability to direct the relevant
activities has power, even if its rights have yet to be exercised". IFRS 10 para B47 also
requires an investor to consider potential voting rights in considering whether it has
control and (para B22) whether they are substantive ie, whether the holder has the
practical ability to exercise the right.
Although Congloma does not have the majority of the voting rights in Neida and there
are other powerful investors, two factors in accordance with IFRS 10 suggest that
Congloma may still have control and should therefore account for Neida as a
subsidiary rather than as an associate.
 It has the power to affect its returns from Neida through its control of Board
decisions over research and development, arguably the most important decisions
in a research driven entity such as Neida.
 It has the right to acquire further shares through its call option. The exercise of this
option will give it a majority holding of 65%. In this case the rights to acquire
further shares appear to be substantive as Congloma's additional 20% holding will
cost it £1.5 million compared to the £3.0 million it paid for its initial 45%
shareholding. While this is a higher amount per share it is not substantially higher
and can reasonably be expected to be a competitive price for a stake which takes
it to a majority holding in the company.
The FD's proposal to account for Neida as an associate is therefore incorrect.
Accounting for Neida as a subsidiary means that 100% of its results, assets and
liabilities will be consolidated within the group financial statements and the 55% share
not owned by the group will be accounted for as a non-controlling interest.
The acquisition will have a significant impact on the group statement of cash flows with
the investment shown within investing activities.
Using the share of net assets method to determine goodwill on acquisition and the net
asset information provided will give a goodwill figure of £3 million + (55% of £200,000)
– £200,000 = £2.91 million which will be included as an intangible asset in the group
financial statements and will need to be subjected to a review for impairment.
However further consideration needs to be given to whether some/most of this value
should be attributed to intangible assets which are not shown at present on Neida's
statement of financial position. In particular, there may well be value in the research
and development project for Lastlo which appears to have reached the commercial
exploitation stage.
The Lastlo project should be valued as a separable intangible on acquisition (and
subsequently within the consolidated financial statements) if it could be sold separately
from Neida and has a stand-alone value. Treatment as a separable intangible will also
affect group accounts in future years as intangibles other than goodwill are amortised
through the statement of consolidated profit or loss.
In addition to the Lastlo project there may be other separable intangibles in the form of
intellectual property rights or contractual rights such as patents.

As Neida is accounted for as a subsidiary, its loss for the 3 months ending 31 August
20X4 will be included in group profit before taxation (although 55% of it will then be
attributed to the non-controlling shareholders) – therefore adjustment required of
£300,000  3/12 = £75,000.
Consideration also needs to be given to whether the option to acquire a further 20% of
Neida has a value which should be recorded within the financial statements.
Given Neida's loss for the year, an impairment review should also be considered.
Sale of Tabtop
As a significant interest in Tabtop is expected to be retained, Tabtop will be an
associate following the part disposal. The loss of control triggers the need to re-
measure goodwill and the retained interest will therefore be valued not at net asset
value but at fair value.
Therefore the FD is correct in his recommendation of the accounting treatment in this
instance however the calculation of the gain on disposal is incorrect. There is in fact a
small loss, calculated as shown below:
£m
Proceeds received 6.0
Fair value of 25% interest retained 1.0
7.0
Less:
Net assets of Tabtop 5.6
Goodwill 1.5
(7.1)
Loss on disposal in group accounts (0.1)
This loss includes the downward revaluation to fair value of the remaining
non-controlling interest, thus explaining why it is different to the calculation performed
by Jazz.
Jazz is correct in her proposal that from now on the remaining interest in Tabtop will be
equity accounted for. The full results of Tabtop will be included in the consolidated
statement of profit or loss account up to 30 June 20X4. From that date onwards just the
group's share of Tabtop's loss after tax will be included and this will also be deducted
from the carrying value of the investment in Tabtop in the consolidated statement of
financial position.
Tabtop will be included as an associate rather than a subsidiary for the last two months
of the year. This will mean that rather than a loss of £3m  2/12 = £500,000, only a loss
of 25% of that amount (£125,000) will be included in profit before taxation. Therefore
an adjustment of £375,000.
As Tabtop has been making losses it is possible that it will not succeed under its new
owners and the remaining investment in the company will need to be reviewed for
impairment.
Shinwork
An impairment adjustment will be required if the carrying amount is lower than the
higher of the value in use and the fair value less selling costs. The value in use is
£9.2 million which is below the carrying amount and therefore an impairment charge
should be recorded. The following calculation assumes that it is correct to use the
value in use. If the fair value less costs to sell the remaining business were higher then
that figure should be substituted in the calculations above giving a lower impairment
charge.

The impairment in the overall value of Shinwork needs to be allocated between
Congloma and the non-controlling interest. As the non-controlling interest is
determined using the proportion of net assets method, there needs to be a notional
grossing up of goodwill in order to compare the carrying and recoverable amounts.
The parent company's goodwill of £4 million needs to be notionally adjusted to
include the NCI notional goodwill of £1 million (20%/80%  £4m) giving a total
goodwill figure of £5 million.
Hence the impairment can be calculated as:
£m
Net separable assets 8.0
Goodwill 5.0
13.0
Value in use (9.2)
Impairment 3.8
Of the total impairment, 80% is allocated to Congloma giving a goodwill impairment of

£3.04 million to be recorded in the financial statements which is allocated first to
goodwill.
Other financial reporting issues
Whether there are other costs which should be provided for? There are likely to be
redundancy costs and other costs of closure/disposal which should be provided for at
the point at which a detailed plan and announcement have been made (IAS 37). It is
not clear from the information given whether this is the case or will be by year end.
However both the amount of the required provision and the timing of its recognition
need further consideration.
(2) Effect on consolidated profit before tax for the year ending 31 August 20X4
£'000
Projected profit before adjustments 7,000
Oldone – no effect on profit before taxation but will affect the amount of 0
profit attributable to the non-controlling interest as this will be 20% to 31 May
and nil thereafter.
Bond issue – effect on profit before taxation will be charge of 3 months' (185)
interest on the bond. This will be £9,229 @ 8%  3/12
Acquisition of Neida – as Neida is accounted for as a subsidiary, its loss for (75)
the 3 months ending 31 August will be included in group profit before
taxation (although 55% of it will then be attributed to the non-controlling
shareholders) £300,000  3/12 = £75,000.
Goodwill is not amortised but there will be a further reduction in profit if
there are other intangible assets for which amortisation is charged.
Tabtop – loss on disposal (100)
In addition, Tabtop will be included as an associate rather than a subsidiary
for the last two months of the year. This will mean that rather than a loss of 375
£3m  2/12 = £500,000, only a loss of 25% of that amount (£125,000) will be
included in profit before taxation. Therefore an adjustment of £375,000.
Shinwork
Impairment charge (3,040)
Adjusted projected profit before taxation 3,975

(b) Group audit procedures required on transactions identified
General points on scope of group audit work
The group auditor's ability to obtain sufficient evidence will be affected by significant
changes in the group such as those for Congloma. Identification of significant components
may change as entities are added to the group or sold off or as the relative materiality of
their operations changes. The group auditor should be involved in the assessment of risk
for all significant components which will require a full audit using component materiality;
and audit of specified balances related to significant risks.
If work done at significant components does not provide sufficient audit evidence then
some non-significant components will be selected and additional procedures performed at
those rather than the analytical reviews performed in the past. Changes in the group may
mean that such an approach becomes necessary.
In this case, work at the components is performed by other teams from A&M LLP but the
group audit partner will still need to be involved in planning and directing the work of those
teams to ensure that sufficient assurance is given at group level.
Oldone
 As Oldone has been a subsidiary for some time, few additional audit procedures are
likely to be required.
 However, the sale by the Chief Executive of his shares does increase his incentive to
overstate the results of the company in the period to 31 May 20X4. There is therefore
an enhanced risk of management override of controls and fraud. The subsidiary audit
team should be made aware of this and asked to report to the group team on the
results of focussed audit procedures on journal entries and judgemental provisions.
 The results as at 31 May 20X4 will determine the entry made to reserves and therefore
some additional work may be required to look at whether an accurate cut off in
revenue and costs was achieved at that date. Any unusual trends in the last three
months compared to the earlier part of the year should also be thoroughly
investigated.
 The sale and purchase agreement for the shares should be reviewed to identify key
terms and ascertain any performance conditions or additional liabilities.
 The entries made to record the new investment and the elimination of the non-
controlling interest balance should be reviewed to ensure that they are accurate.
Convertible bonds
 The terms of the convertible loan agreement should be reviewed and agreed to the
loan agreement document and ensure that the financial reporting treatment agrees to
the terms.
 In particular the sources for the comparable interest rate should be checked as it is this
which drives the split of the compound instrument for accounting purposes. A higher
or lower rate could make a significant difference.
 The bond's value is greater than planning materiality and is a complex transaction and
requires scrutiny given the lack of experience of the client's staff.
Neida
 Review purchase agreement and loan agreement to identify key terms and form an
independent assessment as to whether Congloma has control over Neida and whether
there are other key terms which should be considered in forming that assessment or
determining the amounts to be included in the financial statements.

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

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

Shinwork
The impairment rules were explained well and most candidates were able to make a reasonable
attempt at the impairment calculation. The most common error was to not gross up the goodwill
for the NCI component. Other financial reporting issues were rarely identified.
Adjustments to profit before tax
This was generally well done, with candidates demonstrating the ability to assimilate information
on adjustments and prepare a revised profit before taxation. Most schedules were clear and
cross referenced and it was marked on an own figure principle. Weaker candidates ignored the
statement given in the question that the profit figure given was before accounting for any of the
transactions.
Audit procedures
Those candidates who did well approached this section methodically addressing each
transaction in turn and suggesting procedures specifically relevant to that transaction and
stating why the procedure was required. Weaker candidates just produced an unstructured list
of tests including many 'general' procedures relating to intra company transactions and reliance
on other auditors. Many candidates just discussed 'reviewing' and 'looking at' without stating
what they were looking for or why they were reviewing.
Relatively few candidates focused on identifying significant components and instead often
produced lengthy answers discussing materiality.
For Oldone little consideration was given to the potential to manipulate profits arising from the
sale of Oldone's shares held by the CEO. Few candidates thought that there may be an issue
with buying from the CEO and that there may be fraud. Time was wasted discussing fair values
but these would not have been relevant as control was not transferred as a result of the
acquisition.
For Neida most procedures appropriately concentrated on the control aspect. Very little was
discussed about the fair value of the net assets and identifying the intangibles. The losses may
have prompted the need for a goodwill impairment review but the most commonly mentioned
procedure was checking that the future losses were forecast correctly without saying why.
By the time Tabtop was discussed many were running out of fresh ideas and concentrated on
auditing the disposal – checking the calculations and the proceeds to the bank. It was
disappointing that few thought to check that the new holding gave significant influence and
could have been control or just an investment.
For Shinwork there were audit procedures of the VIU and little else. Some mentioned the need
for a going concern review but not many.
41 Heston
Scenario
Heston is a listed company which manufactures engines. It has four autonomous divisions
operating from separate factories. The candidate has recently joined Heston as deputy to the
finance director.
Heston has had some difficult years recently but a new chief executive is beginning to turn the
company around. It has been decided to close the lawnmower division but at the accounting
year end under consideration it has not yet been sold. In order to boost sales volumes in the
other three divisions, selling prices were reduced by 10% at the beginning of the current
financial year. Steel is a significant raw material used in production. Fluctuations in steel prices
are a major risk so the company has entered into a cash flow hedge for a highly probable
purchase of steel. Candidates are required to:

 set out the financial reporting adjustments for the decision to dispose of the lawnmower
division and for the cash flow hedge;
 redraft the draft financial statements including comparatives; and
 analyse Heston's performance and position for the current year using the redrafted
Marking guide

I would like you to: 14  Apply technical knowledge to determine
Set out and explain the financial the adjustments required for the
reporting adjustments required in discontinued operation, including assets
respect of the issues in Exhibit 3. held for sale.
 Set out the adjustment for cash flow
hedge determining the correct amount
and the presentation of the FV movement
in OCI and OCE.
 Apply relevant adjustments required to
comparatives for SPL but identify that no
HFS adjustments required for comparative
SoFP.
 Explain relevant adjustments clearly
identifying the source of authority for
treatment from the relevant standard.
Prepare an adjusted statement of profit 8  Assimilate adjustments and prepare in
or loss for the year ended 30 June appropriate format.
20X5 and an adjusted statement of  Identify separate disclosure of continuing
financial position at that date in a form and discontinued activities.
suitable for publication, including
comparatives.
Analyse Heston's performance and 8  Identify causal factors for changes.
position for the year ended 30 June  Communicate in an appropriate style
20X5. Include calculations and use the relevant to the context of the FD's section
adjusted financial statements. Outline on the annual report and analysts'
any further information needed, so I questions.
can ask somebody to investigate.
 Identify separately the performance of
continuing and discontinued activities,
explaining the significance of each for
shareholders and other stakeholders.
 Link price decrease to revenue increase
and provide reasoned explanation
highlighting changes in sales volumes.
 Extrapolate results of analysis to infer
reasons for GP and profit changes.
 Identify liquidity as an issue and explain
main factors affecting liquidity.
Total marks 30

Set out and explain the financial reporting adjustments required in respect of the issues in
Exhibit 3
Loss from discontinued operations
The Lawn Mower Division is a substantial and separate part of the Heston business as it is one of
only four divisions and it is a profit centre where revenues and costs are therefore separately
identified. In accordance with IFRS 5 para 31 it is therefore a component of the entity and should
be treated as a discontinued operation in accordance with IFRS 5 para 32. It is therefore
required that Heston makes appropriate presentation and disclosure of the effect of the division
in the year ended 30 June 20X5 in accordance with IFRS 5 para 33 including comparatives for
20X4.
The costs identified are those that will no longer be incurred when the division is disposed of.
The post-tax loss for the Lawn Mower Division amounts to £12.274 million and is shown in
Working 1 below.
Asset disposals – Held for sale
Plant and equipment appears to qualify as a held for sale asset in accordance with IFRS 5 from
the date they are marketed (ie, advertised for sale) and should be held at its fair value and in its
current condition (IFRS 5 paras 7 and 8). This is 1 April 20X5. Heston should charge depreciation
up to the time of classification and then no depreciation for the last three months. In Exhibit 3 a
full year has been charged which must be reversed and replaced by depreciation for nine
months (see Workings 1 and 2 below).
It is not a disposal group as assets are to be sold to 'a range of different buyers'.
At this date, according to IFRS 5 para 15, each asset of the Lawn Mower Division should be
stated at the lower of:
(1) their carrying amount, less depreciation up to the time it is classified as held for sale; and
(2) their fair value less costs to sell
If fair value is lower than carrying amount (as is the case above for plant and equipment but not
for the land and buildings) then an impairment charge should be made.
Thus the non current assets held for sale should be recognised as a current asset and measured
at £17.27 million. An impairment charge of £1.235 million would be recognised. The details are
shown in Working 2 below.
The provision for redundancy appears to meet the conditions under IAS 37 but further
information should be obtained to confirm this.
The brand is not recognised (IAS 38) as it was not recognised previously in Heston's financial
statements as it was internally generated.
Cash flow hedge
The arrangement qualifies for hedge accounting under IFRS 9, Financial Instruments, and meets
the objective-based test for hedge accounting, which focuses on the economic relationship
between the hedged item and the hedging instrument, and the effect of credit risk on that
economic relationship. It is a cash flow hedge.
Cash flow hedge accounting by Heston attempts to reflect the use of the forward contract to
purchase steel to hedge against future cash flow movements from inventory purchases arising
from steel commodity price movements. To do this, the movement in the fair value of the
contract of £42,000 (which is a loss), in the year ended 30 June 20X5, which would normally be
recognised in profit or loss, is recognised in other comprehensive income and in other
components of equity and as a financial liability.

This balance of £42,000 is recycled to profit or loss in the same period in which the hedged
highly probable forecast purchase of steel affects profit or loss. In this case, this is in the year
ending 30 June 20X6 as the contract will be settled in September 20X5.
Note that under cash flow hedge accounting, the change in the fair value of the future cash flows
(the hedged item) is not recognised in the financial statements.
It is assumed that the contract is a fully effective hedge as it is based on the price of steel which
Heston acquires regularly.
An adjusted statement of profit or loss for the year ended 30 June 20X5 and an adjusted
statement of financial position at that date in a form suitable for publication, including
comparatives
Statement of financial position as at 30 June 20X5 20X5 20X4
£'000 £'000
ASSETS
Non-current assets
Property, plant and equipment (113,660 – 18,260) 95,400 120,400
Development costs 10,380 10,380
105,780 130,780
Current assets
Trade and other receivables 36,100 30,400
Cash and cash equivalents – 5,600
68,400 59,200
Non-current assets held for sale (W2) 17,270 –
Total assets 191,450 189,980

Equity
Retained earnings (68,520 + 15,710) 84,230 68,520
Other components of equity (W3) (42) –
121,188 105,520
Current liabilities
Current tax payable 4,420 6,060
Financial liability 42 –
Overdraft 8,400 –
Provision for redundancy costs 3,800 –
48,262 45,460
191,450 189,980
for the year ended 30 June 20X5
20X5 20X4
£'000 £'000
Revenue (436,000 – 92,000)/(451,700 – 119,300) 344,000 332,400
Cost of sales (306,180 – 72,084)/(318,500 – 77,400) (234,096) (241,100)
Distribution costs and administrative expenses
(107,200 – 33,800)/(101,400 – 34,700) (73,400) (66,700)
Finance costs (1,500) (1,500)
Income tax expense (4,420 + 2,600)/(6,060 – 1,400) (7,020) (4,660)
Profit for the year from continuing operations 27,984 18,440

20X5 20X4
£'000 £'000
(Loss)/Profit from discontinued operations (W1) (12,274) 5,800
Cash flow hedge (W4) (42) –
Total comprehensive income for the year 15,668 24,240
WORKINGS
(1) Loss from discontinued operations
£'000
Per draft accounts (Exhibit 3) (11,284)
Add back depreciation
for 3 months (980 – 90 – 645) 245
Impairment (W2) (1,235)

(12,274)
(2) Non-current assets held for sale

Plant and
Land Buildings equipment Total
£'000 £'000 £'000 £'000
Carrying amount at 1 July 20X4 5,600 5,040 8,600 19,240
Depreciation charge for
9 months
Buildings (6,000/50  9/12) (90) (90)
Plant (8,600  10%  9/12) (645) (645)
Carrying amount at 30 April
20X5 5,600 4,950 7,955 18,505
Fair value less costs to sell

(13,000 & 7,000  96%) 12,480 6,720
Impairment loss (discontinued) Nil (1,235) (1,235)

Carrying amount 17,270
(3) Cash flow hedge

Value of contract: £'000
Price at 30 June 20X5 (6,000  £158) 948
Price at 1 May 20X5 (6,000  £165) (990)
Loss (42)

CREDIT Financial liability 42
Analysis of financial statements – for inclusion in finance director's section of the commentary in
the annual report.
Revenue
The headline figure in the draft financial statements showed a decrease in revenue of 3.5%
overall for the company.
The adjusted financial statements strip out the Lawn Mower Division as a discontinued activity.
The revenue from Lawn Mowers fell significantly by 22.9% in the year but this, in part, was due to
a major new entrant in the industry over which Heston had no control. The response has been to
decide to sell off the Lawn Mower Division to prevent further losses.

The adjusted statement of profit or loss shows revenue of £344 million from continuing activities
(ie, from the three remaining divisions). This shows that revenue from these three divisions
actually increased compared to the previous year by 3.5%.
One of the underlying possible causes of this change could have been the reduction in all selling
prices of the three divisions of 10%, which may, as intended, have increased sales volumes. If we
adjust for this price change to show changes in sales at constant prices then this shows:
20X4 £332.4m
20X5 £382.2m (£344m/0.9)
This shows that sales volumes (crudely measured) have increased by about 15%. More
information is need to explore the extent to which the price decrease was the primary causal
factor for the volume increase (for example, sales mix between products will also affect the year
on year analysis) but it is indicative that the policy has proved successful in expanding sales
volumes.
Profit
The headline figures in the original draft financial statements show a significant fall of 31.1% in
profit for the year from £24.24 million to £16.7 million.
A key factor for analysts is the extrapolation of profits into the future by exploring trends. The
adjusted statement of profit or loss strips out the losses from the Lawn Mower Division and
shows profit from continuing activities which will form the basis of profit in future.
The adjusted figures reveal that the three divisions collectively showed an increase in profit for
the year on continuing activities of 52% from £18.44 million to £27.98 million.
This is a positive trend which can be emphasised to analysts, particularly if there is evidence that
it will continue in future.
Gross margin
The unadjusted gross profit margin has not changed significantly from 29.4% to 29.7%. However
the gross margin from the discontinued operation has fallen from 35.1% to 21.6%.
The adjusted financial statements show that gross margin on continuing operations has
increased from 27.5% to 31.9%. At first sight this may seem surprising as selling prices have
been reduced which would normally indicate a reduction in gross margin. However, the
increased sales volume has taken advantage of the high level of fixed costs, and therefore
operating gearing, in order to enhance the gross margin and compensate for the selling price
reduction.
Financial position and liquidity
The liquidity position of Heston has worsened significantly as measured by the decrease in cash
of £14 million from a positive balance of £5.6 million to an overdraft of £8.4 million.
On the other hand, £17 million of the long-term loan has been repaid in the year.
A concerning aspect of liquidity which may raise questions from analysts is the apparent
worsening of the working capital position. Both receivables and inventories have risen
significantly, whilst payables have decreased. All these have had a detrimental effect on cash
and have been financed from cash generated from operations. The reasons for the changes in
working capital need to be ascertained by further investigation.
There has been no cash spent on PPE in the year. It is not clear whether this is because there
were no viable opportunities to acquire new assets or because the cash was not available given
it is being consumed by increases in working capital.
A summary of the liquidity changes can be seen by drawing up a statement of cash flows for the
year ended 30 June 20X5 from the draft financial statements provided.

Tutorial note
Candidates are not expected to prepare a statement of cash flows, but may refer to individual
figures or groups of figure (investing, financing, or operating cash flows) within their narrative.
The statement of cash flows therefore provides a framework for such an approach.
£'000 £'000
Profit before taxation 21,120
Adjustments for:
Depreciation (120,400 – 113,660) 6,740
Provision 3,800
Increase in inventories (9,100)
Increase in receivables (5,700)
Decrease in payables (7,800)
Cash generated from operations 9,060
Income taxes paid (6,060)
Net cash from operating activities 3,000

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

 An analysis of the fair value of assets. This would include the credentials of those who have
completed the valuation. This should evaluate the potential for borrowing using the assets
as security in order to enhance liquidity.
 Comparison of the ratios with those for other companies in the sector, to assess relative
performance.
 Additional segmental analysis for each of the three continuing divisions, to assess
performance and development opportunities for each segment independently. IFRS 8
segment disclosure may be appropriate.
Examiner's comments
Financial Reporting adjustments
Candidates demonstrated a good knowledge of IFRS 5 and most answers focused on the
accounting treatment of assets held for sale. Some candidates wasted time by simply copying
out every criteria from the standard rather than focusing on the specific scenario given. The
calculations of the impairment of PP&E were generally well done although a minority incorrectly
combined the land and buildings and PP&E when carrying out their review. Although most
candidates did recognise that depreciation should stop when an asset is held for sale not all
selected the right date and/or calculated the adjustment correctly.
The consideration of discontinued operations was less well done with few candidates showing
the calculation of the collated loss from discontinued operations. A minority of candidates
appeared confused as to the difference between assets held for sale and discontinued
operations.
Most questioned the need for the provision for redundancy and whether the brand could be
identified.

The cash flow hedge was not explained well. Many candidates copied the principles from the
learning materials but could not apply them to the scenario. The value of £42,000 was often
calculated correctly but then mistaken for a gain. Sometimes the calculations and the
descriptions were made and then concluded that the cash flow hedge did not apply because
there was no hedged item – demonstrating that some candidates did not understand the
difference between the fair value and cash flow hedges.
Adjusted financial statements
Answers to this part of the question were extremely disappointing with many not taking note of
the requirement which stated – 'in a form suitable for publication'. Candidates often failed to
demonstrate even basic skills relating to the construction and presentation of financial
statements eg, allocating all assets categories into current or non-current assets, failing to adjust
retained earnings for profit adjustments.
In addition, candidates were unable to apply practically the disclosure rules from IFRS 5. Even
though most candidates identified that there was a discontinued operation in their earlier
discussion many just ignored this when re-stating the profit or loss statement. Even those who
adjusted the current year often failed to adjust the comparatives even though sufficient
information was given to do this. Assets held for sale were not shown as a separate line item of
current assets. Some very weak candidates incredibly wasted time copying out the question
without adjustment.
Analysis of performance and position
Answers to this part of the question were extremely variable. Many candidates failed to consider
the context of the question and their content and communication style was either not
appropriate or irrelevant. Even if a candidate had not presented the financial statements
appropriately showing discontinued operations, the quality of the financial statement analysis
would be significantly improved had candidates considered that the division should be
removed to identify the performance of the continuing business. Weak candidates failed to
interpret the scenario and to identify separately the performance of the continuing and
discontinued activities. Another common weakness was to consider only performance and not
position. At the other extreme there were some exceptionally good answers which clearly and
concisely communicated the key issues including identifying high operating gearing and the
relationship between price increase and sales volume.
Some candidates spent quite a lot of time calculating pages of ratios which were not then used
in their narrative. At Advanced Level ratios in isolation receive little or no credit.
42 Homehand
Scenario
The candidate is the senior on an audit of a manufacturing company. The audit is in its closing
phase. The candidate is required to review working papers provided by an assistant, to identify
the financial reporting issues arising and to propose audit adjustments as appropriate to add to
the schedule of uncorrected misstatements and to set out and explain the adjustments the client
should be requested to make. The candidate is also required to assess ethical issues in respect
of non-disclosure and auditor independence.
The question required a good understanding of financial reporting requirements for leases and
deferred tax and the skills in assessing the adequacy (or otherwise) of audit procedures.
Analytical skills and application of general principles to a particular situation are required
throughout the question.

Marking guide

(a) Explain the financial 10  Identify and explain incorrect financial
reporting issues you reporting treatment of lease.
have identified and  Apply technical knowledge of IAS 17 to
recommend appropriate recommend treatment.
adjustments.
 Explain the missing entry in the current tax
computation for share option and the
incorrect adjustment for the warranty costs.
 Link information concerning tax liability
and underpayment to propose adjustment
to profit or loss in respect of prior year.
 Calculate the adjustment for deferred tax
required for the share option charge.
(b) Prepare a revised 4  Assimilate adjustments and prepare
schedule of all schedule of uncorrected misstatements.
uncorrected  Apply materiality to the adjustments to
misstatements determine which should be adjusted.
(Exhibit 1), including
your adjustments from  Identify and explain need for further work
(a) above. Identify and arising from the nature of the errors
explain the identified.
misstatements, if any,
that we require
Homehand to correct.
(c) Set out the audit 10  Link errors noted in financial reporting to
procedures we need to weaknesses in the procedures prepared by
perform to complete our Min.
audit of the current tax  Explain the need to consider the work
and deferred tax performed on opening balances.
balances.
 Determine the appropriateness of the tax
rate used in determining deferred tax
liability.
 Evaluate the need for auditor expert in tax.
 Identify appropriate procedures for the
deferred tax adjustments for share options.

(d) Identify and explain the 6  Evaluate the lack of professional care in the
ethical issues for our firm quality of work performed to date by Karen
and any actions you and her motives.
believe we should take.  Explain that BW cannot be associated with
an undisclosed error to the tax authorities.
 Explain the need to apply professional
scepticism.
 Explain responsibilities under money
laundering legislation.
 Explain the duty to report to ICAEW if in
the public interest.
 Identify an appropriate course of action;
identify the facts, inform Karen to disclose.
 Consider need to resign as auditor and to
report to those charged with governance.
(a) Explanation of financial reporting issues and recommendation of appropriate adjustments

Lease of production machinery
The adjustment Min has proposed is incorrect. Homehand has treated this transaction as an
operating lease. However it would appear that it is a finance lease for the following reasons:
There are five indicators which could indicate a finance lease:
(1) The lease transfers ownership of the asset to the lessee at the end of the lease term –
this does not appear to be the case in this instance.
(2) The lessee has the option to purchase the asset at a price sufficiently below fair value at
the option exercise date, that it is reasonably certain the option will be exercised –
again not the case here.
(3) The lease term is the asset's three year economic life even if title is not transferred.
(4) Present value of minimum lease payments amounts to substantially all of the asset's fair
value at inception – this is the case (see calculations below) as PV = £122,452/
£123,000 = almost 100% of normal selling price
(5) The leased asset is so specialised that it could only be used by the lessee without major
modifications being made – this is not entirely clear but if it is designed for the
customer would probably be the case.
Based on indicators 3, 4 and 5 the lease does appear to be a finance lease and the risks and
rewards of ownership are with the lessee.
Homehand will recognise a receivable equal to its 'net investment in the lease'.
As Homehand normally sells the equipment itself, dealer/manufacturer considerations are
relevant. Homehand will need to recognise separately its normal selling profit and its
finance income from the lease. Its initial sales revenue will be calculated as the lower of the
fair value of the asset and the present value of the minimum lease payments computed at
the market interest rate of 8%.

Present value of minimum lease payments:
Payment Amount Discount factor @ 8% PVMLP
£ £
1 44,000 1.000 44,000
2 44,000 0.926 40,744
3 44,000 0.857 37,708
Total minimum lease
payments 122,452
As this is approximately the same as the normal selling price / fair value, revenue
recognised will be £122,452.
In the case of a manufacturer, the cost of sales will be its production costs. Hence cost of
sales will be £102,000.
Finance income and net investment in the lease
Net investment in the lease can be calculated as follows:
£
Present value of minimum lease payments 122,452
Less: Payment made on 1 April 20X4 (44,000)
78,452
Finance income at 8% 6,276
84,728
Finance income of £6,276 will be recognised in the statement of profit or loss for the year
ended 31 March 20X5.
Net investment will be split between receivables falling due within one year (£44,000) and
receivables falling due after more than one year (£40,728).
Adjustment required:
£ £
DEBIT Revenue 44,000
CREDIT Net investment in lease 44,000
DEBIT Cost of sales 102,000
CREDIT Inventory 102,000
DEBIT Net investment in lease 122,452
CREDIT Revenue 122,452
DEBIT Net investment in lease 6,276
CREDIT Finance income 6,276
Tax effect is trivial

DEBIT Current tax liability 3,454
CREDIT Current tax expense 3,454
Net effect on profit for the year is debit £17,272 – 3,454 = £13,818
Notes
1 Current tax liability for the year ended 31 March 20X5
The calculation of the current tax liability for the year ended 31 March 20X5 is incorrect
– it does not include an 'add back' for the share option expense or a deduction for
warranty costs actually incurred.
The current tax expense calculation should have included a disallowance for £450,000
for the share option expense as the tax rules state that a deduction for these costs will
not be given by the tax authorities until the options are exercised.

The warranty cost disallowed by Karen is the total charge for the year and includes the
warranty costs paid which are allowable according to tax rules – only the movement in
the provision should be disallowed.
Therefore the calculation of the current tax liability should be:
£'000
Taxable profit per Karen 2,180
Add share option expense 450
Less warranty costs incurred (150)
2,480
Tax at 20% 496
Karen has accrued a current tax liability of £436,000 and the
liability should have been £496,000
An adjustment is therefore required:
DEBIT Tax expense £60,000
CREDIT Current tax liability £60,000
2 Adjustment in respect of prior year tax – year ended 31 March 20X4

The current taxation paid for the prior year was higher than that recorded in the prior
year financial statements. As this has simply been recorded as a reduction in the
liability, the tax liability is understated by £47,000 at 31 March 20X5. The amount of the
error even when added to the prior year uncorrected warranty provision is not material
so no prior year adjustment will be made and the effect will be to record the amount in
the current year tax charge.
In addition Karen has identified a further under declaration of tax relating to non-
deductible legal expenses. As we will be informing the client to notify the tax
authorities of the error (see ethics points below), we can expect additional tax to
become payable. There may also need to be a provision made for penalties or interest.
This would give rise to a further tax liability for the year ended 31 March 20X4 of
£105,000  20% = £21,000
An adjustment is required in respect of prior year tax as follows:
£ £
DEBIT Tax expense 21,000
DEBIT Tax expense 47,000
CREDIT Current tax liability 68,000
Prior year element of tax charge (which will also include the error above) will need
separate disclosure.
Deferred tax balance
The calculation of the deferred tax balance is incomplete as it does not take into
account all temporary timing differences.
Share option scheme
The share option scheme gives rise to a temporary difference and a deferred tax asset.
A deferred tax asset arises on the temporary difference which is measured as the
intrinsic value of the options which are expected to be exercised at 31 March 20X5.
This temporary difference can be calculated as:
450 remaining employees  1,000 options  (market price £8.50 less exercise price
£4.00 = £4.50) = £2,025,000 divided by 3 as first year of 3 = £675,000.

As this is higher than the cumulative remuneration expense of £450,000 recorded
under the scheme, the total tax benefit of £675,000 @ 20% = £135,000 will be
recorded as follows:
Profit or loss (450,000  20%) £90,000
Equity £45,000
Hence adjustment would be:
£ £
DEBIT Deferred tax asset 135,000
CREDIT Tax expense 90,000
Deferred tax balance now becomes:
Taxable temporary difference £'000
Carrying amount of plant and equipment at 31 March 20X5 6,400
Tax base of plant and equipment at 31 March 20X5 (5,300)
1,100
Deductible temporary difference
Warranty provision at 31 March 20X5 (600)
Share option at 31 March 20X5 (675)
(175)
Closing deferred tax asset = £175,000  20% = £35,000

Journal – assuming set off of deferred tax asset and liability
£
Closing deferred tax asset 35,000
Brought forward deferred tax liability = (87,000)
Therefore:
£ £
DEBIT Deferred tax liability 122,000
CREDIT Equity – re share options 45,000
CREDIT Profit or loss – other temporary differences 77,000
Tutorial note
Reconciliation of accounting profit to taxable profit
Deferred tax
movement
P&L Reserves
£'000 Tax rate 20% £'000 £'000 £'000
Accounting profit 2,050 410
Add: permanent disallowables 45 9
Temporary timing differences

(TTD ) Depreciation – capital
allowances (1,185 – 1,450) (265) (53) 53 DR
(DTD) Warranty (as amended) 200 40 (40) CR
(DTD) Share option (as added
back in revised computation) 450 90 (90) CR
Taxable profit 2,480 496 77 CR

Deferred tax
movement
P&L Reserves
£'000 Tax rate 20% £'000 £'000 £'000
DTD Share option (Equity) 225 45 CR
Deferred tax liability brought

forward (87)
Less movements to p&l and
reserves 122
Deferred tax asset carried 35
forward
(b) Revised schedule of uncorrected misstatements

Including prior year items and the items identified from the audit work on tax; the revised
statement of uncorrected adjustments is as follows:
Statement of profit or Statement of financial
loss position
Original proposed adjustments £'000 £'000 £'000 £'000
(1) Over-provision of warranty costs due
to error in formula used to derive
general provision for warranty – 75 75 –
Tax effect 15 – – 15
(2) Over-valuation of inventory projected
due to sample testing of inventory
costs 115 – – 115
Tax effect – 23 23 –
Further adjustments
(3) Effect of prior year over-provision of
warranty provision – 60 60 –
(4) Net effect of lease 14 – – 14
(5) Current year tax liability – correction
for share option and warranty 60 – – 60
(6) Prior year tax liability – disallowable
expenses 68 – – 68
(7) Deferred tax journal – 77 122 45
In assessing adjustments, consideration needs to be given to the effect on individual line
items as well as the overall position:
Taking into account the prior year item as well as the current year warranty items shows that
the actual charge for warranty is £60,000 + £75,000 higher than it should be. This is material
and the warranty charge is shown separately within the financial statements as part of the
disclosure of the movement on provision. The prior year item is not material and cannot be
corrected without a prior year adjustment which would not be appropriate for an immaterial
item. However the client should be asked to book the current year adjustment of £75,000
so that the remaining uncorrected item for warranty is not material. Tax effect of this item
would be an increase in the deferred tax liability of £75,000 @ 20% = £15,000.
The error in respect of the previous computation - disallowable expenses in respect of the
previous year (£68,000) and the correction for the share option expense and warranty costs
in the current year computation (£60,000) all impact on the current tax liability and must be
adjusted (see ethics section).

The share option creates a deferred tax asset of £135,000 which taken together with the
other temporary differences means that the adjustment for deferred tax is above materiality
and should be adjusted.
The remaining uncorrected items for the current year are as follows:
Statement of profit or loss Statement of financial position
£'000 £'000 £'000 £'000
Under-valuation of inventory 115 – – 115
Tax effect 23 23
Net effect of lease 14 – – 14
Additional deferred tax on
warranty adjustment – see above 15 – – 15
The net impact of these adjustments is £121,000 which is close to the materiality level of
£120,000 and we should ask the client to adjust for the remaining items.
We therefore need to consider whether we should do more work to assess whether the
uncorrected items taken together with any undetected items could be material. This is
particularly the case as one is an error in the application of an accounting standard (lease)
and the other is based on a projected error calculated from sample results (inventory). Such
work could include extending further the inventory sample and looking in more detail at
other judgmental decisions.
If management do conclude that there are adjustments that they do not wish to correct in
the financial statements then these should also be disclosed to the audit committee / those
charged with governance as they may have a different view.
(c) Audit procedures to complete work on tax balances
General
 Need to ensure that we have audited all elements of the movement in the tax liability
balance. Not clear from Min's working papers that the brought forward balances have
been agreed to prior year financial statements - this needs to be done for current and
deferred taxation.
 In addition the tax payments should be agreed to the cash book and tax authorities'
record of receipts.
 Consider whether 20% tax rate is appropriate for current as well as deferred tax
balance – will depend on whether any new rate has been enacted or substantively
enacted at the reporting date.
 Need to ensure that there has been appropriate input to the audit of the tax balances
from a tax expert within BW.
Prior year tax balances
 All correspondence with the tax authorities should be reviewed either by the audit
team or by an expert from within the tax department. Any issues arising should be
assessed fully using expert input as appropriate.
 Need to assess the potential for penalties and interest in respect of the erroneous tax
return filed for the previous year – consultation with an expert may again be required to
assess the range of outcomes and the probability of each. If client makes immediate
disclosure to tax authorities then settlement on this could be reached before the audit
is finalised and judgment will not be needed.
 Need to review differences between tax computations used for prior year financial
statements and those submitted to tax authorities to ensure that explanations provided
by the client are accurate as these have been relied on to propose adjustments.

Current tax computation
 Errors have been noted in the computation prepared by the client – see above financial
reporting issues. Need to consider whether all of the adjustments made by the client to
arrive at taxable profit are correct.
 Prior year experience shows that non-deductible expenses were higher than the
amount shown in the current year tax computation. Should review the nature of
expenses to ensure that the amount added back is complete and a realistic estimate of
the actual non-deductible expenses. Particular attention should be paid to any one off
expense items, legal expenses etc.
 Should consider whether the adjustments to arrive at taxable profit are complete by
reference to any other adjustments made in previous years and consideration of
whether there are other general provisions etc.
 Share option scheme: Charge to profit or loss has already been audited and detail
should be agreed to the relevant working papers. Additional information required to
arrive at tax treatment is the share price at the year end and this should be agreed to a
reliable data source.
Deferred tax
 Review the current tax computation for any temporary differences not accounted for as
a deferred tax adjustment.
 Obtain a reconciliation of profit per the financial statements to taxable profit and
ensure that deferred taxation has been appropriately provided for temporary
differences only.
 Verify that the tax rate at which the liabilities and assets unwind is in line with tax
legislation enacted.
 Agree the opening position of the deferred tax liability to the prior year financial
statements.
 Consider whether it is appropriate for the company to recognise deferred tax assets
and liabilities ie, will profits be made in the future.
 Agree that the intrinsic value of the shares at 31 March 20X5 is reasonable. Vouch
exercise price to supporting documentation.
(d) Implications of ethical considerations
Karen knows that the prior year tax return is incorrect but is not proposing to notify the tax
authorities of the error. Karen is an ICAEW trainee Chartered Accountant and therefore
expected to follow the fundamental principles of the ICAEW Code. She should not be
associated with a tax return which she knows to contain an error and it is unclear why she
does not wish to report the error to HMRC. It may be that she is worried about the effect on
her reputation/employment if she admits to the error.
As ICAEW Chartered Accountants, the BW tax and audit team have a duty, where it is in the
public interest, to report to the ICAEW any facts of matters indicating that a member or
trainee member may have become liable to disciplinary action. Deliberate underpayment
of tax cannot be in the public interest so there may well be duty to report Karen.
BW is not the tax advisor submitting the return, however it should not be associated with
the false return and risks disciplinary action if it does not act within the spirit of the ethical
code.
The first action we should take is to ask Karen to disclose the error to the tax authority. If she
refuses to do so then the matter should be raised with those charged with governance at
Homehand. BW will need to consider whether it can continue to act as auditor to a

company which has knowingly filed a false tax return. The Ethics partner at BW should be
consulted throughout the deliberations. There may also be reporting implications under the
Money Laundering regulations and the MLCP should be consulted.
There is also a quality issue over using a junior member of staff to audit complex tax
balances – although the firm in completing this review has addressed the issue in part.
However BW should consider its own quality procedures to ensure professional
competence of staff assigned to complex audit work.
With regards to the comment from the Homehand finance director regarding unwillingness
to adjust, this potentially raises an intimidation threat. Appropriate action would be to
discuss with the assignment partner and the firm's ethics partner – ultimately the matter
should be raised with those charged with governance and the relevant adjustments made
to the financial statements.
Examiner's comments
This was the least well answered question on the paper. In particular, candidates seemed unable
to deal correctly with the current and deferred tax adjustments.
Financial Reporting adjustments
The accounting for the lease of the production machinery was generally well done with
candidates correctly applying their technical knowledge of IAS 17.
The treatment of errors in the current tax computation was poor with few candidates recognising
the need to add back the share option expense and adjust the warranty cost. The errors on last
year's tax computation were also not well addressed. Those candidates who did comment on
the issue often incorrectly proposed a prior year adjustment.
The deferred tax calculation for the share option was reasonably well attempted.
Schedule of uncorrected misstatements
The schedule was prepared well by a significant number of candidates. Few, however, answered
the second part of the requirement which was to identify and explain the misstatements which
Homehand should correct.
Audit procedures
Relevant audit procedures were generally good although weaker candidates tended to produce
generic procedures which were not always tailored to meet the scenarios given. The question
specifically asks for audit procedures on tax and deferred tax balances and weak candidates
wasted time by setting out procedures relating to the warranty provision and share option.
Ethical issues
Most candidates identified the key points relating to the undisclosed error on the tax return, the
potential intimidation threat and the issues around professional competence, and stronger
candidates were able to link these to the ICAEW's ethical code and the need to comply with it.
Weaker and more marginal candidates veered off into discussion on possible modifications to
the audit report. Many candidates seemed to believe that the auditors were responsible for the
trainee accountant who actually worked for the client. An alarming number of candidates
believed they should report Karen to HMRC.

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

43.1 (a) Prepare the consolidated 18  Assimilate and demonstrate
financial statements for understanding of a large amount of
Larousse for the year ended complex information.
30 September 20X5,  Identify errors in the partially prepared
correcting any errors. consolidation schedule, and related
Provide explanations and information.
journal entries for any
adjustments you make.  Identify appropriate accounting
treatments for complex items such as
goodwill, intangible assets, deferred
consideration, intra-group trading,
share-based payments.
 Apply technical knowledge to identify
appropriate accounting adjustments in
the form of journal entries.
 Assimilate adjustments to prepare draft
(b) Prepare notes for the board 7  Analyse given information using
analysing the performance appropriate measurements such as gross
and profitability of each of profit margin.
the two subsidiaries.
 Demonstrate understanding of the
importance of intra-group trading on the
results.
 Identify transfer pricing issue.
(c) Respond to the proposals 9  Apply knowledge of the scope of
from the board about social external auditors' responsibility in
responsibility reporting by: respect of voluntary disclosures.
ICAEW 2019 November 2015 answers 483

 explaining the  Identify issue of auditor firm competence

responsibilities of our to produce additional assurance report.
external auditors in  Identify likely contents of additional
respect of the report.
proposed social
responsibility reporting  Assimilate knowledge, drawing upon
(Exhibit 3); and question content, to describe type of
work required to provide verification
 evaluating the evidence.
feasibility of an
additional assurance
report and describing
the type of work that
might be involved in
providing verification
of progress on the four
key targets (Exhibit 3).
43.2 Identify any potential ethical 6  Discuss appropriate responses and
issues arising for you and for actions in respect of the apparent ethical
Dennis Speed from the dilemma.
information in Exhibit 4,  Identify potential money-laundering
describing the actions that you issue.
should take.
 Recommend caution in taking action.
Total marks 40
43.1 (a) Completion of draft consolidated financial statements

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

2
Fair value of deferred consideration at 30 September 20X5: £6m × 1/(1.05) = £5.4m.
The journal entry required to recognise the unwinding of the discount is as follows:
£m £m
DEBIT Finance cost (£5.4m – £5.2m) 0.2
CREDIT Deferred consideration 0.2
Working 2: Acquisition of Softex
The research asset can be recognised at acquisition as it is a separable identifiable
asset and the subject of a transaction at fair value. Goodwill is therefore reduced by
£2 million; the correcting journal entry is as follows
£m £m
DEBIT Intangible asset 2.0
CREDIT Goodwill 2.0
Intangible assets are subject to annual amortisation, but more information would be
required in order to determine an appropriate amortisation rate.
Working 3: Adjustments for intra-group trading
Intra-group trading items must be eliminated upon consolidation.
Intra-group sales from HXP to Larousse: 50% × £12m = £6m
Sales outside the group therefore: £6 million
Intra-group sales from Softex to Larousse: 50% × £16m = £8m
Sales outside the group therefore: £8 million
The journal entry required to remove intra-group sales from group sales and cost of
sales is as follows:
£m £m
DEBIT Revenue (£6m + £8m) 14.0
CREDIT Cost of sales 14.0
In addition, a provision for unrealised profit is required in respect of any inventories
remaining in hand at the year end.
HXP: provision for unrealised profit = £6m × 20% × 40% (margin) = £480,000
(£500,000 to nearest £0.1 million).
Softex: provision for unrealised profit = £8m × 25% × 20% = £400,000
Consolidated revenue: £56.5m + £6m + £8m = £70.5m
Consolidated cost of sales: £53.3m – £14m + £0.5m + £0.4m = £40.2m.
Journal entry required to recognise provision for unrealised profit:
£m £m
DEBIT Cost of sales (£500,000 + £400,000) 0.9
In addition, an adjustment is required to eliminate intra-group payables and
receivables:
£m £m
DEBIT Trade payables (£1.2m + £1.4m) 2.6
CREDIT Trade receivables 2.6
Working 4: Share option scheme
The incentive scheme started by Larousse involves the exchange of services for equity
instruments in the entity. Therefore, this scheme falls within the scope of IFRS 2,

Share-based Payment, as an equity-settled share-based payment transaction. Marie is
correct in recognising this transaction in the financial statements, but the calculation is
incorrect. Where payments are received in the form of share options in exchange for
services rendered, IFRS 2 requires that the fair value of the transaction is recognised in
profit or loss, spread over the vesting period. The indirect method of measurement is
appropriate here: ie, measurement of the fair value of the equity instruments granted
at the grant date. The grant date in this case is 1 October 20X4, and the fair value to be
used in the transaction is at that date ie, £20 per share.
An adjustment is also required in respect of the non-market based vesting condition
that share options will vest on 30 September 20X8 only to those employees still in
employment with Larousse at that date. At 30 September 20X5, four of the 50
employees have actually left, and a further six are expected to leave. Therefore, the
calculation of the expense to be recognised is based on 40 (50 – 4 – 6) employees. The
expense must be spread over the four-year vesting period, and the calculation is as
follows:
(1,000 × 40 × £20.00)/4 = £200,000
The adjusting journal entry is as follows:
£m £m
DEBIT Equity: share options (£1m – £200,000) 0.8
CREDIT Administrative expenses 0.8
It is acceptable to recognise the adjustment to equity as a separate component of
equity.
Larousse Group: draft consolidated financial statements for the year ended
30 September 20X5
Draft consolidated statement of profit or loss
Ref to
First draft Adjustment Working Revised draft
£m £m £m
Revenue 84.5 (14.0) 3 70.5
Cost of sales (53.3) 14.0 3 (40.2)
(0.5)
(0.4)
Administrative expenses (12.3) 0.8 4 (11.5)
Selling and distribution costs (6.8) (6.8)
Finance cost (1.6) (0.2) 1 (1.8)
Profit before tax 10.5 (0.3) 10.2
Income tax expense (2.4) (2.4)
Profit for the year 8.1 (0.3) 7.8
Draft consolidated statement of financial position

Ref to
£m £m £m
ASSETS
Non-current assets
Intangible assets:
Research asset 2.0 2 2.0
Goodwill 5.6 3.2 1 6.8
(2.0) 2

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

Share capital 10.0 10.0
Share options 1.0 (0.8) 0.2
Retained earnings at 35.8 35.8
1 October 20X4
Profit for the year 8.1 (0.3) 1,3,4 7.8
Non-current liabilities 30.4 3.2 1 33.8

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

HXP overall gross profit percentage £4.5m/£12.0 × 100 = 37.5%
Internal to group: £6.0m (ie, 50% of sales)
External to group: £6.0m (ie, 50% of sales)
Gross profit on all sales = (£12.0 – £7.5) £4.5m
Gross profit on internal sales = 40% (given) = £2.4m
Gross profit on external sales (£4.5m – £2.4m) = £2.1m

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

(c) Response to the board on social responsibility reporting
External auditors' responsibilities in respect of social responsibility reporting
Even though the proposed reporting is voluntary, there are implications for Larousse's
external auditors. The auditors will be obliged to consider the potential impact of the
new policies and targets upon the financial statements. They will primarily be
concerned to ensure that any disclosures relating to social responsibility are not
inconsistent with information seen by the auditor in the course of the audit. In
accordance with ISA (UK) 720 (Revised June 2016), The Auditor's Responsibilities
Relating to Other Information the auditor's report will need to include an Other
Information section. This will either include a statement that the auditor has nothing to
report or, if there is an uncorrected material misstatement of the other information, a
statement that describes the issue (ISA (UK) 720.22(e)).
The additional reporting by Larousse will therefore involve additional audit work. All four
targets can be expected to involve additional expenditure, and there may be
implications such as constructive obligations giving rise to the need for provisions. The
auditors will also be interested in the extent to which HXP and Softex are obliged, by
local law and regulation, to take responsibility for clean air and water. Such obligations
could give rise to the recognition of additional provisions. The auditors will be obliged to
consider the existence of such factors in undertaking their assessment of inherent risk. In
extreme cases, non-compliance with relevant laws and regulations or any of the new
performance targets might affect a company's going concern status and the auditors
would need to consider this as part of their own assessment of Larousse's going concern
status.
Proposal for additional assurance report
The proposal that the auditors should be asked to produce an additional assurance
report goes beyond the normal external audit appointment. The auditors could be
invited to provide assurance in respect of the proposed social responsibility reporting,
and this would form a new engagement for services, separate from the statutory audit.
This is a perfectly feasible suggestion, although the audit firm would need to consider
carefully its own competence to provide such services, and it may decide that it does
not wish to tender for such work. In such a case, it would be necessary to appoint
another external verifier.
Because there is no statutory or other regulatory requirement to produce a social
responsibility report, the terms of any assurance engagement can be determined by
Larousse in discussion with the appointee. However, it is likely to involve the use of the
assurance standard AA1000 Accountability Principles issued in 2018 by AccountAbility,
a non-profit network that works with business and governments to promote sustainable
development. The key part of this social responsibility reporting is therefore content
which outlines how we report our sustainability credentials. AA1000 provides guidance
on what this includes: in summary though, this kind of reporting is expected to
consider four main principles:
 Inclusivity – consideration of all stakeholders who affect, and are affected by, our
work
 Materiality – consideration of any relevant or significant factors, not just financial
 Responsiveness – consideration of the actions taken by us in response to
stakeholders' issues
 Impact – consideration of the impact that we have on the economy, the
environment, society, stakeholders and even ourselves as an organisation

The additional assurance report might include the following:
 The objectives of the engagement and any limitations on its scope (to manage
users' expectations)
 Intended users of the report
 The responsibilities of both ourselves and the external verifier for this reporting
 Description of the scope of the report, including any limitations
 Description of the disclosures covered and the methodology used in verifying
them, including criteria used for evaluation
 Statement on level of assurance
 Findings and conclusions concerning the reliability of performance in line with the
four AA1000 principles (specified above)
 Observations and recommendations
 Notes on competencies and independence of the external verifier
 The name of the external verifier of the report, the date and place signed
Where there is objective, third-party, evidence about progress towards Larousse's
targets as set out in Exhibit 3, their verification will be relatively straightforward. For
example, in the case of target 1, there should be regular monitoring reports about
water quality, produced by appropriately-qualified scientific observers. Provided that
this can be assessed as high-quality, third-party evidence, it should provide a good
level of assurance for the verifier. Similarly, it should be possible to assess, from
employment records, the extent to which the employment of child labour under
target 3 is being successfully phased out. Where there are distinct, quantifiable targets
and records, verification is likely to be straightforward.
However, where targets are more qualitative in nature, it may be more difficult for the
verifier to draw conclusions. In this respect, targets 2 and 4 are more vague (what is an
'effective' health and safety programme?) and it may be that the targets will require
redrafting to be more specific and quantifiable. It would be important to gain a precise
understanding of the nature of the proposed social responsibility reporting, as these
would be the starting point for any additional assurance report.
43.2 Ethical implications and actions arising from incident set out in Exhibit 4
Alex's note of the overheard conversation is potentially highly significant. However, it
contains no actual evidence and the allegations are apparently informed by dislike of
Dennis Speed. This may be no more than malicious gossip, without any foundation in fact.
The preliminary calculation of goodwill on the acquisition of HXP (see earlier calculation)
produces a relatively high figure, but it may include as yet unrecognised intangible assets.
HXP is profitable, and there is no clear evidence that Larousse has overpaid for its
investment in HXP.
Even if Alex considers that the allegation is malicious gossip, he is not entitled to ignore this
information. His first task should be to investigate the allegations, as discreetly as possible.
If the allegation that Dennis was involved in adjusting the price paid for the acquisition of
HXP is correct, then the issue is not just one of unethical behaviour; it may also have a
criminal dimension, as fraudulent manipulation of documents may have taken place. The
transaction could even be defined as money laundering. If this is the case, then Alex must
take care that his enquiries do not 'tip off' Dennis.
Once Alex is sure that he has all the relevant facts in the case, he may decide to escalate the
matter. He would be well-advised to contact the ICAEW for help in determining whether or
not the matter should be taken forward, what kind of evidence is required, and what action
would be most appropriate.

Both Alex and Dennis are ICAEW Chartered Accountants and are bound by the ICAEW
Code of Ethics. They must act with integrity in all circumstances and must display
professional behaviour. If the allegations are correct, then Dennis has been involved in
fraudulent manipulation for personal gain. This involvement, if more widely known, is likely
to bring the profession into disrepute.
It will be helpful to Alex if Larousse has established internal procedures for dealing with the
allegations. Larousse is unlisted and may not have appointed non-executive directors.
However, if there are non-executives, it may be appropriate for Alex to approach the chair
of the audit committee. However, before getting to this point, he must be certain of his
facts, and must be very careful about how he presents the allegations.
At all stages, Alex must keep a detailed record of his investigations, deliberations and
conclusions as this may be required as evidence in the event of criminal and/or professional
disciplinary action.
Aside from the ethical and legal issues that are potentially involved in this case, there are
also accounting implications in respect of the disclosure of related party transactions. A
related party is a person or entity that is related to the entity preparing its financial
statements, in this case Larousse. A person, or a close member of that person's family is
related to the reporting entity if they are a member of the key management personnel of
the reporting entity. Dennis as finance director is, clearly, a member of Larousse's key
management personnel and his wife is a close member of his family. Therefore, Lola
Gonzalez is a related party to Larousse. HXP is a related party to Larousse, as its subsidiary.
According to IAS 24, Related Party Disclosures, a related party transaction is a transfer of
resources, services or obligations between related parties. The transaction involving the
sale of Lola's shares to Larousse is therefore very clearly a related party transaction that will
require disclosure in the group financial statements.
Examiner's comments
General comments:
This was the best answered question on the paper, especially with regards to the financial
reporting treatment and adjustments to the consolidated financial statements. In general, the
quality of the journals throughout question 43.1 was better than in prior sittings, with many
candidates generating accurate correcting journals.
The weakest part of the question by far was the analysis of the subsidiaries, with many
candidates stopping at explaining that one subsidiary was better than the other due to having
higher margins. Weaker candidates who had been unable to adjust for intra group sales and
PURP therefore were also unable to produce meaningful financial statement analysis. The
questions at CR are designed to integrate financial reporting and financial statement analysis
(and when relevant assurance). Stronger candidates discussed the intra-group sales, the high
distribution costs and the lack of information.
Most students were able to answer the ethics discussion well, and a high number came up with
reasonable attempts at measuring the effectiveness of the KPIs in the social responsibility aspect
of the question. Credit would have also been given for suitable alternatives to AA1000, such as
adopting the Global Reporting Initiative (GRI) or a selection of the 17 United Nations (UN)
Sustainability Goals.
Detailed comments:
Preparation of consolidated statement of profit or loss and statement of financial position
including explanations of financial reporting treatment
Generally, this part of the question was well answered with many candidates achieving full
marks. Nearly all candidates recognised that the deferred consideration used to calculate

goodwill needed to be discounted to present value and that this would change the value of
goodwill (although a minority of candidates did discount for the wrong number of years).
The share options were also well dealt with, with most candidates identifying the errors made by
not using the fair value of the option at the grant date or adjusting for future leavers.
Answers to the issue relating to the recognition of an internally generated research asset were
more mixed. Many candidates wasted time discussing the general recognition criteria for
development costs missing the point that this was now a purchased intangible.
The most disappointing aspect to this question was the section relating to intra-group trading.
The adjustments required to revenue and cost of sales to eliminate intra-group trading, a
straightforward matter which is covered in FAR at professional level, proved baffling to many
candidates. Although most candidates realised that some adjustments had to be made it was
surprising that not all managed the simple contra out of intra-group trading or were able to
calculate the correct PURP. However most did manage to correctly discuss the elimination of
intra-group balances. Some candidates tried to use cumulative journals eg, to adjust for intra
group trading candidates tried to combine the revenue, profit and receivables in one journal
rather than splitting them down into one journal per adjustment. Invariably the journal did not
balance.
Pleasingly most candidates did prepare correcting journals and revised financial statements.
However, some wasted time on the latter by copying out the figures for all three group
companies then making adjustments rather than starting with the draft consolidated figures
given in the question. Some candidates also struggled with the credit side of the journal for the
deferred consideration often crediting retained earnings rather than a liability. Some also lost
easy marks by not discussing and showing the journal for the unwinding of the discount for this
consideration.
Notes for the board analysing and comparing the performance and profitability of the two
subsidiaries
Answers to the analysis and interpretation part of the exam were very mixed. Good candidates
identified the impact of the margins on the intra-group trading and the inventory impairment in
the year. It was expected that having asked the candidates to perform simple adjustments for
PURP in the first part of the question that they would then realise that this would impact on the
performance analysis. Most candidates calculated gross profit and some sort of operating/net
profit margin but the weaker ones simply stated the obvious ie, one company's margin was
higher than the other. Many candidates wasted time in anodyne and pointless description (eg,
'Gross profit is low because cost of sales are high') which is not appropriate at this level. The
poorer quality answers tended to be lengthy and repetitive. Relatively few candidates identified
the key point that the margins on intra-group trading are subject to influence by Larousse which
controls them, and that this factor inevitably skews the analysis.
A number of candidates wasted time by calculating and commenting on ratios relevant to
position rather than performance.
Social responsibility reporting proposals
Answers to this requirement relating to social responsibility reporting were quite mixed and
candidates missed out on easy marks such as discussing the potential impact on the financial
statements. However, most candidates did identify the auditor's responsibility to identify
inconsistencies between the financial statements and 'other information' and that if a separate
engagement was carried out it would result in a lower level of assurance than the audit report.
Nearly all candidates also discussed the type of work that could be carried out on the four key
targets and the difficulties involved in obtaining good quality evidence for the more qualitative
targets. However sometimes the suggested work was vague ('ensure the health and safety
programme is effective') or unrealistic ('visit the factory and identify any underage workers').

Ethics
The ethical issues were generally quite well addressed. Most candidates realised that the facts
should be determined rather than just relying on 'gossip', discussed the potential money
laundering issues and suggested contacting the ICAEW helpline for advice. However relatively
few commented on the accounting implications of the related party transaction. Very few
commented on the need to keep a detailed record of any investigations/discussions.
A few candidates had clearly not read or understood the question properly as they thought the
main protagonist in the question, Alex Chen, was the company's auditor. In such cases the
recommendations to eg, contact the ethics partner were irrelevant and inappropriate.
44 Telo
Scenario
The candidate is required to respond to the instructions of an unlisted company's operations
director. The candidate assumes the position of the recently-appointed financial accountant of
Telo plc. There is a range of issues which remain to be resolved in the preparation of Telo plc's
draft financial statements. A trial balance is provided, with notes and descriptions of outstanding
issues. These include: a prior period error, translation of foreign currency sales invoices and
related receipts, accounting for a property which has become an investment property during the
accounting period under review and deferred tax adjustments. Having made appropriate
adjustments, the candidate is required to prepare a draft statement of comprehensive income
and a statement of financial position.
Marking guide
Requirements Marks Skills assessed

(a) Explain the appropriate 22  Assimilate complex information in
financial reporting treatment of order to produce appropriate
the outstanding issues, setting accounting adjustments.
out the necessary adjustments.  Apply knowledge of prior period
adjustments, accounting for foreign
currency transactions, accounting for
investment properties, deferred tax to
the information in the scenario.
 Clearly set out and explain appropriate
accounting adjustments.
(b) Prepare a draft statement of 8  Assimilate and use adjustments
profit or loss and other identified in (a) in drafting the two
comprehensive income for the financial statements requested.
year ended 31 August 20X5,  Use knowledge of financial statement
and a statement of financial presentation to present the financial
position at that date, including statements in appropriate format.
your adjustments.
Total marks 30

(a) Outstanding issues arising from draft trial balance
Prepared by: Sophie Blake
(1) Calculation error in brought forward work-in-progress balance
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors requires that
material prior period errors should be corrected retrospectively. The error in
calculation of opening work-in-progress meant that work-in-progress was
overestimated by £613,000, which is 16.3% of the correct balance, almost 4% of sales
revenue and which is likely to be material in relation to profit. Assuming that the error is
material, it will be necessary to restate the comparatives in the financial statements.
Profit for the year ended 31 August 20X4 was overstated by £613,000, as was work-in-
progress, and these comparative figures must be altered. In respect of the financial
statements for the year ended 31 August 20X5, the correction of the error is to be
reflected in the statement of changes in equity.
£'000 £'000
DEBIT Retained earnings 613
CREDIT Work-in-progress 613
Cost of sales for the year ended 31 August 20X5, before any other necessary
adjustments to operating costs, is calculated as follows:
£'000
Corrected opening WIP 3,742
Add operating costs 11,353
Less: closing WIP (4,437)
10,658
(2) Accounting for foreign currency transactions
John correctly recorded the two invoices to Sourise during the year. However, his
recording of the receipt is in error as it failed to recognise any exchange gain or loss on
settlement or at the year-end in respect of retranslation of monetary assets. John's
treatment produced the following trade receivable amount due from Sourise at
31 August 20X5:
£'000
Invoices recorded (208 + 155) 363
Less: receipt ($250,000/1.12) 223
140
The first invoice, dated 31 December 20X4, for N$220,000 was settled in full out of the
receipt of N$250,000 on 31 August 20X5.
£'000
Amount at which 31 December invoice recorded 208
Settlement: N$220,000 at rate of £1 = N$1.12 (196)
Loss on translation 12
The remainder of the amount received on 31 August 20X5 (N$250,000 – N$220,000 =

N$30,000) is set off against the second invoice dated 30 June 20X5. The balance that
remains outstanding, as a monetary asset, must be translated at the year-end date ie,
31 August 20X5. As this is the same date as the receipt, the necessary adjustment can
be calculated as follows:
£'000
Amount at which 30 June invoice recorded 155
Settlement: N$30,000 at rate of £1 = N$1.12 (27)
Retranslation of closing monetary asset:
(N$180,000 – N$30,000) N$150,000 at £1 = N$1.12 (134)
Gain on translation 6

The required correcting journal is:
£'000 £'000
DEBIT Profit or loss (net loss on translation) 6
CREDIT Receivables 6
The directors have decided that an allowance of 50% of the debt should be made ie,
£134,000 × 50% = £67,000.
The required journal is:
£'000 £'000
DEBIT Profit or loss (operating costs) 67
CREDIT Receivables 67
This has been adjusted in profit or loss via operating costs, although it would also be
valid to classify it under another expense heading, such as administrative expenses.
Other transactions in foreign currencies should be checked, to ensure that similar
errors have not been made.
(3) Investment property (53 Prospect Street)
As the letting of the property is to an unrelated third party, and the property is no
longer occupied by Telo, it is likely to be classified under IAS 40 as investment
property. IAS 40 permits two alternative accounting treatments: the cost model as
under IAS 16, Property, Plant and Equipment, or the fair value model. Under the latter
model, any change in the value of the property is recognised in profit or loss.
The property at 53 Prospect Street was subject to a change of use during the year. For
the four-month period from 1 September 20X4 to 1 January 20X5, it was recognised
as property, plant and equipment under the IAS 16 revaluation model. For the
eight-month period from 1 January 20X5 to the year end on 31 August 20X5 it was
recognised as investment property under the IAS 40 fair value model.
Where there is a change in use, IAS 40 requires that the property is revalued at the
date of change and any difference recognised as a revaluation gain or loss under
IAS 16.
Calculation of revaluation gain or loss at change of use
Depreciation is charged on property, excluding land, held under IAS 16. No
depreciation has been charged for the four months to 1 January 20X5, and this must
be adjusted.
Depreciation on building: (£3,180,000 – £600,000)/98 years × 4/12 = £8,775 (£9,000 to
nearest £'000)
Carrying amount of property at date of change of use:
£3,180,000 – £9,000 = £3,171,000
Property at revalued amount on 1 January 20X5: (£2,600,000 + £620,000) =
£3,220,000
Revaluation gain to be recognised under IAS 16 at change of use: £3,220,000 –
£3,171,000 = £49,000
Journal entries to reflect adjustments for depreciation and revaluation:
£'000 £'000
DEBIT Operating costs (depreciation) 9
CREDIT Revaluation gain 49
49 49

Recognition of investment property
IAS 40 permits the inclusion of certain costs in an investment property. John has
recognised professional fees in respect of leasing 53 Prospect Street and this is
acceptable. The subsequent capitalisation of the cost in March 20X5 of installing the air
conditioning system is also likely to be acceptable. However, the inclusion of relocation
costs of £30,000 to the 15 Selwyn Road property is not permissible, and this item must
be recognised as an expense in profit or loss:
£'000 £'000
DEBIT Operating costs 30
CREDIT Property 30
The carrying amount of investment property at 1 January 20X5 and 31 August 20X5 is
therefore as follows:
£'000
Property at revalued amount on 1 January 20X5 3,220
Professional fees in respect of lease 25
Investment property at 1 January 20X5 3,245
Add: subsequent expenditure on air conditioning system 100
Investment property at 31 August 20X5 3,345
Revaluation of investment property
Investment property held under the IAS 40 fair value model is not subject to
depreciation. Any change in the value of the property, as noted earlier, is recognised in
profit or loss.
The surveyor's valuation at 31 August 20X5 of £3,500,000 (£650,000 for land and
£2,850,000 for buildings) exceeds the carrying amount above of £3,345,000 by
£155,000. This amount is recognised as a gain in profit or loss:
£'000 £'000
DEBIT Investment property 155
(4) Deferred tax
The deferred tax balance at 1 September 20X4 arose in respect of the 53 Prospect
Street property. Because a revaluation under IAS 16 does not affect taxable profits, a
deferred tax adjustment is required, calculated as the difference between the tax base
of the asset and the carrying amount.
The deferred tax treatment of an investment property depends upon the valuation
model that is adopted. Where investment property is held under the cost model, the
accounting treatment is the same as for IAS 16, where revaluation gains are recognised
through other comprehensive income, thus not affecting profit or loss. However, where
investment property is held under the fair value model, gains are recognised through
profit or loss and the amount of the gain is taxable, or in the case of a loss, allowable
for tax.
Therefore, the revaluation gain arising under IAS 16 of £49,000 is subject to deferred
tax, whereas the gain arising in the last eight months of £155,000 under IAS 40 is not
subject to deferred tax as it is taxed as part of profits for the year.
Because deferred tax on IAS 16 revaluation gains is recognised through other
comprehensive income, the amount of the revaluation surplus reported at 31 August
20X4 was reduced by the amount of the deferred tax balance. The 'gross' revaluation
surplus was therefore: £971,000 + £243,000 = £1,214,000. This amount has been
increased by £49,000 in the year ended 31 August 20X5 to a total of £1,263,000.
Deferred tax on this amount: £1,263,000 × 20% = £253,000 (to nearest £'000), an
increase of (£253,000 – £243,000) £10,000.

Therefore an adjustment is required as follows:
£'000 £'000
CREDIT Deferred tax 10
(b) Draft financial statements
Telo plc: Draft statement of profit or loss and other comprehensive income for the year
ended 31 August 20X5
£'000
Revenue 15,680
Cost of sales ([W1] 10,658 + 6 [W2] + 67 [W2] + 9 [W3] + 30 [W3]) (10,770)
Gross profit 4,910
Selling costs (1,162)
Administrative expenses (2,340)
1,408
Other income 70
Gain on investment property [W3] 155
1,633
Current tax (350)

Revaluation surplus 49
Less deferred tax (10)
39
Telo plc: Draft statement of financial position as at 31 August 20X5

£'000
ASSETS
Non-current assets
Property, plant and equipment (242 – 110) 132
3,632
Current assets
Work-in-progress 4,437
Receivables (3,281 – 6 [W2] – 67 [W2]) 3,208
Cash 82
7,727
Total assets 11,359

Share capital 60
Retained earnings (5,051 – 613 [W1] + 1,283) 5,721
Revaluation surplus (1,263 – 253 [W4]) 1,010
6,791
Deferred tax 253
Current liabilities
Trade payables 3,965
Current tax payable 350
4,568

Examiner's comments
General comments
This question examined three Advanced Level topics IAS 21, IAS 40 and IAS 12 which are not
covered at Professional Level. It was therefore very disappointing that some candidates
appeared to have not studied these areas and performed very poorly.
Detailed comments
This question required candidates to explain the financial reporting treatment of four issues and
most candidates did approach the requirement in a structured way.
(1) Prior year adjustment
The first issue was a straightforward prior year adjustment arising from an error in the
valuation of opening inventory. Although most candidates did identify that this was an IAS 8
issue requiring retrospective adjustment through retained earnings relatively few seemed
able to calculate the revised cost of sales figure. Some candidates appeared to miss the
point completely instead discussing general inventory valuation issues or even whether this
was an adjusting event. Some candidates ignored the adjustment completely and others
thought that it was up to the company's auditors whether or not such an adjustment should
be made. Common errors were to adjust closing inventory and also to put the PYA against
revenue. Relatively few candidates were able to calculate cost of sales correctly, which is a
surprising error at this level.
(2) Foreign currency
The second issue related to foreign currency sales with an outstanding foreign currency
receivable at the year-end. Most candidates did realise that both the settled transaction and
the re-translation of the year-end balance would result in foreign currency gains or losses
and attempted to calculate these. Most then realised that such gains and losses should be
taken to the profit or loss account although a significant majority thought they should be
recognised in equity and other comprehensive income – a very basic technical error. The
question also involved the requirement to write the closing receivable down which nearly
all candidates did respond to. However, it was worrying to see how many candidates
thought this would result in an IAS 37 provision rather than a reduction in the receivable
balance. Some candidates wasted time in this part of the question by discussing general
revenue recognition issues at great length.
(3) IAS 40 investment property
The third issue involved a revalued property being transferred from property, plant and
equipment to an investment property part way through the year. In addition, candidates
needed to identify whether some additional costs should have been capitalised. Answers
were often confusing and difficult to follow and many candidates wasted time discussing
and calculating figures for the revaluation of the property that had taken place at the end of
the previous year. Although candidates frequently stated that the property should have
been depreciated up to the time of the change in use it was relatively rare to see a
completely correct calculation of this figure. Most candidates did understand that the
revaluation gain at the time of the change of use should have gone to equity with
subsequent gains going to profit and loss but it was not that unusual to see this the other
way round or be unable to follow which revaluation candidates were referring to. With
regard to the capitalised costs by far the most common error was to state that professional
fees should be expensed and not capitalised.
(4) Deferred tax
The final issue related to deferred tax on the revalued property. Some candidates wasted
time by not reading the information carefully and therefore discussed irrelevant deferred
tax issues (such as the write down of the receivable). Most candidates understood how the

deferred tax balance relating to the property had arisen but fewer understood the
implication of the tax treatment of gains on investment property matching the accounting
treatment.
Financial statements
The requirement to produce financial statements from the trial balance plus relative adjustments
was generally well answered with many candidates achieving full marks.
45 Newpenny (amended)
Scenario
This question requires the candidate to show both financial reporting skills and the ability to
assess the adequacy of internal controls from an audit perspective. The financial reporting
elements require the ability to analyse a complex and specific contractual arrangement together
with an issue in product performance and relate those to the principles of provisioning and
revenue recognition, as well as identifying that there are also effects on inventory valuation.
The audit element requires a detailed assessment of controls over purchasing, looking in turn at
each relevant audit assertion and using the information given in the question. The candidate is
also required to use judgement in assessing the adequacy of the controls to meet relevant
objectives.
The candidate must then set out further concerns regarding Newpenny's internal control system
for purchase orders based on the data analytics dashboard provided.
Marking guide

(a) Draft an email to Rosa Evans 8  Assimilate complex information in order
providing, with explanations, the to produce appropriate accounting
financial reporting advice she has adjustments.
requested in her email.  Apply knowledge of provisions,
contingent liabilities, assets to the
information in the scenario.
 Identify the need for further information
and appreciate that further liabilities
may arise.
(b) Prepare a memorandum which 22  Apply technical knowledge to explain
will help me to consider Rosa's assertions relevant to the scenario.
suggestion that we should place  Assimilate information to identify
more reliance on internal controls control activities relevant to audit
in our audit of Newpenny's trade assertions.
payables and accruals for the year
ending 31 December 20X5.  Identify weaknesses in control and
impact on audit procedures.
 Determine the additional information
needed to ensure audit assertion is
met.

(c) Set out further concerns regarding 10
Newpenny's internal control
system for purchase orders based
on data analytics dashboard.
Total marks 40
Email to Rosa Evans:

(a) Financial reporting advice
JE agreement
The new agreement with JE introduces the possibility of a retrospective change in the price
paid for motors from 1 August 20X5 to 31 December 20X5. This is unlikely to be
determined before August 20X6 as it depends on the quantity of motors purchased for the
year to 31 July 20X6.
In considering whether a provision for any additional payment is required, Newpenny will
need to have regard to the requirements of IAS 37 which requires a provision where:
 there is a present obligation as a result of a past event – that is the case here so long as
the order threshold of 100,000 units has not already been exceeded by the year-end as
the contractual arrangement was made before the year-end;
 a reliable estimate can be made – that is likely to be the case here as Newpenny should
have a budget showing predicted purchases and will know both the number of motors
purchased pre year end and the additional cost of £1 per motor if total purchases less
than 100,000; and
 it is probable that there will be an outflow of resources. This will depend both on the
number of motors purchased to date and those which Newpenny expects to purchase
in the 7 months following the year end.
If actual purchases to date and projected purchases for the next 7 months show that the
target of 100,000 motors will be exceeded then no provision is required, although this
should be kept under review in the period after the reporting date until such time as the
financial statements are issued.
If the actual and projected purchases total less than 100,000 then a provision equivalent to
£1 for every motor purchased between 1 August 20X5 and 31 December 20X5 should be
made. To the extent that the motors have been used in vacuum cleaners that have been
sold, this will increase the cost of goods sold.
The number of motors purchased is in Newpenny's control and it would be possible to
achieve the cheaper price by stockpiling motors. However, it would then be necessary to
consider whether any provision would be required against potentially excess inventory and
there would also be considerations regarding the level of purchases Newpenny could
commit to in future years.
To the extent that motors are held in inventory at the year-end this may affect the value at
which inventory is carried. However, this will need careful consideration as the standard
cost established at the start of the year is likely to be based on the then agreed price of
£20 per motor and may or may not have been changed when the agreed price changed.
Newpenny will need to look carefully at what standard cost has been used and what
variances have been included in inventory to ensure that the inventory of motors is carried
at the actual expected cost of £20 per motor assuming an additional payment is required.

The liability being considered here is not a contingent one as the future event (that is orders
of motors) which will determine the price per motor is within Newpenny's control.
In order to recognise at year end any refund for motors purchased, Newpenny would need
to have already exceeded the target quantity of 110,000 motors. As the future purchases of
motors are within its control it can also recognise an asset if it is virtually certain that it will
meet the threshold. If this is the case, then the inventory carrying value will again require
consideration as outlined above.
Warranty
The issue with the Model2000 cleaners appears to be a specific one and is unlikely to be
covered adequately by the general warranty provision which is based on the history of past
claims. Newpenny has an obligation to repair or replace faulty products which are under
warranty and there is therefore a present obligation in respect of a past sale. A specific
provision should therefore be made.
If the issue is regarded as a warranty issue then the maximum population of cleaners which
can be returned will be those still in warranty at the year-end (and not already replaced). It
seems likely that not all of these will develop the fault so the provision should be based on
the total number of Model2000 cleaners which Newpenny expects to be returned under
warranty and the cost of repairing or replacing them (based on an engineer's assessment of
the work required and the cost of the relevant parts/product).
However, as one customer has alleged that the fault has caused a fire, there is also the
potential for legal claims for consequential losses and the potential for these needs to be
taken into consideration when determining the total amount to be provided.
Newpenny should take legal advice as to whether it should recall all potentially faulty
product as further issues like this could be costly both financially and reputational and there
may also be a safety issue which Newpenny has an obligation to resolve. This might well
increase the replacement cleaners/parts which Newpenny has to provide but reduces the
potential for damaging and expensive legal cases.
The basis for the provision can therefore only be determined when Newpenny has legal
advice as to the steps it should take and the likelihood of significant claims against it if it
does not take those steps. The details of the product returned to date and the findings of
the engineers will be important in determining the appropriate course of action.
(b) Memorandum to assist in planning audit – initial assessment of controls in place
General observations
In order to place reliance on the operating effectiveness of controls we will need to be
confident that the controls were in place throughout the period. That may not be the case
as the procedures documentation was prepared by the purchasing manager who only joined
Newpenny in May 20X5. He may have changed the procedures on his appointment.
While the purchasing manager will clearly have some insight into procedures and controls
in this area he may not be the best person to provide an overview of all relevant procedures
and controls. We also need to consider where additional relevant controls may be present
but not visible to the purchasing manager.
In addition, we need to understand the extent to which controls have changed or been
strengthened following the audit findings in the prior year.
Existence/rights and obligations – should the liability be recognised in the accounts at all?
The liabilities which are recorded have occurred and pertain to products or services which
Newpenny has purchased.

Control activities identified:
The liability for goods received is triggered by the goods received clerk posting details of
the physical receipt of goods which match to goods ordered by Newpenny. There is
segregation here between that clerk, the purchase clerk who inputs the orders and the
finance clerk who inputs invoices.
Invoices are either matched to purchase orders or goods received entries or are sent for
authorisation by the relevant department prior to posting. They are only posted to the
purchase ledger once that approval has been obtained.
Orders for materials are authorised by a manager in accordance with the authorisation
limits set by the finance department so transactions should only be initiated for materials
which are required by the business.
Purchase orders for services are also prepared and authorised by the relevant departments.
There is segregation between the preparation of purchase orders, the receiving of goods
and the processing of invoices.
Month end accruals for open purchase orders are reviewed by the financial controller who
also tests a random sample of items to back up to ensure that they are valid.
Initial assessment of the design of the controls:
The activities identified are designed reasonably effectively for ensuring that the liabilities
recorded for materials used in manufacturing reflect the goods which have been delivered.
However, in the prior year there were old items on the GRNI accruals listing which did not
represent valid accruals. We need to determine whether similar items are there this year
and also whether a control process such as a review of the listing has been introduced.
The control activities have more significant design weaknesses for other purchases either of
goods or services as, if there is no purchase order, it appears that the invoice may be
posted without any further check as to whether the goods or services have actually been
received. It is therefore possible that a liability may be recognised without a valid
underlying transaction pertaining to Newpenny.
Completeness and allocation – are there any more liabilities which should be recognised?
Liabilities have been recorded for all goods and services delivered before the year end and
not yet paid. The cut-off procedures at the period end accurately differentiate between
goods and services which were delivered before the year end and those which were
delivered after year end.
The recognition of a GRNI accrual is initiated by the matching of goods received on the
system.
There is segregation of duties between those posting the receipt of goods and those who
have authorised and posted the orders.
Posting details of the physical receipt of goods generates a 'received' sticker. The store
manager checks for the presence of this sticker before moving the goods into the stores
area thus ensuring that all goods received have been booked into the system and an
accrual has therefore been recorded.
At the month end the purchase clerk reviews all open purchase orders to determine
whether the goods and services were received before the period end and an accrual
should therefore be made.
Supplier statement reconciliations are performed if a supplier provides a monthly
statement.

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

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

manufacturing an outlier.
managers
This provides some assurance about the processes
and controls for a large majority of manufacturing
managers.

Average value per £2,343 The average value per individual order is less than
individual order half (47%) the maximum of £5,000. This indicates
that the limit is well within manager's normal
operating limits and does not constrain most
managers making orders without the need for
authorisation.
There is the risk of split orders however to avoid the
need for authorisation. For example, managers may
split an £8,000 order into two orders for £4,000.
Average value of £45,864 The average monthly value of orders is less than half
monthly total orders per (46%) the maximum of £100,000. This indicates that
manager the limit is well within manager's normal operating
limits and does not constrain most managers
making orders without the need for authorisation.
There is the risk of managers early ordering to avoid
the need for authorisation. For example: if July is a
peak month then they could order more at the end
of June than is needed, so there is enough
inventory to avoid £100,000 being exceeded in July
orders. Patterns of orders late in the month
preceding a peak month could be investigated.
Frequency of managers 16 There are no instances of managers exceeding
exceeding £90,000 in £100,000 in a month (which would have required
any one month authorisation) but a number of instances where
managers came close to this limit.
Frequency of managers zero Investigate where managers have been near limit
exceeding £100,000 in and investigate behaviour around limit, eg, delaying
any one month orders at the end of the month and making early
(requiring approval from orders at the end of the previous month.
senior manager) Understand role of managers. Some managers may
be responsible for higher value/volume orders.
Understand why a flat limit for all managers has
been applied if this is the case.

Outlier – John Fuller

Average value per £3,246 The average order is 39% higher than the average
individual order order for all managers and 65% of the maximum for
a single order.
This places John Fuller as a high risk item in
ordering more than other managers.
This may mean a build-up of inventory arising from
excessive orders or inefficient usage.
An alternative explanation is that John may work in
a high cost area. He may therefore need a higher
limit than other managers.
Average value of £64,379 The average monthly total of orders is 40% higher
monthly total orders than the average monthly order total for all
managers and 64% of the maximum for a single
month. Investigate the price and volume causes of
the high average value.
% of individual orders 35% A high proportion of John's orders were near the
exceeding £4,000 £5,000 limit yet the next most frequent incidence is
0–£1,000. This may be regarded as an unusual
pattern.
Benford's Law (First digit law) is that numerical data
sets frequently show that the leading digit is likely to
be the most common. (ie, in this case there should
be more small orders than large orders). This is true
in other sections of John's distribution but not of the
highest grouping of £4,001– £5,000.
This may be a risk of excessive ordering or possibly
fraud.
% of individual orders in 27% A significant proportion of orders occurred in a
last three days of the short period of time at month ends. If this does not
month reflect the pattern of usage then it may be a
behavioural response by John to circumvent
monthly maxima for ordering without authorisation
(see above).
Investigate the reasons why this pattern of ordering
should have occurred and whether there is any
commercial rationale.
Compare with other managers whose order
patterns have not been extracted by DAACA
analytics as outliers.
Frequency of John 7 There were only 16 occurrences of orders
exceeding £90,000 in exceeding £90,000 by 30 managers and John made
any one month 7 (almost half) of these.
Despite this, on no occasion did his monthly order
total exceed £100,000, thereby requiring
authorisation. There may be a risk he is avoiding
authorisation and any scrutiny.

Test 2
Dashboard data:
Number of orders 13,546 The norm is that orders should be matched with
matched with GRN GRNs. This total figure should be reconciled with
the total number of orders and GRNs issued in the
period.
Number of unmatched 1,175 This could be a timing difference between the order
orders being made and the goods arriving.
Analyse by each individual supplier and assess
whether the time delay is normal for each supplier's
delivery terms.
Predict number of outstanding unmatched orders
based on totals of orders made and usual time
delay for each supplier.
Number of unmatched 22 Two months seems excessive for a delayed delivery.
orders over 2 months This is a small number so all 22 could be
old investigated in case they reveal a control weakness
(eg, undelivered orders not been followed up;
inability of supplier to deliver).
Number of unmatched 17 The goods received department staff are instructed
GRNs that if there is no matching purchase order on the
system, materials should not be accepted.
If this instruction had been fully applied, then this
number should be zero. This suggests a control
weakness in that goods may have been received
and delivery accepted for goods not ordered.
There may be a further risk that an invoice has been
received and paid which would be a more serious
control weakness.
Investigate all 17 items and establish the causes.
Examiner's comments
General comments
The discussion of the contract price and warranties was the lowest scoring section of the paper.
Many students failed to apply IAS 37 to the contract price and instead spent a lot of time
discussing issues which scored little or no marks. The warranty provision fared slightly better. A
number of students were able to attempt a discussion of IAS 37 and score marks on the issues
surrounding the legal case and the warranties.
The controls assessment produced a wide variety of answers. Strong candidates laid their
answers out according to the layout suggested by the question. These candidates were often
then able to discuss the assertions and then identify the relevant controls, with reasonable
attempts to analyse the strength of these.
Weaker candidates simply listed facts from the scenarios, picking up some marks for identifying
controls but without really analysing the strengths or weaknesses of them. A significant minority
of candidates listed controls that weren't mentioned in the scenario, suggesting they were
simply copying out of all controls relevant to liabilities, rather than studying the controls given
and their suitability.

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

46 Earthstor
Scenario
The candidate is asked to review the work of an audit senior who has summarised the minutes of
board meetings during the audit of Earthstor an AIM-listed company. The audit senior identified
the company's financial reporting treatment of the transactions in the minutes in a separate
exhibit. The CEO of Earthstor dominates the board which presents both ethical and governance
issues. The finance director has resigned after raising concerns over transactions with a supplier
TraynerCo and has not been replaced. Potentially Earthstor is assisting TraynerCo to evade tax
in a non-UK tax jurisdiction. The candidate is required to review the work of the audit senior and
identify appropriate financial reporting treatments for the transactions noted in the minutes
which include an interest free loan in a foreign currency to a supplier; an equity investment in a
foreign company; IAS 40 issues in respect of a foreign investment property; and website
development costs.
Marking guide
(a) Explain the financial reporting 18  Assimilate and demonstrate

implications of each of the understanding of a large amount of
transactions noted from the board complex information.
minutes by Greg (Exhibit 2 and 3).
 Identify appropriate accounting
Recommend appropriate
treatments for complex transactions
accounting adjustments. Please
including an interest free loan in a
ignore any tax implications of
foreign currency to a supplier; equity
these adjustments.
investment in a foreign company;
IAS 40 issues in respect of a foreign
investment property; and website
development costs.
inappropriate accounting adjustments.
 Recommend appropriate accounting
adjustments.
(b) Identify the key audit risks arising 10  Assimilate knowledge, drawing upon
from each of the transactions question content to identify key audit
(Exhibits 2 and 3) and recommend risks.
the audit procedures we will need
 Describe relevant audit procedures
to complete to address each risk.
required to provide verification
evidence for each risk.
(c) Prepare a revised draft statement 5  Assimilate adjustments to prepare draft
of financial position at 30 June statement of financial position.
20X6 (Exhibit 1). This should
include any adjustments identified
in (a) above.

(d) Explain any corporate governance 7  Assimilate information to identify

issues for Earthstor that you potential problems with the
identify from Greg's file note governance of Earthstor.
(Exhibit 2). Also explain any ethical
 Identify potential ethical and
issues for our audit firm and set
money-laundering issues.
out any actions that our firm
should take.  Discuss appropriate responses and
actions for the firm in respect of the
potential ethical issues.
Total 40
Parts (a) and (b)

Working paper for the attention of Tom Chang
Financial reporting treatment and key disclosure requirements of each of the transactions
noted by Greg
Loan to TraynerCo
The loan to TraynerCo represents a financial asset for Earthstor. IFRS 9 requires a financial asset
to be measured initially at fair value. A zero interest rate loan issued at par would not result in an
arm's length transaction and IFRS 9 requires the fair value in such a case to be determined as the
present value of the cash receipts under the effective interest rate method. The discount rate
should be that on similar loans. The loan will meet the business model test and the contractual
cash flows test (payments of principal, being the initial fair value and interest, being interest
accrued using the effective interest rate method), and should be subsequently measured at
amortised cost.
The initial fair value of the loan when issued on 1 July 20X5 is therefore:
MYR20m/(1.06)2 = MYR17.800m
In terms of £ sterling this would be translated at this date as:
MYR17.800m/5 = £3.560m
The difference of £0.44 million between the £4 million recognised by the company in trade and
other receivables and £3.56 million is recognised as an expense in profit or loss.
Each year the unwinding will be treated as finance income. It would be appropriate to use the
amortised cost method as the loan is a non-derivative financial asset; there is a determinable
repayment date and the intention appears to hold the investment to maturity. The loan at the
financial year end of 30 June 20X6 is:
MYR17.8m  1.06 = MYR18.87m
This is a monetary asset and would be translated at the year-end rate of £1 = MYR6. In the
financial statements of Earthstor it would therefore be translated as:
MYR18.87m/6 = £3.15m
There are two elements to this transaction for financial reporting purposes:
 Interest income on the loan
 Exchange loss

Interest income
The interest income is recognised at the effective rate, even though there is no cash interest
received. As the interest accrues over the year, it is translated at the average exchange rate.
The interest cost in MYR is therefore:
MYR17.8m  6% = MYR1.07m
Translated using the average rate into £ this is:
MYR1.07m/5.5 = £0.20m
Exchange loss
The exchange loss has two elements:
 On the interest
 On the loan
The exchange loss on the interest is:
MYR1.07m/5.5 – MYR1.07m/6 = £0.02m
The exchange loss on the loan is:
MYR17.8m/5 – MYR17.8m/6 = £0.59m
£'000
Interest income 200
Exchange loss:
On interest (20)
On loan (590)
(410)
This reconciles with the opening balance divided by the opening exchange rate less the closing
balance divided by the closing exchange rate as above (£3.56m – £3.15m) = £0.41 million.
The loan is currently recognised at MYR20m/5 = £4 million and should be recognised at
£3.15 million.
Exchange differences and interest should be reported as part of profit or loss. An adjustment is
required as follows:
£'000 £'000
DEBIT Financial asset (debt instrument) 3,150
CREDIT Trade receivables 4,000
DEBIT Exchange differences – retained earnings (0.02 + 0.59) 610
CREDIT Interest income – retained earnings 200
DEBIT Interest cost – (£4m – £3.56m) 440
TraynerCo Loan – Audit risks and procedures
Audit risk Audit procedures
The supplier may not be able to repay the loan Check procedures used to verify the
and it would then be impaired. This is a key creditworthiness of the supplier when the loan
risk as there are no cash interest payments to was originally extended.
observe that these can at least be serviced.
Verify the terms of the loan and whether any
security has been pledged if the loan is not
repaid – eg, enquire whether there is a charge
over assets as security for the loan.
Examine correspondence (legal
correspondence, board minutes, as well as
letters/emails/memos with TraynerCo) for any
possibility of early repayment.

The market rate of interest of 6% may not be a Compare rates to corporate loans to similar
risk equivalent in which case the measurement companies where interest is paid in full.
of the loan and the interest payments would
be incorrect.
Classification of the loan as loans and Confirm terms by examining the loan
receivables may be inappropriate. agreement.
Examine correspondence for any possibility of
early repayment.
There is a control risk in authorising a large Review level of authorisation of loan (main
loan on favourable terms. board).
Review treasury procedures to attest
information on creditworthiness, legal advice
and means of drawing up loan agreements.
Consider whether there is a risk of a link Examine the contractual supply agreement
between the provision of the loan and the cost with TraynerCo for example deep discounting
of goods from TraynerCo – the CEO has of purchase cost of goods as part of loan
referred to a deal on the rent and this may also agreement.
apply to the loan.
Prepare analytical procedures on history of
cost of goods from TraynerCo.
Risk of incorrect exchange rates. Verify exchange rates and estimate average
exchange rates.
Confirm the date on which loan was extended.
TraynerCo – equity investment

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

was incorrect either deliberately or unintentionally as suggested by the comments made by the
finance director.
As the fall is due to market conditions, then the loss including the exchange difference is taken
to other comprehensive income.
The following adjustments are required:
Recognition and subsequent recognition
£'000
Initial recognition of shares is MYR45m/5 including transaction costs 9,500
At year end MYR36m/6 6,000
Loss to be recognised in OCI 3,500
As the loss is recognised in other comprehensive income an adjustment is required as follows:

£'000 £'000
DEBIT Equity investment: TraynerCo 1,500

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

Singapore investment property
The property should be recognised as an investment property. The company has adopted the
fair value method to account for investment properties and therefore the property should be
revalued at the year end to its fair value. Movement on the change in fair value of investment
properties is recognised in profit or loss.
The Singapore investment property should be recognised at cost on 1 February 20X6 and the
change in fair value measured as follows:
£'000
At 1 February 20X6 SG$10,000,000/2.1 4,762
At 30 June 20X6 SG$11,000,000/2.7 4,074
Change in fair value 688
The property should be separately recognised as investment property.

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

The costs of acquiring and developing software that is not integral to the related hardware
should be capitalised separately as an intangible asset. This does not include internal website
development and maintenance costs which are expensed as incurred unless representing a
technological advance leading to future economic benefit.
Capitalised software costs include external direct costs of material and services and the payroll
and payroll related costs for employees who are directly associated with the project.

Capitalised software development costs provided they meet the criteria under SIC 32 and IAS 38
– the fact that the costs integrate the website with other process systems of the business and are
not merely providing content and advertising would suggest that they do – should be stated at
historic cost less accumulated amortisation. Amortisation is calculated on a straight-line basis
over the assets' expected economic lives. Amortisation is included within administrative
expenses in the statement of profit or loss.
Therefore, Earthstor has probably incorrectly capitalised the planning costs, and also possibly
the fees paid to Tanay and the photography and graphic design costs (further information is
required on the nature of these expense). These costs should be expensed during the year. An
amortisation charge of £22m/7 years  2/12 = £524,000 is required to be charged from 1 May
20X6. This is below the materiality level on its own but taken together with the incorrect
capitalisation of costs, this should be adjusted:
£'000 £'000
DEBIT Operating expenses (£3,000,000 + £1,300,000 + £5,000,000 +
£524,000) 9,824
CREDIT Intangible assets 9,824
Reporting to Audit committee
The adjustments will be required to be reported to the Audit committee as they are all above
the agreed £120,000 reportable limit.
Given the increased capital expenditure Obtain details of internal software

during the year there is a risk that both development costs and agree to:
external and internally generated expenditure
 invoices from third parties; and
relating to the website have been incorrectly
capitalised instead of being written off to  where the costs relate to staff costs,
profit or loss. agree to time records.
There is a risk that the useful life of seven Ensure that costs capitalised are incremental
years may be excessive given the nature of costs relating to the project and not time
the expenditure. spent on management.
Consider the appropriateness of the useful
life, enquire of appropriate management and
past history of similar projects.
Related party transactions

TraynerCo
TraynerCo is a supplier and although there is significant interdependence between Earthstor
and TraynerCo, TraynerCo is not a related party of Earthstor.
Part (c)
Revised statement of financial position as at 30 June 20X6
£'000 £'000
Non-current assets Revised
Intangible assets – website 31,300 – 9,824 21,476
Financial asset – TraynerCo 8,000 – 2,000 6,000
PPE 56,309 – 4,762 51,547
Loan to TraynerCo 3,150

£'000 £'000
Current assets
Trade and other receivables 22,420 – 4,000 18,420
Cash and cash equivalents 71,139 71,139
Total assets 333,548 320,186

Equity
Ordinary share capital (£1/€1 shares) 10,000 10,000
Other components of equity (1,500) + (2,000) (3,500)
Retained earnings 163,362 – 850 – 688 – 9,824 152,000
Non-current liabilities 12,175 12,175
Current liabilities 149,511 149,511
Total liabilities and equity 333,548 320,186
Part (c)
Ethical and corporate governance implications
Dominic appears to dominate the board which represents a governance issue – but not
necessarily an ethical issue. There seems to be no separation between the chair of the board's
role and the CEO. The company is also operating without a finance director which would again
present a governance issue as the board would not be operating with the appropriate skills to
manage the company effectively. The board is therefore not acting effectively and there is a lack
of transparency in Dominic's behaviour.
A deal appears to have been made to charge no rent to TraynerCo in exchange for lower cost of
goods sold. There may potentially be an ethical issue as the company may be entering into a
transaction which could be assisting a supplier company to evade tax in a non-UK tax
jurisdiction. However, more detail of the tax treatment of the rental deduction and the taxation
of profits would need to be obtained and consulting a tax expert in Singapore and Malaysia.
Also need to ensure that Earthstor's tax position is correct and that the company is paying the
correct UK taxes.
There may be an intimidation threat if Dominic attempts to intimidate the audit staff – the firm
should ensure that appropriately briefed and experienced staff are assigned to the audit.
As there is no finance director, the firm may face a management threat if it acts in the finance
director role.
Actions the firm should take:
The increase in audit risk should be addressed with additional audit procedures in respect of the
above transactions.
AIM listed companies are not required to make disclosures of compliance with the provisions of
the UK Corporate Governance Code. However, from September 2018 they have to comply with
or explain their non-compliance with a recognised code. Furthermore ISA 260 (UK) (Revised
June 2016) requires matters of concern to be raised with those charged with governance; the
audit committee would be a point of contact to raise concerns. In addition, information
published in the financial statements should be reviewed for consistency and appropriate
professional scepticism. In respect of the potential tax evasion, further information should be
obtained and the matter reported to the firm's money laundering compliance principal. The firm
will need to engage expert tax advice in Malaysia and Singapore.

Examiner's comments
General comments
This was the best answered question on the paper, especially with regards to the financial
reporting treatment and identification of risks and procedures. Very few candidates commented
on the need to report to the audit committee.
Detailed comments
(a) Financial reporting treatment
Many candidates identified (erroneously) a related party issue with this question and those
who did often produced lengthy explanations of the disclosures that would be required.
Some better answers identified that there was an issue with transactions not conducted at
arm's length, but that this did not create a related party.
The financial asset aspects of the question were often not handled well. In relation to the
interest-free loan, weaker candidates simply accounted for the foreign currency movement
and disregarded discounting and interest altogether. Only a small number of candidates
who managed to discount the opening receivable could explain that discounting resulted
in an initial expense in the profit or loss. Some recognised that the transaction resulted in
the recognition of a receivable but then accounted for the unwinding of the receivable
(interest income) as a cost to profit or loss. Some even considered the asset was a liability.
However, this was a relatively difficult topic and it was pleasing that so many candidates did
manage to make the necessary adjustments correctly.
In relation to the investment in 10% of Trayner's shares, it was quite common to find
candidates accounting for this as an associate and therefore recommending the equity
method. Sometimes this was as a result of arguments that Earthstor and Trayner are very
closely linked, and that the apparent overpayment for the 10% investment could have
involved a premium related to significant influence. However, in many cases it appeared
that candidates think that an investment of 10% automatically results in significant influence.
Most candidates (but not all of them) realised that the treatment of transaction costs was
correct. However, many thought that the creation of a translation reserve was also correct.
Occasionally there were some reasoned debates demonstrating higher skills about the
nature of and reason for the movement in the fair value and these were credited in the
marking.
Most candidates gained marks on the website asset. Weaker candidates took the
opportunity to write out sections of the standards for the markers to read – unfortunately the
marks at this level are for the application of knowledge to the scenario – to gain marks the
candidate has to explain why a particular standard applies to the scenario.
However, in general candidates were able to articulate that costs for the website should
only be capitalised when future economic benefit had been demonstrated. Almost all then
went on to undertake a reasonable calculation of the amortisation for the period.
There were some surprising errors in relation to the mainstream topic of investment
property. A substantial minority of candidates put time and effort into isolating the foreign
currency effect of the investment property fair value movement and reporting it separately,
which is not required. More surprising at this level was the readiness to post the fair value
movement to a revaluation reserve rather than to profit or loss. Many candidates got
tangled up in lengthy explanations about the granting of rent-free accommodation to
TraynerCo.
(b) Audit risks and procedures
In general, the audit risks and procedures were sufficiently well identified and discussed for
candidates to score highly with many scoring close to maximum marks for this section.
Marks were lost when the audit tests were not appropriately linked to the scenario or were

repetitious. The best answers highlighted the recoverability issues with the TraynerCo loan
and suggested appropriate procedures to address this risk. However, a significant number
thought that an acceptable approach to many risks would be to obtain management
representations, despite the governance and ethical issues discussed in relation to Dominic
Roberts in the last section of the question.
Candidates should identify the main risk with each issue. Weaker candidates start by
discussing the exchange rates and the correct discount factors and then do not comment
on the more obvious issues like the recoverability of the loan. Candidates score better if
they produce quality rather than quantity.
For the investment many discussed disclosure as an equity investment at FVTOCI and the
exchange rate issues again but did not think that the fall in value would be significant (some
had called it a non-adjusting post period end event). This meant that the procedures were
weak too.
The risks surrounding the website and the investment property were identified more
clearly.
Procedures were not thought through well. Many mentioned looking at board minutes
although it was clear from the question that Dominic may not have discussed/minuted
these and had cancelled meetings.
There was a lot of discussion about related parties which was not relevant. Many thought
the incorrect/insufficient disclosures of related parties was the main risk for some issues.
There was also a lot of discussion about the reliance of Earthstor on Trayner for supplies
and that there was a going concern risk for Earthstor. The question said that if they could
not buy supplies from Trayner they may not be able to trade successfully in the footwear
market but this was sometimes interpreted as imminent corporate failure for Earthstor.
(c) Statement of financial position
Most candidates were able to use their own figures from part (a) to complete enough of the
key elements of this section. However, few presented the loan to Trayner separately from
trade receivables and many candidates failed to demonstrate that the balance sheet should
balance.
(d) Corporate governance and ethics
The corporate governance element of this section was generally well completed with most
candidates identifying the dominance of Dominic Roberts, lack of segregation of
CEO/chairman and the cancelling of board meetings as indicative of poor corporate
governance. Some very weak candidates speculated on the nature of the 'close friendship'
with Henry and said this was unethical.
However, many incorrectly noted that, as the company was AIM listed, it was required to
comply with the UK Corporate Governance Code, rather than it being best practice.
The ethics section was poorly completed by most. A large proportion of candidates
interpreted the requirement as relating to Dominic Roberts ethics rather than the audit
firm's and commented on potential unethical business practices. Where candidates did
interpret the question correctly, few raised anything other than the intimidation threat as an
ethical issue. Very few recognised the potential for tax evasion. Consequently, the 'actions'
were very limited.

47 EyeOP
Scenario
The candidate is working in the finance department of a listed company, HiDef plc, and is
required to respond to the instructions of the CEO. HiDef has an investment in EyeOP Ltd and is
planning to acquire a controlling interest. The candidate is required to explain the impact of
financial reporting issues including: the calculation of consolidated goodwill; the correction for
the accounting treatment of the company's pension scheme obligations; the treatment of
development costs and revenue recognition. Having made appropriate adjustments, the
candidate is required to prepare a draft forecast statement of comprehensive income assuming
HiDef makes the acquisition of EyeOP's shares. Finally, the candidate is required to analyse the
impact of the acquisition on key performance targets.
Marking guide
(a) Calculate the goodwill relating to 4  Use technical knowledge to calculate

the proposed purchase of the goodwill on consolidation.
650,000 ordinary shares in EyeOP
on 1 August 20X6, which would
be included in HiDef's
consolidated statement of
financial position as at
30 November 20X6. For this
purpose, use the expected fair
value of EyeOP's net assets at
1 August 20X6 of £63 million.
(b) Explain the impact of each of the 12  Assimilate complex information in
outstanding financial reporting order to recommend appropriate
issues (Exhibit 1) on EyeOP's accounting adjustments.
forecast financial statements for
 Apply technical knowledge to the
the year ending 31 December
information in the scenario to
20X6. Recommend appropriate
determine the appropriate accounting
adjustments using journal entries.
for pension accounting, development
costs and revenue recognition.
accounting journals.
(c) Prepare a revised forecast 6 • Assimilate and use adjustments
consolidated statement of identified in (b) in drafting the
comprehensive income for HiDef statements requested.
for the year ending 30 November
• Use knowledge of financial statement
20X6. Assume that HiDef acquires
presentation to present the financial
650,000 shares in EyeOP on
statements in appropriate format.
1 August 20X6 and incorporate
any adjustments you recommend • Appreciate that control threshold
in respect of the outstanding passed and therefore a gain on
financial reporting issues re-measurement to fair value arises
(Exhibit 1). which is recognised in OCI.

(d) Analyse the impact of the 8 • Analyse information to determine

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

In addition, a gain on re-measurement must be calculated and taken to OCI as follows:
Plan assets Plan obligations
£m £m
At 1 January 20X6 22.0 (60.0)
Interest cost on obligation (5%  £60m) (3)
Interest on plan assets (5%  £22m) 1.1
Current service cost (5.9)
Payments to pensioners (2.1) 2.1
Contribution paid 6.4
Curtailment (4.2)
Sub total 27.4 71.0
Gain/(Loss) on re-measurement recognised in OCI 5.2 (3.5)
At 31 December 20X6 32.6 (74.5)
Tutorial note
Above table shown for marking purposes – a merged presentation also acceptable.
Recommended adjustments:
£m £m
DEBIT Finance costs (£3 million – £1.1 million = £1.9 million) 1.9
CREDIT Net benefit obligation 1.9
DEBIT Operating expenses (£5.9 million + £4.2 million) 10.1
CREDIT Net benefit obligation 10.1
DEBIT Net benefit obligation 6.4
CREDIT Operating expenses 6.4
CREDIT OCI 1.7
DEBIT Net benefit obligation 1.7
IAS 19 requires that the interest should be calculated on the net benefit obligation. This
means that the amount recognised in the profit or loss is the net of interest charge on the
obligation and the interest income on the assets. Therefore, the actual return on the plan
assets is not relevant here.
EyeOP has taken on an additional liability in respect of the senior employees made
redundant – this cost is a curtailment cost which is charged to the statement of profit or loss.
Medsee camera – revenue recognition (Note 2)
This item does not represent a non-recurring item and it is incorrect to expense all the
development costs as it is possible that some of the costs should be capitalised.
In the period to 1 January 20X6 not all the criteria in IAS 38 appear to have been satisfied as
the technical breakthrough in relation to the project happened on 1 January 20X6, and so
the costs of £4 million a month should be expensed in the statement of profit or loss.
Therefore, the treatment was correct for the financial statements for the year ended
31 December 20X5 as the probable future economic benefits were uncertain before that
date.
Once the technical breakthrough was made on 1 January 20X6, the development costs
should have been capitalised until the project was completed on 30 April 20X6. An
intangible asset of £14 million (4  £3.5m) should therefore have been created.
The following adjustment is therefore required:
£m £m
DEBIT Intangible asset 14
Once production of the Medsee commenced in May 20X6, the development costs should
be amortised. This can be done on a unit of production basis (per IAS 38 para 98).

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

(c) Prepare a revised forecast consolidated statement of comprehensive income for HiDef for
the year ending 30 November 20X6. Assume that HiDef acquires 650,000 shares in
EyeOP on 1 August 20X6 and incorporate any adjustments you recommend in respect of
the outstanding financial reporting issues (Exhibit 1).
Consolidation adjustments
 Disposal of previously held shareholding in EyeOP
When control is achieved:
 any previously held equity shareholding should be treated as if it had been disposed of
and then reacquired at fair value at the acquisition date; and
 any gain or loss on re-measurement to fair value should be recognised in other
comprehensive income in the period because the original investment was at FVTOCI.

As the shares in EyeOP were previously classified as being at fair value through other
comprehensive income, any gains in respect of it which were previously recognised in other
comprehensive income may not be reclassified from other comprehensive income to profit
or loss, and any gain arising on derecognition is also recorded in other comprehensive
income.
Therefore, the following journal is required in HiDef's statement of comprehensive income
to dispose of the shareholding in EyeOP before consolidation:
£m £m
DEBIT Investment in EyeOP: £6.2m – 2.5m 3.7
CREDIT Other comprehensive income and other components 3.7
of equity
To recognise the gain on the deemed disposal of the existing holding prior to control being
obtained.
IFRS 10 states that where a subsidiary prepares accounts to a different reporting date from
the parent, that subsidiary may prepare additional statements to the reporting date of the
rest of the group, or if this is not possible, the subsidiary's financial statements may be used
for consolidation provided that the gap is three months or less and that adjustments are
made for the effects of significant transactions.
EyeOP
20X6 Adjusted Consolidated
£m £m £m £m
Revenue 383.0 145.9  4/12 48.6 431.6
Cost of sales 264.2 80.5  4/12 26.8 291.0
Gross profit 118.8 65.4 21.8 140.6
Administrative expenses (102.0) (40.2)  4/12 (13.4) (115.4)
Profit from operations 16.8 25.2 8.4 25.2
Finance costs (5.5) (14.1)  4/12 (4.7) (10.2)
Profit before tax 11.3 11.1 3.7 15.0
Income tax (2.3) (4.8)  4/12 (1.6) (3.9)
Profit for the year 9.0 6.3 2.1 11.1
for the year (1.8) + 3.7 1.9 1.7 1.7 3.6
Total comprehensive income
for the year 10.9 8.0 3.8 14.7

Owners of HiDef 10.5
Non-controlling interest (2.1 × 30%) 0.6
Consolidated statement of other comprehensive income

Other comprehensive income 3.6

Owners of HiDef 13.6
Non-controlling interest (3.8  30%) 1.1
14.7

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

WORKING:
Revenue Cost of sales
EyeOP £m £m
20X6 excluding Medsee 142.9 79.4
Add: new contract additional revenue 875 52.5 19.3

cameras
Projected for year ending 31.12.20X7 195.4 98.7
Add HiDef 383.0 264.2

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

The finance cost is a significant figure on EyeOP's profit or loss indicating that EyeOP is
highly geared. In addition, EyeOP has a significant pension obligation which affects this
cost.
EBITDAR before consolidation of EyeOP £m
£m
Add:
Depreciation 28.1
Lease rentals 35.5
80.4
Interest 5.5
EBITDAR/Interest 14.6 times
Before consolidation, this key ratio target has been met comfortably. On consolidation
of EyeOP, the ratio decreases to 9.0 times and therefore the target of 12 times will not
be met.
EBITDAR after consolidation of EyeOP £m
Group profit from operations 25.2
Add:
Depreciation (£4.1m  4/12) + £28.1m 29.5
Lease rentals (£5.5m  4/12) + 35.5m 37.3
Amortisation of
development
costs £0.2m  4/12 = £0.07m 0.1
92.1
Interest 10.2
EBITDAR/Interest 9.0 times

Examiner's comments
General comments
This question was generally well answered by most candidates although some found the
sections relating to the production of a P or L and subsequent analysis quite challenging.
Detailed comments
(a) Goodwill calculation
This was extremely well completed by candidates with many scoring full marks.
(b) FR issues
Candidates attempted this element well. Most identified the difference between the two
pension schemes and were able to calculate correctly and account for the movements in
the defined benefit scheme. In addition, the issues in relation to the capitalisation of the
Medsee expenses were well discussed. Many then went on to correctly identify that there
should also be an adjustment to revenue and cost of sales, although often missing the
contract liability element.
Some candidates became confused between the two pension schemes, but follow through
marks were given where information was correctly applied. Marks were lost however when
candidates were not explicit regarding which statement the various movements should be
posted to.
A worrying aspect of some candidates' answers was the lack of understanding regarding
the recognition of revenue with many failing to apply the recognition criteria as the point of
delivery.
(c) Financial statements
Whilst most candidates were able to complete the basic requirements of this question,
many did not correctly identify the time period over which the results of EyeOP should be
apportioned and/or did not time apportion the profit adjustments in addition to the original
P or L amounts.
Some of the more common errors were:
 adjusting EyeOP but then failing to add it to HiDef;
 inability to work out the number of months between 1 August 20X6 to 30 November
20X6 (it is 4 months not 5 or 11);
 adjusting HiDef rather than EyeOP; and
 taking 70% of EyeOP's revenue and expenses.
(d) KPIs
There were few candidates who made a satisfactory attempt at this question – calculating
the ratios and then linking the data back to the scenario for both the current and future
periods. Of the remaining candidates, the majority just calculated some ratios and then
concluded whether or not the KPI was met; a significant minority did not attempt this
element of the question.
48 Topclass Teach
Scenario
This question requires the candidate to provide accounting advice on an arrangement which
may include a lease and then to identify the risks associated with the audit of PPE, together with
an outline audit approach. The question required the application of knowledge of IFRIC 4 and
lease accounting and the ability to differentiate between inherent, control and detection risks.

The candidate was also required to prepare an outline audit plan using appropriate approaches
and timing for the given situation.
Marking guide
(a) Draft a response to Karel's request 6 • Assimilate complex information in

for advice on the financial order to produce appropriate
reporting implications of the accounting adjustments.
proposed agreement with
• Apply knowledge of relevant
Beddezy on the TT financial
accounting standards to the
statements for the year ending
31 August 20X6 (Exhibit 3). You
appreciate that the rights of use of the
can ignore any tax or deferred tax
two assets result in different accounting
consequences.
response.
• Determine that the management
training centre arrangement results in a
lease under IAS 17.
• Identify the need for further
information needed to conclude on
whether the training centre
arrangement results in an operating or
finance lease.
• Provide reasoned calculations
regarding the NPV of the MLP to
determine the arrangement is not a
finance lease.
• Clearly set out and explain appropriate
(b) Identify and explain the inherent, 12 • Apply technical knowledge to explain
control and detection audit risks risks relevant to the scenario.
associated with our audit of the
• Assimilate information to identify
PPE balance in TT's financial
control activities relevant to audit
assertions.
31 August 20X6.
• Identify weaknesses in control and
impact on audit procedures.
• Determine the additional information
needed to ensure audit assertion is
met.

(c) Prepare an outline audit approach 12 • Appreciate that evidence of good

for TT's PPE balance at 31 August controls over additions last year should
20X6 which explains those again be tested for effectiveness and
aspects of our audit of PPE where: informal nature of recording system
indicate controls would not be
(1) we are able to test and place
effective.
reliance on the operating
effectiveness of controls; • Identify the need for an auditor's expert
in terms of valuations.
(2) we will need expert input;
• Identify specific areas for audit software
(3) audit software can be used to
for depreciation arithmetic, samples for
achieve a more efficient audit;
control testing, to identify unusual
(4) substantive analytical journal entries.
procedures will provide us with
• Appreciate that substantive analytical
adequate audit assurance; and
procedures over depreciation
(5) tests of details can be calculations will be effective.
performed during our interim
• Determine areas where tests of control
audit visit.
would be required – eg, additions,
classification and existence.
Total marks 30
(a) Draft response to Karel's request for advice

Draft financial reporting advice
The proposed arrangement with Beddezy involves both the sale of a piece of land and
ongoing arrangements in respect of two buildings which will be built on it.
To determine how both the initial land sale and the ongoing arrangements should be
accounted for, it is necessary to consider whether the arrangements in respect of the
buildings constitute lease arrangements. This is addressed by IFRIC 4.
Key considerations are whether:
 the arrangement is fulfilled by the use of a specific asset – that is clearly the case in both
elements of the arrangement here as both have a specified asset which it is intended
that TT will use in some way – in one case the hotel and in the other the management
training centre; and
 the arrangement conveys the right to use the asset. In both cases TT will obtain more
than an insignificant amount of the asset's output which is the first requirement.
However, for the arrangement to qualify as a lease:
(1) TT will need to have the ability to operate the asset or to direct others to do so or
the ability to control physical access to it while obtaining or controlling more than
an insignificant amount of the output or other utility of the asset; or
(2) there must be only a remote possibility that parties other than TT will take more
than an insignificant proportion of the asset's output and the price is not fixed per
unit or linked to the market price at the time of delivery.

In the case of the hotel, this condition is not met as TT will not have the ability to operate the
hotel and there is more than a remote possibility that more than an insignificant amount of
its capacity will be taken by parties other than TT. Indeed, TT has no commitment to take
any rooms.
In the case of the management training centre, the condition is met as the centre will be
operated by TT and its manager will supervise those controlling access to the building. It
will also have exclusive use of the centre. The arrangement does therefore include a lease
for the management centre and this should be accounted for under IAS 17.
Having established that the arrangement contains a lease, it is necessary to return to the
sale of the land and consider how that should be accounted for. Half of the land which has
been sold will be used for the hotel and TT has no right to re-acquire that land and no lease
over it during the term of that arrangement. That element of the sale should therefore be
accounted for as a disposal, resulting in the disposal of an asset with a carrying amount of
£1.5 million (assuming the entire plot is priced at the same price per acre) and the
recognition of a profit of £1 million in the period in which the arrangement is signed.
Further information is needed to assess whether the price for the land is a fair market price
given that the sale is part of a much more complex arrangement.
This entry will give rise to an increase in net assets as the profit is recognised.
The financial accounting treatment of the sale and leaseback of the land provided for the
management training centre and for the centre itself will depend on whether the lease is
considered a finance lease or an operating lease. That will depend on whether the risks and
rewards of ownership remain with TT or have been transferred to Beddezy.
For the land element, it is likely to be an operating lease as the land will have a useful life
considerably in excess of 15 years and the option to re-acquire the land and building is at
market value and it is by no means certain to be exercised.
For the building lease, we need to consider in turn the factors which would normally lead to
a lease being considered a finance lease:
 the lease contains no automatic transfer of ownership to TT at the end of the term;
 TT's option to purchase back the land along with the building on it is at market value
and so there is no real certainty as to whether that option will be exercised;
 the asset's economic life is not known at present. The lease term is for 15 years which
seems less than the 'normal' expected life of a building but that will depend on the
construction and further information is required to conclude on this point.
 the present value of the lease payments cannot be calculated without first determining
what element of the payments relates to the cleaning, maintenance, security and
reception services to be provided as this would need to be excluded from the
calculation. The cost of the building to Beddezy will be £4 million. Excluding the
element (of £100,000 per annum) which relates to staff costs and services, the
minimum lease payments (undiscounted) will be £3 million (15  £200,000).
However, this covers the lease of the land as well as the building. Apportioning between
them in the ratio of the cost to Beddezy would mean that (£3 million  4.0/6.5) =
£1.84 million would relate to the building even before discounting. This is only 46% of the
cost. Even if none of the lease payment is allocated to the service element, total lease
payments will be £4.5 million which is 69% of the total cost to Beddezy of both land and
buildings without any discounting. We can therefore conclude that the net present value of
the minimum lease payments will not amount to substantially all of the fair value of the
asset.

This criterion for a finance lease is not met.
 If the training centre were a specialised building, then it would be classified as a
finance lease. However, as the building has a wide variety of uses, this would not
appear to be the case. Hence this criterion for a finance lease is not met.
We can therefore conclude that the lease is an operating lease.
Financial reporting adjustments
The element of the lease payments which relates to the services to be provided should be
taken to profit or loss as a charge in the period in which those services are provided.
The land sale for the management training centre will be recognised immediately as for the
hotel. Assuming that the sale of land is determined to be at fair value, £1 million profit will
be recognised immediately and the lease and service payments recognised over the course
of the lease in the period to which they relate. If the land sale is determined to be at above
fair value, then an element of the profit (equal to the difference between the proceeds and
the fair value) will be deferred and recognised over the period of the lease. As above the
profit recognition will increase net assets.
(When the planned changes to IAS 17 lease accounting take place, the accounting will
change and the lease liability and asset will be recognised in the statement of financial
position.)
(b) Identification and explanation of audit risks associated with PPE
Inherent risks
Management incentive to misstate the balance
We need further information to assess the extent to which management may be under
pressure to overstate assets and it is possible that there is an incentive to do so. This risk is
considered further below in connection with the judgements involved in the proposed
revaluation.
Overall business environment
Training needs and revenues will fluctuate with changing regulations and so facilities and
courses offered may need to change over time as the engineering courses have in the
current period. This means that asset lives could be shorter than anticipated. The fact that
the disposals recorded in the 9 months to 31 May 20X6 had a carrying value which
represented 40% of their cost is also indicative that the useful lives used for depreciation
may be too long and need to be reassessed in the light of actual experience and the
changing business environment.
Carrying value and level of transactions in the period
The PPE balance is very significant and is many multiples of materiality in size. This increases
the risk of material misstatement as individual transactions may well be material if
accounted for incorrectly.
There are a number of ongoing capital projects with a high value and this increases the risk
of mis-statement due to the large number of transactions which need to be processed.
Complexity of transactions
The proposed transaction with Beddezy is complex and the client is seeking assistance in
determining the financial reporting treatment. Complex transactions increase the risk that
inappropriate accounting policies may be adopted or the nature of a transaction
misunderstood by the accounts department.

In addition to the Beddezy transaction, major renovation projects such as those on the
science laboratories are likely to have elements which are capital and other elements which
are revenue in nature as they represent more routine repairs. Separating the different
elements can be difficult in practice especially if projects evolve or change as they progress.
In addition, the capital elements of the projects will result in the construction of components
which have differing lives – some relating potentially to the fabric of the building and others
to shorter lived assets such as air conditioning or lift systems or moveable partitions. In
addition, there may be elements which should be classified as furniture, fittings and
equipment rather than freehold land and buildings and it is surprising that, on the transfer
of the new business school into depreciable assets, the whole of the
£13.5 million was categorised as freehold land and buildings. This suggests that
appropriate componentisation and classification may not have taken place.
Work on the renovation of Laboratory 2 includes some rework costs which should not be
capitalised as they will not contribute any value to the finished building. We will need to
ensure that, to the extent that the costs incurred by year end have not added value, they are
charged to profit or loss rather than being capitalised and should also consider whether
there are other similar costs included in the total cost of other projects.
The IT project is likely to include elements which are PPE – ie, physical equipment – but also
elements which should be classified as intangible assets such as software. There may also
be other elements such as training which should not be capitalised at all.
Expert input
TT is proposing to revalue its assets in the current year and has included in its plan an
upward revaluation of £40 million, representing nearly 30% of the carrying value of land
and buildings prior to that revaluation. This is not totally unreasonable when compared to
the observed movement in market prices since the estate was last revalued (25%) or the
anticipated profit on the sale of the land to Beddezy (67%) although that may or may not be
at fair value and may not reflect existing use. However, the uplift of the valuation is very
significant in the context of an organisation which may be trying to maximise its net asset
value (see above).
The revaluation of an extensive campus is a complex and judgemental exercise especially
when the campus includes specialised assets such as the laboratories. It is unlikely that such
properties will have moved with market indices and, indeed, an alternative valuation model
such as depreciated replacement cost may in fact be appropriate. In addition, there is
evidence as summarised above that land values may have moved more than building
values so separate consideration of each element needs to be made.
TT had a professional valuation 3 years ago and is not required to have another one for 3–5
years. It may therefore be entitled to use its internal experts for the valuation at 31 August
20X6 providing that they have the requisite skills and experience. However, use of internal
experts increases the risk of management manipulation of results and the influence of
senior management such as the finance director. It is also questionable when the expected
revaluation change is so significant.
Judgements
Assessment of useful lives for depreciation purposes is inherently judgemental and, as
outlined above, there are some indications that past judgements may have been incorrect.
This increases the risk of mis-statement. The average useful life for fixtures, fittings and
equipment appears to be around 8 years (Depreciation charge for the year = £3.8 million;
average cost = (£32.1m + £0.5m – £29.5m)/2 = £31.05m; £31.05m/£3.8m = 8.17 years)
which is quite long for some types of equipment. However, this may well be offset by assets
which do have a longer useful life.

Another factor which will make a difference to the depreciation charge is the timing of the
transfer of completed assets from assets in the course of construction which are not
depreciated into categories of asset which are depreciated. If this entry is not made on a
timely basis, then depreciation will be understated. Karel's email says that Laboratory 1 has
been completed but the forecast figures for the final quarter in the management accounts
do not show any transfer to Freehold land and buildings (other than the Business School
which has already been transferred).
Susceptibility to theft
Certain of the PPE assets are susceptible to theft – in particular IT equipment such as
laptops and expensive but portable equipment in other areas.
Unrecorded disposals
Major renovation projects such as those on the science laboratories potentially result in the
replacement of components created by previous renovation work or indeed the initial
construction of the building. The level of disposals recorded in the management accounts is
very low and there is therefore a risk that the recording of disposals may be incomplete.
Quality of accounting systems
The systems for accounting for property, plant and equipment are not part of the main
accounting system and were developed by the finance department. There is therefore a risk
that they have not been maintained correctly or that mis-programming has occurred.
However, the fact that there have been no audit adjustments in prior years suggests that the
systems have in fact worked well.
Control risks
Staff
The long term sickness of Harry George and the fact that another individual has had to take
over the accounting for PPE increases the risk that errors are made. As the individual who
has taken over is not within the accounts department there is also a risk that they might
have less knowledge of the financial reporting treatment of more complex transactions. This
means that it will be difficult to place reliance on their assessment in the more judgemental
and complex areas such as major projects.
Segregation of duties
The person who has taken over responsibility for the PPE accounting sits within the estates
department rather than the finance department. They may have other responsibilities within
that department and will, in any event, report to a manager who does. There is therefore a
risk that segregation between approval, initiating and recording transactions may be
compromised although additional information is required to assess the extent to which this
might be the case.
Use of spreadsheets and PC
The use of spreadsheets to calculate key accounting entries and record extensive data
increases the risk that the IT systems are not robust, reliable and subject to appropriate
security and integrity checks.
A PC is also likely to have poor built in controls and security.
Detection risk
There are no specific factors (such as first year audit or incomplete records) which affect the
detection risk associated with this balance. Prior year audits have highlighted no major
issues or limitations of scope and the fact that the balance is largely comprised of relatively
few high value assets helps to reduce the detection risk.

(c) Outline audit plan
(1) Areas where we may be able to test and rely on the operating effectiveness of controls:
 Completeness and accuracy of additions to fixtures, fittings and equipment
posted during the year. Controls in this area were operating effectively last year
and, although there have been changes in staff, the basic processing and
classification of invoices may not have been affected adversely. While further
judgement and analysis may well be required for major projects, accounting for
additions to fixtures, fittings and equipment is more straight forward and controls
reliance may still be possible.
 The physical verification exercise proposed is a good control over unrecorded
disposals and should be relied on to the extent that we can.
While there may also be some good controls in other areas, the informal nature of the
accounting system and the change in personnel make it less likely that they are
operating effectively.
(2) Areas where we will need expert input:
 The key area for expert input will be in the revaluation of freehold land and
buildings. We will need our expert to look at the methodology, assumptions and
conclusions in the valuation report and to ensure that they are reasonable and do
not show signs of bias.
 Expert input may also be required when considering the componentisation of
major projects or indeed the revalued assets.
(3) Areas where audit software can be used:
 To re-perform depreciation calculations for individual assets looking both at the
charge for the year and the remaining carrying amount
 To check the arithmetic accuracy of the PPE register and also the integrity of
formulae used to create reports etc
 To select samples for controls testing or tests of detail
 To identify any journal entries or other unusual transactions which require further
investigation
(4) Areas where substantive analytical procedures will give adequate assurance:
 If the depreciation charge is not tested in its entirety using audit software, then it
can be tested using substantive analytical procedures to establish an expectation
of the depreciation charge for the year by category based on the cost/valuation of
assets; additions and disposals in the year; assets already fully depreciated; the
average useful life of assets in that category. This can then be compared to the
actual charge for the year.
(5) Tests of detail which can be completed during the interim audit visit:
 Review of major projects completed in the year (Business School and Laboratory 1
of the Science refurbishment) to test the appropriateness of the amounts
capitalised, the timing of the transfer from assets in the course of construction, the
classification and componentisation of assets, the complete recording of any
associated disposals
 Testing of additions to property, plant and equipment for the first 9 or 10 months
of the year
 Testing of disposals recorded in the first 9 or 10 months of the year

 Review of the agreements with Beddezy and further consideration of the financial
reporting treatment
 Testing of the data provided to be used by the estates department as part of the
revaluation of freehold land and buildings
 Consideration of the useful lives used in the depreciation calculation, taking into
account the risk factors identified above
 Our own testing on the existence of assets on the register, including sample
testing of freehold land and buildings to evidence of ownership such as the land
registry
Examiner's comments
General comments
It was evident that quite a number of candidates did not allow sufficient time for this question as
their answers were clearly rushed and disorganised. The question was capable of being done
well, as some very good candidates demonstrated.
Detailed comments
(a) Financial reporting – Sale of land
In general, this element was reasonably well completed by most candidates. Whilst, only
around half the candidates identified that the two transactions should have been dealt with
separately, most then demonstrated sufficient relevant technical knowledge to obtain
follow through marks. Many candidates spotted that there was a possible sale and
leaseback in the scenario, although most concluded that it was a finance, not an operating,
lease. Explanations were quite often lengthy, disorganised and incoherent. But some did
this section well and scored full marks.
Weaker candidates used this section to knowledge dump by copying out sections of IAS 17
– it is the application to the scenario which gains the marks – even if an inappropriate
conclusion were drawn provided that there was supporting evidence presented, follow
through marks were awarded.
(b) Identification of inherent, control and detection audit risks associated with the audit of
PPE
Overall strong candidates identified a good selection of inherent and control risks, relating
them to the scenario. In particular, most identified the absence of Harry George, complexity
of accounting, materiality of assets, segregation of duties and the use of spreadsheets as
risks. There was some confusion between what was an inherent risk compared to a control
risk, but marks were awarded as long as the risks were linked to the scenario. Limited marks
were given for generic risks not linked to the scenario of Topclass Teach plc.
Hardly any candidate identified that there were no specific factors that impacted detection
risk, instead discussing team structure and lowering materiality as risks/actions. A handful
identified that the absence of Harry George might give rise to difficulty in accessing
supporting evidence and potential limitation in scope.
A common error was to set out a generic set of risks, largely or wholly unrelated to the

(c) Outline audit approach for TT's PPE balance at 31 August 20X6
The majority of candidates provided a well-structured answer to this part of the question,
dealing with each of the aspects requested and relating the areas for testing to the facts of
Topclass Teach plc. Weaker candidates lost marks where the answer was not structured as
requested or where the audit approach was merely a list of audit procedures often generic
rather than a reasoned approach to each aspect. These candidates were not demonstrating
higher skills required at this level. The question requirement was very helpful in organising
the answer but many weaker candidates simply ignored this.
The main weaknesses were:
 candidates could not identify the areas where controls could be relied upon;
 'substantive analytical procedures' was often read as 'substantive procedures' and so
detailed tests were listed and not analytical procedures;
 vague descriptions of tests of detail lost marks eg, 'look at additions and disposals';
and
 also some candidates provided tests that would have been more relevant at the year
end and not for an interim audit – for example cut off procedures.

49 Zego
Scenario
The candidate is in the role of audit senior assigned to the audit of Zego, a 100% owned
subsidiary of Lomax plc. Zego's revenue has declined in the financial year and a competitor
brought out a superior product to its Ph244 which has had a significant impact on the
recoverable amounts for capitalised development costs and PPE related to the product. Also,
important to the scenario is that Lomax has previously provided loans but evidence is presented
in the question to show that this support will not be continued for new projects and that Zego
must now look for alternative sources of finance.
The candidate is required to prepare analytical procedures on financial information provided
after adjusting for the impact of impairment of the development costs and inventory write down.
The bank has requested a meeting with Zego. The bank monitors performance by reference to
interest cover and gearing as key ratios. Zego has achieved positive cash flows from operating
activities but there are indications that some of its other products may be coming to the end of
their lifecycle too.
The financial reporting implications include impairment adjustments for development assets and
a specially constructed production facility. This question requires information to be collected
from different exhibits and sources and a specific requirement for additional information means
increases the skills difficulty in this question. The candidate must also identify key risks and
implications for audit of Zego and implications of these risks for the financial statements of Zego,
Lomax and the Lomax group.
Marking guide
(a) Notes explaining and, where 18  Assimilate and demonstrate

possible, calculating adjustments understanding of a large amount of
that are required to Zego's draft complex information.
financial statements for the year
ended 31 October 20X6
treatments for complex items including
(Exhibit 3).
PPE/Intangible impairments and
Do not prepare revised financial deferred taxation.
statements, but you should clearly
identify areas where more
information is required to make
appropriate adjustments.

(b) A working paper setting out 12  Assimilate knowledge, drawing upon

preliminary analytical procedures. question content, to describe type of
Include relevant calculations and work required to provide verification
explanations. Your calculations evidence.
should take into account any
 Prepare analytical procedures having
adjustments that you have
made assimilated adjustments and
proposed to the financial
restated relevant account balances.
statements.
 Identify areas for further investigation
and areas of audit risk.
(c) A memorandum explaining the 10  Link analytical procedures to relevant

key audit risks for Zego. Set out audit risks
the implications of these risks for
• Use the information in the scenario
the financial statements for the
from different sources to identify audit
year ended 31 October 20X6 of:
risks
• Zego
• Apply scepticism to the information
• Lomax plc
provided by inexperienced financial
• The Lomax Group
controller
• Apply the risks to the financial
statements seeing the risks from
different company perspectives
Total 40
(a) Notes explaining and, where possible, calculating adjustments that are required to Zego's
draft financial statements for the year ended 31 October 20X6 (Exhibit 3).
Information is available (Exhibit 2) that allows for an estimation of impairment adjustments
in respect of Zego's non-current assets.
The property, plant and equipment and intangible development assets relating to
non-Ph244 production do not appear to be impaired but more information would be
required on this point.
Impairment of Ph244 PPE and intangible development asset
Specially-constructed production building
Recoverable amount is the higher of fair value less costs to sell and value in use. In the case
of the specially-constructed production building, the asset can apparently be sold only if it
is adapted for more general use. Fair value less costs to sell therefore appears to be
£6.5 million (£8m – £1.5m). The value in use of the asset is uncertain as it is dependent upon
funding being made available for future R&D projects.
The carrying amount of this building is £6.2 million. This is less than the estimated
recoverable amount of £6.5 million and so no impairment loss appears to arise in respect of
this building.
The renegotiation of the bank loan and the apparent unavailability of future funding from
the Lomax Group suggests that the asset may not have a value in use.

More information is required on this point, and such information may not become available
until the conclusion of renegotiations over funding. However, at the moment, as the
recoverable amount is higher than the carrying amount, the value in use calculation would
not be required.
R&D: Intangible development asset
The balance on the Ph244 development asset at 31 October 20X6 of £6 million and the
balance of PPE £0.9 million (£7.1m – £6.2m) can be examined together for recoverability,
especially as an offer exists that covers both elements. If recoverable amount is lower than
£6.9 million, an impairment loss should be recognised.
The fair value less costs to sell of the Ph244 assets is estimated at £2.4m – £0.2m =
£2.2 million, based on the offer from the non-UK competitor.
The value in use of the Ph244 assets can be estimated by discounting projected net cash
inflows from the project, as follows:
Net cash Discount Discounted net
Year ending inflows factor cash inflows
£m £m
31.10.X7 1.4 1/1.08 1.3
31.10.X8 1.0 1/ (1.08)2 0.9
31.10.X9 0.5 1/ (1.08)3 0.4
Total 2.6
Applying the IAS 36, Impairment of Assets criteria, recoverable amount appears to be
around £2.6 million, as value in use is higher than fair value less costs to sell.
If this value is realistic, the impairment loss that should be recognised is £6.9 million
(carrying amount) – £2.6 million (recoverable amount) = £4.3 million.
However, there is a great deal of uncertainty surrounding the above calculation of
impairment loss. Questions arise as follows:
 Are the projected net cash flows dependent upon the availability of the Ph244
production building? If so, the value in use depends upon Zego continuing to own the
production building.
 Is the discount rate of 8% pa supplied by Zego's Finance Director in September 20X6
realistic? The discount rate used should be a pre-tax rate that reflects current market
assessments of the time value of money and the risks specific to the asset for which
future cash flow estimates have not been adjusted. We would require more information
to be satisfied that 8% pa is appropriate.
 The fair value less costs to sell figure of £2.2 million comprises one offer from a non-UK
competitor and a rough estimate of costs to sell. Neither may be representative of
potential outcomes. More information would be required about the potential market
for the technology.
Inventories
Inventories fall outside the scope of IAS 36, Impairment of Assets. Inventories should be
measured at the lower of cost and net realisable value, according to IAS 2, Inventories.
£3.6 million of the inventories balance relates to Ph244 products. Cost = 60% × sales value,
so this inventories balance represents (£3.6m × 100/60) £6 million in potential sales and
(£6m – £3.6m) £2.4 million in potential gross profit.
The total forecast future sales of Ph244 can be estimated from the sum of forecast net cash
inflows as follows:
(£1.4m + £1.0m + £0.5m) = £2.9m. Forecast cost of sales = (£2.9m × 60%) = £1.7m.

Therefore, if the forecast of future net cash inflows proves to be reliable, the maximum
amount of inventories that can be sold at cost = £1.7 million.
The impairment loss on inventories that should be recognised now is therefore estimated at
(£3.6 – £1.7) = £1.9 million.
Clearly, a great deal more work would be needed to confirm that the estimates of future
cash inflows are realistic.
Taxation
The draft financial statements include no estimates in respect of tax, possibly because Julia
Brookes is not technically qualified to perform tax calculations. Adjustments are likely to be
necessary. The impairment losses estimated so far total £6.2 million (£4.3 million in respect
of Ph244 assets and £1.9 million in respect of Ph244 inventories), and there may be
adjustments to the tax charge or deferred tax balance in respect of these losses.
However, insufficient information is currently available to estimate the tax impact.
(b) A working paper setting out preliminary analytical procedures to identify key audit risks.
Include relevant calculations and explanations. Your calculations should take into account
any adjustments that you have proposed to the financial statements.
Working Paper
Zego Ltd: Analytical review
Prepared by: Andy Parker
Date: November 20X6
I have estimated impairment losses totalling £6.2 million. These estimates are likely to
require revision, and there will probably be further accounting adjustments required,
especially in respect of taxation.
However, assuming additional losses of £6.2 million, the profit figures in profit or loss are all
affected.
Gross profit (assuming impairment losses are recognised in cost of sales) falls to (£9.6m –
£6.2m) £3.4m.
Operating profit becomes a loss of (£2.4m – £6.2m) £3.8 million.
Profit before tax and profit for the year become losses of (£0.6m – £6.2m) £5.6 million.
On the statement of financial position:
Non-current assets fall from £32.6 million to (£32.6m – £4.3m) £28.3m.
Inventories fall to (£12.0 – £1.9m) £10.1m.
Retained earnings are reduced to (£17.0m – £6.2m) £10.8 million.
Key accounting ratios for Zego are those specified by the bank covenants ie, interest cover
and gearing.
Interest cover
Interest cover per the draft financial statements: (2.4/1.8) = 1.33
Interest cover for 20X5: (3.8/1.4) = 2.71
Interest cover per the draft financial statements is therefore just within the parameter set by
the bank of 1.2
Clearly, once impairment losses are considered, the interest cover covenant is breached as
there is an operating loss of £3.8 million.
Gearing = net debt/equity

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

However, the ratio of capital expenditure to depreciation and amortisation, although much
reduced from the previous year, shows a positive figure, and the company is continuing to invest
at a slightly faster rate than depreciation and amortisation.
Zego benefitted from £13.0 million in financing inflows in the 20X5 financial year, much of which
appears to have been invested in the Ph244 development. By contrast, in 20X6, the only
financing cash flow has been a repayment of £1.8 million. The meeting notes (Exhibit 5) show
that £1 million was repaid to the bank on 1 June 20X6, but no mention is made of an additional
£0.8 million repayment. This may have been a repayment made to Lomax, but further
investigation would be required.
Efficiency
Inventory turnover in the Zego business appears to be very slow indeed. This may be a feature
of the industry, but better control would improve working capital usage. The ratio has worsened
significantly in the 20X6 financial year because of the effects of failing to sell Ph244 products.
Trade receivables days have remained constant between 20X6 and 20X5. Without knowing the
terms of Zego's trade it is not possible to say if 67–68 days represents a good performance.
Liquidity
The ratio of current assets to current liabilities is high in both years under review. However, once
inventories are removed from the equation Zego looks somewhat exposed at the 20X6 year end
in this respect, as current liabilities exceed trade receivables balances.
Appendix to part (b): Zego – accounting ratios
20X6 20X5
Gross profit margin (9.6/24.8) × 100 = (12.6/31.4) × 100 =
(Gross profit/revenue) × 100 38.7% 40.1%
Gross profit margin after impairment (3.4/24.8) × 100 = N/A
adjustment 13.7%
Operating profit margin (2.4/24.8) × 100 = 9.7% (3.8/31.4) × 100 =
(Operating profit/revenue) × 100 12.1%
Operating loss margin after impairment ((3.8)/24.8) × 100 = N/A
adjustment (15.3%)
Operating expenses as a % of revenue (7.2/24.8) × 100 = (8.8/31.4) × 100 =
(Operating expenses/revenue) × 100 29.0% 28.0%
Interest rate on year-end borrowings (1.8/(20.6 + 3.2)) × 100 (1.4/(22.4 – 3.6)) × 100
(Finance costs/Year end net debt) × 100 = 7.6% = 7.4%
Return on capital employed (2.4/(21.0 + 20.6 + 3.2)) (3.8/(20.4 + 22.4 – 3.6))
(Profit before interest and tax/(Equity + net × 100 = 5.4% × 100 = 9.7%
debt)) × 100
Return on capital employed after ((3.8)/(14.8 + 20.6 + N/A
impairment losses 3.2)) × 100 = (9.8%)
Cash from operations compared to profit (3.0/2.4) × 100 = 125% (7.3/3.8) × 100 =
from operations 192.1%
(Cash generated from operations/profit
from operations) × 100
Cash interest cover 3.0/1.8 = 1.67 7.3/1.4 = 5.21
Cash return/interest paid
Non-current asset turnover (before 24.8/32.6 = 0.76 31.4/31.2 = 1.0
impairment)
Revenue/non-current assets
Capital expenditure to depreciation and 5.6/4.2 = 1.3 17.0/2.9 =5.9
amortisation
Capital expenditure
(additions)/depreciation

20X6 20X5
Inventory turnover (before impairment) (12.0/15.2) × 365 (7.8/18.8) × 365
Inventory/cost of sales × 365 = 288 days = 151 days
Trade receivables turnover (4.6/24.8) × 365 (5.8/31.4) × 365
Trade receivables/revenue × 365 = 67.7 days = 67.4 days
Current ratio (before impairment) 16.6/7 = 2.4: 1 17.2/5 = 3.4:1
Current assets: current liabilities
Quick ratio (16.6 – 12.0)/7.0 = 0.66 (17.2 – 7.8)/5.0 = 1.88
(Current assets – inventories) : current
liabilities
(c) Memorandum – Audit risks for Zego

Prepared by: Andy Parker
Date: xx November 20X6
Breaching gearing ratio and financing.
There is a significant element of financial risk related to the continuing financing of the
company. Zego is already highly geared, even before the effects of impairment losses are
considered. Once impairment losses are recognised the business has breached its loan
covenants. The fact that the bank has called a meeting to take place next week suggests
that the bank is aware of the company's current difficulties. The worst-case scenario is that
the bank will exert its fixed and floating charge over the assets of the business. Although the
value of assets has fallen significantly because of impairment losses, it is likely that there will
be sufficient assets to recover the entire value of its outstanding loan with the bank. Also, a
payment of £1 million to the bank is due on 1 December 20X6 (Exhibit 5) and the company
has no cash to pay it.
However, this would mean that the company would face liquidation unless group support
(eg, a commitment by Lomax Group to repay the bank borrowings) could be obtained. The
notes of the meeting with Grahame Boyle, Group Finance Director, suggest that Lomax's
main board directors are reluctant to provide further support to Zego, in which case the
level of financial risk is heightened.
The bank may be prepared to renegotiate its lending to Zego, and the liquidation of the
company could be averted. A significant factor that is likely to be considered by the bank is
that the business is fundamentally profitable; it has produced positive operating cash flows
in 20X6. However, there are indications that some of the Zego products could be reaching
the end of their life cycle, and further investment would be required to fund new R&D to
develop a pipeline of new products.
The financial risk is augmented because of timing. Zego is material in group terms, and the
Lomax Group has made a commitment to a preliminary announcement of results on
5 January 20X7. Negotiations with the bank may not have been concluded by that date,
which adds to the overall financial risk.
From an audit viewpoint, compliance with ISA 570 (UK) (Revised June 2016), Going
Concern, would be required, and this is likely to be a significant element of the audit work.
Auditors are required to evaluate management's assessment of the business's ability to
continue as a going concern. This would involve examining the process involved in the
assessment, the assumptions upon which the assessment is based and management's plans
for future action.
The extent of the financial risk facing Zego is currently uncertain and developments during
the period of the audit must be monitored closely.

Operating performance
During 20X3 and 20X4 Zego's management made a significant investment in a new
product. The investment has now largely failed, resulting in major impairment losses. The
failure may call into question the R&D capability of the company, making it less likely that
further finance will be committed to future related projects.
There is some evidence arising from the preliminary analytical procedures on the draft
financial statements that investment in other projects may have tailed off, and a suggestion
that other products are nearing the end of their life cycles. More information is needed on
Zego's product range to confirm or refute these possibilities.
The Ph244 product was superseded by a better product from a competitor. If the
competitor maintains its technological superiority, Zego's longer-term prospects could be
prejudiced.
Lomax's group directors appear to be sceptical about the capabilities of Zego's
management team. This may be no more than a reaction to the failure of Ph244, but the
lack of confidence is likely to feed into future decisions by group of the level of support they
are prepared to provide Zego.
Absence of a finance director and inexperienced financial controller
Compliance risk is, currently, less of a concern than financial and operating risks for Zego.
However, the absence of a finance director is a significant concern and a suitably qualified
replacement has not been appointed.
There is currently no qualified Chartered Accountant, as far as we know, working in Zego.
The part-qualified financial controller has prepared draft financial statements, but has not
recognised any adjustments in respect of impairment or taxation, which may cast doubt
upon her technical abilities. She may not be sufficiently technically competent to recognise
compliance needs and the company could therefore find itself in breach of regulations.
The audit team needs to be vigilant to ensure that compliance risk is recognised by Zego's
management, and that sufficient steps are taken to ensure compliance with relevant
regulation.
Implications for financial statements
Zego
If renegotiation fails for additional finance and the Lomax Group is unable/unwilling to
provide support, Zego may no longer be a going concern and its financial statements
would probably have to be prepared under the break-up basis of accounting. Additional
disclosures would be required under IAS 1, Presentation of Financial Statements.
If doubt continues over the business's ability to continue as a going concern, the financial
statements must disclose clearly that there is a material uncertainty. If the auditors consider
that adequate disclosures have been made, the audit opinion is unmodified but a Material
Uncertainty Related to Going Concern section is added. If adequate disclosures are not
made, the auditors must express a qualified or adverse audit opinion.
Lomax plc
The main implication for the financial statements of Lomax plc, the parent company, is the
measurement of the assets of investment in Zego Ltd and the long-term receivable. Either
or both may be impaired, and additional audit work will be required in respect of
measurement and recoverability.

Group
The main implication for the group financial statements (given that intra-group balances
cancel out) is in respect of the measurement of goodwill on acquisition of Zego, which may
be impaired.
Examiner's comments
General comments
The corporate reporting issues examined in this question were mostly straightforward, but the
question required advanced level skills in the understanding, collating and ordering of pieces of
information embedded in various parts of the question. Better-prepared candidates could
demonstrate their skills in this respect.
There were some very good answers to this question, producing clear, rational and concise
figures, discussions and conclusions.
Points candidates covered well were:
 descriptions of impairment were explained well;
 calculations of the value in use of the intangible development asset (although this was
sometimes attributed to the building);
 identifying that the building's fair value was higher than the CV so there was no impairment;
and
 identifying that the intangible needed impairing and taking the higher of VIU and FV less
costs to sell and comparing to the CV. The journals were clearly stated and correct.
However, some candidates evidently struggled.
Some basic errors included the following:
 The assumption that where recoverable amount exceeds carrying value IAS 16 requires the
increase in valuation to be recognised. Also, some candidates pondered at length the
question of whether the company had an accounting policy of revaluation, although it
should have been clear from the absence of any revaluation surplus in equity that it did not
have this policy.
 Musings, often extended, about impairment but without calculating any impairment losses.
This was particularly noticeable in respect of inventories. Better candidates produced an
estimate of inventory write-down, while noting that more information would be required to
confirm it.
 Failure to carry through impairment losses from the first to subsequent parts of the
question. Better candidates realised that impairment losses would produce an operating
loss for the year and that interest cover and gearing would therefore be affected and that
this was a big deal for the company. Weaker candidates ignored their own impairment
calculations and analysed unadjusted financial statements.
 Having calculated impairment losses in the first part of the question, a lot of candidates then
speculated upon the need for impairment losses in the second and third parts,
disregarding the fact that they had already calculated them.
 Layout of candidates' answers was often messy and discussions were incoherent.
 Some candidates majored on speculations about, for example, assets held for sale while
ignoring the key points about impairment.

 Some candidates, evidently spotting the key words 'development expenditure' gave
lengthy descriptions of the IAS 38 criteria for capitalising development costs. Although the
question clearly stated that the criteria for recognition had been fulfilled, weaker candidates
spent time on reproducing the IAS 38 criteria, while ignoring the key issue of impairment.
Analytical procedures
The answers for the analytical procedures were very mixed. Good candidates focused on the
two key ratios which were 'flagged up' in the question ie, interest cover and gearing and did
make adjustment to the numbers given for the issues identified in part (a). These candidates also
tended to focus on the obvious cash flow problems, the high level of inventories and the quick
ratio. Weak candidates calculated numerous ratios and then simply repeated facts such as
'revenue has fallen' without making any attempt to relate this to other information in the
question ie, the launch of a rival product and the fact that underlying revenue had also fallen.
Candidates also wasted time discussing audit issues not arising from the analytical review which
were more relevant to Part (c) of the question.
Improvements to marks could have arisen from simple presentation of a working paper as
requested and using adjusted figures from the financial reporting treatment in Part (a).
The calculation of gearing was often inept. The question clearly stated that gearing in this case
was to be calculated as net debt/equity, but many candidates used D/D+E and/or ignored the
'net' element of net debt (some even missed out the share capital from equity).
Key audit risks
Weak candidates failed to focus on key risks such as going concern and instead spent time
discussing relatively low risk areas such as having to contra out intra-group balances. Where
candidates identified the key audit risk as going concern and focussed on the analysis on the
breaching of the gearing and interest cover, the operating performance and its anticipated
further decline were often neglected.
However nearly all candidates did refer to the implications in the three sets of financial
statements and correctly discussed the use of the break up basis and impairments to the
investment, loan and goodwill. Worryingly it was clear that some candidates believed that
goodwill was recognised in the individual financial statements of the parent rather than in the
50 Trinkup
Scenario
The candidate is in the role of a financial accountant working for Trinkup plc. Trinkup has
acquired an overseas company called ZCC, which operates under a different GAAP. The
candidate must advise on the appropriate financial reporting treatment of several adjustments
including those relating to intragroup trading, pension and deferred tax. Key to answering this
section is to appreciate which adjustments impact on the parent and the subsidiary financial
statements. The candidate is then required to prepare a consolidated statement of
comprehensive income and the consolidated goodwill and foreign exchange reserve.

Marking guide
(a) Set out and explain the 18  Apply technical knowledge to the
appropriate adjustments for the information in the scenario to
outstanding financial reporting determine the appropriate accounting
issues (Exhibit) for the year ended for intragroup trading, pension
30 September 20X6 for: accounting, deferred tax and the loan.
(1) the individual company  Appreciate that the accounting for the
financial statements of loan represents a net investment in a
Trinkup and ZCC; and foreign operation and recommend
appropriate accounting treatment.
(2) the consolidated financial
statements.
You should assume that the  Demonstrate high level technical
current tax charges are correct, knowledge by explaining how the
but you should include any adjustments impact on the financial
deferred tax adjustments. statements for the group, parent and
subsidiary.
(b) Prepare Trinkup's consolidated 8  Assimilate complex information to
statement of comprehensive produce financial statements.
income for the year ended
30 September 20X6. Please use
the adjusted individual company
(c) Calculate Trinkup's consolidated 6  Clearly set out and explain appropriate
goodwill and consolidated foreign workings for the translation and the
exchange reserve at consolidation of the overseas
30 September 20X6. Show your subsidiary.
workings.
Total 32
Set out and explain the appropriate adjustments for the outstanding financial reporting issues
(Exhibit) for the year ended 30 September 20X6 for:
 the individual company financial statements of Trinkup and ZCC.
 the consolidated financial statements.
You should assume that the current tax charges are correct. However, you should include any
There are adjustments to be made for Trinkup and ZCC and on consolidation:
Issue 1 Inventory – PURP adjustment – on consolidation
An adjustment is required for the profit on coffee in Trinkup's inventory. This is because in the
consolidated income statement this profit is not realised and therefore should not be reflected
in the combined results of the two entities. Once the inventories are sold to a third party this
adjustment will no longer be required.

This is an adjustment to the consolidated financial statements and not the individual company
accounts (although it is required to calculate the NCI).
£18m × 30%/130% = £4.2 million
The temporary difference results in a deferred tax asset as in the group accounts there is a tax
charge (or in ZCC's case the tax losses may be understated) for a non-existent asset which needs
to be removed.
Although no adjustment is required to the individual financial statements, a deferred tax asset
would be included in the consolidated financial statements as follows:
Carrying amount of inventory in the consolidated financial statements
£m
£18m – £4.2m 13.8
Tax base 18.0
Difference 4.2
Deferred tax asset at 20% 0.8
Journal required on consolidation:
£m £m
CREDIT Inventory 4.2
CREDIT Tax charge 0.8
This is a consolidation adjustment and will impact the consolidated reserves (Cost of sales) and
inventory.
Intragroup trading must be eliminated on consolidation. Therefore, the revenue and costs of
sales must be adjusted for the intragroup sales and purchases.
£m £m
DEBIT Revenue K294m @ average rate £1 = K4.8 61.3
Issue 2 – Management charge
Also, the intragroup management charge must be eliminated:
£m £m
DEBIT Operating income – K75m @ £1 = K4.8 15.7
CREDIT Operating expenses 15.7
As the transactions are settled transactions, there are no adjustments required for exchange
differences.
These are consolidation adjustments and will cancel each other out on the consolidated
statement of profit or loss. They will not impact on the individual financial statements.
Issue 3 – Deferred tax on tax losses – adjust ZCC before consolidation
Potentially an adjustment is required for deferred tax in respect of the tax losses of ZCC. The
future profits may allow ZCC to recognise a deferred tax asset. However, there is a risk that not
all the losses will be recoverable ie, to the extent that the tax loss arises from an intragroup
charge.
A deferred tax asset could therefore be recognised of K100m – K75.3m = K24.7m × 20% = K5m
Km Km
DEBIT Deferred tax asset 5
CREDIT Tax charge 5
This is an adjustment to ZCC before consolidation to align Zland GAAP to IFRS.

Issue 4 – pension contribution adjustment to ZCC before consolidation
ZCC's financial statements must be adjusted to comply with IFRS before consolidation.
The contribution to the pension should be shown in expenses in the statement of profit or loss
because this is a payment to a defined contribution scheme. Under IAS 19 this is shown under
expenses and not as a reserve movement.
A deferred tax adjustment arises on this because the tax base is zero. A tax deduction will be
available in the future of K56.6m × 20% = K11.3 million.
These are adjustments to ZCC before consolidation.
Km Km
CREDIT Tax charge – Profit or loss – deferred tax on pension cost 11.3
DEBIT Profit or loss – transfer of pension cost to expenses 56.6
CREDIT OCI 56.6
Issue 5 – Loan from Trinkup to ZCC
 Interest
The interest should be accrued in both companies - In Trinkup this will be:
5.25% × K160m × 6/12 = K4.2m/4.8 = £1 million (rounded) – this will affect the statement of
profit or loss and receivables and payables but these will all cancel on consolidation.
Tutorial note
Year end rate also accepted.
It is assumed that the interest has been correctly treated for current tax purposes.
 Loan to ZCC – net investment in foreign operation
The loan to ZCC is a monetary item and as it is denominated in the functional currency of
the subsidiary the exchange difference is recognised in the parent company's profit or loss.
Therefore, an adjustment is required in Trinkup's own financial statements to record the
exchange gain as follows:
£m
K160 million @ 4.4 (1 April 20X6) 36.4
K160 million @ 4.2 (30 September 20X6) 38.1
Exchange gain 1.7
DEBIT Amount owed by ZCC £1.7m

CREDIT Profit and loss £1.7m
On consolidation, however, the loan is treated as a net investment in a foreign operation
and the exchange difference is removed from profit or loss and it will be recognised as
other comprehensive income and recorded in equity in the consolidated statement of
financial position.
On consolidation, the exchange gain should be transferred to OCI and shown as part of
total exchange differences on consolidation.
This is because the loan is similar to an equity investment in ZCC as the loan is not required
to be settled in the near future. Therefore, accounting for the exchange difference in equity
ensures that the monetary item is effectively treated in the same way as an equity
investment.

The intra group loan cancels on consolidation.
DEBIT Long term liabilities £38.1m
CREDIT Amount owed by ZCC £38.1m
Issue 6 – Fair value adjustment for land – consolidation adjustment
Adjustments to the fair values of assets and liabilities of a foreign operation under IFRS 3 are
recognised in its functional currency; the adjusted carrying amounts are then translated at the
closing rate.
The land should be revalued for consolidation purposes by K76 million and this will form part of
the goodwill calculation.
 Prepare Trinkup's consolidated statement of comprehensive income for the year ended
30 September 20X6. Please use the adjusted individual company financial statements.
 Calculate Trinkup's consolidated goodwill and consolidated foreign exchange reserve at
30 September 20X6. Show your workings.
Consolidated statement of comprehensive income
Before
ZCC consol.
Trinkup Working 1 adjust. Adjustments
£m £m £m £m £m £
(61.3)
intragroup
Revenue (Note 1) 189.2 103.0 292.2 sales 230.9
(4.2)
unrealised
Cost of sales (Note 1) (124.0) (73.8) (197.8) 61.3 profit (140.7)
Gross profit 65.2 29.2 90.2
(15.7)
Management
Operating income 15.7 15.7 charge
Operating expenses and 1.7
finance costs exchange
(£35m – £1.7m gain on loan
exchange gain – £1.0m to OCI
interest) (32.3) (52.0) (84.3) 15.7 (1) 1 interest (70.3)
Profit/loss before tax 48.6 (22.8) 19.9
0.8 deferred
tax on
unrealised
Taxation (9.0) 3.4 (5.6) profit (4.8)
Profit/(loss) for the year 39.6 (19.4) 15.1

Owners of the parent company 19.7
Non-controlling interests
(£19.4m × 20% = £3.9m + share of PURP – deferred tax
adjustment = £3.4m × 20% = £0.7m) (4.6)
Other comprehensive income 21.3 foreign
exchange
gain 21.3

Owners of parent company 19.7 + 18.0 37.7
Non-controlling interest
(£4.6m share of loss – £3.3m share of gains) (1.3)
Tutorial note
Alternative presentation of PURP adjusting the subsidiary results also accepted.
WORKINGS
(1) ZCC – process journal adjustments and translate the profit or loss at average rate and
SOFP at HR/closing rate
Pension and Average
deferred tax Interest rate
Km Km £m
Revenue 494.6 494.6 4.8 103.0
Cost of sales (354.2) (354.2) 4.8 (73.8)
Gross profit 140.4 140.4 4.8 29.2
Operating expenses and
finance costs (188.8) (56.6) (4.2) (249.6) 4.8 (52.0)
Profit/loss before tax (48.4) (109.2) 4.8 (22.8)
Tax 0.0 16.3 16.3 4.8 3.4
Profit/(loss) for the year (48.4) (92.9) 4.8 (19.4)
Other comprehensive
loss (56.6) 56.6 –
Total comprehensive
income for the year (105.0) (92.9) (19.4)
(2) Goodwill
Calculate goodwill – the percentage of net assets has been used.
Calculating goodwill involves:
Comparing the consideration plus NCI with the fair value of net assets – this is done in the
functional currency of the subsidiary – before translation.
Net assets at acquisition
Km
Share capital 50.0
Pre-acquisition profits 240.5
Fair value adjustment on land (Issue 6) 76
Fair value of net assets acquired 366.5
Goodwill
Km £m
Consideration transferred 350.0
366.5 × 20% 73.3
423.3
Fair value of net assets acquired 366.5
Goodwill 56.8 at HR 5.4 10.5
Exchange gain – balancing figure 3.0
Carrying amount goodwill at 30 September 20X6 56.8 at CR 4.2 13.5

(3) Foreign exchange reserve
£m
Exchange gain on goodwill (W2) 3.0
Exchange gain on net investment in foreign operation (Issue 5) 1.7
Exchange gain on retranslation of subsidiary (W4) 16.6
Total gains to OCI 21.3
NCI share of gains (3.3)
Consolidated exchange reserve at 30.9.20X6 18.0
(4) Exchange differences on retranslation of subsidiary

Km £m
Opening net assets 366.5 5.4 (HR) 67.9
4.2 (CR) 87.3
gain 19.4
Retained loss for year (92.9) 4.8 (AR) 19.3

4.2 (CR) 22.1
loss (2.8)
Overall gain 16.6
NCI share in exchange gain (20%) 3.3
Examiner's comments
General comments
Generally, this was well answered with most candidates methodically working through the
information given and explaining the required adjustments. The deferred tax aspects of the
question were answered well and many candidates recognised the deferred tax implications of
the PURP and the pension contributions. The answers to the third part, requiring consolidated
goodwill and consolidated foreign exchange reserve, were often excellent. It is incredible
however, that some candidates consolidated 80% of the subsidiary's results on a line by line
basis.
Detailed comments
Outstanding financial reporting issues
The main issue with this part of the question was that students failed to 'explain'. In some cases,
all that was given were journals, even though the numbers were correct. There were also some
very basic errors and weaknesses which included:
 calculating the PURP incorrectly and/or adjusting for it through revenue rather than cost of
sales or deducting, rather than adding it, to cost of sales;
 failing to link the challenge from the tax authorities to the management charges
recoverability with the deferred tax asset on the losses;
 failing to recognise that under IFRS pension contributions should be an expense rather than
taken to reserves;
 basic adjustments for cancellation of intra-group sales and cost of sales were often
presented as unbalanced journals – with a different figure cancelling cost of sales from
revenue – sometimes even in different currencies;
 some candidates clearly have difficulty distinguishing between a deferred tax liability and a
deferred tax asset as the pension adjustment was often presented as a liability;
 the forex gain was labelled as 'difference' which was not clear and very few identified the
net investment to the OCI; and

 the fair value of the land was a fair value adjustment for goodwill although some candidates
explained incorrectly that there needed to be a revaluation reserve created with
movements through OCI. Most also went on to produce journals to show the effect of the
deferred tax even though this was not required.
Trinkup's consolidated statement of comprehensive income for the year ended
30 September 20X6
The quality of workings was sometimes poor and it took significant forensic effort to identify
relevant figures in the financial statements. Also, if the requirement is to prepare the statement
of comprehensive income, as in this case, there is nothing to be gained by preparing the SFP as
well which some candidates did.
Most candidates translated the subsidiary profit or loss at the average rate. Very often the
adjustments were not shown in the correct place demonstrating a lack of understanding of
which adjustments impact on the subsidiary and which are consolidation adjustments. Many
showed a separate working for the subsidiary profit or loss and included all the adjustments for
the consolidation (eg, eliminating inter-company revenue). Generally, adjustments were added
randomly in brackets with no identification. NCI share of profit is the share of profit in the
subsidiary only, not the whole group's profit (this was a very common error).
Consolidated goodwill and consolidated foreign exchange reserve
These calculations were completed accurately and most candidates showed workings and
achieved maximum marks on this section. A few candidates had difficulty with finding the net
assets at acquisition deciding to use 'Net Current Assets' instead but otherwise this section was
done well.
51 Key4Link
Scenario
This question is an audit scenario requiring the candidate to identify and respond to several
accounting and auditing issues. The scenario for this question is the final stages of the audit. The
audit manager has had a cycling accident and the candidate is in the role of audit manager and
needs to determine whether matters identified by the partner and manager have been
adequately resolved by the audit senior. The successful candidate is required to explain the
financial reporting implications of related party disclosures, accruals, provision for restructuring,
share options and building revaluation. Audit procedures are also required for each of these.
The ethics requirement asks the candidate to consider the tender for tax work for the audit client
given the context of the client being reluctant to correct the company's tax return.

Marking guide
(a) For each of the matters identified 21  Apply knowledge of relevant

in Carey's file note (Exhibit 2) accounting standards to the
taking into account the information in the scenario to
procedures already undertaken appreciate financial reporting
by Kevin (Exhibit 3) and Max's adjustments arising from errors,
email (Exhibit 4) identify and omissions and incorrect application of
explain: financial reporting standards.
(1) any additional financial  Assimilate complex information to
reporting adjustments, produce appropriate accounting
including journals; and adjustments.
(2) any auditing issues and the  Apply scepticism to identify potential
additional audit procedures for fraud.
required in order to complete
 Identify the need for further
our audit and reach a
information needed to conclude on
reasoned conclusion on the
whether the related parties are
unresolved matters. Identify
appropriately disclosed.
any further information
required from Key4Link.  Link information on related parties to
additional audit procedures on
You do not need to consider any tax or
creditors (Farnell creditor).
 Apply technical knowledge to explain
auditing issues relevant to the scenario.
(b) Explain any ethical issues for HJM 7 • Identify threats to the firm using
arising from Max's request for appropriate analysis of the ethical
HJM to bid for Key4Link's tax code.
advisory work (Exhibit 4). Set out
• Apply judgement in terms of the level
any actions that HJM should take.
of errors and misstatements in the
scenario to consider whether the firm
should continue with the assignment.
• Recommend appropriate actions.
Total 28

Part (a)
Supplier statements
On Barnes, there appears to be a clear error. Although immaterial on its own, it adds to the
unrecorded misstatement of £50,000 already identified and is above £5,000 (the level at which
adjustments should be accumulated for further consideration). Hence, I propose an adjustment
to record the missed liability:
DEBIT Cost of goods sold £57,230
CREDIT Accruals £57,230
Auditing issues and additional auditing procedures
Kevin has completed the remaining audit procedures but his work has identified some errors.
We will therefore need to look again at whether there could be further material errors in the
untested balance and may need to extend our testing.
On Farnell, Kevin has already taken the right action by raising an audit adjustment (although we
may want to consider if cost of goods sold is the right classification for engineering services).
The related party nature of this transaction is considered below along with other procedures to
ensure that it related to pre-year end transactions at a fair price.
In addition, we should undertake further audit procedures to determine whether there are other
examples of goods delivered direct to customers as was the case with the Barnes accrual and
therefore not captured by the normal accruals process. This should be discussed with the
operations manager.
Overall, the understated accruals identified by our work now amount to £267,230
(£160,000 + £57,230 + £50,000) which is a material amount and we should ask Max to make this
adjustment.
We should also enquire further about the reasons for the errors and consider any possible
motivation for under-stating costs. One such motivation might be the share option scheme
target of £2.6 million for profit before taxation (depending on the precise definition in the share
option agreement) although at present this is still met when this adjustment, and the addition to
the reorganisation provision proposed by Max are made – see below.
With enhanced fraud risk, it is likely that we will need to do more work in this area. However, this
is not straightforward as it is Max who is himself proposing the additional provision (albeit for an
amount which ensures that the target is still met before any other adjustments are made).
Building revaluation
Financial reporting adjustment
Assuming the £200,000 uplift is correct and that the previous revaluation uplift has been
recorded correctly, the adjustment to be made in the financial statements will be:
DEBIT Carrying value of freehold property £200,000
CREDIT Revaluation reserve £200,000
Carey identified only the signed final valuation report as outstanding. This has still not been
received but Max has indicated that he will bring it with him tomorrow.
Max also indicates that the new report will show a higher valuation than the one on which we
performed our audit procedures. Such a last-minute change is unexpected and requires further
investigation.
In addition, Max's email implies that the valuation may have been influenced by a discussion
between Jan and the valuer, who clearly know each other socially.

In the light of this knowledge and the last-minute change, we will need to perform additional
audit procedures on the revised valuation and should reconsider whether we involve our own
expert for an independent view on the assumptions and methodology used now that the
independence of the company's valuer has been called into question.
Specific procedures to be performed are as follows:
 Obtain a copy of the updated valuation report.
 Discuss with the valuer the reviewed assumptions/methodology used and the reasons for
the last-minute change in his assessment of the value.
 Conclude as to whether the revised valuation is on an appropriate basis and within a
reasonable range.
 Consider whether management might have any motivation for increasing the asset value
such as future borrowing requirements secured on the asset or the net asset value in any
potential sale of shares/the business.
 Assess the valuation used in the light of our assessment of other estimates within the
financial statements and our overall consideration of bias.
Restructuring cost provision
Whether the provision should be made as suggested by Max depends on the outcome of
additional audit procedures.
The auditing issue here is that the financial statements may be misstated if Max makes the
£175,000 provision as proposed.
Kevin has performed some detailed work on the provision proposed by Max. His work on the
accuracy of the redundancy costs and the carrying value of the trucks is sufficient. However, his
work does not address adequately the following points:
 Is it appropriate for the provision to be made as at 30 September 20X6? IAS 37 states that
for a constructive obligation to exist for restructuring costs there must be a detailed plan
and an announcement made to those who will be affected by the restructuring (in this case
the lorry drivers). Kevin has not ascertained whether this is the case.
 Whether it is correct to assume that there will be no proceeds at all from the sale of the
trucks. This appears to be what is being assumed and it seems an unlikely outcome.
 Whether the trucks should be reclassified as assets held for sale and how any anticipated
reduction in their value should be treated within the financial statements.
 Are there any other legal or other costs which should also be provided for within the
provision?
Further procedures and information required is as follows:
 Enquire as to when the decision was made to outsource the delivery function and seek
evidence such as board minutes to corroborate this. If the decision was not made until after
the year end, then the provision should be reversed as there is no present obligation as at
30 September 20X6.
 If the decision was made before 30 September 20X6, seek further evidence that detailed
plans had been made at that date identifying the number of employees affected and setting
out costs and timetables. Much of that clearly exists now but the question is whether it did
at the year end.

 Request evidence that an announcement had been made to the employees affected by
30 September 20X6 and corroborate this through discussion with HR personnel and, if
deemed appropriate, those affected (such as the manager of the delivery function).
 Enquire what plans there are for the trucks and whether they were held for sale at
30 September 20X6 or were still in use at that date. To be reclassified as 'held for sale'
assets and valued at the anticipated net proceeds, they would need to be both held for sale
and actively marketed.
 Ascertain why Max has assumed no sales proceeds on disposal of the trucks given that they
have a carrying value and therefore would appear to have remaining useful life (unless the
depreciation rate is inappropriate).
 Seek external evidence of the prices for similar second hand trucks and determine whether
an audit adjustment is required to reduce the amount of the provision made.
 Consider further how any 'impairment' to the carrying value of the trucks should be
reflected within the financial statements – it would seem more appropriate to show this as
impairment/additional depreciation thus reducing the carrying value of the asset rather
than including it within provisions.
 Enquiry as to whether there will be legal or other costs incurred which should also be
included within the provision.
One additional point for consideration is the need to reconsider our materiality figure given the
reduction in profit from this adjustment and the creditor adjustments identified above and the
share option scheme considered further below.
Share option scheme
Financial reporting adjustment
Max's response about the share option scheme raises a new issue as entries should have been
made to record the cost of the share option scheme over the vesting period.
Considering the adjustments identified above, the company's profit before taxation (before any
charge for the share option scheme) is:
£3.2 million – £175,000 (maximum) for the reorganisation provision – £267,230 for missed
accruals = £2,757,770 – which is above the target profit of £2.6 million. Thus, a share option
expense should have been recorded as follows:
2,500 options × fair value of £45 = £112,500, which should have been recognised equally over
the four years to 30 November 20X6 falling into financial years as follows:
Year ending
30 September 20X3 (10 months) £23,438
30 September 20X4 £28,125
30 September 20X7 (2 months) £ 4,687
Prior period errors have clearly occurred here and IAS 8 requires these to be corrected
retrospectively where material, thus presenting the financial statements as if the error had never
occurred. In this case the error in each year and cumulatively to 30 September 20X5 is not
material (£79,688) and therefore the error should be corrected in the financial year ended
30 September 20X6, resulting in an additional charge to profit or loss of £107,813. The
correcting journal entry is as follows:
DEBIT Share option cost – operating expenses £107,813

The fact that Max has not told HJM about the share option scheme previously raises some
questions about his openness with the auditor (especially as he might have been expected to
know how to account for it) but it may also be, as he suggests, an honest mistake and he has
been open about it in response to Carey's question. It also seems surprising that the scheme
was not identified from a review of the minutes of Board and shareholder meetings so steps
should be taken to ensure that it was approved appropriately. We should also consider carefully
whether any changes should be made to the audit approach to ensure that other similar items
are not missed, albeit that this one was not material to any of the years signed off.
Max's apparent failure to understand how to account for the share option scheme does also
raise questions about his competence and we should consider carefully whether there are other
matters he may have got wrong.
Our audit procedures to corroborate this charge are as follows:
 Obtain a copy of the rules for the share option scheme and ensure that all relevant factors
have been considered in the calculation of the accounting entries.
 Evaluate the basis on which the fair value of £45 was calculated, the expertise of Max who
calculated it and the need for expert input in assessing it.
 Ensure that appropriate disclosures are made in the financial statements. Required
disclosures include:
– a description of the scheme;
– the number of options outstanding at the beginning and end of the year (2,500), along
with the exercise price (£5);
– details of how the fair value was determined;
– for key management (such as Max and possibly others), the share options should be
disclosed as related party transactions; and
– the total expense in the period.
When the shares are issued £2,500 should be credited to share capital and £10,000 to share
premium as the exercise price is higher than the nominal value of a share.
Completeness of related party disclosures
There are several related parties and transactions which may require disclosure in the financial
statements. Further audit procedures need to be undertaken to identify these before
recommendations can be made.
There is still outstanding audit work in this area as the matter raised by Carey has not been
addressed by Kevin or in the response from Max.
Kevin's work has however identified one potential related party with whom there have been
transactions during the year, Farnell.
IAS 24 sets out details of what constitutes a related party and what needs to be disclosed.
Farnell is owned by Jan and his brother but it is not clear from Kevin's work whether Jan, Carol
and/or their close family members control or have significant influence over the company. This is
information that should be sought from Jan or from independent sources. If they do control it
then Farnell will be a related party (as Jan and Carol are key members of management of
Key4Link) and the nature of the relationship, along with details of transactions and balances
must be disclosed. Audit procedures will need to be performed to agree the balances disclosed

to accounting records and to review those records for evidence of any further transactions with
Farnell.
Also, we need to apply additional scepticism in respect of the Farnell liability and to perform
further testing to ensure that the liability does indeed relate to pre-year end services and that
the amount charged represents a fair price.
In addition, audit work is required to conclude as to whether there are also other related party
transactions to disclose. The procedures to be performed will include:
 enquiry as to the procedures Key4Link have in place to identify director/shareholder
interests – this will include the register of interests maintained by the board;
 review of publicly available records to ascertain whether the directors/shareholders have
interests in other companies which might be controlling interests. Might also be helpful to
identify any companies in which they hold directorships although this will not of itself
necessarily make the other company a related party;
 review of minutes for any disclosed conflicts of interest;
 enquiry of the directors as to the other interests they have; and
 scrutiny of the company's ledgers and minutes to identify transactions with any parties
identified as related parties from the procedures performed.
The share option scheme is also a related party transaction – the accounting and disclosure of
this are considered above.
Part (b)
Explain any ethical issues for HJM arising from Max's request for HJM to bid for Key4Link's tax
advisory work (Exhibit 4). Set out any actions that HJM should take.
Max's request and comments about his current tax advisors raise several potential issues for
HJM.
One of the fundamental principles in the ICAEW Code is integrity and this states that a
professional accountant should not be associated with a return where they believe that the
information includes a false or misleading statement. The current tax advisor, Blethinsock Priory,
is therefore acting appropriately by requesting an open and honest approach in respect of the
error noted in the tax return. Max himself may also be a Chartered Accountant and therefore
bound by the same code.
Having become aware of the underpayment of tax, HJM may have a duty to report this under the
money laundering regulations if Key4Link chooses not to make good the tax owed. That is
because the definition of criminal property under those regulations includes tax evasion. The
partner will therefore need to report this to HJM's money laundering compliance principal
(MLCP) who will decide whether a report to NCA is required.
If appointed as tax advisor, HJM could not put itself in the position of making a knowingly false
tax return or, indeed, omitting to mention the error in a subsequent return. This would have to
be made clear to Max in any response to the tender and he should also be reminded of his own
personal position. However, care will also need to be taken to avoid tipping off and the advice of
the MLCP should be sought before there is direct communication with Max on this matter.
As auditor, HJM also needs to consider compliance with the Ethical Standard for auditors which
requires it to consider carefully whether any non-audit services performed are consistent with its
role as independent auditor. The proposed tax advisory services give rise to several potential
threats in this respect:

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

52 Konext
Scenario
The candidate is asked to assist in the preparation of an assurance report on the interim financial
statements for Konext plc a company listed on the AIM. The financial controller Menzie Mees has
identified some transactions which he believes may have been treated incorrectly for financial
reporting purposes by the finance director, Jacky Jones. These transactions involve potential
financial reporting issues around revenue recognition, deferred advertising costs, pension
schemes and the impairment of a CGU. To prepare a good answer to this question the
candidate needs to appreciate the requirements of IAS 34. Also, that the audit procedures
required may be different when reporting on the interim financial statements and the year-end
The candidate was also asked to comment on the adequacy of management's comments in the
interim financial statements regarding a suspected cyber attack. Also, to explain any ethical
issues for Noland, the auditor, and set out the actions Noland should take.
Marking guide
(a) Explain the appropriate financial 15  Assimilate and demonstrate understanding

reporting treatment of the issues in of a large amount of complex information.
the summary provided by Menzie
 Identify appropriate accounting treatments
(Exhibit 3). Recommend
for complex transactions including revenue
appropriate adjustments to the
recognition, the impairment of a CGU,
draft consolidated interim financial
deferred advertising costs and pension
statements for the six months
schemes.
ended 30 June 20X4.
 Apply technical knowledge to distinguish
accounting treatments at the interim and
year end.
adjustments.
(b) Prepare a revised consolidated 12  Assimilate adjustments to prepare draft
statement of profit or loss for the six statement of profit or loss.
months ended 30 June 20X4. Set
 Use financial statement analysis to prepare
out the relevant analytical
relevant analytical procedures.
procedures on the revenue and
gross profit in the revised statement  Assimilate knowledge, drawing upon
of profit or loss. Identify potential question content and own procedures to
risks of material misstatement. identify key risks of misstatement.

(c) Set out briefly the key audit 5  Describe relevant audit procedures
procedures required to address any required to provide verification evidence for
risks of misstatement of revenue each risk.
you have identified. For these risks,
 Apply technical knowledge to determine
set out separately the audit
the procedures relevant to the interim
procedures for:
financial statements and the financial
 the interim financial statements for the year ending
statements; and 31 December 20X4.
 the financial statements for the  Present information in accordance with
year ending 31 December instructions.
20X4.
(d) In respect of the details you receive 8  Assimilate information to identify adequacy
from Jacky about the information of the disclosure.
security issue (Exhibit 4):
 Identify potential ethical and reputational
 evaluate the adequacy of the issues for Noland.
management commentary
 Discuss appropriate responses and actions
disclosure in relation to the
for the firm in respect of the potential
information security issue
ethical issues.
(Exhibit 2); and
 Appreciate the public interest and role of
 explain any ethical issues for
corporate social responsibility.
Noland and set out the actions
Noland should take.  Demonstrate understanding of the
importance of contributing to the culture of
the profession.
Total 40
(a) Financial reporting treatment and adjustments

Revenue recognition
Konext has recognised £15 million revenue in respect of the Denwa+ device. However,
following IFRS 15, Revenue from Contracts with Customers, revenue should only be
recognised when the performance obligations in the contract have been satisfied. There
are two performance obligations: supply of the mobile devices and provision of the
software services. In the case of the mobile devices this is a performance obligation
satisfied at a point in time. It is satisfied when control of the devices has been transferred to
the buyers, that is upon delivery. This takes place on 1 August 20X4, so no revenue for this
will be recognised in the financial statements for the six months to 30 June 20X4.
In the case of the software services, this is a performance obligation satisfied over time. This
is because the customer simultaneously receives and consumes the benefits provided by
Konext's performance as it performs. Time elapsed (an input method) is an appropriate way
to measure progress towards satisfaction of the performance obligation, and therefore the
software services should be recognised separately over the two-year period.
Therefore, none of the £15 million will be recognised in the interim financial statements and
only some of it will be recognised in the year ending 31 December 20X4.
The cash received in relation to orders not yet fulfilled should be treated as a contract
liability.

The deposits should be recognised in cash and included as a contract liability. Although
they are non-refundable it does not create an obligation to complete the contract.
IAS 34 requires the same recognition and measurement principles to apply in the
preparation of the interim financial statements as at the year-end. Therefore, although
ultimately the sales will be recognised in the year to 31 December 20X4, no revenue should
be recognised in the six months to 30 June 20X4 in respect of the Denwa+ devices as
delivery will take place in August 20X4.
Guarantee of replacement device
This is a multi-element sale and it needs to be determined whether there is a market price
for the guarantee element – which would require separate recognition.
As no revenue is recognised at 30 June 20X4 the adjustment for guarantees, if any, would
be made at the year end.
At 30 June 20X4, I would need to determine where the original entries had been booked
and to reverse them – therefore I recommend the following adjustments:
Debit Credit
£'000 £'000
Revenue – sales of devices 10,000
Revenue – software services 5,000
Contract liability 2,000
Receivables 13,000
Accrued costs 6,000
Cost of sales 6,000
Being removal of revenue and related cost of sales
This will leave the deposits as a balance of £2 million as a payable on the statement of
financial position at 30 June 20X4.
Impairment of Refone
Refone is a cash generating unit. The net assets of the Refone business should be carried at
no more than the recoverable amount which is defined as the higher of the fair value less
costs to sell and the value in use.
Indicators of impairment
The launch of the new product with a guaranteed replacement of the device rather than
repair, is one factor which could indicate impairment. The amount of third party business is
not known but if a significant part of its business comes from Konext customers then a
decline in the number of devices needing repairs will be an indicator of impairment.
However, the trend of results would indicate too that there is impairment of the Refone CGU.
The Refone business has generated £2.1 million in revenue in the first six months. The
results from the previous year suggest that the business is in decline. The business
generated £5.2 million in the six months to 30 June 20X3 and only £2.6 million in the
second half of the year.
Calculation of the impairment charge
The recoverable amount is the higher of the value in use and the fair value less costs to sell.
A recent offer to buy Refone suggests that the fair value is £8 million.
The value in use should be calculated using management-approved forecasts. Jacky
estimates £1.2 million as a reasonable forecast of the cashflows from the division for five
years.
Basing the value in use on the pre-tax cash flow of £1.2 million over five years then the PV of
a five-year annuity is:
£1.2m  4.329 = £5.2 million.

The fair value less costs to sell is £8 million (which is greater than the value in use and
therefore represents the recoverable amount).
This would suggest an impairment loss of £12.450 million – £8 million = £4.45 million.
However, there are several risks arising from this calculation:
 The discount rate – no information is given as to how this has been calculated and
therefore management should be asked to justify this rate.
 The cash flows would appear to be optimistic considering the division's declining
performance.
 The recoverable amount is based on one offer and there is no indication of when this
offer was received and how firm the offer was.
IAS 36.76 states that the carrying amount of the CGU should not include the carrying
amount of liabilities unless the recoverable amount cannot be determined without
considering the liabilities – the net assets have been used in this calculation as it is assumed
that the business would be sold with the liabilities.
If the liabilities were not going to be assumed by the buyer, then the comparison to
determine the recoverable amount would have taken into consideration the gross assets
only.
The impairment is recognised first against goodwill and then the remaining amounts
allocated to the other non-monetary assets – this precludes it from being allocated against
inventory because inventory valuation is dealt with under IAS 2.
£'000 £'000
Brand name 4,175 881
Goodwill 1,975 1,975
4,450
£4.45 million – £1.975 million = £2.475 million to allocate

£2.475  £7,550/£7,550 + £4,175 (£11,725) = £1,594,000 to PPE
£2.475  £4,175/£11,725 = £881,000 to Brand name
Timing of the impairment
There is uncertainty about when this impairment should be recognised. IAS 34 states that
the same recognition and measurement principles should be used in the interim financial
statements as in the annual financial statements. Therefore, if the conditions for impairment
were met at 30 June 20X4 the impairment should be recognised.
Further enquiries should be made of the directors to determine the future of this business
after the launch of the new mobile device. Particularly regarding the recent offer for the net
assets.
The adjustment required is:
£'000 £'000
CREDIT Property, plant and equipment 1,594
CREDIT Brand name 881
CREDIT Goodwill 1,975
The above assumes that none of the PPE had been revalued.

Deferred advertising costs
The cost of the advertising services should be recognised when the service has been
delivered.
There does not appear to be any grounds for deferring the costs. IAS 34 states that a
guiding principle is that an entity should use the same recognition and measurement
principles in its interim statements as it does in its annual financial statements.
As the costs would not be regarded as an asset at the year-end it would not be appropriate
to recognise the deferral of the costs as a prepayment since they have already been
incurred before 30 June 20X4.
Share issue to Nika
The issue of shares to Nika falls within the scope of IFRS 2, Share-based Payment. It is an
equity settled share-based payment because essentially Konext has received a service in
exchange for an issue of shares. This type of transaction with a third party is normally
measured at the fair value of the services received. The value of the shares at the settlement
date will therefore be irrelevant. The cost should be shown in profit or loss when the service
has been delivered – therefore the cost has been incorrectly prepaid.
The adjustment required is:
£'000
CREDIT Prepayments 1,000
Pension schemes
The treatment with respect to the defined contribution payment is correct.
IAS 19, Employee Benefits encourages the use of a professionally qualified actuary in the
measurement of the plan's defined benefit obligations. For interim reporting purposes,
IAS 34 states that reliable estimates may be obtained by extrapolation of the latest actuarial
valuations.
The treatment of the contribution paid in respect of the defined benefit payment is
incorrect and estimates should be made by extrapolation as follows:
£'000
Fair value of assets 12,200
Present value of obligations (14,500)
Net benefit obligation at 31 December 20X3 (2,300)
Interest cost 3.25% × 2,300,000 (75)
Service cost £2,800,000 × 6/12 (1,400)
Contributions paid into the scheme 900
Estimated net benefit obligation at 30 June 20X4 (2,875)
Therefore, the following adjustment is required:

£'000
DEBIT Profit or loss – administrative expenses service cost 1,400
CREDIT Profit or loss – administrative expenses –
contribution paid 900
DEBIT Finance costs 75
CREDIT Net pension benefit obligation 575

(b) Revised consolidated SPL and analytical procedures
A revised consolidated statement of profit or loss for six months ended 30 June 20X4
20X4
External Revenue (Note 1) £000
Mobile device business
Customised mobile devices (30,300 – 10,000) 20,300
Software services sales (18,010 – 5,000) 13,010
Other mobile devices 15,700
Refone – mobile device repairs 2,100
Total 51,110
Gross profit (39,541 – 9,000) 30,541
Distribution costs (3,823)
Administrative expenses (6,563 +1,400 – 900 + 1,000 + 4,450) (12,513)
Finance costs (1,280 + 75) (1,355)
Taxation (2,000)
Profit for the period 10,850
Analytical procedures to identify risks of misstatement
The purpose of the following analytical procedures is to identify relationships and unusual
items that may indicate a risk of misstatement.
Revenue
6 months to Projected
30.6.20X4 6 months to revenue to Year ended
Restated 30.6.20X3 31.12.20X4 31.12.20X3
Revenue £'000 £'000 £'000 £'000
Hardware 20,300 20,700 (2%) 50,750 51,700
Software 13,010 10,800 20% 32,525 25,900
Repair 2,100 5,200 (60%) 5,250 7,800
Other mobile
services 15,700 6,100 157% 39,250 20,500
Total 51,110 42,800 127,775 105,900
120% 127,080
The projected revenue to 31.12.20X4 has been calculated by considering the seasonality of
the business by multiplying the results to 30 June 20X4 by 100/40.
If the business remains seasonal and 60% of revenue is generated in the second half of the
year and after adjusting for the error in recording the revenue for the new Denwa+
deposits, the directors' prediction of an increase in revenue of 20% by 31 December 20X4
is achievable overall based on the performance to 30 June 20X4.
Sales of other mobile devices have increased by 157% – although this increase is in line with
the figures estimated for the number of devices to be delivered in 20X4 as per the
management commentary, the increase could be indicative of a revenue recognition risk of
misstatement – see later conclusion.
The above analysis reveals some unusual trends which could be linked to a risk of material
misstatements as follows:
The revenue from sale of customised mobile devices is not predicted to increase in
absolute terms. The above analysis indicates that revenue will fall by 2%.
Using the above analysis and adjusted revenue figures, the estimated selling price of
Konext devices appears to have fallen whereas the sales price of third party devices
appears to be remaining constant.
Also, the software service element has increased from £41 to £50.

Konext devices and software
Number Selling price device only Software
20,300,000/260,000 = 13,010,000/260,000
650,000 × 40% = 260,000 260,000 £78.08 = £50
12 months to 51,700,000/636,000 = 25,900,000/636,000
31 December 20X3 636,000 £81.3 = £41
Other mobile devices
Number Selling price
392,000 × 40% = 156,800 156,800 15,700,000/156,800 = £100
12 months to 31 December 20X3 205,000 20,500,000/205,000 = £100
Gross profit
An analysis of the gross profit margins also reveals some unusual relationships:
6 months to
30.6.20X4
As originally 6 months to Year ended
Gross profit analysis stated Revised 30.6.20X3 31.12.20X3
£'000 £'000 £'000 £'000
Customised mobile
devices and Balancing
software figure 34,986 25,986 18,540 46,560
Other mobile devices 25% 3,925 3,925 1,525 5,125
Repair 30% 630 630 1,560 2,340
39,541 30,541 21,625 54,025
Gross profit % on
customised devices 34,986/48,310 25,986/33,310
and software × 100 ×100
72% 78% 59% 60%
The gross profit on customised devices and software can be calculated by taking the gross
profit for repairs and third-party sales from the total GP figure. The gross profit margin has
increased from 20X3. Although the management commentary does refer to an increase this
is not quantified. An increase from 60% to 78% would require explanation as it suggests
that there is potentially further risk of misstatement possibly in the recognition of software
revenue which shows a 20% increase in the same period for 20X3 revenue recognition.
There may also be risk of cut off errors which would lead to an understatement of the cost
of sales.
Conclusion
Risk of misstatements
(1) The number of proposed adjustments indicates that there may be risk of other errors
which may be a deliberate attempt to present the results favourably. Professional
scepticism should be applied to any information produced by Konext. The queries
have been raised with us by the finance director's assistant and we have only his word.
It would be appropriate to discuss the proposed adjustments with Jacky first before
concluding on whether there has been deliberate attempt to manipulate the results.
(2) Revenue recognition – the results indicate that there is a potential issue with the
application of appropriate revenue recognition policies based on control transferred to
the customer.

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

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

other non-monetary assets (although some described this but didn't go on to do the actual
allocation calculation). For the share-based payment most realised that the treatment as a
prepayment was incorrect and had to be reversed out although many then went on to make
unnecessary adjustments to equity. Most candidates clearly understood the different treatments
of the two pension schemes although disappointingly few managed to get the calculations for
the defined benefit scheme completely correct.
Some basic errors included:
 inappropriate double entry for the adjustment to cost of sales – often by debiting
inventories rather than accrued costs;
 allocating some of the impairment to inventory and receivables;
 crediting equity for the future share based payment; and
 mixing up the contributions paid on the two pension schemes and/or failing to time
apportion the service cost for six months and/or incorrectly time apportioning the interest
cost when the rate given was for six months.
Part (b) Draft consolidated profit or loss and analytical procedures for revenue recognition and
gross profit to identify potential risk of misstatement
Most candidates managed to produce an adjusted income statement showing the adjustments
and then adding across to complete the statement of profit or loss.
The analytical review section was done surprisingly well by many candidates. Overall, they took
the task seriously and produced a review that was consistent with their earlier answers. A few
candidates did not read the question with enough care. The question asked for 'analytical
procedures on the revenue and gross profit…'. Some candidates made other comments on for
example the net profit and the effect of the adjustments for impairment and pension scheme
that were not relevant. A few simply described what would be involved in an analytical review,
but did not actually perform any analysis using the revised figures. The candidates who
produced additional calculations on percentage change in the year, or prices per product, were
generally able to produce a much higher standard of analysis and commentary.
Nearly all candidates realised that cut off to revenue was a key risk but far fewer focused on the
high level of errors and potential 'window dressing' of the interim accounts.
Part (c) Audit procedures on revenue to address identified risks
This section was generally well done. A few candidates overlooked the fact that the requirement
related to revenue procedures only, and wasted time by setting out audit procedures relating to
other areas of the financial statements.
Part (d) Evaluate adequacy of management commentary and ethical issues and actions for
Noland
This section was not done well, and many candidates wasted time on long-winded explanations
of how any related provisions and other potential adjustments should be identified and/or
audited. Some candidates told the client how to set up a squad responsible for cyber security
reporting directly to the board or discussed at length the potential impact such a breach could
have on everyone (from customers through to the general public at large), or instructed the
board to perform an overhaul of the IT systems. All of which would make interesting answers but
to a different question.
Candidates demonstrated some significant errors in understanding. A few were under the
impression that the client was preparing management accounts rather than interims. Some
candidates felt that the auditors should be responsible for communicating directly with Konext's
own customers.
Some candidates completely ignored the second part of the requirement and failed to mention
Noland at all. Some thought that Noland was the client rather than the auditor.

Not many identified that Jacky was an ICAEW member and should abide by the ethical code –
they simply stated that the directors need to show integrity and be honest. The actions were
often for the client and not for Noland.
When actions for Noland were discussed, many candidates favoured the simple option to
resign, an attitude which is going to make them popular with their firms when they reach more
senior positions. Few wished to get further information or to talk to the ethics partner but most
would call the ICAEW ethics hotline.
53 Elac
Scenario
The candidate is the financial controller for Elac plc, a construction company listed on the LSE.
The candidate returns from holiday to find an unqualified assistant has prepared a first draft of
the financial statements using briefing papers prepared by the finance director. The assistant
has made several errors in interpreting the information and the candidate is required to correct
the financial reporting entries and explain the adjustments required for complex transactions
which include; the midway consolidation of an associate company; foreign exchange and intra
group trading transactions; incorrect treatment of an onerous contract as a contingent liability
and recognition of a provision for commission. The candidate needs to assimilate information
from different exhibits to determine the appropriate financial reporting treatment and to
prepare a revised consolidated statement of profit or loss and financial position.
Marking guide
(a) Explain the financial reporting 20  Assimilate complex information to

adjustments required in respect of recommend appropriate accounting
the matters described in the adjustments.
briefing papers prepared by Elac's
 Apply technical knowledge to the
finance director (Exhibits 1 and 2).
Include relevant journal entries.
determine the appropriate
Identify any further information
accounting for the acquisition of
required. Ignore the effects of
shares in Fenner.
accounting adjustments on
taxation.  Identify further information required
to recommend appropriate financial
reporting treatment.
 Clearly set out and explain
appropriate accounting journals.
(b) Prepare Elac's revised consolidated 10  Assimilate and use adjustments
statement of profit or loss for the identified in (a) in drafting the
year ended 31 May 20X7 and statements requested.
consolidated statement of financial
 Use knowledge of financial statement
position at that date. These should
presentation to present the financial
include any adjustments identified
statements in appropriate format.
in (a) above.
Total 30

(a) Elac's investment in Fenner Ltd
Until 1 February 20X7, the investment in Fenner was recognised in the consolidated
financial statements of Elac at cost in non-current asset investments. Any dividends received
from Fenner were credited to investment income. On 1 October 20X6 Elac received a
dividend from Fenner of 20p per share: £100,000 (20p × £10m × 5%). This was correctly
recognised in investment income.
However, a change of status of the investment took place on 1 February 20X7 with the
purchase of an additional 20% of Fenner's ordinary share capital. Elac's holding of 25%
appears to confer significant influence over the operations of Fenner and therefore Fenner
is an associate of Elac from 1 February 20X7. Normally, a holding of over 20% of the
ordinary share capital of another entity suggests significant influence, and this is further
reinforced by the power to appoint a director. It is clear that no one party exerts control over
Fenner and this factor also makes it more likely that Elac can exert significant influence.
As Fenner is an associate, Elac must recognise the investment using the equity method of
accounting. This means that in the consolidated statement of financial position, the
investment in Fenner is shown at cost plus the group's share of post-acquisition retained
profits or less the group's share of post-acquisition losses (less any dividend received). In
the statement of profit or loss Elac takes credit for its share of the associate's profit after tax,
or deducts its share of the associate's loss after tax.
Fenner was an associate for four months of the financial year (1 February to 31 May 20X7).
Elac recognises its share of the loss for that period: £46.5m × 4/12 = £15.5m × 25% =
£3.9 million in consolidated profit or loss.
Elac's share of the dividend of 40p per share paid by Fenner on 30 April 20X7 is: £10m ×
25% × 40p = £1 million. This reduces the carrying amount of the investment in the
associate.
Therefore, the carrying amount of the investment in Fenner in Elac's consolidated statement
of financial position at 31 May 20X7 is calculated as follows:
£m
Original 5% investment at cost 50.0
20% investment at cost 350.0
Less share of post-acquisition losses (3.9)
Less dividend received (1.0)
395.1
The journal entries (1) required are as follows:

Debit Credit
£m £m
Investment in associate 350.0
Suspense account 350.0
Investments 50.0
Profit or loss 3.9
Investment income 1.0
Being the recording of the investment in, and income from, the associate.
Trading with Fenner
Equity accounting requires elimination of any unrealised profit in inventory, to the extent of
the group's share. Where the associate sells to the parent, as in this case, the unrealised
profit is in group inventories, from which it must be eliminated. The group share of
unrealised profit at 31 May 20X7 is calculated as follows:

20/120 × £35m = £5.8m × 25% = £1.5m (to nearest £100,000)
This is recognised by debiting the share of profit/loss of Elac and crediting group
inventories. The journal entry (2) required is as follows:
£m £m
DEBIT Share of profit/loss of associate 1.5
Accounting for the group share of unrealised profit arising from trading with associate.
Sales to Otherland
Daniel has made several errors in respect of the transactions with Otherland customers.
Provision for onerous contract
IAS 37, Provisions, Contingent Liabilities and Contingent Assets, requires that a provision
should be made for onerous contracts at the time a contract becomes onerous. This is the
point at which future benefits under a contract are expected to be less than the unavoidable
costs under it. The contract with Otherland is described by the finance director as
"expected to make a much larger margin than UK sales".
The consolidated profit or loss statement includes the results of Elac itself plus its other
subsidiaries, therefore Elac's normal gross profit margin on UK sales cannot be calculated.
However, the group gross profit margin is 20%. If this is indicative of Elac's own gross profit
margin, the margin on the Otherland contract is likely to be higher than this. Assuming a
gross margin of 30% on the Otherland contract, gross margin for the remaining seven
months of the year could be calculated at 30% × (7 months × 1,600 × O$5,000) =
O$16.8 million.
The pound is clearly weakening over the 20X7 calendar year, with a loss in value of over
20% expected. However, the anticipated exchange losses are very likely to be outweighed
by the profits to be earned under the contract. Therefore, it is unlikely that the contract with
the Otherland customers is onerous, although more precise information about profitability
would be required to confirm this.
The provision made by Daniel must be reversed: The journal entry (3) is as follows:
£m £m
DEBIT Provision 5.5
Trade receivables
Trade receivables denominated in foreign currencies are monetary items. As required by
IAS 21, The Effects of Changes in Foreign Exchange Rates monetary items in foreign
currency outstanding at the reporting date should be translated at the closing rate.
Using the closing rate at 31 May 20X7, the balances due from Otherland customers
translate at: O$10.1m/2.4 = £4.2 million (to nearest £100,000).
Therefore, an exchange loss has arisen of (£4.8m – £4.2) £0.6 million. The journal entry
required (4) is as follows:
£m £m
DEBIT Exchange loss (profit or loss) 0.6
CREDIT Trade receivables 0.6
Gains and losses arising from the retranslation of monetary items are recognised in profit or
loss for the year. Such gains and losses could be reported under various headings in the
statement of profit or loss. The adjustment in this case will be recognised in operating
expenses.

Agent's commission
It is incorrect to classify the agent's commission as a contingent liability. At the reporting
date, 31 May 20X7, an obligation exists to pay the agent commission for sales over the
five-month period from 1 January 20X7. It is a present obligation arising from past
transactions (the sales) and it can be measured with a reasonable degree of certainty.
The finance director has stated that average monthly sales for the first five months of 20X7
are 1,600 windows. If this level of sales continues to be achieved for the rest of 20X7, total
sales for the year will be 19,200 windows, which comfortably exceeds the 16,000 windows
at which the agent is paid 5% commission. Because commission depends upon total sales
for the year it is not possible at 31 May 20X7 to calculate the commission figure with
complete accuracy because a fall in sales for the rest of the year could result in total sales
falling below 16,000 units.
However, in the absence of any information to the contrary, it is reasonable to assume that
the commission accrual should be calculated at 5%, as follows: (1,600 × 5 months ×
O$5,000) × 5% = O$2 million.
This is a monetary liability and so should be translated at the closing rate on 31 May 20X7:
O$2m/2.4 = £0.8 million (to nearest £100,000).
The journal entry (5) required is as follows:
£m £m
CREDIT Provisions 0.8
Further information:
More precise information regarding profitability of the Otherland contract. Confirmation of
expected level of sales of windows to confirm commission.
(b) Revised draft of the Elac group's financial statements for the year ended 31 May 20X7
Revised consolidated statement of profit or loss
Jnl ref Adjustment Adjusted
£m £m £m
Revenue 1,855.4 1,855.4
Cost of sales (1,482.9) 3 5.5 reverse provision (1,478.2)
5
(0.8) Agent comm
Gross profit 372.5 4.7 377.2
Operating expenses (270.8) 4 (0.6) Ex loss receivables (271.4)
Investment income 3.6 1 (1.0) Dividend 2.6
Loss from investment in 1 (3.9) (3.9)
associate 2 (1.5) Inventory (1.5)

Profit/(loss) before tax 95.9 (2.3) 93.6
Income tax (19.1) (19.1)
Profit/(loss) for the year 76.8 (2.3) 74.5
Draft consolidated statement of financial position
£m £m £m
ASSETS
Non-current assets
Tangible assets 1,799.7 1,799.7
Investments 456.0 1 (50.0) 406.0
Investment in associate 1 350.0 395.1
1 50.0
1 (3.9)

£m £m £m
1 (1.0)
Suspense account 350.0 1 (350.0) –
Current assets
Inventories 243.8 2 (1.5) 242.3
Trade receivables 238.9 4 (0.6) 238.3
Cash 16.4 16.4
Total assets 3,104.8 (7.0) 3,097.8
Equity
Ordinary share capital
(£1 shares) 150.0 150.0
Reserves 2,255.4 4 (0.6) 2,253.1
5 (0.8)
1 (1.0)
3 5.5
1 (3.9)
2 (1.5)
Long-term liabilities 388.3 388.3
Current liabilities
Trade payables and 305.6 305.6
accruals
Provision 5.5 3 (5.5)
5 0.8 0.8
Total equity and liabilities 3,104.8 (7.0) 3,097.8
Examiner's comments
Part (a) Explain the financial reporting adjustments required
Investment in Fenner Ltd
The reasons for treating the increased holding as an associate were set out well with many
candidates showing good technical and assimilation skills. Many thought that it was a joint
venture. This is a possibility, but there is no mention of a contractual agreement in the question,
therefore associate would be the more likely classification.
A minority seemed to not understand the difference between significant influence and control
and suggested that Fenner should be consolidated as a subsidiary. This assertion was usually
based on Elac's entitlement to appoint a director, but ignored the fact that the other three
shareholders could do the same, which results in no investor having control. This treatment led
them into various difficulties, mostly because they had to spend time on consolidation. A small
number of candidates could not make their minds up, and in a few cases, they produced
workings as if Fenner was an associate, then crossed them out in favour of accounting for a
subsidiary, or vice versa. The amount of time wasted on this pointless exercise often left
insufficient time for other questions.
Common mistakes were:
 not distinguishing between the pre- and post-acquisition dividends and/or eliminating
them all and then forgetting about them – or suggesting a correction by crediting cash (?);
 incorrectly calculating the loss of the associate. Many took 5/12 × £46.5m × 25% or just 25%
× £46.5m;
 not knowing how to calculate the investment in associate – many simply took £400 million
cost; and
 not taking 25% of the PURP adjustment.

Journals were often confusing with quite a few trying to post one half of the PURP journal to
Fenner's books and the other to Elac's.
Sales to Otherland and Onerous Contract
Most recognised that this provision was not required however the explanations for this were
quite poor with many spending some time on exploring hedging contracts. Many recognised
that the contract would be profitable although this could then morph into a discussion of
commission rates and exchange differences and generally get very muddled. Most focused on
detailed explanations of exchange rates and provisions as to why the contract provision should
not be recognised.
Agent commission
The commission was often noted as needing a provision based on the number of windows sold
at the year end. However, there were some poor descriptions as to why and basic mathematical
errors in the calculation of the amount of provision required.
Common errors seen were:
 using the annual sales to calculate the commission;
 translating at the average or forward rate;
 deciding that the 5% rate would be appropriate and then using 3%;
 not translating the figure calculated; and
 netting this provision off against the onerous contract provision.
Part (b) Revised consolidated profit or loss and statement of financial position
This was well answered with many candidates achieving full marks by including their own figure
adjustments and adding across to produce the consolidated financial statements.
54 Recruit1
Scenario
The candidate is an audit manager working for Hind LLP, a firm of ICAEW Chartered
Accountants with offices in several countries. The candidate has been assigned to the group
audit of Recruit1 plc for the year ended 30 April 20X7. Recruit1 is the parent of an international
group of companies engaged in executive recruitment and training. The Hind UK audit team is
responsible for the audit of the parent company, Recruit1 plc, the Recruit1 UK subsidiaries and
the audit of the consolidated financial statements. The audits of Recruit1 plc's non-UK
subsidiaries are performed by Hind audit teams in the countries where the subsidiaries are
located. The candidate is asked initially to review an audit memorandum which has been
prepared by a Hind audit team in Arca who are responsible for the audit procedures for
Recruit1's subsidiary R1-Arca Inc. The candidate should identify initially that movement in
exchange rates impacts on the materiality level and that this should be considered when
determining the need for further work. Issues the candidate should identify and explain why
include inadequate performance of procedures on revenue, payroll and taxation and a potential
prior period adjustment. Key to answering this well is to explain why the procedure performed
was inadequate and then to determine the procedures to be performed at group and subsidiary
level.
The candidate is then required to explain the financial reporting implications of a property
transaction in another of Recruit1's subsidiaries R1-Elysia Ltd. This transaction has implications
for classification and measurement of a loan and property and for deferred taxation.

Marking guide

(a) Review the reporting 18  Identify weaknesses in the audit procedures
memorandum from the Hind performed at subsidiary level.
Arcan audit team (Exhibit 2)  Critically review the work of the junior and
and for each account identified: prioritise key issues.
 describe any weaknesses  Distinguish and explain the additional
in the audit procedures; procedures required at group and
 explain any potential subsidiary level.
financial reporting and  Appreciate and apply the concept of
audit issues; and materiality in relation to group and
 set out further audit subsidiary.
procedures that either the  Appreciate and demonstrate technical
UK group audit team or understanding of the role of component
the Hind Arca team should auditors.
perform, together with any
additional information for  Relate different parts of the question to
these procedures. identify critical factors.
(b) In respect of R1 – Elysia's 12  Assimilate complex information to produce

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

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

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

Taxation
There is insufficient work done on taxation. No assessment has been made of whether their
tax advisers are suitably competent.
The taxation charge comprises current tax only and there is no mention of a deferred tax
balance even though it is clear that there are some temporary differences from the
explanation of work done on the current tax charge. Where such differences exist, a
deferred tax asset or liability will exist and should be recognised (unless in the case of an
asset it is not considered recoverable).
More information is required as to what temporary differences exist and whether any
deferred tax has been or should be recognised. It is possible that any balance will be totally
immaterial for group purposes but that cannot be assessed without further information.
Reserves
The audit procedures comprise no more than identifying why the reserve balance is
different and are completely inadequate.
The commentary on the brought forward reserves figure appears to identify a material item
which relates to the prior year and was erroneously recorded within group revenue in the
year ended 30 April 20X6. A$2,250,000 equates to £1,250,000 at the year-end exchange
rate which is above group materiality.
A material error should be treated as a prior period adjustment and the comparatives
restated. However, as the amount is only just above materiality, it should be considered
along with any other smaller and similar adjustments noted in other group entities which
might offset (or indeed add to) it. In addition, it is important to determine whether there are
related direct costs which should also be deferred thus reducing the effect on reported
profit.
However the error is treated, it should not be shown in the way it has been, simply as a
reserves movement. If a prior period restatement is required, then it should be shown as a
reduction in the prior year revenue. If not, then the reduction in revenue will be reflected in
the current year profit or loss account. There is also likely to be an adjustment to the tax
charge (unless this has already been taken into account).
The discovery of the error raises some potential issues with the accuracy of the prior year
financial statements in other areas and potentially with the competence of the finance team
and the way in which they keep the parent company informed. The group team should
therefore consider whether it affects the determination of component materiality or the level
of work required in Arca.
Non-current assets
The overall balance is above component materiality and we would therefore have expected
some work on existence, ownership and potential impairment.

There is no audit evidence to confirm the existence, ownership and valuation of a material
balance in the financial statements. The potential is that the balance is therefore not fairly
stated.
The team in Arca should be asked to perform these procedures as the scope set for them
was to test all balances over £300,000 and not all movements.
Trade receivables
A significant amount of the sample has not been followed up for further enquiry.
The receivables balance and revenue cut off are key audit areas and there is a potential for
misstatement of both balances.
The Arcan team should be asked to perform additional procedures to update their work on
post year end cash receipts and to perform alternative procedures to confirm the accuracy
and validity of the receivables balance if payment has not been received.
Procedures need to be performed to address the completeness of any receivable provisions
by reference to ageing, balances not paid within normal credit terms etc. These do not
appear to have been performed at present.
Cash and short-term investments
Although agreements to confirmations are key procedures, this is a very significant balance
and no detail is given of what is included.
The key issue here is presentation – there could be investments which need to be disclosed
separately within the financial statements or for which the valuation needs further
consideration. It is also possible that some items should not be treated as cash and cash
equivalents within the cash flow statement.
The Arcan audit team should obtain a breakdown of the balance and determine the
appropriate presentation of the balances.
Trade payables and accruals
The balance appears not to be material and therefore the Arcan team have not performed
any procedures.
However, it seems likely from the error discovered in prior year revenue that the balance is
understated, at least as far as deferred revenue is concerned. Even excluding this
consideration, the total balance of A$503,000 (excluding tax) seems very low compared to
staff and other costs and is potentially understated.
In addition, the tax payable balance will need to be classified separately within the group
financial statements and the group audit team will need to ensure that this has happened.

Audit procedures should be performed to check completeness by looking at post year end
cash payments and invoices and ensuring that the costs have been accrued in the correct
period.
Other points
The memo does not set out any details of the team in Arca, their qualifications, their
independence etc. These confirmations will be required by the group audit team.
There may also be other general procedures that the Arcan team should perform such as
review of minutes, consideration of local laws and regulations etc. To the extent that these
are required, the results should be reported.
There is not clear identification in the memo of the audit risks identified and the focused
procedures performed in response to them. Would expect head office and Arcan teams to
have input into the identification of the risks.
Overall need to be satisfied that the UK team has had sufficient involvement in the planning,
execution and results of the work in Arca as required by auditing standards.
(b) R1-Elysia's property transaction, review the further information provided
Bank loan
As there is no discount or premium on redemption, it is correct to recognise the loan at
E$6,000,000 and accrue interest at 6%. The bank loan will be measured at amortised cost
and the interest accrued over the term of the loan. The interest 'charge' of E$210,000
appears correct being 7/12 of E$6 million at 6%. However, the total balance owing on the
loan of E$6.210 million at 30 April 20X7 should be split between current and non-current
elements and converted at the year-end exchange rate of E$3.6: £1.00 resulting in the
following balances within the group accounts:
Non-current liabilities £1,667,000
Current liabilities £58,000
Audit procedures: loan agreement should be requested and reviewed to ensure that all
relevant terms have been summarised and considered in determining the financial
Classification of property
The property has been treated as an investment property in Elysia but is unlikely to qualify as
such under the provisions of IAS 40. This is because R1-Elysia uses the building for its own
training courses and provides services to the lessees of the property in the form of
administrative support and catering. Such services are unlikely to be insignificant to the
rental arrangement.
As a result, the building should be included within PPE in the Recruit1 consolidated financial
statements and stated not at fair value but at depreciated cost in line with Recruit1's
accounting policies. The revaluation gain of E$500,000 should therefore be reversed.
Audit procedures: further information should be requested on the extent to which R1-Elysia
intends to use the property to ensure that this cannot be regarded as insignificant and
examine further the total rental package and terms for external tenants to ensure that the
services provided by R1-Elysia could not be regarded as incidental.
Accounting for interest cost
At present, none of the interest cost has been included within the capitalised cost of the
building. However, assuming six months is considered 'a substantial period of time' (which
seems reasonable given the substantial conversion costs incurred) then capitalisation would
be required under IAS 23 as the purchase cost has been 'funded' for that period before the

asset can be brought into use. As a result, interest of E$180,000 should be capitalised. No
further borrowings were needed to fund the building costs of conversion so there is no
additional interest cost to consider.
Audit procedures: Confirm interest rate to loan agreement and dates to schedule of works
or board meeting minutes.
Measurement of property cost
Costs capitalised should be only the directly attributable costs of bringing the asset into
working condition for its intended use (IAS 16). As a result, it is incorrect for R1-Elysia to
have capitalised the following:
 E$900,000 relating to marketing costs
 E$750,000 relating to security, insurance and other running costs
The E$850,000 capitalised for allocated salary costs should only be capitalised if directly
attributable to the project and not if the members of staff would have been employed in any
event.
Depreciation
No depreciation has been charged but the property was brought into use one month before
the year end. There should therefore be a charge for one month's depreciation although this
is not material at E$10.38 million/25 years × 1/12 = E$34,600 (£9,600).
Assuming it was not correct to capitalise the allocated salary costs, the revised carrying value
of the property is:
E$ million
Cost 6.000
External contractor costs 4.200
Capitalised interest 0.180
10.380
Less depreciation (0.035)
10.345
E$10.345 million is translated at the year-end rate of E$3.6: £1 = £2.874 million as this is
translation arising on the consolidation of a subsidiary which maintains its books in a
currency other than the group functional currency.
Audit procedures: As the amounts capitalised are material to the group results, the group
team will require supporting documentation for a sample of the costs incurred and will also
want to see land registry or equivalent documentation to establish ownership. In addition,
physical verification work may be required either by the team or a representative in Elysia.
Deferred tax
 There are temporary differences arising because of the treatment of interest and capital
expenditure which will give rise to deferred tax balances.
 In respect of the building, the tax base is stated as E$12.7million less the 50% capital
allowance = E$6.35 million.
 The tax base of the accrued interest is nil as it will all be tax deductible in the future.
 The carrying value of the property in the financial statements (including the capitalised
interest) is E$10.38 million less depreciation of E$35,000 = E$10.345 million.
 The carrying value of the accrued interest is a liability of E$210,000.
 Any deferred tax on the revaluation is irrelevant in the group accounts as the
revaluation is not recognised in the group accounts.

A deferred tax liability arises in respect of a timing difference between the tax written down
value of the building (E$6.350 million) and its carrying amount. A deferred tax asset arises
on the accrued interest cost as tax relief is only available when the interest is paid on
30 September 20X7.
Audit procedures: As the Elysian tax regime is unlikely to be familiar to the group team,
expert advice should be sought to ensure that the information provided regarding the tax
treatment of the property investment and income is correct. The team should question
whether the additional costs capitalised for the contractor, salary and marketing really
qualify for capital expenses. The tax computation should also be requested so that the
treatment within the current tax charge can be confirmed.
There may also be other deferred tax implications from other items within the financial
statements but these are unlikely to be material.
Carrying Temporary
amount Tax base difference DT at 35%
E$m E$m E$m E$m
Property (excluding
capitalised interest) 10.165 6.350 3.815 1.335
Accrued interest 0.210 0 0.210 (0.074)
1.261
Alternative workings are acceptable.
Other points
The fact that the group finance director seemed unaware of such a large transaction in a
wholly owned subsidiary suggests that there may be a weakness in governance and internal
controls and a risk that other significant transactions may have been missed at group level
as there are several subsidiaries where detailed audit procedures have not been carried
out. While the desk top review will have identified significant balances, for example it may
not have identified business relationships, investments, contingent liabilities. The team
should ascertain the extent to which senior management was aware of the investment and
then consider additional procedures such as review of subsidiary board minutes, discussion
with local financial controllers to ensure that no other significant transactions have been
missed.
Examiner's comments
Part (a) Review of reporting memorandum
Part (a) was often done very well, especially by those candidates who had planned their time
carefully and were able to give the question their full attention. Weaker candidates, who had not
planned their time well, usually demonstrated this by providing very brief answers.
A common error in approach was failing to focus on the specific weakness in the audit
procedures eg, completeness of revenue or the fact that a third-party service company was
being relied on without any assessment of their work. Instead, weaker candidates launched into
generic tests which were often unrelated to the scenario. For example – checking delivery notes
without saying why or indeed why delivery notes would be relevant to a company engaged in
recruitment and training. Or suggesting a need for a cash after date procedure when one had
already been performed albeit unsatisfactorily.
Very few picked up on the issues relating to cash and cash equivalents – items not meeting the
definition being included and investments potentially misclassified.
Other disappointing points were: not spotting that the PPE balance was material and
concentrating on depreciation; not appreciating that a bank statement was insufficient evidence;
not spotting that the procedures on operating expenses were fine and setting out additional
procedures which were already covered in the memorandum.

Technically, most candidates made some sound points, although a surprisingly large proportion
failed to identify the absence of any deferred tax adjustment, or to consider the prior period
adjustment. Although there were some excellent answers which identified and explained the
possibility that this error could have been replicated in the current period and linked the issue to
the weak procedures performed on revenue.
There seemed to be the principle of 'more procedures = more marks' being applied when the
approach of 'quality rather than quantity' would be more appropriate.
Part (b) Financial reporting and audit procedures for R1-Elysia property transaction
Answers to this were quite varied and often very brief. Most candidates did consider whether the
property met the definition of an investment property but not all reached the right conclusion.
Again most candidates considered which costs should be capitalised but many did not suggest
including the capitalisation of interest on the loan. Few identified that the company used the cost
model for property, plant and equipment so wasted time talking about the revaluation.
Pleasingly a majority of candidates did realise the deferred tax implications of the interest and
capital allowances. Very few realised the loan needed to be recognised as part of current and
non-current liabilities and/or commented that apart from that the treatment was actually correct.
Many candidates ignored the audit aspects or produced irrelevant generic procedures.

55 EF
Scenario
The candidate is an audit senior working on the audit of EF Ltd. The initial audit planning was
performed earlier in the year. After the audit plan had been completed, EF Ltd was acquired by
a large multinational company, MegaB. The management of EF are under pressure to process
financial reporting adjustments in respect of four matters relating to a brand, goodwill, PPE and
a receivable allowance which are set out in the attachment to an email from the EF CFO.
The candidate must also assimilate information to identify changes in key elements of audit
approach which includes, for example, the impact of the acquisition on the control environment
and materiality, management incentives to manipulate the financial statements, and complex
financial reporting issues. Also following the acquisition responsibility for routine accounting
work was moved to a shared MegaB service centre which the candidate was required consider
as part of the changes to the audit approach.
The candidate's firm is facing a potential conflict of interest regarding its ability to obtain further
consultancy work from MegaB and the fact that the EF audit will be performed next year by
MegaB's auditors puts additional pressure on the candidate's firm. The candidate is required to
identify the ethical matters in the scenario for the audit firm and to explain the appropriate
actions.
Marking guide
(a) Explain, for each of the adjustments 18  Assimilate and demonstrate

required by MegaB (Exhibit 2), the understanding of a large amount of
appropriate financial reporting complex information.
treatment in the financial
statements of EF for the year
ending 31 December 20X7. Identify
including recognition of intangible
any additional information you
assets, the difference between
need to finalise the accounting
recognition of intangibles on
entries required. Ignore any
consolidation and in the subsidiary
adjustments for current and
financial statements, investment
deferred taxation.
properties and IAS 40, and
allowances for bad debt.
adjustments.
(b) Identify and explain the changes 14  Appreciate and demonstrate
that we need to make to each technical understanding of the role of
element of the planned audit component auditors.
approach summarised in the file
 Relate different parts of the question
note (Exhibit 1). You should also
to identify critical factors.
consider any additional key areas of
audit focus and risk using all the  Be able to respond to changes in the
information available. audit plan due to changes in the
business environment.

 Identify key judgement areas from a

complex scenario and different
sources in a changing time frame.
 Identify gaps and where more
information is required to develop a
revised plan.
 Appreciate the impact on materiality
level due to changes in the business
operations.
 Understand the difference between
component and planning materiality.
 Identify the risk of management
override of controls and the potential
for manipulation of judgement areas.
(c) Explain any ethical matters which 8  Demonstrate understanding of the
MKM now needs to consider in importance of contributing to the
respect of the 20X7 EF audit and culture of the profession.
any actions that MKM should take.
 Discuss appropriate responses and
actions for the firm in respect of the
potential ethical issues.
 Appreciate the public interest and
role of an ICAEW Chartered
Accountant.
 Demonstrate the principle of
objectivity and the threat derived
from external time and fee pressure
imposed by other audit firms and
management.
 Identify and recommend actions for a
self-interest and intimidation threats.
Total 40
(a) Financial reporting matters relating to the acquisition of EF by MegaB

(1) Valuation of EF brand at £20 million
The brand is an intangible asset and the relevant accounting guidance is set out in
IAS 38. For it to be recognised within the separate financial statements of EF, it would
need to be identifiable, that is capable of being sold separately from the business or
arising from contractual or other legal rights. It is debatable whether this is the case
and clear that EF has not historically recognised the asset as an intangible within its
In addition, to recognise an intangible, EF would need to be able to measure its cost
reliably. It could subsequently choose to adopt a revaluation model for intangibles but
only if the requirements for initial recognition were met and an active market can be
demonstrated. The 'cost' to MegaB has been determined as part of the overall
acquisition cost but this is not the cost to EF and the CFO's email makes it clear that he

is unsure what costs were incurred. Indeed, it seems likely that the value of the brand
has built up over time through reputation rather than because of direct expenditure.
Unless it can clearly be demonstrated that there has been an error and the brand could
and should have been recognised in the past, it would not be correct to do so now just
because a valuation has been obtained. Additional information is required. Clear
evidence of an error seems unlikely as the costs will have been considered at the time.
Hence the brand should not be reflected in the separate financial statements of EF as it
does not meet the requirements for recognition within those financial statements. No
entry should be made. The brand will be recognised on consolidation only as part of
the acquisition accounting entries.
(2) Goodwill of £1.2 million
This is goodwill generated internally by EF and it is clear from IAS 38 that internally
generated goodwill should not be reflected within an entity's financial statements.
No entry should be made. The goodwill will be recognised on consolidation only as
part of the acquisition accounting entries in the consolidated financial statements.
(3) Revaluation of PPE
PPE, including the head office building, has historically been recognised within the EF
financial statements at depreciated cost – and the company can choose to change its
accounting policy and move to a revaluation model, providing the fair value of the
asset can be measured reliably (which does appear to be the case). It does however
have to apply this model consistently to a class of assets. In this case, MegaB has
specified that the revaluation model is to be used both for investment properties and
all other land and buildings.
The only asset with an uplift if the revaluation model is used will be the Head Office
Building. In the fair value exercise conducted by MegaB this has been treated as an
investment property and we therefore need to consider whether this is the correct
classification. The relevant accounting guidance is set out in IAS 40.
For the whole property to qualify as an investment property, only an insignificant
portion should be owner-occupied. That is clearly not the case for the head office
property as EF still occupies two floors out of three. However, it is still possible that the
portion which is rented out could be regarded as an investment property if it were
capable of being sold separately or leased separately under a finance lease. Further
information is needed to determine whether this is the case.
If the rented-out floor is regarded as an investment property, then the carrying value
will need to be apportioned between the two portions and the valuation of the rented
floor determined separately from the value of the remaining owner-occupied portion.
It is clear from the information that historically the whole property was owner–occupied
and therefore we need to follow the guidance on 'change in use' within IAS 40. The
change in use date could be 1 September 20X7 when the rental agreement
commenced. A valuation should be obtained at that date and the uplift over carrying
value (for the rented floor) recognised under IAS 16 as a credit to revaluation reserve
(within other comprehensive income). The valuation of the investment property
element is then re-measured at fair value at each period end with subsequent gains
and losses going to the profit or loss account.
The remaining two floors of the property which are still owner occupied will also need
to be valued as the fair value model is to be adopted. Any uplift will be taken to
reserves thorough other comprehensive income and to revaluation surplus and will
need to be apportioned between land and buildings so that depreciation can be
based on the fair value.

Depreciation will need to be charged on the owner-occupied building element based
on the revalued amount and this will reduce operating profit.
The revaluation would increase reserves by £2.4 million. However, this depends on
whether the valuation method used is appropriate. For both elements of the valuation,
accounting guidance on the determination of fair value within IFRS 13 needs to be
followed and the income-based approach used by MegaB is not necessarily correct. It
should be a market value considering the ability of a market participant to generate
value by using the asset in its highest and best use. Further input from an expert will be
necessary to ensure that both elements of the valuation are on the correct basis before
accounting entries are made.
There is also a lease to the new tenant to account for. Rental income of £13,333 should
therefore be accrued in the statement of profit or loss for the 4 months to 31 December
20X7.
(4) Trade receivable allowance
IFRS 9, Financial Instruments uses an expected credit loss model for impairment of
financial assets in which credit losses are recognised in three stages:
Stage 1 Initial recognition (and subsequently if no significant deterioration in credit
risk): 12 months' expected credit losses recognised and interest calculated on
the gross carrying amount.
Stage 2 Credit risk increases significantly (rebuttable presumption if > 30 days past
due): lifetime expected credit losses recognised with interest calculated on
the gross carrying amount.
Stage 3 Objective evidence of impairment exists at the reporting date: lifetime
expected credit losses recognised with interest calculated on the net carrying
amount net of allowance for credit losses after date evidence exists
A simplified approach is permitted for trade receivables, contract assets and lease
receivables. For trade receivables or contract assets that do not have an IFRS 15
financing element, the loss allowance is measured at the lifetime expected credit
losses, from initial recognition. Provided the receivables do not have an IFRS 15
financing element, it is legitimate to adopt this simplified approach.
Although the amount which would have been booked at 31 December 20X6 is
material, there will be no prior year adjustment as the change in the allowance is a
change in estimate and not an error (unless allowances were missed which should have
been made at the time). Hence, if you conclude that you can support the higher level of
allowance, the entire charge of £1.35 million will be shown as irrecoverable debt
expense within the 20X7 statement of profit or loss. However, more information is
required concerning the justification for the allowance.
(b) Changes to overall audit plan and areas of audit focus because of information received
Audit timing
The timing of the audit will need to change as final audit work was planned for March and
Lewis Morson require sign off by the middle of February. Whether EF can be ready by this
date is debatable as its October results will not be ready until early December implying that
it takes it more than a month for it to close its books. A difficult year end is likely to take
even longer, leaving little if any time for audit.
This issue needs to be discussed with the client as soon as possible to determine when it is
possible for audit work to start, what work can be done before the year end and rolled
forward and what can be left until after the group reporting date on the basis that is will not
be material given the higher level of component materiality. Leaving work until later may

however not work as more staff are due to leave at the end of February and it may be
difficult to get answers to enquiries about 20X7 after that date.
A realistic timetable needs to be agreed with the client and Lewis Morson, especially as the
new issues and approach mean that the audit is likely to take more time than in the past.
Controls reliance
In the past, the audit approach has relied on testing the operating effectiveness of controls
over revenue and trade receivables. The controls were operating effectively until June
20X7. Since that date there have been significant redundancies among finance and other
staff and day to day accounting has moved to a shared service centre. It is therefore highly
likely that both the controls and those responsible for carrying them out have changed. We
know that the CFO is now responsible for both reviewing the financial statements and
posting journal entries for the more complex and judgemental items which may be
indicative of a lack of review and segregation of duties.
In addition, there is a new and very significant revenue stream relating to sales to overseas
distributors which will not have been covered by the controls work done to date.
More information is needed on when processes changed, what the new processes are and
what assurance, if any, can be given by Lewis Morson on the controls operating at the
shared service centre. Additional audit work will be required to assess the design and
implementation of controls in the post-acquisition period and to determine whether
operating effectiveness should be tested and relied on. It seems likely that in at least some
areas, design and implementation testing will identify weaknesses in control (due to staff or
other changes) and that additional substantive work will be required either on the whole
balance or, for income statement balances, for transactions processed under the new and
potentially weaker control environment. Where the old controls are relied on for 10 months
of the year, we will still need to update the interim testing to cover the 2 months from
1 November 20X7.
Urgent work on the control environment is needed to re-assess the audit approach and
determine what additional substantive procedures are required. This should include
discussion with Lewis-Morson.
Materiality
The forecast result for the year has changed significantly because of the additional revenue
following the acquisition. Planning materiality of £800,000 was based on a profit after tax of
£16 million whereas the expected profit is now £26 million which might imply a rise in
materiality to £1.3 million on the same basis.
However, there are other factors to consider:
 Lewis-Morson have asked us to use component materiality of £3 million both for
reporting to them and for the statutory audit. We cannot simply accept this but need to
form our own view on what materiality should be.
 That view should be based, not only on the financial results, but on factors such as the
ownership structure (which has clearly changed) and the focus of the users of the
accounts. Given that EF is now a wholly owned subsidiary of MegaB rather than a
standalone entity reliant on external financing, it might be appropriate to increase
materiality.
 We also need to consider the key focus for users of the financial statements. For
management, the key focus will clearly be operating profit as they each earn a
significant bonus based on achieving the forecast profit of £34 million. If actual results
are close to this level, then a small change could make the difference between
achieving and not achieving profit. That will need to be considered in determination of
the materiality level we use.

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

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

 Intimidation – there is implied intimidation both in the CFO's comments about fees and
the manager's view that MegaB may not give the firm non-audit work if it does not
meet their expectations on the audit work. This does give rise to the threat that the firm
may be deterred from acting objectively and we need to be very sure that appropriate
safeguards are put in place.
In addition, we need more information about the proposed non-audit services to MegaB
and whether these affects either our independence in respect of the EF audit or our ability
to provide an independent audit opinion to Lewis-Morson in respect of their audit of
MegaB. Different rules may well apply for MegaB as a listed entity and we need to discuss
the proposed work not only within MKM but also with Lewis Morson.
We also need to understand the proposed consultancy contract in much more detail both
in terms of its timing and the nature and extent of the work, the likely level of fees and the
fee basis.
It may be that MKM decides it will perform the more extensive audit procedures for the
quoted fee in which case there will need to be more focus to ensure that this 'low-balling'
does not lead to any short-cuts on the audit work and that the staffing is appropriate, and all
necessary procedures undertaken.
It also seems that the CFO is being instructed what entries to make and may be tempted to
make these without question and without bringing his own professional judgement to bear.
If he is an ICAEW member, then we would have a duty to report any deliberate
manipulation / fraudulent reporting although there is no real indication that has happened
here, and he has asked for advice.
Further actions
We would need to discuss the above issues with MKM's ethics partner at an early stage, and
arrange for additional partner file review. Advice from ICAEW ethics helpline should be
obtained. Full documentation of any audit based decisions on level of work, contentious
audit/ethical issues, need to be fully documented. Consideration should be given to make
changes to ensure appropriate level and resilience of audit team.
Examiner's comments
General comments
question required advanced level skills in the understanding, collating and ordering of pieces of
information embedded in various parts of the question. Better-prepared candidates could
There were some very good answers to this question, producing clear, rational discussions and
conclusions.
Part (a) Explain the financial reporting treatment of four matters in the email attachment.
This part of the question was not generally well answered. A small minority of candidates
misread the requirement and provided accounting treatment of items in Exhibit 2, in addition to
the attachment to Exhibit 2.
EF brand – Most candidates correctly stated that the brand could not be recognised in EF's
financial statements but could be recognised on consolidation. They were less skilled at
explaining the reasons why. Few identified the possibility that the brand may have been
purchased by EF and therefore could potentially have been recognised in its financial
statements.

Goodwill – As with the brand, candidates could state that goodwill is not recognised in
individual financial statements but will be recognised on consolidation. However, the
explanation of why goodwill could not be recognised in EF's accounts was often lacking or
inaccurate.
Revaluation of PPE – Answers to this part of the question were very mixed and generally lacked
structure. Many candidates correctly recognised that the rented-out portion could be classified
as an investment property, but then lost marks by not explaining the correct accounting
treatment for an IP adopting a fair value model.
A common error was to state that the change in classification should be dealt with under IAS 8
when the correct treatment under IAS 40 is to apply IAS 16 with a change of use requiring
revaluation gains to be taken to Reserves.
The owner-occupied portion was in most cases correctly identified as being treated as PPE. Only
the best candidates questioned the validity of the income based approach to the valuation
obtained by MegaB.
In respect of the proposed receivables allowance – many candidates applied inappropriate
standards eg, IAS 8, 37 and 36. IAS 37 was a particularly popular choice – an allowance for
irrecoverable debts is not an IAS 37 provision. Few candidates accurately identified that the
movement was a change in estimate, rather than a correction of an error or change in policy,
and therefore should be accounted for through profit or loss.
Part (b) Identify and explain the changes needed to each element of the planned audit
approach – consider key areas of audit focus and risk.
Part b focussed on the impacts of several factors within the scenario upon the proposed audit
plan for the EF audit. This requirement was well answered, with a significant number of
candidates scoring maximum marks. This scenario was set from the perspective of a subsidiary
auditor under pressure from group audit requirements. Pleasingly, a lot of candidates
considered the higher-level issues such as the implication of the need to change proposed
subsidiary audit timings to meet group reporting requirements and subsidiary materiality
requirements being separate from group materiality. Even without these higher-level points
students could still (and did) score well due to the number of different contributing factors
presented within the scenario.
A common weakness in unsuccessful candidates was the repetition of points eg Looking at the
change in controls, applying this to revenue and then to pensions, redundancy, bonus, then
looking at incentives to manipulate applying this to revenues and then to pensions, redundancy,
bonus. These answers were laboured and sometimes led to candidates losing the focus of the
question. The better answers were produced by candidates who spent time planning and
organising focussed answers rather than rushing headlong into an unstructured answer.
Part (c) Explain the ethical matters and actions for the audit firm.
Answers to this part of the question were disappointing. Almost all candidates identified a self-
interest threat from the consultancy work. A smaller number of candidates identified the
intimidation threat. Fewer candidates than usual put their answer into an audit context, such as
reporting to the ethics partner or suggesting an additional partner review.
The structure of answers was mixed with some candidates failing to break down their answers
into the different areas of ethics. Issues identified were generally not backed up with appropriate
actions to address the ethical challenges.
A significant minority failed to look at ethical issues from the auditor's perspective, instead
focusing on client-focused ethical problems.

56 Wayte
Scenario
The candidate is working in industry for a manufacturing company called Wayte Ltd. Returning
from sick leave, the candidate is required to redraft information schedules to support an
application for a £10 million loan from the bank. The schedules have been prepared by an
unqualified accountant and require adjustment for: an investment in equity instruments which
has increased in value but because of the impact of exchange rate, has suffered a loss which is
taken to OCI; a FVTPL investment where the increase, a profit, goes to PorL; revenue incorrectly
recognised which requires an understanding of IFRS 15 and the current or deferred taxation
implications of the adjustments. The skills tested in this question require the candidate to
identify errors in the financial reporting treatment.
The question requires candidates to demonstrate understanding by revising extracts and
specified ratios of a schedule of information prepared by the client to support a bank loan
application. Because the adjustments involve movements to the statements of profit or loss and
financial position, the statement of cash flow is only minimally impacted.
The candidate is required to analyse and interpret the financial position and performance of the
company using the revised schedule of information and the statement of cash flows and provide a
reasoned conclusion of whether the bank will extend the loan. In this scenario, there are plenty of
positive points to identify. For example, there is a very positive cash from operations/profit from
operations ratio. However, the candidate should also question why £4 million has left the company
in dividends and bank loan repayment when the company is applying for a £10 million loan.
Marking guide
(a) Explain the financial reporting 15  Assimilate complex information to

adjustments required in respect of recommend appropriate accounting
the issues identified in Jenny's adjustments.
handover notes (Exhibit 3). Include  Apply technical knowledge to the
journal entries. information in the scenario to
determine the appropriate
accounting for the equity investments
and revenue.
 Understand the accounting treatment
required by IFRS 15.
 Identify the different treatment in
deferred tax adjustments arising from
the classification of the investment in
equity instruments and the
accounting treatment of revenue.
 Identify further information required
to recommend appropriate financial
appropriate accounting journals.
(b) Prepare a revised information 8  Assimilate and use adjustments
schedule for the bank (Exhibit 1) identified in drafting the schedules
including all relevant adjustments. requested.

(c) Prepare a report for the board in 7  Use financial statement analysis to
which you analyse and interpret the prepare relevant analysis.
financial position and performance  Apply scepticism to the payment of a
of Wayte using the revised dividend of £4 million when the
information schedule and other directors are seeking further bank
available information. Provide a finance.
reasoned conclusion on whether
the bank is likely to advance the  Assimilate knowledge, drawing upon
£10 million loan. question content and own procedures
to provide a reasoned conclusion on
the loan.
Total 30
(a) Adjustments to information prepared by Jenny

(1) Foreign exchange
 The investment in PSN, held at fair value through other comprehensive income,
has increased its fair value, and the increase should be recognised through OCI.
The asset is measured at 30 September 20X7 at:
2,000 shares  AS$310 per share = AS$620,000
Translated at spot rate on 30 September 20X7:
AS$620,000/1.6 = £387,500.
Although the value of the shares has increased, the exchange rate movement
results in an overall loss: £430,000 – £387,500 = £43,000 (rounded up).
The journal entry required is:
£'000 £'000
CREDIT FVTOCI financial asset 43
 The investment in LXP is classified as at fair value through profit or loss (FVTPL)
and so any change in fair value is recognised in profit or loss.
50,000 shares at AS$7 = AS$350,000
Translated at spot rate on 30 September 20X7:
AS$350,000/1.6 = £218,750
The increase in fair value is therefore: £219,000 (rounding up) – £192,000 =
£27,000. The journal entry required is:
£'000 £'000
DEBIT FVTPL financial asset 27
This transaction affects profit before tax, and therefore the opening item in the
reconciliation of profit before tax to cash generated from operations.
(2) Service contract
IFRS 15, Revenue from Contracts with Customers sets out the steps that must be taken
in recognising and measuring revenue, one of which is to identify separate
performance obligations. In this case, the sale of goods is separate from the
performance obligation to provide services in future.

It seems clear that there are separate components, and that the components are
capable of being measured by reference to the price of the goods. The service
component should therefore be treated as a contract liability (deferred revenue), to be
recognised in the future in the period(s) in which the service is carried out and
therefore the performance obligation is satisfied. The value of the service element to
be deferred is £750,000.
The journal entry required is:
£'000 £'000
DEBIT Revenue 750
CREDIT Contract liability 750
This transaction affects profit before tax, and therefore the opening item in the
reconciliation of profit before tax to cash generated from operations. Because no costs
have been incurred in respect of the service revenue, no adjustment is required to cost
of sales.
(3) Deferred tax
Adjustments are required as follows in respect of deferred tax.
 Land and buildings
When the land and buildings are eventually disposed of, tax will arise on the gain
calculated as the difference between sale proceeds and original cost. At
30 September 20X7, therefore, the deferred tax balance in this respect is:
(£19,200,000 – £11,400,000)  20% = £7,800,000  20% = £1,560,000. The
balance brought forward was £1,200,000, and so the deferred tax balance is
increased by (£1,560,000 – £1,200,000) £360,000. The deferred tax charge is
recognised as an increase in the deferred tax liability, and a decrease in the
amount recognised through other comprehensive income and reserves in respect
of the revaluation.
 Temporary differences arising in respect of gains/losses on financial assets
Wayte has sustained a fair value loss in respect of the investment in PSN, held at
fair value through other comprehensive income. This is recognised in other
comprehensive income in the year ended 30 September 20X7. The related
deferred tax effect is also recognised in OCI so has no impact on profit or loss.
The treatment of the increase in fair value of the investment in LXP is different
however. This is recognised in profit or loss in the year ended 30 September
20X7, and a current tax charge is increased in respect of the gain. This is because,
in this jurisdiction, tax treatment follows accounting treatment in respect of
recognition of gains and losses through profit or loss. At an income tax rate of 20%
this increases the current tax charge by (£27,000  20%) £5,400.
 Temporary differences arising in respect of the contract liability
The service income has been received. But, because it is now being treated as a
contract liability it is not subject to immediate taxation (because tax treatment
follows accounting treatment in respect of income recognition). The current tax
charge and current tax liability are therefore reduced by an amount of £750,000 
20% = £150,000.

Journal entries required are as follows:
£'000 £'000
DEBIT Revaluation reserve (i) (Head office
revaluation) 360
DEBIT Current tax charge (ii) (LXP) 5
CREDIT Current tax liability (ii) (LXP) 5
CREDIT Current tax charge (iii) (deferred revenue) 150
DEBIT Current tax liability (iii) 150
CREDIT Deferred tax (i) 360
515 515
Note: The deferred tax asset and liability have been offset. This is recommended
presentation where the entity has a legally enforceable right to set off current tax
assets against current liabilities and where the income taxes are levied by the
same taxation authority. Both conditions are assumed and are likely to be the case
here.
(b) Revised information schedule for the bank (Exhibit 1)
Amendments shown in bold
Performance information for the year ended 30 September 20X7
20X7 20X6
£'000 £'000
Revenue (£35,400 – £750) 34,650 34,500
Gross profit (£10,020 – £750) 9,270 9,660

Extracts from statement of financial position at 30 September 20X7
20X7 20X6
£'000 £'000
Total assets (£35,670 + £27 – £43) 35,654 33,560
Total liabilities (£8,490 + £750 + £360 – £145) 9,455 8,730
Equity 26,199 24,830
Net debt 450
Non-current assets available as security at 30 September 20X7
20X7
£'000
Land 1,000
Buildings 18,200
Financial assets: fair value through OCI 387
Financial assets: fair value through profit or loss 219
Plant and equipment 8,678
28,484
Key ratios
20X7
£'000
Gearing (Net debt/equity)  100
20X7 (450/26,199)  100 1.7%
Gross profit margin (9,270/34,650)  100 26.8%

Return on capital employed (operating profit/net debt +
equity)  100
20X7 (3,660/ [450 + 26,199])  100 13.7%
(Operating profit: 4,440 – 30 – 750)

WORKING:
Summary of amendments required in journal entries above:
As stated JNL 1 JNL 2 JNL 3 Total
£'000 £'000 £'000 £'000 £'000
Revenue 35,400 (750) 34,650
Gross profit 10,020 (750) 9,270
Operating profit 4,410 (750) 3,660
Profit before tax 4,440 27 (750) 3,717
Total assets 35,670 (43) 35,654
27
Total liabilities 8,490 750 5 9,455
360
(150)
The adjusted figure for equity is (£35,654 – £9,455): £26,199
(c) Report to the board of Wayte
Prepared by: Damian Field, Financial Controller
Analysis of the schedule of information prepared as part of the application for a long-term
loan of £10 million.
The revised statement of cash flows is very little different from the draft – because the
accounting adjustments that are required do not involve cash flows.
Cash generated from operations is at a very healthy level in the 20X7 financial year
compared to the previous year. The key differences are in the non-cash items of
depreciation and in the working capital movements. Depreciation has increased by
£410,000. This is partly attributable to the purchase of new items of plant and machinery.
The movements in working capital between the 20X6 and 20X7 year ends all show either
decreases in current assets or increases in current liabilities. While the direction of these
movements can signal prudent management of working capital, it can also be interpreted
as a likely effect of cash shortages. A shortage of cash, as indicated by the existence of an
overdraft at the 20X7 year end compared with a positive cash balance a year earlier, tends
to put management under pressure to keep inventories to a minimum, to accelerate
receipts from debtors and to extend credit taken from creditors. These can indicate sound
management but there are risks in taking this type of working capital management too far.
Wayte may experience stock-outs and could lose credibility and goodwill with debtors and
creditors.
Gearing is extremely low and interest-bearing debt is limited to the bank overdraft.
Therefore, Wayte is in a very good position to make a credible case to a lender for
substantial borrowings. However, the borrowings proposed are £10 million for investment
in non-current assets. The implication is that the scale of operations of the business will be
significantly larger in future. It is important that cash flow forecasts take full account of the
consequent increased requirement for working capital, which does not appear to be
envisaged in the plans.
Turning to performance issues, Wayte is profitable, although the figures do show declining
profitability. After deferring service income, revenue has increased only slightly and gross
profit has reduced. The gross profit margin has deteriorated from 28.0% to 26.8% which is
quite a significant fall. Return on capital employed has also fallen between the two years,
once the adjustments are considered.

The issues that are likely to emerge in discussion with the bank are as follows:
(1) The level of dividend payment. No dividend was paid in the 20X6 financial year, but a
very significant amount of £3,000,000 was paid in the 20X7 financial year. The bank
may well wish to question why the directors chose to return so much cash to
themselves. Had they not done so, or had the dividend been at a low level, Wayte
would have had a substantial balance at bank at the 30 September 20X7.
(2) A similar question is likely to arise over the repayment of loans to directors of
£1,000,000. In total £4 million has left the company in the year. The bank may wonder
if the directors/shareholders lack confidence in the expansion plans for the business. If
they were confident, then it would surely make sense to leave the £4 million in the
business on the basis that it can generate higher returns than is likely to be the case
elsewhere.
The bank's schedule does not require the presentation of cash flow ratios. Cash interest
cover is not an issue because there is so little interest-bearing debt in the business.
However, cash return can be expressed as a percentage of capital employed, as follows:
20X7
£'000
Cash return (cash generated from operations + dividends
received)/ capital employed)  100
20X7: ([6,320 + 30])/26,199)  100 24.2%
Capital employed = £26,199 + £450 = £26,649 – but left as equity above to enable
comparative
This accounting ratio clearly shows the company in a good light. Another cash flow ratio,
cash from operations/profit from operations is also impressive:
20X7
£'000
(Cash from operations/profit from operations)  100
20X7: (6,320/3,660)  100 172.7%
Conclusion
The value of assets available as security is significantly higher than the borrowings sought. The
bank is likely to be reassured by the recent valuation of land and buildings. While the bank may
have specific questions about certain aspects of the historical information shown in the
schedule, Wayte's performance on both a profitability and cash-generating level is impressive,
and the board could be cautiously optimistic that finance will be obtainable.
Examiner's comments
Part (a) Explain the financial reporting adjustments.
The financial reporting implications of the various adjustments were generally well answered
and most candidates identified the key elements of the treatment of the PSN and LXP
instruments and the adjustment required in respect of the service element of the contract,
together with some basic principles in relation to the tax accounting.
Regarding the revenue recognition issue, most candidates recognised that the revenue for the
service component needed to be separated out and deferred. However, a significant minority of
candidates thought that some revenue needed to be recognised in the current year even
though the question clearly stated that no service visits were due until the following year.
In relation to the tax accounting, most were able to calculate the appropriate tax charge or
credit.
Many candidates recognised that the revaluation of land and buildings resulted in a deferred tax
liability that was to be adjusted.

A recurring mistake was to not recognise the movement of £360,000 and not to take this
movement to reserves.
Weaker students often failed to appreciate the current tax implications caused by the FVPL
financial asset.
A reasonable number of candidates discussed the impact on current tax of the adjustment to
revenue.
Part (b) Revised information schedule for the bank including all relevant adjustments.
Most candidates prepared well-presented draft financial statements and ratios, incorporating
the effects of their proposed adjustments. Many candidates achieved maximum marks for this
requirement. Credit was given for own figures.
Common errors were:
 Lack of workings, particularly for the ratios
 Adjusting cash from operations
 Incorrect calculation of ROCE based on cash from operations.
Part (c) A report for the board to analyse and interpret the financial position and performance
of Wayte using the revised information schedule and other available information. Provide a
reasoned conclusion on whether the bank is likely to advance the £10 million loan.
This was mostly done very well. Weaker candidates could not unpack the cash flow issues to
reconcile the positive operating cash flows with the end of year overdraft.
Better candidates were able to analyse the statement of cash flows, highlighting the core
strength of the business and commenting on the high dividend payment and the repayment of
the directors' loans. Many candidates were able to take a step back and comment on the low
gearing and high asset values as security for the loan although few attempted to calculate
additional ratios to support their arguments.
Weaker candidates simply focused on a decrease in revenue and the presence of an overdraft,
showing poorer analytical skills as they concentrated on two figures rather than understanding
the context of the situation.
Some candidates failed to draw any conclusion on the likelihood of bank finance and thus
missed easy marks.
57 SettleBlue
Scenario
The candidate is in the role of an audit senior who is required to evaluate whether an equity
investment of the client, SB plc should be accounted for as an associate or a subsidiary. The
shareholding acquired does not meet the 50% control threshold, however the call option, the
involvement of SB in the operation of the company and the share options in SB for the two
remaining shareholders provide strong indications that SB has control and the investment
should be accounted for as a step acquisition.
The candidate is also required to review the work of an audit associate who has gone on leave.
The audit associate had identified weaknesses in control procedures and requested data
analytics of the client's purchases and payables. The candidate should identify that the audit
assertion of valuation and accuracy have not been substantiated. The audit associate's testing of
just 10 GRN is insufficient and she has not performed any appropriate post year procedures nor
obtained third party evidence. The data analytics indicate that although the number of
unmatched GRN's would indicate an under recording of purchases and payables, the client has

made two adjustments; a large GRNI accrual and an adjustment for a debit balance on its largest
supplier's account. Comparing the analytics with this information indicates that purchases and
payables are overstated rather than understated.
Marking guide
Marks
(a) Explain, for each of the two matters 12  Assimilate complex information to
identified in Geri's email (Exhibit 1), produce appropriate accounting
the appropriate financial reporting adjustments.
treatment in SB's consolidated
 Apply knowledge of relevant
financial statements for the year
ended 30 September 20X7. Set out
appropriate adjustments. Ignore
any potential adjustments for  Identify the need for further
current and deferred taxation. information.
appropriate accounting adjustments.
(b) Review the file note prepared by 18  Identify weaknesses in the audit
Ann (Exhibit 2) and the dashboard procedures performed.
(Exhibit 3) and:
 Critically review the work of the junior
 identify any weaknesses in the and prioritise key issues.
audit procedures completed
 Distinguish and explain the additional
by the audit team on the two
procedures required.
issues identified;
 Appreciate and apply the concept of
 analyse the information
materiality.
provided in the dashboard to
identify the audit risks; and  Relate different parts of the question
to identify critical factors.
 set out any additional audit
procedures that we will need
to perform.
Total 30
(a) Explain, for each of the two matters identified in Geri's email (Exhibit 1), the appropriate
financial reporting treatment in SB's consolidated financial statements for the year ended
30 September 20X7. Set out appropriate adjustments. Ignore any potential adjustments
for current and deferred taxation.
Investment in CG
The issue here is whether the purchase of 40% of John's shares by SB on 1 January 20X7
and the call option on 1 January 20X8 establishes control by SB over CG and whether the
investment is treated as an associate or a subsidiary in the consolidated financial
statements.

Associate?
SB holds 10% + (40%  60%) 24% = 34% of the shares of CG at 30 September 20X7. This
would indicate that SB has significant influence as this is presumed if an investor holds 20%
or more of the voting power. Further evidence of significant influence is that CG has a
representative on the board of directors and is effectively 2 of the 4 board members. There
are other indicators too – for example:
 CG is a key supplier of SB so there are material transactions between the investor and
the investee; and
 Ken and Sharon have roles as directors with SB so there is an interchange of
management personnel between CG and SB.
Significant influence would require SB to account for CG as an associate and to equity
account for the investment under IAS 28.
Is CG a subsidiary?
SB has signed a call option which means that they will own 70% of the shares in CG on
1 January 20X8. IFRS 10 requires an investor to consider potential voting rights in
considering whether it has control and whether it has the practical ability to exercise the
voting rights.
Although SB does not have the majority of the voting rights, it seems likely that it may still
have control at 30 September 20X7 as SB has 2 out of 4 members of the board.
Recommended financial reporting treatment
It would therefore seem likely that control is established. SB should be accounted as a
subsidiary which means that 100% of the net assets and liabilities will be consolidated
within the group financial statements. The profit or loss account is consolidated from the
date of control.
The acquisition represents a step acquisition which crosses the control boundary as a
previously held investment is increased to a controlling holding.
A profit on the disposal of the previously held shareholding is recognised in the statement
of profit or loss. This is calculated by comparing the FV of the previously held equity with
the carrying amount. The profit on disposal also includes recycling the gain previously
taken to OCI.
Goodwill is calculated by comparing the net assets at the date control is established
(1 January 20X7) with the consideration plus non-controlling interests, and the fair value of
the previously held equity.
Share-based payment
IFRS 2 requires an entity to recognise share-based payments in its financial statements.
Therefore, the fact that no cash is involved is not a reason for not recognising an expense.
This transaction involves a choice of settlement and results in a compound financial
instrument.
The fair value of the cash route is:
28,000  £22 = 616,000
The fair value of the share route is:
32,000  £20 = 640,000
The fair value of the equity component is therefore:
£24,000 (£640,000 – £616,000)

The share-based payment is recognised as follows:
Year ended 30 September 20X7 Liability Equity Expense
£ £ £
9/24  28,000  £24 252,000 252,000
9/24  £24,000 9,000 9,000
Disclosure implications of share-based payments:

SB will need to disclose the nature and extent of the share-based payments in the period to
help users of the financial statements to understand how the fair value is measured and the
impact on the earnings per share.
Share-based payments are also disclosed in accordance with IAS 24, Related Party
Disclosures.
Share-based payments will also impact on the earnings per share (EPS).
(b) Review the file note prepared by Ann (Exhibit 2) and the dashboard (Exhibit 3) and:
 identify any weaknesses in the audit procedures completed by the audit team on the
two issues identified;
 analyse the information provided in the dashboard to identify the audit risks; and
 set out any additional audit procedures that we will need to perform.
The weaknesses in audit procedures performed by Ann have resulted in the audit
assertions of accuracy and valuation not being appropriately tested.
GRNI accrual
The audit team has identified a control weakness which revealed that the incorrect goods
had been matched to the purchase invoice – no tests of detail have been performed by Ann
in respect of this weakness.
Sample sizes should have been increased in response to the control weakness being
identified.
It is not clear whether Ann has agreed the GRNI list to GRN or linked this to work on
supplier statement reconciliations. Therefore, she has not tested accuracy of the GRNI
accrual.
Ann has selected just 10 GRNI from the list to make sure they are pre- year end, but she has
not linked this to purchase invoices and the payables ledger to ensure appropriate
valuation and cut off. Audit procedures (tests of detail) are required to match invoices to
GRNs pre-and post-year end and vice versa to ensure completeness and accuracy.
There is no justification for the sample size of 10.
Ann has only agreed to bank payments and confirmed that no invoices have been received
– she has not tested accuracy and authorisation by agreeing to GRN.
No work has been completed on supplier statement reconciliations to obtain third party
evidence of completeness, valuation and accuracy.
Examining key supplier statements may identify that a significant proportion of the accrual
can either be substantiated or confirmed as not required.
Audit procedures have not been focused on older and material items in the list of unmatched
GRNs.

£290,000 for debit balance on MAK
The audit procedures on the £290,000 allowance for the debit balance are inadequate and
lead to inaccurate recording of cost of sales.
There has been no cross check to the accuracy of the accrual and to identify whether the
adjustment for the debit balance is double counted with the GRNI accrual – the results of
the data analytics would suggest that this is the case (see below).
No testing has been carried out on the timing of these payments to ensure that they are not
paying against earlier invoices.
Analysis of information in the dashboard to identify audit risks:
Dashboard data: Data Analysis of data
Number of purchase orders 7,246 6,884/7,246  100 = 95%

Number of GRNs raised and 6,884 95% of purchase orders raised are
matched to purchase orders matched to GRN.
The difference could be a timing
difference. However, as liabilities
are not recognised based on a
purchase order but are recognised
when control is transferred to SB,
no accounting adjustment is
required.
This percentage does however
provide some comfort that goods
received are authorised by a
purchase order and reduces the
audit risk of misstatement due to
authorisation.
Average time from GRN to 10 days The audit team reported that
receipt of purchase invoice controls in the agreeing of GRN to
purchase invoices are ineffective.
The data analytics graph suggests
that the problem is related mainly
to one outlier supplier MAK Ltd.
The average time to match the GRN
to an invoice is 10 days and only
MAK is exceeding the average time
and by 11 days at 21 days.

Dashboard data: Data Analysis of data
Number of GRNs not invoiced 311 This number represents the GRNs
which have been matched to
purchase orders evidencing that
goods received are authorised,
but the liability has not been
recorded in the financial
statements as the suppliers'
invoices have not been received
and hence are not yet been
recorded on the system.
311/6,884  100 = 4.5%
This means that 4.5% of total GRNs
matched to purchase orders are
not matched to a suppliers'
invoice and should be accrued as
a liability and a cost.
(SB has established an accrual for
GRNI based on the GRNI list at
30.9.20X7 (see below).)
Of the 311 unmatched GRN 142
relate to MAK. Of the 156
unmatched GRNs over 2 months,
122 relate to MAK.
Number of GRN unmatched to 156 156/6,884  100 = 2.3%
invoice over 2 months
2.3% of GRN unmatched are over
2 months old.
Average order £1,900
Test for MAK Ltd Data
Number of purchase orders 771 732/771  100 = 95%

Number of purchase orders 732 95% of MAK purchases orders
matched with GRN are matched to GRN. This is
equal to the general population.
This provides some assurance
that purchases are authorised.
MAK is SB's large supplier.
Average time from GRN to 21 days The analytics supports the
receipt of purchase invoice information received elsewhere
on controls testing that a specific
problem regarding invoicing at
MAK is one of the reasons for
the large GRNI accrual.

Test for MAK Ltd Data
Number of GRNs not invoiced 142 142/732  100 = 19%

at 30 September 20X7
This represents 19% of total
GRNs matched to purchase
orders compared to 4.5% for the
total population.
Number of GRNs unmatched to 122 122/732  100
invoice over 2 months old
16.6% of MAK GRNI are over 2
months old –
142/307  100 = 46%
46% of all GRNI relate to MAK
GRNs.
Audit risks
Delay in invoicing – accuracy and completeness
As there is a delay of 10 days between GRN and recording of invoices, there is an audit risk that
delays in invoicing could lead to inaccurate recording of inventory valuations and purchases.
This is increased for MAK where the delay is up to 21 days.
Unmatched GRN over 2 months – overstatement
GRN unmatched over 2 months increase the risk that purchases and payables are overstated
and not accurately recognised. The analytics supports the information received elsewhere on
controls testing that a specific problem regarding invoicing at MAK is one of the reasons for the
large GRNI accrual. Procedures performed by Ann are inadequate and do not confirm the
accuracy and completeness of the GRNI accrual and the adjustment for the debit balance on
MAK.
There is a risk that the purchases and payables (accruals) have been overstated by £290,000
because the accrual for the debit balance and the GRNI accrual both include the costs of goods
supplied by MAK Ltd.
Using the above analysis, the expected GRNI accrual can be calculated approximately as follows:
£
MAK GRNI 142  £2,040 289,680
Other unmatched GRNI 311 – 142 = 169  £1,900 321,100
610,780
GRNI accrual 610,000
Control weakness – measurement and accuracy

Control testing identified weakness in controls by staff matching the GRN to the correct
purchase invoice. The risk therefore exists that invoices have been recorded for goods not
received or more likely that the GRNI accrual is overstated.
SB has recorded an adjustment for payments made to MAK without invoices of £290,000 which
would represent 142 MAK orders based on the average order value of £2,040. There is a total of
732 MAK purchased orders matched to GRN.
An expected number of unmatched GRN based on the whole population would be
732  10 days/365 days = 20. As the total of unmatched GRN for MAK is 142, it suggests that the

adjustment for unmatched payments has been double counted in the GRNI accrual and the
accrual for the debit balance should be reversed:
 Further controls testing should be undertaken on the matching of GRN to invoice to confirm
whether the control weakness applied to other suppliers.
 MAK GRNs included in the GRNI should be tested 100% to ensure that they are
appropriately accrued. In addition, audit procedures should be focused on older and
material items from other suppliers in the list of GRNI. Any unmatched GRN's should be
removed from the GRNI accrual and an audit adjustment calculated.
 Obtain the MAK supplier statement and agree invoices received post year end to the GRNI
accrual.
 Other key supplier statements should be agreed to invoices and GRN pre-and post-year
end.
 Agree a sample of purchases invoices to purchases orders to ensure accuracy and
valuation.
 Review supplier terms for each large supplier and assess whether the time delay is normal
for each suppliers' invoice terms.
 Ensure appropriate valuation procedures are performed on inventory to record the correct
cost of inventory.
 Perform invoice cut off procedures by agreeing invoices pre-and post-year end to inventory
records and payables accounts to ensure correct recognition of payable and accruals and
inventory.
Examiner's comments
Part (a) Explain the financial reporting of the share acquisition and the share options.
The explanation of the two financial reporting issues was handled well by most candidates. They
were able to identify the implications of control arising from the call option and the board
representation. There were many good discussions around the principle of control and step
acquisitions. However weaker candidates failed to expand on control and how it was achieved
and concluded that CG was an associate (although marks were awarded for appropriate
accounting treatments).
The choice of settlement for the share-based payment was also answered well – common
weaknesses were to fail to notice the choice of settlement and incorrect or lack of time
apportioning. Overall, this section was attempted well.
Part (b)
Review the file note prepared by Ann (Exhibit 2) and the dashboard (Exhibit 3) and:
 Identify any weaknesses in the audit procedures completed by the audit team on the two
issues identified.
Whilst many candidates were able to correctly identify where the procedures performed by
Ann could be improved, many expressed these improvements as additional audit
procedures rather than the specific deficiencies in the procedures performed.
A significant majority of candidates focussed only on completeness issues and failed to
detect the potential overstatement caused by the adjustment for the debit balance on
Mak's account.
Some candidates discussed at length the shortcomings and weaknesses of the system
and/or what the auditor should do about it rather than discussing the weaknesses of Ann's
procedures.

 Analyse the information provided in the dashboard to identify the audit risks.
In general, many candidates performed a good level of analysis, identifying the fact that the
terms of business with MAK are significantly different to other customers. Good answers
produced analysis from the dashboard to identify risks
Weaker answers simply involved repeating facts from the question rather than developing
them and linking them to specific audit risks.
 Set out any additional audit procedures that we will need to perform.
Most were able to identify additional procedures to be performed on the payables and
purchases balances. Weaker candidates would often resort to a 'knowledge dump'
approach simply listing generic risks and procedures surrounding payable.

58 EC
Scenario
The candidate is in the role of an audit senior assigned to the audit of the EC group for the year
ended 31 May 20X8 reporting to the EC audit engagement partner. The individual company
audits of EC Ltd and its subsidiaries for the year ended 31 May 20X8 are in progress. The EC Ltd
audit team has identified three audit issues which involve judgements made by the EC Ltd
directors and therefore increase audit risk.
The first issue concerns the incorrect financial reporting treatment of the disposal of a
shareholding in a subsidiary company. The company has treated the disposal as discontinued
and has calculated the loss on disposal of the shares incorrectly.
The second issue requires the candidate to evaluate whether the directors are correct to include
a contingent liability disclosure instead of a provision and to identify that the accounting
treatment of the 'provision for future operating losses' is incorrect.
The final issue involves the classification and measurement of assets in a Spanish manufacturing
division as held for sale and an investment property. The candidate is required to set out audit
risks and procedures arising from the three issues, to revise the extract from the consolidated
financial statements and to comment on the implications of the adjustments on the income tax
expense.
Marking guide
For each of the three audit issues: 21  Assimilate and demonstrate

(a) Explain and set out the correct understanding of a large amount of
financial reporting treatment in the complex information.
EC group financial statements and EC  Identify inappropriate accounting
Ltd financial statements. Ignore any treatments for the disposal of Luka
adjustments for taxation. shares.
 Explain complex transactions including
the recognition of sale of shares
crossing the control boundary from
subsidiary to associate
 Identify inappropriate treatment of a
discontinued operation
 Evaluate the treatment of the legal claim
as a contingent liability note
 Identify that no provision should be
made for future operating losses
 Explain the appropriate treatment for
PPE under IFRS 5
adjustments

(b) Set out clearly the key audit risks and 10  Identify relevant key risks
the audit procedures weshould
 Describe appropriate audit procedures
perform.
required to provide verification
evidence for each risk.
Prepare a revised summary consolidated 5  Assimilate adjustments to prepare draft
statement of profit or loss, including your statement of profit or loss.
adjustments, where appropriate, for the
three audit issues.
Explain briefly how your adjustments will 4  Distinguish between impacts on current
impact on the income tax expense. tax and deferred tax timing differences.
Total 40
Disposal of shares in Luka

The directors have made a judgement that EC Ltd no longer has control or significant influence
over Luka and have recognised its shareholding in Luka as a simple investment.
The key judgement area here is whether EC retains a significant influence over Luka.
Significant influence is defined as the 'power to participate' but not to control.
Significant influence is presumed to exist if an investor holds 20% or more of the voting power of
the investee unless it can be shown that this is clearly not the case.
EC now owns just 15% and there are only two other shareholders – Walter Brown, the CEO
clearly holds the majority of the voting shares. However, there are other facts which may
establish significant influence for EC.
Together with the Japanese minority shareholder, EC could control the board of directors with
majority decisions as two of its board members are also on the Luka board.
There are material transactions between the two companies – the filters for Luka's product are
specific to Luka's product and are provided by a 100% owned subsidiary of EC Ltd. Also, EC
continues to provide support services to Luka.
The above would suggest that Luka is an associate of EC and IAS 28 requires the use of the
equity method to accounting for investments in associates. The results of the subsidiary are
included until disposal.
The loss on disposal calculated in profit or loss as part of discontinued operations of £500,000
has been calculated incorrectly and is the amount which should be recognised in the parent
company financial statements not the group profit or loss - it is incorrect regardless of whether
the investment is treated as an associate or an investment.
Because the shareholding crosses the control boundary, the retained interest is measured at the
fair value at disposal, and the gain is measured by reference to the net assets at the date of
disposal.
Net assets at date of disposal, 1 December 20X7
£'000
At 31 May 20X8 9,250
Loss for period 1 December 20X7 – 31 May 20X8 £1.5 million  6/12 750
Net assets at 1 December 20X7 10,000

This results in a group profit as follows:
£'000 £'000
Proceeds received 7,900
Add: Fair value of 15% retained 1,000
8,900
Less: amounts recognised immediately before disposal
Net assets of Luka at 1 December 20X7 10,000

Goodwill (fully impaired) –
Less: NCI share was 25% at disposal (2,500)
7,500
Profit on disposal 1,400
Alternative presentation £'000

Proceeds 7,900
Less: 60%  £10,000,000 of net assets have been sold 6,000
1,900
Retained interest at fair value 1,000
Retained interest at carrying amount 15%  10,000 1,500
500
Total group profit 1,400
Treatment as discontinued?
To be presented as discontinued the sale of EC's shares in Luka need to be part of a single
coordinated plan to withdraw from a major business line – the level of commercial links between
EC and Luka would indicate that this is not a discontinued operation and its results should be
presented in continuing operations to the date of sale which is 1 December 20X7.
6-months results for Luka are included on a line by line basis in the statement of profit or loss
until the date of sale – 1 December 20X7.
As Luka is to be presented on the SOFP as an associate using equity accounting, the group's
share of the associate's loss should be presented also as continuing operations.
£1.5 million  6/12  15% = £112,500
As an associate, Luka would be a related party of EC and disclosure would be required of
transactions and services between the two parties.
Intercompany trading may give rise to adjustments for unrealised profit.
Audit risks
The key audit risk is that the group financial statements will be presented incorrectly, omitting the
results of
the subsidiary from continuing operations and calculating the loss on disposal incorrectly and the
presentation of the remaining shareholding as an investment instead of equity accounted as an
associate.
Audit procedures required:
 Obtain and test the key assumptions made by management regarding the level of
significant influence.
 Agree costs to the sales agreement and ensure that they have been recognised correctly
and that the consideration has been fairly stated in accordance with the agreement.

 Agree the accuracy of the accounting entries and ensure the profit on disposal is correctly
stated and reperform the calculations for revenue and expenses to ensure that they have
been correctly time apportioned.
 Agree the calculations of fair value of the remaining interest and ensure calculated in
accordance with IFRS 13. Test the assumptions of the cash flow projections and the
appropriateness of the discount rate used.
 Verify consideration to contract and agree to bank.
Contingent liability
IAS 37 states that a provision should be recognised if an entity has a present obligation as a
result of a past event which will result in a transfer of economic benefit which will be probable
and a reliable estimate can be made of the amount of the obligation.
The issue here is whether the company should be providing for potential costs in the first
instance and then to determine if the uncertainty means that the current treatment as a
contingent liability is correct and whether the disclosure is sufficient.
The contingent liability disclosure sets out the nature of the liability and states that its financial
effect cannot be estimated reliably. Audit procedures set out below should confirm whether the
disclosure is adequate.
Legal advice suggests that the outcome may not be probable at 52% – which means that it is a
48% probability that fines would be payable – this is a very narrow margin and audit procedures
would need to challenge the assumptions made by the internal legal team (the management's
expert). Should a provision be required it would be established at the most likely outcome.
With respect to the provision for future operating losses of £433,000, the directors appear to
have incorrectly included a provision for future operating losses as the costs relate to continuing
business and there is no obligating event either legal nor constructive at the reporting date. We
should recommend that this amount be adjusted by debiting provision and crediting profit or
loss.
Audit risk
The key audit risk is that liabilities are incorrectly stated, disclosure in respect of the contingent
liability is not appropriate or in proportion to the risk as described by the directors within other
sections of the financial statements – eg, directors' review of risks.
 Evaluate and test the Group's policies, procedures and controls over the selection and
renewal of intermediaries and responses to suspected breaches of policy.
 Identify and test payments made to intermediaries during the year and ensure that
payments are only made in compliance with the Group's policies.
 Enquire of management, the Audit Committee and the Board as to whether the Group is in
compliance with laws and regulations relating to bribery and corruption in the countries in
which EC operates.
 Discuss the areas of potential or suspected breaches of law, including the ongoing
investigations, with the Audit Committee and the Board as well as the Group's legal
advisers and assess related documentation.
 Communicate with relevant component auditors to ensure that vigilance and scepticism is
maintained to identify possible indications of significant non-compliance with laws and
regulations relating to bribery and corruption whilst carrying out our other audit
procedures.

 Evaluate whether the disclosure in the contingent liability note to the financial statements is
adequate for the users to understand the Group's exposure to the financial effects of
potential or suspected breaches of law or regulation.
 Conclude on whether it is the case that the investigations remain at too early a stage to
assess the consequences and whether a provision should be included in the financial
statements. Challenge management's estimations of the probability of the outcome of the
investigation.
Sale of manufacturing operation
The directors' treatment of the non-current assets of the manufacturing operation is incorrect.
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations requires non-current
assets to be held for sale if the carrying amount is recovered principally through a sale
transaction rather than through continuing use.
In respect of the factory building and the plant and equipment, the criteria appear to have been
satisfied. The factory has been advertised for sale and an offer has been received for the
equipment.
These assets should be classified as held for sale at fair value and should not be depreciated
after the decision to sell the assets on 1 March 20X8. The assets should be measured in current
assets at the lower of the carrying amount and the fair value – the fair value is in the case of IFRS 5
defined as the fair value less costs to sell – there is no requirement to follow the definition in
IAS 36, Impairment of Assets to determine the recoverable amount.
Depreciation for the last three months should be reversed as follows
£'000 £'000
DEBIT Accumulated depreciation
Plant and machinery 72
Factory building 34
CREDIT Operating profit 106
Subject to the valuation being appropriate, the factory does not appear to be impaired.
£'000
Cost at 1 June 20X7 4,385
Less: Depreciation £685,000 + for 9 months/12 months  137 = £103,000 (788)
3,597
Fair value
€5,040,000/1.20 4,200
Therefore, the factory should be held at the carrying amount of £3,597,000.
The plant and equipment however may be impaired if the offer received on 30 June 20X8 is
indicative of its fair value at the year end.
£'000
Less: Depreciation £1,986,000 + 9 months/12 months  £286,000 = £215,000 (2,201)
2,649
Fair value
€2,519,000/1.12 2,249
Impairment charge to PorL 400
The office should not be recognised as held for sale – Instead the office should be accounted for
as an Investment property as per IAS 40.
The property should be revalued at the date the change of use occurred to fair value and a
revaluation gain recognised in accordance with IAS 16.

The depreciation charge for the final three months should be written back to profit or loss as
follows:
£'000 £'000
DEBIT Office building accumulated depreciation 40
CREDIT Operating profit 40
A gain on reclassification is calculated as follows:
£'000
Less: Depreciation £800,000 + 9 months/12 months  £160,000 = £120,000 (920)
3,720
Fair value at date of reclassification
€5,570,000/1.20 4,642
Gain recognised in OCI 922
Audit risks
There is an increased risk associated with the assets being purchased in a different currency and
located in different jurisdictions. There is specific risk over the valuations and the valuations
methods used which would lead to the assets not being correctly recognised in the financial
statements.
No mention has been made of how the lease has been recognised and the financial reporting
treatment of this may also be incorrect.
 Evaluate the design and implementation of controls around property valuations by
considering the involvement of the EC board of directors and the expertise of the board
members.
 Obtain the valuation report prepared by the Spanish surveyor and test its integrity by:
– Comparing the valuation for the factory with the surveyor's evidence of the recent sale
of the similar property in the area.
– Agreeing the price per square metre to other properties for sale in the area.
– Appoint an auditors' expert to agree the valuations
 For the office building valuation, obtain the surveyor's calculation and test the inputs to the
valuation by
– confirming the rental price per square metre with properties advertised for let in the
area.
– agreeing the accuracy of the calculation and the reasonableness of the occupancy
rates.
 Arrange a meeting with the valuer and assess the independence of the scope of the work
they have performed for EC. Agree the surveyor's qualifications and ensure appropriate
level of expertise to carry out the valuations.
 Agree the valuation of the plant and machinery to evidence of the offer made by the
Spanish company.
 Obtain a copy of the lease agreement to ensure that the classification of the office is correct
as an investment property.
 Enquire of management how the lease agreement has been accounted for in the financial
statements.

EC Group – draft summary consolidated statement of profit or loss for the year ended
31 May 20X8
Continuing operations
Issue 1
Profit on
Issue 1 disposal
Luka's and Issue 3
results for associate's Issue 2 Depreciation
6 months profit Provision impairment
£'000 £'000 £'000 £'000 £'000 £'000
Revenue 31,170 7,500 38,670
Profit before tax 1,896 (890) 1,400 433 146 – 400 2,585
Income tax (380) 140 (240)
Profit from continuing
operations 1,516 (750) 2,345
Post-tax loss of
associate (113) (113)
Explain briefly the impact of the adjustments on the income tax expense
Profit on disposal of shares
The profit on disposal of the shares is not taxable and therefore will not change the current tax
nor the deferred tax.
Write back of provision for operating losses
Because tax and accounting rules are the same – an adjustment made to the accounting profit
will be reflected in the income tax expense by increasing the current tax charge – therefore the
write back of the provision for future operating loss will result in an increase in the accounting
profit and therefore an increase in the current tax expense.
Depreciation for buildings
The decrease in the depreciation expense for the factory and the office building are disallowable
expenses and will not be compensated for by a deferred tax timing difference. Any cost for
depreciation of a building recognised in the income statement is added back to profit to
calculate current tax and no timing difference is required for deferred tax purposes.
Plant and equipment – write back of depreciation and impairment
The depreciation and impairment in respect of the plant and equipment will give rise to a
temporary timing difference – therefore the reduction in the cost for depreciation will cause the
accounting profit to increase but the impairment will cause the profit to fall – however both costs
are added back to calculate current tax. Deferred tax is calculated based on the timing
difference arising between the accounting base and the tax base. The carrying amount of the
plant and equipment at the year end is compared to the tax written down value and a deferred
tax adjustment calculated. Therefore, an adjustment to the deferred tax liability will need to be
calculated. Further information concerning the rate of tax depreciation is required.
Office building revaluation
The revaluation is taken to OCI and reserves. As the accounting base is different from the tax
base a deferred tax adjustment is required – the increase in the deferred tax liability is debited to
OCI and credited to the deferred tax liability included in non-current liabilities.
Associate profit
Each company is assessed to tax on its own profits – therefore this adjustment already includes
the group's share of the associate's tax charge and has no impact on the current tax expense.

Examiner's comments
General comments
Some candidates do not always make it clear which part of the question they are answering. For
example, many candidates combined questions 1 (a) and (b), dealing with both FR and audit
aspects of one issue before moving on to the next. There is nothing wrong with this approach,
provided that the line between financial reporting treatment and audit is clearly demarcated.
Weaker candidates merged the two sections in one long paragraph often without punctuation.
Some candidates had not familiarised themselves sufficiently with the software and in particular
the ability to use tables – good advice is to learn how to use the software as this will save time –
particularly the ability to set out information in column forms in parts 2 and 3 and to use the
arithmetical functions.
(1) For each of the three audit issues:
(a) Explain and set out the correct financial reporting treatment in the EC group financial
statements and EC Ltd individual financial statements. Ignore the tax impact arising
from any adjustments.
Candidates generally made a reasonable attempt at this part of the question scoring
most of the easier marks to gain a solid pass.
Disposal of shares
The majority of candidates correctly stated that following the disposal of shares, the
company retained significant influence. This conclusion was supported by appropriate
evidence. Even for those who decided the holding constituted control, or should be
recognised as a financial asset, there were plenty of marks available for assimilation
and structuring of the issue.
Contingent liabilities and provisions
Candidates could state the recognition criteria for provisions but were less skilled at
applying them to the scenario. Better candidates recognised that the probabilities were
very close to cut-off point for recognition and judgement would be required and the
assumptions should be challenged.
The majority of candidates stated that provisions for operating losses could not be
made. To score maximum marks, they needed to go on to explain why they are not
allowed under IAS 37 and also give the correcting adjustment.
Full definitions per IAS 37 were given but there was too much acceptance that the
losses and the fine were treated correctly, and not enough challenging of the
judgement about how close 52% and 48% are to be judged probable. Many calculated
a weighted average probable outcome which means they did not understand the
concept of most likely outcome.
Assets held for sale
Nearly all candidates recognised that the issue was "assets held for sale". However,
answers to this part of the question were very mixed and generally lacked structure.
Better answers tackled the three assets/asset groups separately. Several students found
the foreign exchange element of the question challenging.
The majority of candidates correctly recognised that the factory could be treated as
held for sale, giving a clear rationale for this accounting treatment. Candidates
sometimes ignored the adjustment for depreciation although they frequently stated the
rule.

There were plenty of candidates who, despite typing out the measurement criteria from
IFRS 5, did not understand that when an asset is reclassified as held for sale and the
sales value is greater than the carrying value, that the asset is held at carrying value and
not revalued.
The office building was correctly identified as an investment property, but then
candidates lost marks by not explaining the correct accounting treatment at change of
use for an IP adopting a fair value model.
A common error was to state that gains would go to the profit or loss account on
change of use when the correct treatment under IAS 40 is to apply IAS 16 with a
change of use requiring revaluation gains to be taken to OCI.
Some candidates challenged whether the plant and machinery was part of the IFRS 5
treatment and treated it as a non adjusting post balance sheet event.
(b) Set out the key audit risks and the relevant audit procedures that we should perform.
There were some very high marks on this part of the question and some excellent
answers, with good use of information provided in the question. Most answers covered
a wide breadth of issues and several obtained maximum marks on this section.
Candidates who used active verbs such as evaluate – challenge – inspect – observe –
calculate – using appropriate evidence achieved high marks. Weaker candidates who
used repeatedly review – consider – discuss (without saying what or why or how?) and
set out procedures which were not relevant and reliable scored less well.
59 Raven plc
Scenario
The candidate is an ICAEW Chartered Accountant who has just been appointed as financial
controller of Raven plc, an unlisted business that produces electrical products.
The candidate is supplied with information extracted from the draft financial statements of the
company for the year ended 30 April 20X8. This information has been prepared by an
unqualified accountant, who has also supplied a list of outstanding matters.
The candidate is required to explain the appropriate financial reporting treatment for five
financial reporting matters: a cash flow hedge, the issue of ordinary shares to a supplier in
exchange for goods, an impairment of a previously revalued asset, a sale and operating
leaseback and transactions in relation to a defined benefit pension scheme. The candidate is
also required to prepare revised draft extracts of the financial statements and to explain the
implications of the new leasing standard IFRS 16, Leases in respect of the sale and leaseback
transaction.

Marking guide
(1) Explain the appropriate financial 20  Assimilate and demonstrate

reporting treatment for each of the understanding of a large amount of
items in Simon's notes (Exhibit 2) and complex information.
set out the adjusting journal entries
required
including a cash flow hedge, a share-
based payment, impairment of a
previously revalued asset, a sale and
operating leaseback and a defined
benefit pension scheme.
adjustments in the form of journal
entries.
(2) Prepare revised financial statement 6  Assimilate information and use own
extracts accounting adjustments to prepare
revised extracts from the financial
statements.
(3) Explain the implications of the new 4  Demonstrate knowledge of future
leasing standard for Raven's future issues.
financial statements in respect of the
sale and leaseback of Raven's
administration building.
Total 30
Requirement (1)
(1) Cash flow hedge
Correctly reported at 30 April 20X7.
At 30 April 20X7, provided that the cash flow hedge was effective, it was correct to
recognise a financial asset and a matching credit in other comprehensive income. The
amount of £705,930 was calculated as follows:
£
Value of contract at 30 April 20X7 (R$50,000,000/6.7) 7,462,687
Value of contract at inception on 1 March 20X7 (R$50,000,000/7.4) 6,756,757
Gain on contract 705,930
The change in the fair value of future expected cash flows on the hedged item is calculated
as follows;
£
Value of hedged item at 30 April 20X7 (R$50,000,000/6.5) 7,692,308
Value of hedged item on 1 March 20X7 (R$50,000,000/7.3) 6,849,315
842,993

As this change in the fair value is greater than the gain on the forward contract, the hedge is
deemed to be fully effective and the whole of the gain on the forward contract is recognised
through OCI.
The IFRS 9 criteria to use hedge accounting have been met, so it was valid to use hedge
accounting.
Remeasurement of financial asset at 31.7.20X7
At 31 July 20X7, the settlement date, the further gain and change in value of future
expected cash flows on the hedged item are recalculated:
£
Value of contract at 31 July 20X7 (R$50,000,000/5.7) 8,771,930
Value of contract at 30 April 20X7(R$50,000,000/6.7) 7,462,687
Gain on contract 1,309,243
£
Value of hedged item at 31 July 20X7 (R$50,000,000/5.7) 8,771,930
Value of hedged item on 30 April 20X7 (R$50,000,000/6.5) 7,692,308
1,079,622
As this change in the fair value of the hedged item is less than the gain on the forward
contract, part of the gain on the forward contract is said to be ineffective and this part of the
gain on the forward is recognised in profit or loss.
The effective part of the hedge is calculated on a cumulative basis by comparing the
cumulative gain on the forward contract at inception of the hedge with the cumulative gain
in fair value of the hedged item from the inception.
The cumulative gain on the forward contract is (£705,930 + £1,309,243) £2,015,173.
The cumulative change in value on the hedged item is (£842,993 + £1,079,622) £1,922,615.
The hedge remained effective at 31 July 20X7 at 95.4% ([1,922,615/2,015,173]  100).
The ineffective portion of the hedge is £2,015,173 – £1,922,615 = £92,558, and this is
recognised in profit or loss. The remainder, the effective portion, is recognised in other
comprehensive income: £1,309,243 – £92,558 = £1,216,685.
£ £
DEBIT Financial asset 1,309,243
CREDIT Other comprehensive income 1,216,685
Subsequent treatment of cumulative gain
A cumulative gain of £1,922,615 (ie, 705,930 recognised in year ended 30.4.20X7 +
£1,309,243 – the additional gain in the 3 months to settlement less £92,558 recognised in
profit or loss as the ineffective portion) has been recognised in other comprehensive
income and is held in equity. There are two possible accounting treatments for this gain:
(1) It can be reclassified to profit or loss over the period of useful life of the asset, thus
effectively offsetting the depreciation charges on the asset; or
(2) It can be adjusted against the initial cost of the asset, thus reducing the amount of
future depreciation.
The cash flow hedging arrangement is the first hedging arrangement that Raven has
designated, and therefore it is likely that there is no accounting policy on this issue. Raven's
directors must now select one of the above approaches.

Recognition of asset and depreciation
At the date of purchase, 31 July 20X7, the machine asset is recognised at its fair value. The
effects of the cash transactions at 31 July 20X7 in respect of the purchase of the machine
and the settlement of the forward contract have been recognised in a suspense account.
This suspense account is now eliminated by the following entries.
£ £
DEBIT PPE (R$50,000,000/5.7) 8,771,930
CREDIT Suspense account 8,771,930
DEBIT Suspense account 2,015,173
CREDIT Financial asset 2,015,173
The net credit to the suspense account is (£8,771,930 – £2,015,173) £6,756,757, and so the
suspense account is eliminated.
Assuming that approach 1 is selected as the accounting policy, depreciation is charged on
the full amount of the capitalised value of the machine (£8,771,930). In the financial year
ended 30 April 20X8, nine months' worth of depreciation is charged:
£8,771,930
 9/12 = £1,315,790
5 years
This is recorded by the following journal entry:

£ £
DEBIT Profit or loss 1,315,790
CREDIT Depreciation 1,315,790
The amortisation of the cumulative gain held in equity is calculated as follows:
£1,922,615
 9/12 = £288,392
5 years
£ £
DEBIT Cash flow hedge reserve 288,392
(2) Issue of ordinary shares
The issue of shares to Ester Ltd constitutes an equity-settled share-based payment transaction.
Because the shares are being issued to a third party, the transaction is recognised at the fair
value of goods provided, which in this case is £12,000, with a debit of that amount to cost of
sales, and a credit to equity. Therefore, the accounting entry already made is partly correct, but
the credit should be to equity rather than to trade payables. The credit is normally to either a
separate component of equity or to retained earnings. If the credit is to a separate component
of equity, the correcting journal entry is as follows:
£ £
DEBIT Trade payables 12,000
(3) Non-current assets: fixed production line
Fixed production line
This asset was revalued on 30 April 20X5, three years after purchase, when its carrying
amount was (£8,000,000  7/10) £5,600,000. The amount of the revaluation was therefore
(£6,300,000 – £5,600,000) £700,000. Because Raven does not have a policy of making
annual transfers from revaluation reserve to retained earnings, the revaluation amount of
£700,000 relating to the production line still forms part of Raven's revaluation reserve at
30 April 20X8.

The carrying amount of the asset at 30 April 20X8, before impairment, was:
£6,300,000  4/7 = £3,600,000
The recoverable amount of the asset at that date was the higher of fair value less costs to sell
(£2,600,000) and value in use of £2,800,000. The amount of impairment to be recognised at
30 April 20X8 was therefore (£3,600,000 – £2,800,000) £800,000. This is offset first against
the amount of £700,000 relating to this asset in revaluation reserve, and then the balance is
recognised as an expense in profit or loss. The journal entry is as follows:
£ £
DEBIT Revaluation reserve 700,000
CREDIT PPE 800,000
(4) Leased asset
Although Raven will continue to occupy the building, the likely length of occupation of 10
years is only a relatively short period, compared to the building's remaining useful life.
Raven has no option to reacquire the building, and these facts together suggest that the
lease is an operating lease.
Therefore, a disposal of the asset should be recognised. The sale price is below fair value,
but future lease payments are at market value which means that any profit or loss on
disposal should be recognised immediately. It seems likely that Raven's directors have
accepted a low price, below market value, to generate cash. The carrying amount of the
asset immediately before sale was £10,000,000, therefore a sale price of £7,000,000 results
in a loss of £3,000,000 which must be recognised in profit or loss.
The amount of revaluation reserve of £1,000,000 is now treated as realised and a transfer
must be made between revaluation reserve and retained earnings.
Journal entries are required as follows to record the disposal and to clear the suspense
account:
£ £
DEBIT Suspense account 7,000,000
DEBIT Profit or loss 3,000,000
CREDIT PPE 10,000,000
The disposal of the building on an operating sale and leaseback basis
£ £
DEBIT Revaluation reserve 1,000,000
CREDIT Retained earnings 1,000,000
Transfer of the amount of revaluation reserve relating to the building disposed of on
1 May 20X7.
The lease payment of £540,000 made on 1 May 20X7 has been recognised correctly, and no
adjustment is required.

(5) Pension scheme
Adjustments are required as shown in the table below:
Assets Obligations Notes
£ £
Fair value/Present value at 1 May 20X7 2,830,000 2,966,000
Interest cost on obligation:
£2,966,000  5% 148,300 DR Interest cost PorL
Interest on plan assets:
£2,830,000  5% 141,500 CR Interest cost PorL
Current service cost 390,000 DR PorL
Past service cost 120,000 DR PorL
Contributions 575,000 Adjust for
misposting to PorL
Benefits paid (330,000) (330,000)
Remeasurement gain/loss Gain/loss to OCI
(balancing figure) 31,500 163,300 (net loss of £131,800)
Fair value/Present value at 30 April 20X8 3,248,000 3,457,600
Explanation
The posting of the contribution to staff costs does not reflect the correct financial reporting
treatment under IAS 19. The opening obligation should be adjusted to reflect the service
cost which is the increase in the present value of the defined benefit obligation resulting
from employee services during the year; and the interest costs which represents the
'unwinding' of the present value of the obligation.
The net defined benefit obligation needs to be remeasured to calculate the actuarial gains
and losses and actual return on plan assets which are taken to reserves through OCI.
The journal entries required are as follows:
£ £
DEBIT Interest cost 148,300
DEBIT Profit or loss (salaries) 390,000
DEBIT Profit or loss (salaries) 120,000
DEBIT Reserves 131,800
CREDIT Interest cost 141,500
CREDIT Net pension obligation 648,600
790,100 790,100
Correction of misposting of contributions to profit or loss (salaries)

£ £
DEBIT Net pension obligation 575,000
CREDIT Profit or loss (salaries) 575,000
Requirement (2)
Revised financial statement extracts

Statement of comprehensive income for the year ended 30 April 20X8
£'000
Loss before tax (working 1) (1,678)
Other comprehensive income (working 2) (903)

Statement of financial position at 30 April 20X8
As
stated JNL (1) JNL (2) JNL (3) JNL (4) JNL (5) Revised
£'000 £'000 £'000 £'000 £'000 £'000 £'000
Non-current assets
Property, plant and 53,860 8,772 (800) (10,000) 50,516
equipment (1,316)
Suspense account 6,757 (6,757) –
Financial asset 706 1,309 –
(2,015)
61,323 50,516
Current assets 17,859 17,859

TOTAL ASSETS 79,182 68,375
Equity
Share capital
(£1 ordinary shares) 200 200
Separate component
of equity 12 12
Retained earnings 25,920 1,000 26,920
Working 1
total adjustments (3,978)
Revaluation reserve 6,200 (700) (1,000) 4,500
Cash flow hedge
reserve 706 1,217 1,635
(288)
Other reserves 600 (132) 468
33,626 29,757
Long-term liabilities
Loans 18,650 18,650
Pension scheme net 136 649 210
obligation (575)
Suspense account 7,000 (7,000) –
25,786 18,860
Current liabilities 19,770 (12) 19,758
TOTAL EQUITY AND
LIABILITIES 79,182 68,375
WORKINGS
(1) Revised profit before tax
JNL reference £'000 £'000
As originally stated 2,300
Gain on financial asset 1 92
Depreciation 1 (1,316)
Amortisation of cash flow hedge reserve 1 288
Impairment expense 3 (100)
Loss on disposal of sale and operating
leaseback asset 4 (3,000)
Interest cost pension scheme 5 (148)
Current service cost pension scheme 5 (390)
Past service cost pension scheme 5 (120)
Interest on pension scheme assets 5 141
Correction of misposting 5 575
Net total of adjustments (3,978)
Revised loss before tax (1,678)

(2) Other comprehensive income
JNL reference £'000
As originally stated 0
Recognition of financial asset 1 1,217
Amortisation of cash flow hedge reserve 1 (288)
Impairment (Production line) 3 (700)
Transfer of revaluation reserve to profit or loss 4 (1,000)
Net actuarial loss on pension scheme 5 (132)
Revised other comprehensive income (903)
Requirement (3)
Explain the implications of the new leasing financial reporting standard
IFRS 16, Leases replaces IAS 17. The new standard adopts a single accounting model applicable
to all leases by lessees. Under IFRS 16, a lease is defined as a contract or a part of a contract that
conveys the right to use an asset for a period of time in exchange for consideration.
With a sale and leaseback, IFRS 15, Revenue from Contracts with Customers is applied to
determine whether a sale has taken place. In the case of the administration building a sale would
appear to have taken place and therefore the transfer of rights to the buyer/lessor is recognised.
Raven may select one of two accounting alternatives. It may apply IFRS 16 with full retrospective
effect. Alternatively, it, as the lessee, is permitted not to restate comparative information but to
recognise instead the cumulative effect of initially applying IFRS 16 as an adjustment to opening
equity at the date of initial application.
Examiner's comments
Some candidates had not familiarised themselves sufficiently with the software and in particular
the ability to use tables – good advice is to learn how to use the software as this will save time
particularly the ability to set out information in column forms and use the arithmetical
functionality of the software.
(1) Explain the appropriate financial reporting treatment for each of the items in Simon's notes
(Exhibit 2) and set out the adjusting journal entries required.
Candidates made a reasonable attempt at this part of the question with most addressing all
five issues and including a good mixture of calculations and narrative explanations. Some
candidates lost marks by not providing journal entries, or by providing journal entries
demonstrating failure to understand double entry bookkeeping. However, it was quite
common for good candidates to score maximum, or close to maximum, marks for this
element of the paper.
Cash flow hedge
This part of the question was the least well answered. Whilst a minority of candidates
understood the basic mechanics of a cash flow hedge only the better candidates were able
to correctly deal with the ineffective part of the hedge and the release of the cumulative gain
either over the useful life of the asset or against the asset cost. There was a lack of basic
accounting skills demonstrated by weaker candidates who were unable to provide journal
adjustments to reverse the suspense account.
Share-based payment
Answers were reasonably robust, with many candidates scoring maximum marks.
Revaluation and impairment
This part of the question was well answered. The most common error was to not identify the
revaluation reserve at 30 April 20X5. Follow through marks were as usual available.

Sale and operating leaseback
Nearly all candidates correctly identified this as an operating leaseback and were able to
calculate the loss on disposal. A small minority incorrectly recognised the loss over the life
of the lease rather than recognising it immediately in profit or loss.
Defined benefit pension
This part of the question was well done, demonstrating a good knowledge of the
accounting treatment of Defined Benefit schemes.
(2) Prepare revised financial statement extracts which include your adjustments.
Being able to reflect the impact of financial reporting treatments on the financial statements
of an entity is a key skill. Therefore, it was very concerning that a significant minority of
candidates appeared to lack basic understanding of double entry. Candidates who missed
out this section or were not capable of producing a reasonable attempt lost very
straightforward marks.
There were however some very good attempts which received maximum marks available.
(3) Explain the implications of the new leasing financial reporting standard.
The majority of candidates were able to explain the key principles of the new leasing
standard. Fewer candidates specifically referred to IFRS 15 and the implications for Raven's
sale and leaseback transaction.
60 MRL
The candidate is an audit senior working for Cromer Bell LLP, a firm of ICAEW Chartered
accountants, assigned to the audit of Miles Recruitment Ltd (MRL) for the year ending
31 August 20X8. MRL provides recruitment services and earns revenue by charging business
customers a fee for identifying appropriate employees to fill job vacancies. MRL is a wholly
owned subsidiary of Milcomba, a listed company incorporated in Elysia. Cromer Bell's Elysian
office is responsible for the group audit of Milcomba. The candidate is assisting with the audit
planning and is briefed by the MRL audit manager. The previous year's audit was subject to a
cold file review and was criticised for some of the expectations developed by the audit team in
their substantive analytical procedures being imprecise.
MRL's finance director, Gil Moore was appointed on 1 March 20X8. Gil was, until February 20X8,
a senior audit manager at Cromer Bell. Gil was the manager responsible for the audit of MRL for
the year ended 31 August 20X7. The question includes an analysis of operating expenses and
the results of data analytics, highlighting unusual items and journal postings. Key to answering
the question well is to assimilate the numerical information produced by the data analytics team
and link this to the narrative notes of the conversation with Gil, the finance director and former
audit manager. The candidate is required to identify audit risks and where relevant set out the
financial reporting issues for a rent-free period of a lease, depreciation, revenue recognition and
start-up costs and also management override of controls and the pressure on MRL to achieve
group targets.

Marking guide

(a) Identify and explain the key audit 13  Relate different parts of the question to
risks for our audit of MRL for the year identify critical factors
ending 31 August 20X8. Where  Assimilate complex information to
appropriate, set out and explain any produce appropriate accounting
related financial reporting issues, adjustments
including relevant calculations;
 Apply knowledge of relevant
information in the scenario
 Identify the need for further information
accounting adjustments
 Apply professional scepticism to
identify potential for creative
accounting to achieve management
bonuses
 Identify potential weakness in controls
and the ability of management to
override controls
(b) For each of the operating expenses 10  Appreciate and apply the concept of
(Exhibit 1) explain whether materiality
substantive analytical procedures  Use technical knowledge and
and/or test of details would be the judgement to determine appropriate
more appropriate audit approach. audit approach of Substantive analytical
Identify the key substantive audit procedures or tests of detail
procedures we should perform to test
each operating expense; and  Explain the additional procedures
required
(c) Explain any potential ethical issues in 7  Appreciate the implications for Cromer
respect of Gil Moore's behaviour and Bell of former audit manager working
summarise the actions that Cromer for client
Bell should take to address them.
 Identify the need for a review of Gil's
work and changes that may be
necessary to the current audit team
 Evaluate whether the errors are due to
incompetence or the incentive to
manipulate the results
 Question the reason for journal entries
put through by Gil
 Identify actions – consult with ethics
partner and potential need to report
ICAEW member for breach of ethical
code
Total 30

(a) Financial reporting issues and audit risks
Rent free period and new lease
No rent cost has been recorded for the three months since the start of the six-month
rent-free period awarded on the extension of the lease. This is incorrect as a charge should
be recorded in all periods to reflect the use of the property on a straight-line basis over the
lease term. Total rent to be paid over the remaining 10-year life is 9.5 years @ £960,000 per
annum = £9,120,000. Spreading that evenly over the 10-year lease term gives an annual
rent of £912,000 which equates to £76,000 per month. A rent charge of £76,000  5 =
£380,000 should therefore be recorded for the 5 months to 31 August 20X8 and a provision
will be required for this at the year end.
The new lease is a significant transaction for MRL and should be considered fully and
reviewed as part of the audit.
The expense relating to the allowance for receivables is lower than in the prior year,
although there is still a net charge for the year to date of £80,000. The level of this allowance
is an area of judgement and the movement booked by Gil in February 20X8 highlights that
it is also open to potential manipulation by management.
Gil has provided an explanation for his decision to reduce the allowance in February but this
needs further follow up. Historic levels of debt written off are one relevant factor in
determining the allowance but it is also important to look at the ageing and at whether
irrecoverable debt is just remaining on the receivables ledger rather than being written off.
In addition, it is clear from the meeting with Gil that there has been a change in MRL's
customer base. As a result, the historic level of write offs may not be a good basis to
determining the current required level of allowance.
As this is a judgemental area which is open to manipulation where change has occurred
both in what has been booked and the underlying business, an audit risk has been
identified.
Depreciation calculation
At the date of the lease renegotiation, the total depreciation charged to date on the
leasehold improvements was £1.8 million  5 years/10 years = £900,000. Gil reversed
£300,000 of this based on his assertion that the accumulated depreciation based on the
new lease should have been £600,000 (£1.8m  5 years/15 years). A depreciation charge of
£10,000 per month will then be charged for the remaining 10 years of the lease term.
The entry made by Gil is incorrect as the reassessment of the remaining useful life should
not be applied retrospectively but prospectively as a change in estimate. Hence the
remaining carrying amount of £900,000 at 31 March 20X8 should be depreciated over the
remaining lease term of 10 years. There should be no £300,000 adjustment and this entry
needs to be reversed. However, the depreciation per month from April onwards is £7,500
per month, £2,500 per month lower than the charge that has been made.
Although the lease has been extended, it is not certain that the remaining useful life of the
leasehold improvement is necessarily the same – Gil will need to provide evidence that the
improvements have a useful life which extends at least as long as the lease and expert
opinion may be required to support this judgement.
Legal and professional fees
The significant legal and professional fees in December 20X7 are not explained by the notes
of the meeting and need to be followed up. They could be indicative of a legal claim or of a
significant planned transaction which could give rise to enhanced audit risk or a financial
reporting matter.

Start-up costs
The start-up costs relate to the new company set up with Peerless and appear to relate to an
amount subscribed as initial capital. It therefore appears incorrect that this should have
been treated as an operating cost.
The relevant accounting guidance to consider is that concerning joint arrangements. MP is a
separate entity and will have Articles setting out the contractual arrangements between the
parties. As 50:50 shareholders, neither Peerless nor MRL will have control. MP will have its
own assets and liabilities and the arrangement is therefore a joint venture rather than a joint
operation. It should therefore be accounted for using the equity method in the consolidated
accounts for the Milcomba Group.
The initial capital represents an investment in the JV and should have been shown in the
statement of financial position as an investment and not accounted for as an operating cost.
In MRL's separate financial statements, the investment will in accordance with IAS 27, be
held at cost less any impairment in value or in accordance with IFRS 9. An impairment
seems unlikely as MP is profit making.
For the Milcomba consolidated accounts, the investment value will increase by MRL's share
of the profit made by MP (50% of £50,000 = £25,000 (less any tax)). This, together with any
associated tax charge, will be reflected in the group statement of profit or loss.
MRL will also have transactions with MP to pay its share of the ongoing trading costs and we
will need to ensure that these are properly accrued and accounted for – and this represents
a clear audit risk. It should eliminate from its costs any unrealised profits – this could arise
where costs in respect of an ongoing recruitment job are incurred in MP and carried on the
SOFP of MRL. Only half of the profit is eliminated as the other half accrues to the other
investor, Peerless.
Provision for legal claims
While the net movement on this provision is not material, there have been movements in the
year and the completeness of the provision is an audit risk.
Revenue recognition and WIP
Recruitment fees are invoiced when the position is filled which is the point at which MRL
becomes entitled to a fee. However, the costs will have been incurred over a period of time
before that date. IFRS 15, Revenue from Contracts with Customers requires revenue to be
recognised when a performance obligation is satisfied. The performance obligation in this
case is the service to the customer, which is filling the position so an initial recognition point
at the date on which an offer is accepted seems reasonable, providing the amount of the
revenue can be reliably determined at that date. Direct costs incurred prior to that point
must be expensed as incurred under IFRS 15, and may not be carried in work in progress.
Refunds are payable if the employees recruited leave their positions within 3 months. There
may be established expectations for refunds from the financial services industry but MRL's
knowledge of refund levels for the new sectors it has moved into will be less extensive and it
may be difficult to estimate refund levels.
The inherent uncertainty of refund levels is a key audit risk and financial reporting issue, as is
cut-off and ensuring that costs and revenue are recorded in the right periods.
Risk of management override of controls
There was an incentive at the half year to meet targets so that management bonuses were
paid. Although Gil will not get a bonus himself, he may have been under pressure from the
rest of his team to ensure that their bonuses were earned. Incentives to achieve certain
results will lead to increased audit risk and there is also evidence of pressure from the
Group finance department. It is important that all incentive schemes are understood as part

of the audit and that pressures on management are considered in shaping the audit
response to the risk of management override of controls which is a presumed audit risk.
The fact that the finance director can post journals also increases the risk in this area and we
need to plan a focused audit response which includes all journals and not just those
affecting operating expenses.
(b) Audit approach to operating expenses
Substantive analytical procedures are likely to be a good audit procedure to test
populations where there is a large volume of transactions which is predictable over time.
Whether they are a good test also depends on other factors such as whether a reliable
estimate can be developed from reliable data in order to make a prediction as a benchmark
expectation against which to judge actual results.
In addition, we need to consider whether substantive analytical procedures alone will
provide sufficient evidence or whether they are or need to be supported by other audit
evidence. In most cases, the work on the expenses will be supported by work on liabilities or
provisions.
It is also necessary to consider whether they are likely to be the most efficient audit test.
Wages and salaries for administrative staff
– These meet the criteria for substantive analytical procedures as there is a large volume
of transactions and the costs are generally predictable based on data such as the prior
year costs (already audited), changes in staff numbers (which can be tested) and the
wage rise (which can generally be agreed to support unless very variable across the
population).
– Substantive analytical procedures are therefore a good way to test most of this balance,
supported by detailed tests on the data used to develop that substantive analytical
procedure and a reconciliation of the overall costs to the detailed payroll records.
– Certain elements of the balance such as bonus payments and any termination
payments are not so predictable and should be tested in detail. The work will include
review of any formal agreements to ensure that the costs recorded are complete, in line
with authorised amounts and recognised in the correct period.
Other staff expenses
Other administrative expenses
These are typically not predictable balances and are also not material. It may be possible to
scope them out having gained an understanding of the balance. However there has been at
least one item identified as of audit interest – the tablet computers – and this suggests some
detailed sample testing may be appropriate.
Rent
This is typically a predictable balance which can be tested by substantive analytical
procedures. However, the position here is complicated by the new lease arrangement.
Audit procedures should include a detailed review of that lease from which an expectation
of the rent charge can be derived. Since it is likely that an audit adjustment will be required,
detailed procedures will be needed to calculate and substantiate that adjustment.
Utilities
This is made up of several different charges each of which should be reasonably
predictable. Substantive audit procedures on each element of the balance basing an
expectation on the prior year charge and external data about price rises should be a good
way to test that balance assuming that there has been no significant change in operations.

Depreciation
Substantive analytical procedures would normally be effective to test this balance based on
movements in the non-current assets and the expected useful lives. The expectation for the
year ending 31 August 20X8 will need to incorporate the known change in remaining useful
life. Some further detailed work may be required on the element relating to leasehold
improvements to substantiate the change in useful life and calculate any adjustment
required. This may require expert input if significant judgement is involved.
Receivables allowance
Substantive analytical procedures could be used here for modelling bad debt experience.
The charge here results from movements in the allowance which will be tested as part of our
procedures on receivables. Those procedures will need to include:
– Obtain an understanding of the basis for the allowance and whether that has been
applied consistently
– Agree the ageing of receivables to source documentation and confirm that ageing is
appropriately calculated
– Agree cash collected after the year end to year-end balance and ensure correct
allocation to the customer ageing
– Review historical data for write-offs and whether that can be applied to a changing
population of customers
– Document and understand client's procedures for identifying any new risks arising for
new customers
Legal and professional fees
This is not a predictable balance and will tend to be made up of one off costs. Detailed
testing of a sample of costs is therefore likely to be the best way to understand and test the
balance agreeing individual costs to invoices or other external evidence.
Start–up costs
These should be reversed and will not be tested as part of operating expenses. Substantive
audit procedures are not appropriate for this balance.
Provision for claims and other legal matters
The expense is equal to the net addition to a judgemental provision which will need to be
tested in detail. Procedures will include:
– Understanding the nature of the claims which are being provided for and obtaining
legal or other input to support the amount of the provision
– Considering whether all claims have been provided for by reviewing board minutes,
legal letters etc
– Discussing with management outside the finance department whether there are
matters for which provisions should be made
(c) Potential ethical issues relating to Gil Moore
Gil Moore was an audit manager with Cromer Bell and is almost certainly a Chartered
Accountant. He is therefore required to follow the principles and spirit of the ICAEW Code
and to act at all times with integrity, objectivity and professional competence and due care.

Several questions have arisen concerning Gil's conduct both while at Cromer Bell and in his
role at MRL:
– Review notes raised as part of the cold review appear to have been critical of Gil's work.
While he will not have taken ultimate responsibility for the audit documentation (that is
the role of the partner), the role of senior manager is a key one on the team and the
comments do raise some potential questions about his diligence and focus on detail.
He may have been contemplating or even discussing his move to MRL while working on
the audit and his judgement may have been influenced by his desire to please a future
potential employer.
– Gil took over as MRL finance director on 1 March 20X8, only 2–3 months after the audit
was completed. It is possible that he was talking to MRL about the role while still
operating as the audit manager. If this were the case then there would be questions
about the objectivity he brought to his audit role. I would expect questions to have
arisen on this point when Gil announced his resignation and it may be that there were
conversations with the partner at the time he started to pursue the opportunity at MRL.
More information is needed on this to assess whether he acted with an appropriate
level of integrity and openness. This might also raise questions about Gil's work on the
audit but some comfort can be taken from the fact that an external cold review has
been conducted and that any issues with the audit will presumably have been surfaced
through that. Nevertheless, Cromer Bell should consider the scope of the review and
the need to look again at any areas of the file which were not reviewed.
– The audit planning work has revealed some areas where the returns used by the group
for reporting half year results appear to contain errors – notably in accounting for joint
ventures and failure to accrue the half year bonus. The entries concerned were made
before Gil took up his role as finance director but they are large and distorting and one
might have expected Gil to question them when submitting the half year results. It
would be an issue under the code if Gil were shown to have furnished information
recklessly or without due professional competence or care. Further enquiry is needed
to ascertain when Gil became aware of the entries and the extent to which he took
responsibility for the half year reporting. Given that the entries which are clearly
incorrect understate profit, he would have had no incentive for ignoring them so it
seems likely that he was not aware of them at the time the interim results were
submitted.
– The depreciation adjustment was made by Gil and that is also clearly incorrect which
does suggest either incompetence and a lack of care, or deliberate manipulation of the
results.
– The analysis of operating expenses shows clearly that there appear to have been many
adjusting entries in February and that these have resulted from the release of
judgemental allowance for uncollectible receivables and provision for legal claims, the
latter entry being reversed the following month when an increased provision was
established. While there may have been valid reasons for this, it is also possible that the
half year results were manipulated to ensure that the management bonus recorded
through the journal entry was earned. The entries made are material and any
deliberate misstatement of the half year results would be an ethical issue. The findings
here should be discussed with the group team.
– Gil is clearly under pressure from the group team and this can incentivise unethical
behaviour.

– It is unusual for the finance director to make journal entries. The entry for the bonus is
perhaps understandable as that might be a confidential item. The entry for the
purchase of computers looks very odd and, although immaterial, needs further
investigation as a journal entry for a cash transaction seems odd. Cromer Bell needs to
enquire into this further, to ascertain why normal purchasing and recording processes
were not used and to ensure that the computers are being used in the business, as
such items could be for personal use. Other staff expenses have increased compared
to the prior year.
– Gil appears to have quite detailed knowledge of the results of the cold review for which
a report was received after he left the firm. This is an indication that someone within
Cromer Bell may have been indiscrete and shared with a former colleague confidential
information. However, that needs further discussion as it is not necessarily unusual to
share some of the results of the review.
Actions
– Judgement is involved in all the matters above and it is likely that the engagement
team will want to consult with the ethics partner and possibly other senior partners in
Cromer Bell. Discussion with the group audit team in Elysia is also required, particularly
in relation to errors or potential errors in the half year results.
– As Gil was not the audit partner on MRL, Cromer Bell can continue as auditor. However,
as he was a member of the MRL engagement team and has joined MRL as a key
member of the executive team and a director within two years of being involved with
the audit, Cromer Bell needs to look at the composition of the audit team and to ensure
that it is, for example, appropriately independent of Gil and not made up of individuals
who are close to him or accustomed to working under his instruction. It may therefore
be necessary to change the composition of the audit team.
– If having undertaken all enquiries, there is evidence that Gil has acted unethically or
even fraudulently, then Cromer Bell will need to report the breaches of the code to the
ICAEW and consider the need to talk to the other directors of MRL.
Examiner's comments
Candidates did not always make it clear which part of the question they are answering. This was a
problem with sections (a) and (b). Some answers were a jumble of FR and audit points and failed
to answer the question as set. Candidates answered the question they wanted to see rather than
the one they were asked – for example part (a) asked for risks and financial reporting implications
– not procedures – the paper is designed to be completed within the time therefore candidates
make time pressure for themselves by attempting to give answers to questions not asked by the
examiner.
(a) Identify and explain the key audit risks for our audit of MRL for the year ending
31 August 20X8. Where appropriate, set out and explain any related financial reporting
issues, including relevant calculations;
This was generally well done with the majority of candidates correctly identifying key audit
risks.
Candidates identified the risks arising from the accounting treatment for the rent-free
period, the depreciation on leasehold improvements and the start-up costs but often
calculations of the impact when given were not accurate.
Weaker candidates focused on foreign exchange risks and group issues to the exclusion of
other more relevant risks and also included audit procedures in this section which was not
asked for in the question.

(b) For each of the operating expenses (Exhibit 1) explain whether substantive analytical
procedures and/or tests of detail would be the more appropriate audit approach. Identify
the key substantive audit procedures that we should perform to test each operating
expense.
Answers to this part of the question were generally poor with candidates often failing to
answer the question set. The requirement was to explain whether substantive analytical
procedures or tests of detail would be more appropriate for each line item under operating
expenses. Many candidates simply failed to do this. Others seemed confused about the
difference between substantive analytical procedures and tests of detail. Weak candidates
were unable to distinguish between substantive analytical procedures and tests of detail
and were not able to discuss why each could be used. Some candidates just referred to
"substantive tests" rather than distinguishing between the two types of tests. However,
where it was answered well, candidates could score highly and gain maximum marks.
The question was restricted to operating expenses – some candidates wasted time giving
procedures for revenue and PPE.
This question required candidates to consider the overall approach to the audit of operating
expenses for MRL given the risks already identified and the results of the data analytics.
Weak candidates often just provided a list of procedures rather than an approach.
Candidates who remained focused on the question scored very well on this section and
could score maximum marks answering the question as set, demonstrating that they
understood the difference between a substantive analytical procedure and a test of detail
and justifying their choice of approach.
(c) Explain any potential ethical issues in respect of Gil Moore's behaviour and summarise the
actions that Cromer Bell should take to address them.
The ethics requirement was often dealt with well and most candidates were able to identify
the issues and to suggest appropriate actions.
There were some very high marks on this part and some excellent answers. Most candidates
put their answer into an audit context, such as reporting to the ethics partner or reviewing
work. Most candidates made a good attempt at listing the steps Cromer Bell should take to
address the issues identified.
A minority of candidates accused Gil of fraud/false accounting and wanted to notify the
MLRO/the Police – there was little in the scenario to warrant such a harsh assumption to be
drawn about Gil's integrity and honesty. Gil was until very recently a former colleague.

61 Zmant plc
Scenario
The candidate is an audit manager working for Dealy and Brant (DB), a firm of ICAEW Chartered
Accountants. DB has audited Zmant plc and its subsidiaries for some years.
Zmant plc supplies specialist audio equipment and has several 100%-owned subsidiaries. Zmant
and its subsidiaries have a 30 September year end. During the year ended 30 September 20X7,
Zmant acquired an investment in a company called KJL which operates in Otherland. KJL is
audited by a local firm called Welzun.
DB is not the auditor for KJL and has identified KJL as a significant component. The audit plan
included an assessment of Welzun's professional qualifications and independence and no issues
were noted.
Following a review of KJL's financial statements, DB asked for further information regarding
certain transactions and balances which may impact on the group audit opinion. The report
received from Welzun casts doubt on the integrity of the management and the quality of the
financial reporting at KJL. It also raises concerns that DB's original assessment of Welzun may be
incorrect and further audit procedures will be required to ensure that a misstatement does not
arise in the group financial statements because of the consolidation of KJL with the Zmant
group. The matters giving rise to concern are the recognition of development expenditure in the
statement of profit or loss which is required to be capitalised under IAS 38 and the incorrect
presentation of entertainment costs as research costs. The result of the recording of these
transactions in this way enables KJL to take advantage of a tax relief to claim a significant refund
of tax which it has recorded as a current tax receivable.
The assurance element of the question requires the candidate to identify that Welzun has not
applied the concept of materiality appropriately to these transactions and hence to identify that
insufficient audit procedures have been carried out. Those procedures which have been
completed do not cover all auditing assertions – particularly accuracy and presentation. From a
higher perspective, the candidate should recognise that these issues require a reassessment of
the original audit plan and DB may be required to complete a full audit of KJL using component
materiality.
Further technical issues are raised by Zmant's newly appointed finance director who asks for
assistance with consolidation adjustments for KJL. These include the financial reporting
treatment of a foreign currency loan which represents a net investment in a foreign operation;
the revaluation surplus and deferred tax adjustment in KJL's financial statements; and
intercompany trading adjustments for inventory.
A newspaper article is supplied which highlights that some of the research and development
costs are at best entertaining costs and hence incorrectly form part of the claim for a tax refund
and at worst potentially bribes. The ethical requirement links therefore the audit and financial
reporting aspects of the question.

Marking guide
(1) For each matter in Exhibit 1: 20  Demonstrate understanding of the business

 set out and explain the context by relating nature of project expenditure
appropriate financial to the business context
reporting treatment and  Identify risks within a scenario by linking
recommend adjustments to incorrect financial reporting treatment with the
KJL's financial statements for potential fraudulent claim for R&D tax refund
the year ended 30  Identify elements of uncertainty within a scenario
September 20X7; by appreciating that more information and
 identify and explain any procedures required to ensure appropriate
weaknesses in the audit financial reporting treatment
procedures completed by  Appreciate that Welzun has not applied
Welzun; and technical knowledge of materiality correctly
 set out any additional audit  Appreciate that reassessment of Welzun in
procedures that should be original audit plan is required by seeing an
performed by DB and by overview of the whole scenario and identify a
Welzun to provide range of outcomes
assurance for the group
audit opinion.  Make appropriate recommendations for financial
reporting and additional audit procedures
(2) Set out and explain the 10  Identify the client's requirements by clearly
appropriate adjustments for the setting out which adjustments impact the group
financial reporting queries or individual financial statements
raised by Janet (Exhibit 2) for  Identify the relevance of the information
the year ended 30 September presented to the financial reporting treatment
20X7 for:
 Set out the adjustments and explanations in a
 the individual financial format suitable for presentation to the finance
statements of Zmant and KJL director
 the consolidated financial
statements of Zmant
(3) Calculate goodwill to be 4  Assimilate and apply technical knowledge by
recognised for KJL in Zmant's linking information from the introduction and the
consolidated financial exhibits to calculate goodwill
statements for the year ended
30 September 20X7. Assume
Zmant uses the proportion of
net assets method to value the
non-controlling interest in KJL.
(4) Explain the ethical issues for DB 8 Link information from Exhibits 1, 2 and 3 to identify
arising from the newspaper and structure the ethical issues for different parties
article (Exhibit 3) and any involved.
related matters. Set out and Appreciate that tax evasion is a public interest
explain how DB should matter and has legal implications and risks for the
respond. Advise Janet on any different parties.
actions she should take.
Total 42

(1) Appropriate financial reporting treatment
Research and development (R&D) expenditure $10,700,000
 Project: Sound
Financial reporting implications
The project appears to meet the definition of development expenditure and the costs that
meet the criteria for capitalisation under para 57 should be capitalised under IAS 38 as an
intangible asset. The project involves adapting existing technology for the car industry.
Provided that the technology satisfies the general recognition criteria that there are
expected future economic benefits attributable to the technology and that the costs can be
reliably measured, an intangible asset shall be recognised (IAS 38 para 21).
There is judgement involved in this initial assessment but there is clear external evidence in
the initiation from an external customer for the product and significant orders have been
received from the same customer.
The judgement involved here is not just about whether this expenditure is deemed to be
research or whether it is development expenditure. The project does involve the design
and preproduction of a prototype which is a specific example of development expenditure
given in the standard. The judgement also involves deciding when the criteria are met.
IAS 38 para 65 makes clear that development costs can only be capitalised from the date
when the criteria are first met. Because the customer placed a large order on 1 April this
would seem to be the appropriate date – however the auditors have not carried out audit
procedures to confirm this – see below. Thus, assuming 1 April is the appropriate date, any
of the costs incurred between 1 January and 1 April (other than capital/PPE costs) should
not be capitalised.
Points to indicate capitalisation from 1 April 20X7
Recognition criteria per IAS 38 Points to indicate cost should be capitalised
Technical feasibility? Question says – adapting an existing speaker

Intention to complete and sell? Specific request from an existing customer
Ability to use or sell intangible asset? Company using the development cost to make
Generate probable future markets? a product to sell for which they have a firm
order from a customer
Adequate technical – financial resources?
Measure reliably? Nothing in question to say the company can't
measure reliably – further information is
required
IAS 38 states that the development costs comprise all directly attributable costs. These
include materials for the prototype O$1,725,000, The salary costs of the development staff
O$1,270,000 and the fees to secure the legal right to the design O$910,000. If the costs
meet the recognition criteria for development expenditure the standard says the costs must
be capitalised.
We should be sceptical about the motivation for expensing which has significant tax
benefits for the company.
Amortisation of these costs should commence once the product is ready for sale. To advise
on an adjustment, more information will be needed on amortisation rates.
The allocated general overhead potentially should be written off unless these are specific to
the development of the technology. It is however questionable whether this expenditure
would meet the criteria of research expenditure.

Further information should be obtained to determine how this cost has been calculated and
whether they are specific to the development asset.
With respect to the computer equipment and the car, both these assets meet the definition
of an asset and should be capitalised. Management comment is unacceptable regarding
the hiding of the cost of the car from the tax authorities to prevent personal tax liability for
CEO.
The computer costs of O$1,700,000 should be capitalised as part of PPE and depreciation
over two years. Assuming that this was purchased on 1 January 20X7 depreciation of 9/24
 O$1,700,000 = O$637,500 should be recognised in the statement of profit or loss – it is
possible to include depreciation within the research and development costs and more
information should be obtained.
The car too should be capitalised and the cost less residual value depreciated over its
useful economic life. Further information is required.
Summary of costs to be capitalised:
O$'000 Recommended FR treatment

Materials for prototype model 1,725 Capitalise as development
expenditure
New computer equipment – bought on 1,700 Capitalise and depreciate
1 January 20X7
Salary costs of development staff
 Incurred after 1 April 20X7 1,270 Capitalise as development
expenditure
 Incurred before 1 April 20X7 790 Expense to profit or loss
Registration fees for design 910 Capitalise as development
expenditure
Car used for speaker testing – bought on 555 Capitalise as asset
1 January 20X7
Allocated general overheads 950 Expense to profit or loss
7,900
As all the costs have been expensed an adjustment is required to capitalise the items
identified above.
 Project: Entertain
Financial reporting implications
The recognition of this cost in the profit or loss account is correct because it appears to
represent selling and marketing costs from which the entity will not derive a future
economic benefit. The report will also not satisfy the general recognition criteria of being
capable of future economic benefits and being separable identifiable. The newspaper
article in Exhibit 3 further suggests that the costs are no more than entertainment costs and
are largely for the benefit of KJL's directors and there is limited invitation to customers.
These costs do not meet the criteria for research costs and have therefore been presented
incorrectly in the statement of profit or loss.
Including these costs as research costs has resulted in the company benefiting from
additional tax relief and potentially fraudulently obtaining a tax refund.

Income tax receivable balance $8,025,000
The calculation of this balance assumes that all costs recorded as research costs in the
statement of profit or loss qualify under Otherland tax rules for the tax refund. Clearly if
these costs have been misstated then this balance too is misstated, and further audit
procedures are required to substantiate the accuracy of this balance and whether the
amounts are recoverable from the Otherland tax authorities.
Weakness in audit procedures
Materiality
The materiality level used is the component materiality which has been determined by DB,
the group auditor. For group reporting purposes this is acceptable. However, Welzun's
explanation shows a lack of understanding of materiality.
ISA (UK) 320, Materiality in Planning and Performing an Audit states that the auditor's frame
of reference for materiality should be based on the relevant reporting framework. KJL
reports under IFRS and IAS 1 gives the following definition of materiality: Omissions or
misstatements are material if they could individually or collectively influence the decisions
of that the users make based on the financial statements.
Welzun should have made their own assessment of materiality based on nature, value and
impact and set a performance materiality to reduce the possibility that an aggregate of
uncorrected misstatements exceeds materiality for the financial statements.
Given the profit for the year recorded in retained earnings (See Exhibit 2) is $15 million a
cost of $10.7 million is material by value and, as it includes the cost of a car used by the
CEO, also material by nature.
Furthermore, grouping the costs together results in a balance which exceeds component
materiality level regardless of whether performance level materiality has been set by
Welzun.
R&D
Project Sound
The clear weakness here is that Welzun has not carried out any audit procedures to
determine the audit assertions as per ISA 315.
Project Entertain
The auditors have not carried out audit procedures to determine the nature of these costs
as research costs. Incorrect classification of the costs could result in tax evasion since the
impact is a larger claim for tax to be refunded. The assertion of classification therefore has
not been substantiated.
It also seems extremely questionable that the report has not been received and yet KJL has
accepted the obligations to pay for this service.
Confirmation to invoice and bank statement confirms the audit assertion of occurrence but
does not confirm completeness. Are there any further costs to be recorded?
As the report has not been received, there is no confirmation that the cut off assertion has
been satisfied.
The auditors have accepted management statements without challenge and corroboration.
Income tax receivable
Accepting the work of Welzun's own tax department for the income receivable balance is
also not sufficient. This does not challenge management assumptions about the nature of
the costs included in the claim.
The tax department may not have oversight of the nature and classification of these costs.

Additional procedures
Group auditor responsibilities
The group auditor cannot discharge their responsibility to report on the group financial
statements by unquestioning acceptance of the component's financial statements (ISA (UK)
600 para 11).
The initial assessment of Welzun performed at the audit planning stage should be reviewed
to ensure that DB believes that sufficient audit evidence on which to base a group audit
opinion can be obtained from the work performed on KJL by Welzun. We should question
whether DB's involvement at the planning stage was appropriate.
If the group auditor does not consider that sufficient appropriate audit evidence has been
obtained then the group auditor or the component auditor should perform one or more of
the following:
 a full audit using component materiality
 an audit of one or more account balances, classes of transactions or disclosures
 a review using component materiality
 specified procedures (ISA (UK) 600 para 27)
DB should consider the evidence and determine whether a revision of the audit plan is
needed and whether it has correctly assessed Welzun's ability to complete audit
procedures of sufficient standard to enable an opinion on the group financial statements to
be made. Depending on this assessment, additional procedures should be identified.
These could be completed by the group auditor or by the component auditor (ISA (UK) 600
para 31).
Project Sound
Specific procedures would be:
 Confirm existence of computer equipment and car by physical inspection and agree
the cost to purchase invoice to confirm occurrence.
 Evaluate depreciation and amortisation policies to ensure appropriate to the asset and
consistent with accounting policies.
 Agree costs recorded for other expenditure to supporting documentation such as
invoices, payroll records to confirm accuracy and cut off.
 Obtain schedule of allocated general overheads and re perform the calculations,
applying professional scepticism to ensure the reasonableness of underlying
assumptions.
Project Entertain
Whist it is possible that the report has been delayed, completeness of the costs can be
ascertained by agreeing to a contract between KJL and GetGo – this will also enable
confirmation of the appropriate classification of the costs.
Obtain direct confirmation of costs with GetGo to ensure appropriate cut off.
Income tax receivable
Although it is reasonable to consult Welzun's tax department, the audit team should also
make their own assessment of the claim, agreeing to relevant tax legislation and re-
performing the calculations to ensure accuracy.
Welzun should challenge the assumptions management have made regarding the
classification of the costs as research costs considering their knowledge gained on the
audit.

Consider the appointment of an auditor's expert to review the research and development
claim.
There are potentially deferred tax adjustments if the tax and accounting treatment of these
adjustments require further information.
(2) Loan to KJL
The loan to KJL is a monetary item and because it is denominated in the functional currency
of the subsidiary an exchange difference should be recognised in Zmant's profit or loss
account.
Therefore, an adjustment is required in Zmant's own financial statements to record the
exchange gain as follows:
£'000
O$21 million @ 6.0 (1 January 20X7) 3,500
O$21 million @ 4.8 (30 September 20X7) 4,375
Exchange gain 875
Deferred tax and current tax implications

Because for income tax purposes, tax is not payable on exchange differences, there are no
current tax liability implications. However, because tax liabilities will be higher in the future
when the gain is taxed, a temporary taxable difference will arise.
In the financial statements for Zmant the deferred tax adjustment for the temporary taxable
difference would be taken to the tax charge. This is because IAS 12 requires current tax and
deferred tax adjustments to be recognised in profit or loss except if they arise from a
transaction which is recognised outside of profit or loss.
Temporary taxable difference
£875,000  20% = £175,000
Journals
Zmant's financial statements:
£'000 £'000
DEBIT Loan to KJL 875
CREDIT Profit and loss 875
DEBIT Income tax- PorL 175
On consolidation, the exchange difference will be removed from the consolidated profit or
loss and it will be recognised as other comprehensive income and recorded in equity in the
combined statement of financial position.
Consolidation adjustments:
£'000 £'000
DEBIT Retained earnings £875,000 – £175,000 700
CREDIT Foreign exchange reserve 700
The loan should be presented as a receivable in Zmant's financial statements and it will
cancel on consolidation. As the loans will cancel on consolidation, the following
consolidation adjustment will be required:
£'000 £'000
DEBIT Non-current liabilities 4,375
CREDIT Loan to KJL 4,375
Janet's query was in relation to the receivable balance of £3,500,000 – she also needs to
investigate the treatment of the interest. The loan has an annual interest rate of 6%. She
needs to ensure that 9 months of interest have been accrued or charged in KJL and

credited in Zmant's individual financial statements. If the interest is outstanding at the year
end there would be implications for the forex gain and, depending on the tax treatment, a
deferred tax implication.
On consolidation the interest would require translation at the average rate.
There will also be a consolidation adjustment to cancel the finance cost and income.
Tutorial note
Answers which made reasonable assumptions regarding the interest were accepted.
Inventory adjustment – PURP adjustment and deferred tax adjustment on consolidation

only
The accountant's calculation is incorrect – for example the accountant has adjusted for profit
on goods bought from KJL not on the goods held in inventory.
An adjustment is required for the profit on goods in Zmant's inventory. This is because in
the consolidated income statement this profit is not realised and therefore should not be
reflected in the combined results of the two entities. Once the inventories are sold to a third
party, this adjustment will no longer be required.
This is an adjustment to the consolidated financial statements and not the individual
company accounts.
£2,500,000  35%/135% = £648,148
The temporary difference results in a deferred tax asset as in the group accounts there is a
tax charge for a non-existent asset which needs to be removed.
Although no adjustment is required to the individual financial statements, a deferred tax
asset would be included in the consolidated financial statements as follows:
£'000
Carrying amount of inventory in the consolidated financial statements
£2,500,000 – £648,148 1,852
Tax base 2,500
Difference 648
Deferred tax asset at 20% 130
Journal required on consolidation:
£'000 £'000
DEBIT Cost of sales 648
CREDIT Inventory 648
DEBIT Deferred tax asset 130
CREDIT tax charge 130
This is a consolidation adjustment and will impact the consolidated reserves; NCI and
inventory.
Assuming goods are purchased evenly over the year, an adjustment will also be required to
remove intra group trading.
DEBIT Revenue £5,500,000  9/12 = £4,125,000
CREDIT COS £5,500000  9/12 = £4,125,000

(3) Goodwill on consolidation of KJL assuming Zmant uses the net assets method to value
non-controlling interest in KJL
To calculate goodwill on acquisition, need to first establish the net assets at 1 January 20X7.
The fair value of the net assets acquired at 1 January 20X7 were:
O$'000
Share capital 25,000
Retained earnings at 1 October 20X6 45,000
3 months profit 1 January 20X7 3,750
Net assets at acquisition 73,750
Goodwill
O$'000 £'000
73,750,000  40% 29,500
82,300
Fair value of net assets acquired 73,750
Goodwill 8,550 at HR 6.0 1,425
Exchange gain – balancing figure 356
Carrying amount goodwill at
30 September 20X7 8,550 at CR 4.8 1,781
(4) Ethical implications for DB arising from the newspaper article
DB are not the auditor but is responsible for the group audit report on the consolidated
financial statements which will include the results of KJL. The issues may result in a material
misstatement of the financial statements.
The evidence however is presented in a newspaper article and therefore the source should
be questioned. It is important that the facts are established.
The claims are also made by a former employee and we have no knowledge of the
circumstances or credibility of this individual and the position regarding their departure
from the company.
The article appears to confirm that KJL has been engaged in tax evasion by making a
fraudulent claim for a tax refund based on expenditure which was not related to R&D. The
treatment of the car used by the CEO would appear to support the presence of fraud.
There is evidence from the review of the financial statements that there is some credence to
this story and further audit procedures will be requested to be performed.
Actions for DB
DB needs to establish whether there are any obligations to report the potential tax evasion
in an overseas jurisdiction under the relevant money laundering regulations and should
seek legal advice.
However, the presence of a long-standing customer does indicate that there is a potential
for bribery which would be reportable under the bribery act if any allegations are proven to
be true that the parties are a means of bribing customers for their business.
On completion of audit procedures, DB should discuss the matter with those charged with
governance at KJL and Zmant to establish facts; the DB ethics partner should be contacted
and involved in the resolution. Legal advice and the ICAEW helpline should be contacted.
During this process, DB and its staff should take care not to engage in any activity that could
be construed as 'tipping off'.

The integrity of management is also questionable and therefore DB should consider
carefully any reliance on evidence from KJL's management which supports the audit
opinion in the group financial statements.
Actions for Janet
As the finance director of Zmant, and an ICAEW member Janet must not allow herself to be
associated with fraudulent claims for tax refunds. She should discuss the matter with her
board colleagues.
Janet should be advised to consider her position and whether she wants to continue to
work for Zmant – she should contact ICAEW for advice on how she should proceed.
Examiner's comments
(1) Financial reporting
For Project Sound there was good discussion of IAS 38. A surprising proportion of
candidates made no comment about the strong motivation provided by the tax system to
overstate expenditure. A few superimposed actual UK tax law (eg, R&D allowances, rules on
entertaining expenditure) on to the facts of the question. There was not enough scepticism
as to why the expenditure was being expensed rather than capitalised. A significant
minority of candidates did not identify the car and the computer as PPE, rather stated they
were just 'capitalised'.
For Project Entertain most candidates appreciated that the cost should be expensed but
did not clearly state that the classification was wrong so had less to discuss on the audit
issues.
For the tax receivable issue, most identified that the calculation was wrong and that the
audit approach was not appropriate.
Audit weaknesses and procedures
Only the better candidates attempted to identify a clear distinction between the audit issues
to be performed by Welzun and those by DB. Most however identified that Welzun's
application of materiality was incorrect.
Weaknesses in the procedures were identified well. Better candidates produced additional
procedures which linked back to the audit assertions.
Weaker candidates produced generic audit procedures using vague terms such as 'review'
or 'obtain' – without explaining what and why they are reviewing and what they are going to
do with the information that they obtain.
Weaker candidates failed to apply concepts of reliability of audit evidence (no attempts to
obtain third party evidence) and a lack of appreciation that "checking that the transaction
has been accounted for properly" has no actual practical credibility. Candidates should
illustrate an appreciation of why they are performing certain tests and inspecting certain
documents.
(2) Financial reporting in respect of Janet's queries
This section of the question was usually done well. Candidates gained high marks for
appreciating, and clearly illustrating, the differences between the accounting treatments in
individual and consolidated financial statements. The description of the accounting
treatment of the loan was good with many students picking up all the relevant points. The
main issue missed was the deferred tax on the exchange gain. Some candidates lost easy
marks through not explaining that the gain went to profit or loss in the individual accounts,
with some even explaining that it went through OCI. Better candidates identified that the
gain would then be recognised through OCI in the group accounts.

Many candidates could identify that the client's PURP calculation was incorrect but fewer
could discuss why. The client's calculation included many of the errors we see in
candidate's answers and although some candidates came up with some more errors in their
'corrected' calculations, many candidates did calculate the correct figures including the
deferred tax.
(3) Goodwill
Goodwill was generally calculated correctly. The most common mistake was not pro-rating
the profit correctly to arrive at the pre-acquisition reserves. Most scored full marks on this
section. Some candidates incorrectly adjusted for their findings in the previous section,
which was incorrect as the adjustments had arisen at the reporting date and not the
acquisition date.
(4) Ethics
There were plenty of good answers discussing tax evasion and bribery and not enough time
was devoted to the discussion of actions. Some candidates thought, incorrectly, that Janet
worked for the auditors and so did not identify appropriate actions for her. Those who
scored well identified the points about the money laundering and taking legal advice and
followed a clear structure.
62 Chelle plc
Scenario
The candidate is an ICAEW Chartered Accountant who has just been appointed as financial
controller of Chelle plc, a listed company which imports delicatessen products. The company
has been struggling and has not paid a dividend in the current financial year.
The candidate is supplied with information extracted from the draft financial statements of the
company for the year ended 30 October 20X7. This information has been prepared by the
former financial controller, who has also supplied a list of outstanding matters.
The candidate is required to explain the appropriate financial reporting treatment for each
outstanding issue: a convertible bond, and an equity investment, adjust the financial statements
and prepare a report analysing the performance and position and cash flow of the company.
The candidate is required to:
(1) Set out and explain any 8  Assimilate and demonstrate understanding of a
adjustments required to large amount of complex information
the draft financial  Identify appropriate accounting treatments for
statements for the year complex transactions including convertible bond
ended 31 October 20X7, and an equity investment
in respect of the
outstanding matters  Recommend appropriate accounting adjustments
(Exhibit 2). Provide in the form of journal entries
supporting journal entries.

(2) Prepare a revised 9  Apply technical knowledge to calculate EPS and

statement of profit or loss diluted EPS
for the year ended  Assimilate information and use own accounting
31 October 20X7 and a adjustments to prepare revised financial
revised statement of statements
financial position at that
date. Include calculations
of earnings per share and
diluted earnings per share.
(3) Prepare a report to the 10  Use financial statement analysis to prepare
board, analysing the key relevant analysis in an appropriate format
elements of the financial  Identify potential funding gap in 20X9
position, performance and
cash flow for the year  Assimilate knowledge, drawing upon question
ended 31 October 20X7, content and own procedures to provide a
in comparison with the two reasoned conclusion on performance and
previous financial years. position and cash flow of the entity
Use your revised financial
statements and other
information provided.
(4) Calculate the amount of 3  Assimilate information and apply technical
Chelle's legally knowledge to determine distributable reserves
distributable reserves at
31 October 20X7,
providing explanations to
support your calculations
Total 30
(1) Convertible bond instrument

Although interest of £500,000 has been recognised in the draft financial statements, an
adjustment is required to increase finance costs to reflect the effective interest rate and to
increase the amount of the bond to present value.
Bond present value at 31 October 20X6: £9,603,000
Finance cost on £9,603,000 at 6.5% = £624,195, rounded to £624,000
Bond present value at 31 October 20X7: (£9,603 + £624 – £500 interest paid): £9,727,000
Journal entry required:
£'000 £'000
DEBIT Finance costs (£624 – £500) 124
CREDIT Bond 124
Equity investment
The financial controller has not recognised a gain or loss in respect of the equity instrument.
The value of the holding in Spence plc at 31 October 20X7 is £18.50  100,000 = £1.85m.
This is an increase of (£1,850 – £1,503) = £347,000.
The journal entry required to recognise this gain is as follows:
£'000 £'000
DEBIT Financial asset 347
CREDIT OCI/OCE 347

Current tax effects of adjustments
The adjustments made above increase the loss before tax:
£'000
Loss as stated in draft financial statements (938)
Additional finance costs (124)
(1,062)
The tax credit to be recognised is: £1,062  19% = £202,000 (rounded). £178,000 has
already been recognised, so an additional amount of (£202 – £178) £24,000 should be
recognised.
The journal entry required is as follows:
£'000 £'000
DEBIT Tax asset 24
(2) Revised draft statement of profit or loss and other comprehensive income for the year
ended 31 October 20X7
20X7 20X7
Draft Adjust Revised
£'000 £'000 £'000
Revenue 30,600 30,600
Cost of sales (22,803) 22,803
Finance costs (500) (124) (624)
(Loss)/profit before tax (938) (124) (1,062)
Tax 178 24 202
(Loss)/profit for the year (760) (100) (860)
Other comprehensive income – 347 347
Revised draft statement of financial position at 31 October 20X7

20X7 20X7
£'000 £'000 £'000
Non-current assets
Financial asset 1,503 347 1,850
55,178 347 55,525
Current assets
Trade receivables 7,710 7,710
Tax asset 178 24 202
10,658 10,682
Total assets 65,836 371 66,207

20X7 20X7
£'000 £'000 £'000
Equity
Share capital (£1 shares) 10,000 10,000
Other components of equity 1,416 347 1,763
Retained earnings 37,294 (100) 37,194
48,710 247 48,957
Long-term liabilities (5% bonds) 9,603 124 9,727

Current liabilities
Trade payables 6,304 6,304
Tax payable –
Bank overdraft (limit £5 million) 1,219 1,219
7,523 7,523
Total equity and liabilities 65,836 371 66,207
Note: The extract from the statement of cash flows does not change.
Earnings per share and diluted earnings per share
Chelle is loss-making therefore a loss per share is reported in respect of the year ended
31 October 20X7.
£'000
Loss before tax (as calculated above) (1,062)
Tax credit 202
Loss after tax (860)
Basic EPS is calculated as:

Profit/(loss) attributable to ordinary equity holders of the parent
Weighted average number of ordinary shares outstanding during the period
Basic loss per share = (860) = (8.6) p per share

10,000
As there are bonds which are convertible into ordinary shares at a future date, a diluted
earnings/(loss) per share must be calculated. If the effect of the additional shares would be
dilutive, diluted earnings per share must be disclosed.
Upon maturity of the bond, the bondholders can opt to receive one ordinary share for every
£10 of bond held. The maximum number of shares that could be issued is £10,000,000/10
= 1,000,000. The total number of shares in the denominator of the calculation is therefore
11 million.
Computation of the diluted earnings involves adding back the after-tax effect of the finance
cost saved. In the year ended 31 October 20X7 interest at the effective rate is £624,000
(calculated earlier). The after-tax effect is (£624  81%) £505,000.
Diluted loss per share =
(860) + 505 = (3.22)p per share
11,000
The diluted loss per share is reduced, and therefore antidilutive, and does not require
disclosure.

(3) Report
To: The Chelle Board
From: Aiden, Financial Controller
Analysis of key elements of the financial statements
Position
Liquidity and efficiency
The current and quick ratios confirm that the business is not facing any immediate liquidity
crisis, although they have worsened significantly over the three-year period. The £5 million
overdraft limit helps to cushion any shortage of working capital funds. However, there are
some worrying signs in the efficiency ratios. Inventory seems to be well under control, but
both receivables and payables provide cause for concern. Receivables days are at an even
higher level by the year end compared with the previous years. Chelle's customers include
supermarket chains which are notoriously slow in paying, but even taking this into account,
90 days is a very long element of the working capital cycle. The trade payables collection
period has worsened, too, and suppliers may be inclined to put pressure on Chelle for
payment when the average outstanding period is 101 days.
Long-term liabilities: bonds
The bonds are due for redemption or conversion in slightly under two years' time. The
share price at the 20X5 year end must have suggested to the board that bondholders
would opt for conversion on 31 October 20X9. A holder of a £10 bond at that date would
be entitled to convert to a share worth £17.11p. However, by 31 October 20X7, the
conversion option has become much less attractive. At a share price of only £9.80 a
bondholder would quite probably want repayment of the bonds.
If the share price does not recover over the next two years, Chelle may be faced with the
need to raise further finance to repay the bondholders. However, if this does happen,
raising further long-term finance may not be too difficult. The strong cash flow performance
would help to encourage lenders, and Chelle's gearing level is not particularly high at
around 22% (at the end of October 20X7). Borrowing seems the most likely solution to the
problem of redemption. In current conditions, it seems unlikely that shareholders would
wish to contribute further funds.
Equity investors
Chelle's investors have seen their share price reduced at 31 October 20X7 to only 57% of
what it was two years' previously. In the meantime, they have received a dividend of only 1p
per share and 2p in 20X5 (0p in the 20X7 financial year). Chelle's performance, at least as
far as profitability is concerned, has not been encouraging. It is arguable that the payment
of a dividend, which would currently have to be paid out of overdraft, would make little
difference. However, please see the separate document [section 4 of answer] which
addresses the extent to which a distribution could be made.
Performance
The trend in business performance, as evidenced by the statement of profit or loss, has
clearly been disappointing over the last three years. Gross, operating and net profit margins
have fallen, and the increased cost of supplies from other countries has no doubt had a part
to play in the disappointing performance. However, adverse exchange rates are only one
element.
One striking factor is the downturn in sales revenue. Revenue fell by almost 11% between
20X5 and 20X6, and by almost 4% between 20X6 and 20X7. This is, according to the MD,
the result of increased competition. However, it would be worth investigating this further to
confirm that this is the reason and/or to identify other factors. For example, if Chelle and the
retailers it supplies have attempted to pass on increased product costs to customers in

higher prices there may have been a consequent volume reduction in sales. There is a fall in
GP% which presumably relates to the change in exchange rates.
Operating costs have risen by 17.7% over the period 20X5 to 20X7. Presumably, most of
these costs are incurred in the UK, and therefore there would be no adverse exchange rate
effects. This is an area that would require detailed further investigation.
At its best level over the three-year period the return on capital employed in 20X5 was only
5.7%, with return on shareholders' funds in 20X5 even lower at 4.27%. This performance
has worsened in 20X6 and 20X7. The poor return on investment from a shareholder point
of view may help to account for the fall in share price and the evident lack of shareholder
confidence in the company
Cash flow
Chelle's performance from a cash flow point of view is much better than the profitability
ratios suggest. The cash return on capital employed at around 19% has varied very little
over the three-year period. The extracts from the draft statement of cash flows show that the
cash generated has been utilised almost entirely in investing activities. As financial assets
have remained stable over the three-year period, it is evident that the investment activity
has been in respect of property, plant and equipment (PPE). The statement of financial
position confirms that PPE has risen each year. However, the PPE does not appear to have
been utilised as intensively in recent periods. The non-current asset turnover ratio has
worsened significantly over the period. It may be that the non-current assets have not been
fully functional over the period, or that the nature of the investment has changed, but
further investigation is needed.
If revenue and profitability continue to decline the company's share price is likely to
continue its downward trajectory. Any distribution threatens the company's cash position,
so it is unlikely to be able to make a significant difference to shareholder attitudes by means
of dividend. A continuing weakening of £ sterling would make a bad situation worse as
Chelle would become less competitive. If strong competition in the market continues to be
a factor Chelle's downward slide could be very difficult to arrest.
If the company's cash position worsens then its status as a going concern could ultimately
be threatened. However, as noted above Chelle's gearing level is relatively low and it may
not be too difficult to obtain further borrowings, to repay the bonds in two years' time and
to finance working capital.
Conclusion
Chelle continues to produce strong positive cash flows, although its profitability has
suffered. The fall in sales is a matter of concern, especially when compared to the significant
investments that have been made over the last three years in property, plant and
equipment. Chelle's long-term borrowings mature in two years' time and it currently seems
likely that bondholders will opt for redemption. This would put Chelle into the position of
having to fund a £10 million cash outflow. Directors should start planning for this eventuality
now.
Appendix: ratio calculations
(4) Distributable profit at 31 October 20X7
For most companies, distributable profits is the total of accumulated realised profits less
accumulated realised losses. However, for public limited companies such as Chelle, there is
a potential further restriction. A public company may only make a distribution if its net
assets are not less than the aggregate of its called up share capital and undistributable
reserves. Undistributable reserves include share premium account, capital redemption
reserve, any surplus of accumulated unrealised profits over accumulated unrealised losses

(known as a revaluation reserve) and any other reserve which the company is prohibited
from distributing by its constitution or any law.
Chelle has realised profits in the form of retained earnings, and also in the form of the
accumulated gains and losses on the equity investment, totalling (£850,000 + £37,194,000
revised) £38,044,000. This can be confirmed as follows for Chelle as a public company. The
company's net assets (revised) are £48,957,000. The net assets cannot be reduced below
the total of its aggregate of called up share capital and undistributable reserves of
(£10,000,000 + £913,000) £10,913,000. So, the distributable amount is £38,044,000
(£48,957,000 – £10,913,000).
Distributable profits is the total of accumulated realised profits less accumulated realised
losses.
The amount distributable is calculated and explained in the following table:
Item of reserves Distributable Explanation
£'000
Accumulated gains and 850 This is treated as a realised profit and so

losses on equity investment would be distributable.
Other components of equity – This is likely to be the element of equity
(remainder) calculated under the 'split accounting'
rules for hybrid financial instruments in
IAS 32. Financial Instruments:
Presentation and Disclosure.
It is not distributable.
Retained earnings 37,294 Provided that this item comprises only
realised profits (which is likely to be the
case) then it is fully distributable.
Total 38,144
Chelle's directors should bear in mind that the table above shows amounts that are legally
distributable. The constraint for Chelle in paying dividends is not the amount that is
distributable, but rather the absence of cash.
Examiner's comments
(1) Financial reporting adjustments
Most (although not all) candidates made a good attempt at working out the effect of the
change in valuation of the equity instrument. It was common to find errors in accounting for
the bond. The question stated that the bond issue had taken place in 20X1 but despite this,
some candidates accounted for the bond as a new issue in the financial statements for the
year ended 31 October 20X7. Following this through, they then commented in the next part
of the question about the high gearing level and the influx of cash from the 20X7 bond
issue. Even where candidates recognised that the bond had been issued in 20X1, some still
tried to account for the bond as if for the first time. The size of the company makes it clear
that it is audited. It is unlikely that the auditors of the listed company had completely
overlooked a bond issue for a period of 6 years since 20X1. A common mistake was to
calculate the gain as £850,000 because the existing gain in OCE was ignored.
For the tax section – the question specifically asked for deferred tax to be ignored and yet
many candidates discussed the deferred tax issues of having a loss that may not be
recovered.

(2) Revised Profit or Loss and SOFP and EPS
Most candidates made a reasonable attempt at this section. Sometimes the redrafting of the
financial statements was incomplete. The weaker candidates stated that there was therefore
no EPS, or incorrectly used PBT or total comprehensive income as opposed to the loss for
the year.
(3) Financial statement analysis
Weak candidates produced very short and superficial answers which simply calculated
some ratios and then worked through them listing why they may have changed. This
approach meant that they did not link important areas of the financial statements together.
However, in some cases the analysis was done well and all the pertinent points were picked
up including the fact that the bond was due for repayment in two years – a great
achievement under exam conditions.
(4) Distributable profits
A fairly common error was to ignore the legality of the dividend payment, to concentrate
only upon what the business could afford to pay (ie, not very much). However, most gained
some marks for understanding the basic rule for legally distributable reserves and for
demonstrating some knowledge of the further restrictions applied to public companies.

63 Solvit plc
Scenario
The candidate is an audit senior working for Kanes LLP, a firm of ICAEW Chartered Accountants
assigned to the audit of Solvit plc for the year ending 31 March 20X8. Solvit plc is a listed
company supplying software and related services. Some of Solvit's customers purchase only
software but others enter into multiple element contracts, purchasing software together with
customisation, integration services and maintenance. Solvit is a new audit client for Kanes LLP.
The candidate is presented with extracts from last year's audit report (Exhibit 1) which includes
the key audit matters (KAMs) identified by Solvit's previous auditor, Fenn Yo LLP. These matters
are in respect of revenue recognition and a provision for an onerous contract. Also provided are
notes from the meeting with the Fenn Yo LLP audit partner and manager (Exhibit 2) with
additional information concerning these matters and a summary of points from the audit
manager's initial meeting with the Solvit Finance Director, Sam Browne (Exhibit 3) which
includes financial reporting issues relating to the current financial year ending 31 March 20X8.
The question involves the skills of assimilation, and structuring by identifying critical factors in
the scenario which lead to the selection of issues for key audit matters which ultimately require
disclosure in the audit report. The candidate also is required to advise on the implications of a
new accounting standard IFRS 16 on the leasing transactions of the entity.
Marking guide
(1) In respect of the key audit matters 10  Relate different parts of the question to
to be included in our plan for the identify critical factors
Solvit audit for the year ending  Interpret information provided in
31 March 20X8: various formats and different sources
(a) Explain why the key audit  Present the analysis in accordance with
matters identified by Fenn Yo the instructions of the manager
LLP (Exhibit 1) continue to be
relevant and explain how each  Appreciate when expert help is
of these has changed this year. required to confirm fair values
(b) Identify additional key audit  Recognise potential for bias and
matters for this year's audit and manipulation in management's
explain the factors which have judgement to achieve bonus targets
led you to select each of them
as a key audit matter.
(2) For each of the key audit matters 18  Assimilate complex information to
identified in (1) above: produce appropriate accounting
(a) Identify the relevant financial adjustments
reporting standard and explain  Apply knowledge of relevant
how it should be applied to the accounting standards to the
key audit matter in Solvit's information in the scenario
financial statements for the  Identify the need for further
year ending 31 March 20X8. information
(b) Explain the specific audit
objectives of our audit
accounting adjustments
procedures to provide assurance
in respect of the key audit matter.

(3) Draft a brief response to the 3 Apply technical knowledge to describe

Finance Director's question (Exhibit alternative financial reporting treatment of
3) about the likely impact of complex transactions under IFRS 16
IFRS 16, Leases, on Solvit's financial
31 March 20X9
Total 31
Maximum 28
(1) (a) Revenue recognition

Why key audit matter is still relevant
 It is a presumed key risk under auditing standards and there appears to be no
good reason to challenge this in Solvit's case.
 It was identified as a key audit matter in the prior year and there is no reason to
believe that the level of audit effort this year will be lower.
 Revenue is a very material balance in the financial statements.
 Some of the revenue transactions made by the company are complex, involving
multiple elements.
 There is judgement involved in allocating revenue to elements and this will affect
the timing of revenue recognition where not all elements have been delivered at
year end.
 An audit adjustment was identified in this area in the prior year.
 There is a relatively new revenue accountant and it is this individual who made an
error in the prior year. The previous auditors raised doubts about his level of
experience.
Changes this year
 There are indications that the company has struggled to apply IFRS 15. There also
appears to have been reliance on the revenue accountant whose expertise has
been called into question.
 There is a new education sector product which may be sold on different terms to
other products and for which additional discounts for future maintenance have
been given.
 The new product has had issues, including problems in the software which means
there is a heightened risk of returns and credit notes and reputational damage.
Onerous lease
Why key audit matter still relevant
 The provision brought forward is material.
Changes this year
 The provision has been released this year however discussion with the client has
revealed that the sub-lease entered into is not for the entire term of the underlying
lease and so there remains judgement as to what will happen when that lease
ends. Annual rentals are £700,000 (£1.4 million is for 2 years) so the total rental
for the period after the end of the sublease could be material.

 The release of the whole of the provision appears incorrect as there were rentals
incurred in the period before the property was let and there is also a rent-free
period.
(b) Allowance for aged receivables
Factors leading to selection of the matter as a key audit matter
 There was an identified mis-statement in the prior year which was not material –
this was an over-provision.
 There is a new type of customer this year – the educational sector customers and
Solvit has far less history of dealing with such customers and therefore less
evidence to support any provision or lack thereof.
 Days sales outstanding have increased significantly at 30 September 20X7.
Accounting for sale and leaseback
 This is a material one-off transaction.
 The accounting for it is not straightforward and not routine for the accounting
team.
Management bonus – incentive to manipulate results
 Last year management incentive was not identified as a key audit matter but the
facts have changed as this year Solvit is struggling to meet its plan and is not
currently on target to meet the performance targets necessary to trigger the
maximum management bonus. The results for the first half are lower than plan
despite the release of the onerous lease provision and no increase in the aged
debtor allowance.
 Management therefore has a much greater incentive to manipulate results and
judgemental areas (such as bad debt allowance and onerous lease provision) and
one-off items such as sale and leaseback provide potential opportunities for them
to do so.
(2) Revenue recognition
(a) Relevant financial reporting standard
The relevant financial reporting standard is IFRS 15, Revenue from Contracts with
Customers.
Under IFRS 15 there is a five-step model for revenue recognition. This requires the
following:
 Identification of the contract with the client (unlikely to be an issue in the case of
Solvit as we would expect contracts with each customer)
 Identification of the separate performance obligations in the contract – in Solvit's
case there appear to be contracts with three separate elements, all of which are
also supplied separately – software, services, maintenance. Software can be sold
separately but other integration services and maintenance will introduce
complexity here as these would not be sold separately but it does provide the
customer with a separate right.
 Determine the price – that will be the total payable for all elements included in the
initial contractual arrangement and may become more complex where, for
example, discounts are offered for future years.

 Allocate the transaction price between the performance obligations – software,
services and maintenance – this will be done in relation to the stand-alone prices
for each element – the price for software sold on its own; the day rates for services
sold on their own; the renewal rate for maintenance per the standard price list.
 Recognise revenue when or as the performance obligations are satisfied, ie, when
the service is provided. For standard software that is likely to be when it is
delivered. For customised software the question is more complex and it is
necessary to consider whether there is an obligation to deliver the customised
product and recognise revenue on delivery or separate obligations to deliver
standard product and then services. For maintenance, the obligation is likely to be
satisfied over time and so the revenue will be spread over the maintenance
period.
(b) Specific audit objectives of our audit procedures to provide assurance in respect of
revenue recognition
The application of IFRS 15, is the key focus of the revenue recognition risk for the
20X7/X8 audit, although the risk is also enhanced by the operational factors.
In particular, the audit objectives of our audit procedures on this key audit matter are:
 to ensure that any prior period adjustment has been accurately calculated and that
all relevant contracts have been considered;
 to examine if software and services are separate performance obligations where
Solvit is delivering a customised software product;
 to ensure that the allocation of the total price between the elements of larger,
multi-element contracts is performed accurately using prices which are those
applied when the elements are sold separately;
 to identify if sales have been made to customers who have been given the rights
to future discounts; and
 to identify revenues where there appears to be delay in customer payment and
consider whether this is indicative of any early revenue recognition. In particular
there is a risk that revenue may be recognised for faulty software which the
customer has not accepted and which is not fit for purpose.
Our audit procedures should do the following:
 Identify contracts where not all elements have been delivered at the year end, as
such contracts are the ones where revenue recognition will be affected by
allocation between delivered and undelivered elements. They should agree that
revenue has been recognised appropriately for these contracts.
 Perform analytical procedures on the pattern of revenue recognition over the year
for each type of revenue and investigate unusual items – these might include
variations in maintenance revenues which might be expected to be spread evenly
over the year or peaks in the recognition of software or services revenues which
might be indicative of cut-off issues or manipulation of the results.
 Identify revenue postings not generated by cash, trade receivables or from
reversal of a contract liability as these are inherently unexpected transactions
worthy of follow up.

Onerous lease
The relevant financial reporting standard is IAS 37, Provisions, Contingent
Liabilities and Contingent Assets.
 The lease for a property no longer used by the company is an onerous lease
for which provision needs to be made under IAS 37.
 The amount to be provided is the directors' best estimate of the net cash
outflows they will incur under the contract, having taken account of the
income from the present and any future sub-tenant.
 Discounting needs to be applied if the time value of money is material – it is
likely to be so if the anticipated net cash outflows are sometime in the future –
ie, after the initial 5-year rental period.
 The brought forward provision should not have been released completely as
the rent for the 4 months to 31 July should have been charged against it
along with the first 2 months of the initial rent-free period, meaning that
£350,000 of the brought forward provision has been utilised at 30 September
20X7 and that a further provision for 4 months rental (£233,333) is needed to
cover the remaining rent-free period.
(b) Specific audit objectives of our audit procedures to provide assurance in respect
of the onerous lease
The objectives of our audit procedures should be to eliminate the following risks:
 The movement on the provision in the year ending 31 March 20X8 is not
correctly recorded and disclosed within the financial statements.
 The provision is not adequate to cover a future shortfall in rentals received
when the sub lease ends in 5 years' time at which point the property may
remain empty for some time or a lease be negotiated which does not cover
the rentals payable under the head lease.
 Confirm that the head lease permits sub-letting and that any conditions have
been complied with and obligations recorded.
 Evaluate the need for discounting to be applied at an appropriate rate.
 Agree the terms of the sublease to ensure correct accounting for the rent-free
period.
The relevant financial reporting standard is IFRS 9, Financial Instruments.
The impairment model in IFRS 9 is based on the premise of providing for
expected losses. The financial statements should reflect the general pattern of
deterioration or improvement in the credit quality of financial instruments within
the scope of IFRS 9. Expected credit losses are the expected shortfall in
contractual cash flows, defined in IFRS 9 as the weighted average of credit losses
with the respective risks of a default occurring as the weights.
On initial recognition, an entity must create a credit loss allowance/provision equal
to 12 months' expected credit losses. This is calculated by multiplying the
probability of a default occurring in the next 12 months by the total lifetime
expected credit losses that would result from that default. Solvit has complied with

IFRS 9 in this respect. However, IFRS 9 requires that, if the credit risk increases
significantly since initial recognition this amount will be replaced by lifetime
expected credit losses. Lifetime expected credit losses are defined as "the
expected credit losses that result from all possible default events over the
expected life of a financial instrument" (IFRS 9: Appendix A). There is a rebuttable
presumption that lifetime expected losses should be provided for if contractual
cash flows are 30 days overdue. Receivables days have increased from 45 days at
31 March 20X7 to 75 days at 30 September 20X7. Credit risk has therefore
increased significantly, so lifetime expected credit losses must be recognised and
the increase charged to profit or loss.
IFRS 9 allows a simplified approach to the expected loss model in respect of trade
receivables which do not have an IFRS 15 financing element. The loss allowance is
measured at the lifetime expected credit losses from initial recognition. Should a
receivable exceed the credit limit it is likely that the allowance established based
on expected credit losses at initial recognition should be increased. This approach
would be appropriate for Solvit in the future.
of the trade receivables allowance
The objectives of our audit procedures are to address the following risks:
 To ensure that adequate allowance is made for receivables from educational
sector clients
 To ensure that the allowance is based on the best information available or
reassessed fully to consider the balances and circumstances at 31 March
20X8
 Perform analytical procedures to identify trade receivables with a
deterioration in ageing.
 Identify factors which might be distorting the ageing reported such as
unmatched credit notes or cash receipts.
 Identify any amounts on the receivables ledger which relate to the prior
financial year so that the adequacy of the prior year allowance can be fully
assessed.
Sale and leaseback
The relevant financial reporting standard is IAS 17, Leases.
The first consideration is whether the lease is an operating or finance lease. It is an
operating lease as it is relatively short term for a building and total rentals are well
below the fair value of the asset even without discounting.
The second consideration is whether the sale is at fair value – in this case it is
above fair value as the fair value is £15 million and the sale proceeds £18 million.
As this is an operating lease, the amount by which the fair value exceeds the
carrying amount is recognised as profit within the statement of profit or loss. This
is calculated as £15 million – £11 million = £4 million. The asset will be
derecognised and shown as a disposal within the financial statements.
The remaining gain of £18m – £15m = £3 million is deferred and amortised over
the period for which the asset is expected to be used. In this case that may be the
20-year life or the 10-year lease term depending on whether there is intention to

renew the lease. This will result in an additional gain of 6/12  £3m/20 years or
10 years (£75,000 or £150,000) in the statement of profit or loss for the year
ending 31 March 20X8.
The rentals of £600,000 per annum are recognised over the lease term, £300,000
will be included in the statement of profit or loss for the year ending 31 March
20X8.
of the sale and leaseback
The objective of our audit procedures is to eliminate the risk of a material
misstatement arising from the incorrect financial reporting treatment of this
complex transaction.
 Determine how the transaction has been recorded in the financial statements.
 Obtain third party confirmation of the fair values.
 Challenge management over the useful life of the property.
 Examine the contract with the leasing company and agree terms.
 Obtain further evidence from an independent source about the likely renewal
of the lease after 10 years.
 Evaluate the need to appoint an auditor's expert to agree fair value.
Management bonus – incentive to manipulate results
IAS 19, Employee Benefits sets out the measurement basis for the employee
bonus. This is based on whether Solvit has a legal or constructive obligation to pay
the bonus based on achieving targets – an expense will be recognised in the year
ending 31 March 20X8 if the targets are judged to be met.
of the management bonus
The objectives of our audit procedures are to address the following risks:
 Management understating judgemental provisions or consistently setting
provisions at the lowest acceptable point in a range, meaning that the
position overall is aggressive and does not truly represent the best estimate.
 Management making accounting entries with the sole purpose of boosting
results.
 The bonus being inappropriately recognised.
 Review closing and other journal entries to identify items of audit interest.
These will include journals booked by senior management who do not
normally make detailed accounting entries; round sum amounts which might
be indicative of estimates of overall adjustments; journals booked outside of
normal working hours to conceal them; journals which are unusual in some
way such as an entry in DEBIT non-current assets and CREDIT revenue which
would not normally be expected.
 Re-perform the calculation of the management bonus at the year end – agree
to contracts of employment to ensure that the calculation is in line with the
contract.

(3) Response to query about IFRS 16
Under IFRS 16, there will be a single accounting model applicable for all leases to lessees
with no requirement to distinguish between operating and finance leases. As a result, Solvit
will need to recognise on its balance sheet for each lease, a right to use asset and a lease
liability, effectively grossing up the balance sheet. In most cases, the initial amount to be
recognised as an asset will be equal to the obligation to make future lease payments
(discounted as appropriate) but the asset value will also be adjusted for payments in
advance, lease incentives and costs. This treatment will apply to the car and equipment
leases and to the property leases, meaning large increases to both the assets and liabilities
shown in the statement of financial position.
After initial recognition, the asset will be depreciated over the shorter of its useful life and
the lease term and it is this depreciation charge, rather than the operating lease rentals
which will be the cost reflected in the profit or loss account. There may also be impairment
charges where a leased asset is impaired.
For the London offices, Solvit is now lessor as well as lessee – the lessor accounting is
largely unchanged and rental income will be accounted for as it falls due.
For the Northern office property, the sale and leaseback transaction will need to be
reconsidered under the specific accounting guidance of IFRS 16. The first consideration is
whether a sale has been made under IFRS 15. It seems likely that it has, in which case Solvit
will need to calculate the asset value of the rights retained and recognise a gain only on the
rights transferred. As the sale was at greater than fair value, the additional proceeds
received will be treated as financing from the buyer.
Examiner's comments
General points
Generally, this question was done very well and quite a lot of candidates scored high marks. The
most common reason for a candidate not scoring well was producing an unstructured answer
– mixing up the different sub-requirements of the question. So, for example, the answer would
start with a description of the key audit matters relating to revenue, but then would wander off
into a description of the financial accounting elements, with some vague audit procedures. The
answer might then develop into a description of other accounting and auditing issues, without
identifying why an area or transaction type might be regarded as a KAM. The questions are
structured to help candidates think through the issues.
(1) Key audit matters
The majority of candidates answered this requirement very well. Many candidates identified
the numerous factors making revenue a KAM as well as the separate issues arising during
the period.
(2) FR issues with KAM and audit objectives and procedures
Weaker candidates missed out either the financial reporting or the audit requirement.
Weaker candidates had problems describing adequate audit procedures and objectives.
Problems included failures to identifying the relevant assertions being tested and why
certain documents would be inspected.
From an FR perspective, the leaseback, onerous lease and revenue recognition rules (via
IFRS 15) were well discussed. The receivable and bonus issues were less confidently
attempted. Some failed to identify the relevant financial reporting standard as required in
the question. Some made errors, the most egregious and common of which was to identify
IAS 37 as relevant to allowances for bad and doubtful debts. A receivable is a financial
instrument and it is therefore subject to IFRS 9 and scoped out of IAS 37.

(3) IFRS 16
Knowledge of the IFRS rules was demonstrated but specific application to the scenario was
attempted by fewer candidates.

ICAEW 2019 Notes
Notes ICAEW 2019
ICAEW 2019 Notes
Notes ICAEW 2019
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Financial reporting questions

Audit and integrated questions

ICAEW 2019 Contents iii

July 2015 exam questions

November 2015 exam questions

July 2016 exam questions

November 2016 exam questions

July 2017 exam questions

November 2017 exam questions

iv Corporate Reporting ICAEW 2019

July 2018 exam questions

November 2018 exam questions

ICAEW 2019 Contents v

vi Corporate Reporting ICAEW 2019

ICAEW 2019 Financial reporting questions 3

At 30 June 20X1 34.0 33.6 67.6

4 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 5

6 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 7

8 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 9

Long-term debt 16.34

Accounts payable and accruals 7.91

Share capital 2.50

10 Corporate Reporting: Question Bank ICAEW 2019

*Note: On initial recognition of the investments in equity instruments, an irrevocable election

ICAEW 2019 Financial reporting questions 11

12 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 13

Retained earnings at 1 July 20X4 15,840 9,000

Exhibit 3: Outstanding financial reporting issues

14 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 15

16 Corporate Reporting: Question Bank ICAEW 2019

To: Marina Nelitova

ICAEW 2019 Financial reporting questions 17

DEBIT Cash £75m

DEBIT Cost of sales £33m

DEBIT Finance costs £0.9m

18 Corporate Reporting: Question Bank ICAEW 2019

Share capital Number of £1 ordinary shares

At 1 October 20X3 40m

ICAEW 2019 Financial reporting questions 19

20 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 21

Note: All calculations should be to the nearest £'000.

To: Anita Hadjivassili

22 Corporate Reporting: Question Bank ICAEW 2019

Other financial information

ICAEW 2019 Financial reporting questions 23

24 Corporate Reporting: Question Bank ICAEW 2019

ICAEW 2019 Financial reporting questions 25

26 Corporate Reporting: Question Bank ICAEW 2019

To: Frank Brown

Notes on outstanding matters

ICAEW 2019 Financial reporting questions 27