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The Institute of Chartered Accountants in England and Wales
CORPORATE REPORTING
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Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-78363-795-9
Previous ISBN: 978-1-78363-487-3
First edition 2014

Fifth edition 2018
All rights reserved. No part of this publication may be reproduced, stored in a

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prior written permission of the publisher.
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examinations, and should not be used as professional advice.
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library
Originally printed in the United Kingdom on paper obtained from traceable,

sustainable sources.
© ICAEW 2018
ii
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Accounting Standards, SIC and IFRIC Interpretations (the Standards). The
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iii
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 3 179
2 Mervyn plc 30 63 5 185
3 Billinge 30 63 7 189
4 Longwood 30 63 8 193
5 Upstart Records 30 63 11 196
6 MaxiMart plc 30 63 13 202
7 Robicorp plc 30 63 16 204
8 Flynt plc 30 63 18 209
9 Gustavo plc 30 63 20 213
10 Inca Ltd 30 63 21 218
11 Aytace plc 30 63 24 223
12 Razak plc 30 63 26 227
13 Finney plc 30 63 29 232
14 Melton plc 30 63 31 239
15 Fly-Ayres 30 63 34 243
16 Aroma 30 63 37 249
17 Kenyon 30 63 38 253
18 Snedd (July 2014) 30 63 40 256
19 BathKitz (November 2014) 26 55 42 262
Audit and integrated questions

20 Dormro 40 84 47 269
21 Johnson Telecom 40 84 50 275
22 Biltmore 40 84 54 282
23 Button Bathrooms 40 84 57 286
24 Hillhire 40 84 60 293
25 Hopper Wholesale 40 84 63 300
26 Lyght plc 40 84 65 305
27 Maykem 40 84 67 314
28 Sunnidaze 40 84 70 319
29 Tydaway 40 84 73 325
30 Wadi Investments 40 84 77 335
31 Jupiter 30 63 79 339
32 Poe, Whitman and Co 30 63 82 346
33 Precision Garage Access 30 63 84 353
34 Tawkcom 30 63 88 359
35 Expando Ltd 30 63 91 364
36 NetusUK Ltd 30 63 93 369
37 Verloc Group 30 63 96 372
iv Corporate Reporting
Time Page
allocation
Title Marks Mins Question Answer
38 KK 30 63 100 380
39 UHN (July 2014) (amended) 45 95 102 387
40 ETP (July 2014) 30 63 106 393
41 Couvert (November 2014) 40 84 109 398
42 ERE (November 2014) 34 71 112 406
July 2015 exam questions

43 Congloma 40 84 117 415
44 Heston 30 63 120 422
45 Homehand 30 63 123 429
November 2015 exam questions

46 Larousse 40 84 127 439
47 Telo 30 63 130 447
48 Newpenny (amended) 40 84 133 453

49 Earthstor 40 84 137 463
50 EyeOP 30 63 140 472
51 Topclass Teach 30 63 143 479

52 Zego 40 84 147 487
53 Trinkup 32 68 151 495
54 Key4Link 28 58 153 501

55 Konext 40 84 157 509
56 Elac 30 63 160 518
57 Recruit1 30 63 163 523

58 EF 40 84 167 531
59 Wayte 32 68 170 538
60 SettleBlue 28 58 173 544
Contents v
Exam
Your exam will consist of:

Three written test questions 100 marks
Pass mark 50
Time available 3.5 hours
The ACA student area of our website includes the latest information, guidance and exclusive resources
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vi Corporate Reporting
Question Bank
1
2
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. In addition, with regard to the trade receivables forward
contract, please state briefly the impact, if any, of the introduction of IFRS 9, Financial Instruments.
Using the trial balance and after making adjustments for matters arising from your review of the
outstanding issues (Exhibit 1) 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
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.
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 totaling £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
4 Corporate Reporting: Question Bank

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.
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) 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 benefits.
No tax deduction is allowed for contributions made to the scheme. 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.
Mervyn has a new arrangement with one particular customer that Mervyn will hold the goods that it
sells until such time as the customer needs them. The customer is invoiced for the goods when they are
ready for delivery, but they are held until the customer needs them. 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
Available-for-sale investments 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)
Available-for-sale
investments 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)
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 an IFRIC 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. Also, IFRS 9, Financial Instruments will come into force soon, and I'd like to
know how, if at all, the treatment will change. 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.
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. This investment was treated by Robicorp as an available-for-sale
financial asset.
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
available-for-sale reserve 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 'loans and receivables' under IAS 39, Financial Instruments:
Recognition and Measurement. No accounting entries have been made to date in respect of these
loans.
Once the accounting treatment for the loans has been determined, Robicorp wishes to continue
the same treatment when IFRS 9, Financial Instruments comes into force.
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)
Operating costs (3,296) (3,007)
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 existing rules and whether we can apply the
amended rules.
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 and the
property transferred. 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 IAS 18 and also whether there would be any difference in treatment 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

Inca Excelsior
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 year
ended 31 May 20X3
Prior to maternity leave, Meg prepared a first draft consolidated statement of profit or loss and other
comprehensive income and has noted some outstanding matters relating to transactions in the year
(Exhibit).
Please prepare a working paper which comprises:
 Advice, with explanations and relevant calculations, on the appropriate financial reporting
treatment of the outstanding matters highlighted by Meg in the Exhibit.
 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 deferred income. 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 twelve
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. The shares were
classified as available-for-sale. 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 1,308
17,433
Current assets
Inventories 1,140
Receivables 960
2,100
Total assets 19,533
Equity
£1 ordinary shares 2,800
Share premium account 7,400
Retained earnings 2,510
Available-for-sale reserve 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. The interest is payable annually in arrears. The bond is redeemable on 30 September 20X4
for £1.575 million. It is currently recognised in 'other financial assets' in the draft statement of financial
position at amortised cost, and has been classified as 'held-to-maturity'. The bond has an effective
annual rate of interest of 15%.
After paying the interest on its due date of 30 September 20X2, Imposter went into administration in
early October 20X2. It is estimated that only 40% of the maturity value will be repaid on the original
repayment date of 30 September 20X4. No further interest will be paid.
The annual market interest rate on a similar two-year, zero-coupon bond is 15% at 30 September 20X2.
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). Draft financial statements are shown in Exhibit 2.
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 Attachment 1. Discuss any further financial reporting consequences that may
arise in respect of these issues in future reporting periods including the implications of the future
implementation of IFRS 9, Financial Instruments.
Please could you also re-draft the financial statements in Attachment 2 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
(a) Sale of specialist mining equipment to Muzza Ltd
Finney sold a piece of specialist mining equipment to Muzza, on 1 October 20X1, for £5 million.
The terms of the transaction were that Muzza would pay for this equipment on 30 September 20X2
and incur an interest charge of 3% per annum until payment is made.
The market interest rate for companies with a similar risk profile to Muzza is 10% per annum.
Muzza contacted Finney in September 20X2 explaining that it is having financial difficulties, and
would not be in a position to make a payment on 30 September 20X2.
Muzza instead offered the following repayment schedule in full settlement of the equipment and
the interest obligation:
Date £'000
30 September 20X3 1,500
Following a discussion with a credit agency, we are confident that Muzza can meet the revised
schedule of payments. We therefore believe we should accept the proposal.
(b) Other trade receivables
The impairment of other trade receivables has been calculated using a formulaic approach which is
based on a specific percentage of the portfolio of trade receivables. The general provision approach
has been used by the company at 30 September 20X2. At 30 September 20X2, one of the credit
customers, Technica, has come to an arrangement with Finney whereby the amount outstanding
of £4 million from Technica will be paid on 30 September 20X3 together with a penalty of

£100,000. The total amount of trade receivables outstanding at 30 September 20X2 was £11 million
including the amount owed by Technica.
The following is the analysis of the trade receivables.
Cash to be
Balance received
£m £m
Technica 4 3.9*
Multica and other receivables 7 6.6
11 10.5
*£4.1m discounted at 5%
Finney has made an allowance of £520,000 against trade receivables which represents the
difference between the cash expected to be received and the balance outstanding plus a 2%
general allowance. Multica is one of Finney's largest customers and has a similar credit risk to the
'other receivables'. (Use a discount rate of 5% in any calculations.)
(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 believes it to be highly effective in offsetting changes in the fair value of the copper.
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) UK investment
On 1 October 20X0 Finney bought two million shares at £1.60 each, representing a 0.9%
shareholding, in Coppery plc. At the acquisition date there was no intention to sell the shares in
the short term.
The gain recognised in respect of the investment in Coppery in other comprehensive income for
the year ended 30 September 20X1 was £300,000.
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.
(e) Overseas investment
On 1 October 20X0, Finney bought ordinary shares in Bopara Inc, an unquoted American copper
mining company, for $15 million. The investment represented a 0.2% shareholding in Bopara and
was classified as available-for-sale.
At 30 September 20X1, Finney's shareholding in Bopara was valued, by a market analyst, at
$12.8 million. The reduction in value was due to changes in copper prices which affected share prices in
the sector. This was reflected in Finney's financial statements for the year ended 30 September 20X1.
In September 20X2 there was an explosion in one of Bopara's largest mines, which caused its
permanent closure. Finney's shareholding in Bopara decreased in value to $11.34 million at
30 September 20X2 as a consequence.

Relevant exchange rates were:
1 October 20X0 £1 = $1.50
30 September 20X1 £1 = $1.60
30 September 20X2 £1 = $1.62
Exhibit 2: 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
Available-for-sale financial assets 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 year ended 30 September
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 available-for-sale financial asset 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 a financial asset which had a carrying value
of £2 million at 1 November 20X7 for £3 million in cash. This asset had always been classified as
available-for-sale by the company and during the period in which it was owned £500,000 of
valuation gains were recognised directly in equity, and on which deferred tax was provided at
20%. Sally correctly included the current tax payable on the sale in the 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 ten 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.
18 Snedd (July 2014)

Snedd Enviroclean plc is engaged in the manufacture and supply of environmentally-friendly home
cleaning products. It was set up several years ago by its two founders and has been very successful.
Snedd is currently unlisted, but the company's founders, who are the two principal shareholders and
directors, plan to list the company on the AIM within three to four years. Snedd's accounting year end is
31 May.
Snedd has built up a substantial cash surplus and the directors decided in 20X3 to use this to achieve
growth, principally through investments in established businesses. On 1 June 20X3, Snedd made its first
acquisition, being 75% of the ordinary share capital of Bellte Ltd, a competitor company. On
1 December 20X3, Snedd made its second acquisition, being 100% of the ordinary share capital in
Terald Inc, an unlisted company in Distanlan, a foreign country.
You are Bill Smyth, the recently-appointed financial controller at Snedd.
You have been supplied with working papers, prepared by an assistant (Exhibit), which contain the
draft financial statements for Snedd and Bellte for the year ended 31 May 20X4, together with Terald's
trial balance as at 31 May 20X4. The working papers also include notes on outstanding issues prepared
by the Snedd finance director before he left on a trip abroad negotiating the acquisition of another
subsidiary.
The finance director has left you the following instructions:
 Set out and explain the correct financial reporting treatment, showing appropriate adjustments for
each of the outstanding issues I have identified.
 Prepare Snedd's consolidated statement of profit or loss and other comprehensive income for the
year ended 31 May 20X4 and a consolidated statement of financial position at that date. Please
take into account any adjustments for the outstanding issues and set out your workings showing
how you arrived at your consolidated figures so that I can understand them.
Requirement
Respond to the finance director's instructions. Total: 30 marks
Exhibit: Working papers
Draft statements of profit or loss and other comprehensive income for the year ended
31 May 20X4
Snedd Bellte
£'000 £'000
Revenue 8,511 2,186
Cost of sales (5,598) (1,544)
Gross profit 2,913 642
Operating expenses and finance costs (1,541) (502)
Profit before tax 1,372 140
Tax (354) (28)
Profit for the year 1,018 112
Other comprehensive income 600 –
Total comprehensive income for the year 1,618 112

Draft statements of financial position at 31 May 20X4
Snedd Bellte
£'000 £'000
Assets
Non-current assets
Financial assets (Notes 1 and 2) 900 –
4,412 1,463
Current assets 2,365 586

Equity
Share capital 300 30
Revaluation surplus 600 –
4,975 1,044
Non-current liabilities – deferred tax brought forward on

1 June 20X3 (Note 3) 92 46
Current liabilities (Note 4) 1,710 959
Notes on outstanding issues

(1) Investment in Bellte Ltd
On 1 June 20X3, Snedd acquired 75% of the ordinary share capital of Bellte for a cash payment of
£800,000. Snedd decided to value the non-controlling interest at its proportionate share of net
asset value. The fair value of the net assets acquired approximated to their carrying amount at
1 June 20X3 of £932,000, except for any adjustments arising from the following information:
 A contingent liability in respect of a product liability, which had not been recognised by Bellte
(but which was referred to in a note to Bellte's financial statements for the year ended 31 May
20X3) was estimated to have a provisional fair value of £20,000 at 1 June 20X3. This liability
was subsequently settled, on 1 October 20X3, for £40,000. An expense of this amount was
recognised in operating expenses in Bellte's individual financial statements on that date.
 Bellte purchased a bespoke soap-making machine for £100,000 on 1 June 20W8, when the
estimated useful life of the machine was 10 years, with a residual value of zero. The
provisional fair value of the machine, which is a specialised item of plant, was estimated on
1 June 20X3 to be £60,000 with a remaining useful life of five years. A specialist valuation firm
was requested to produce a fair value for the plant as at 1 June 20X3. Due to various delays,
the valuation work was not completed until 30 June 20X4. The valuer concluded that the fair
value of the plant at 1 June 20X3 had been £65,000. Snedd's policy is to recognise plant at
depreciated cost, and to recognise all depreciation in cost of sales.
(2) Investment in Terald Inc
On 1 December 20X3, Snedd acquired, for £100,000, 100% of the ordinary share capital of Terald
Inc, a company operating in the country of Distanlan. Terald's accountant has sent the following
trial balance at 31 May 20X4:
D$'000 D$'000
Revenue – 150
Cost of sales 112 –
Operating expenses 15 –
Income tax 3 –
Share capital – 10
Retained earnings at 1 June 20X3 – 140

D$'000 D$'000
Non-current assets 160 –
Current liabilities – 40
Current assets 50 –
340 340
The functional currency of Terald is the Distanlan dollar (D$). The carrying amount of the net
assets of Terald at the acquisition date was D$160,000, which approximated to fair value.
Terald uses Distanlan GAAP in preparing its financial statements. Distanlan GAAP is very similar to
IFRS. However, it differs in respect of the measurement of financial assets. Terald's non-current
assets at 31 May 20X4 include D$10,000, which is the cost of an investment in a derivative
financial asset acquired on 30 November 20X3. Distanlan GAAP requires measurement of this type
of financial asset, subsequent to acquisition, at cost. The fair value of the financial asset at 31 May
20X4 was D$15,000.
Relevant exchange rates are as follows:
At 1 December 20X3 £1 = D$2.0
At 31 May 20X4 £1 = D$2.2
Average for period 1 December 20X3 to 31 May 20X4 £1 = D$2.1
(3) Deferred tax
No adjustments have been made for deferred tax in the draft financial statements for the year
ended 31 May 20X4. At that date, Snedd had taxable temporary differences in respect of
accelerated capital allowances of £300,000. Also, at 31 May 20X4, Bellte had taxable temporary
differences in respect of accelerated capital allowances of £180,000. During the year ended 31 May
20X4, Snedd recognised a revaluation surplus of £600,000 in respect of its head office building. As
permitted by IFRS, Snedd's directors have decided not to make an annual transfer from the
revaluation surplus in respect of this revaluation. The revaluation surplus will be taxed when the
building is sold in the future. Snedd estimates that the appropriate tax rate for recognition of
deferred tax liabilities at 31 May 20X4 is 22%.
It may be assumed that no deferred tax adjustments are required in respect of any other items for
Snedd, Bellte or Terald.
(4) Payment of a supplier in ordinary shares
With effect from 1 April 20X4, Snedd's directors decided to adopt a policy of paying certain key
suppliers in Snedd's shares in order to ensure that the suppliers have a stake in the company's long-
term success.
On 1 April 20X4 Snedd issued 270 of its £1 ordinary shares to Whelkin Ltd, a supplier of soap
flakes, in full settlement of a trade payable amount of £6,000 which had been outstanding since
28 February 20X4. No accounting entries have been made to recognise this transaction, and the
payable of £6,000 is still included in Snedd's trade payables in the draft financial statements at
31 May 20X4. An external consultant has estimated that, at 1 April 20X4, one ordinary share in
Snedd had a fair value of £26.50.
19 BathKitz (November 2014)

You are an ICAEW Chartered Accountant employed as an analyst at the private equity firm, ADV
Investments (ADV), which owns 20% of the equity shares in BathKitz plc. BathKitz is an AIM-listed
company, which sells a range of flat-pack kitchens and bathrooms to building trade customers. Your
manager, who has recently been appointed a non-executive director of BathKitz, gives you the
following briefing:
"I have become increasingly concerned about ADV's investment in BathKitz. In particular, BathKitz's
revenue has increased, but there has been a net cash outflow from operating activities. The financial
controller of BathKitz provided me with some extracts from the draft financial statements for the year
ended 30 September 20X4 (Exhibit 1). I have performed some initial analysis on these and asked the
financial controller for explanations of some of the numbers. The explanations were emailed to me
today (Exhibit 2).

I have to go to a meeting now, so I would like you to review the draft financial statements extracts,
together with the explanations and prepare a briefing note for me. Specifically, in the briefing note I
would like you to:
(a) explain the appropriate financial reporting treatment for each of the matters in the email
(Exhibit 2) showing journal entry adjustments where possible. I will have the tax looked at
separately, so please ignore any current or deferred tax adjustments;
(b) prepare a revised statement of cash flows, after recording your correcting journal entries. Include a
note reconciling the adjusted profit before tax with cash generated from operations; and
(c) explain briefly why the revised statement of cash flows shows a net cash outflow from operating
activities despite an increase in revenue."
Requirement
Prepare the briefing note requested by your manager. Total: 26 marks
Exhibit 1: BathKitz draft financial statements extracts
Draft summary statement of profit or loss for the year ended 30 September 20X4
20X4 20X3
£'000 £'000
Revenue 617,000 553,000
Investment income 5,200 1,200
Finance costs (3,500) (1,000)
Income tax expense (10,000) (11,000)
Draft statement of financial position as at 30 September 20X4

20X4
£'000
ASSETS
Non-current assets
Investment property 12,000
Current assets
Inventories 93,062
Trade receivables 134,500
Cash and cash equivalents 18,622
246,184
Total assets 300,719

Share capital and share premium 70,000
115,339
Long-term borrowings 31,260

Trade and other payables 103,120
Current and deferred tax 23,000
Provisions 28,000
185,380

Draft statement of cash flows for the year ended 30 September 20X4
£'000 £'000
Profit before taxation 42,739
Adjustments for:
Depreciation 10,631
Increase in provisions 3,250
Gain on investment property (4,000)
Interest expense 3,500
56,120
Increase in trade receivables (53,978)
Increase in inventories (23,090)
Increase in trade payables 27,400
Cash generated from operations 6,452
Interest paid (3,500)
Income taxes paid (12,000)
Net cash used in operating activities (9,048)

Dividends paid (5,000)
Proceeds from issuing bonds 20,000
Net cash from financing activities 15,000
Net increase in cash and cash equivalents 5,952

Cash and cash equivalents at beginning of period 12,670
Cash and cash equivalents at end of period 18,622
Exhibit 2 – Email from financial controller

To: Manager, ADV
From: Financial controller, BathKitz
Subject: Explanations – BathKitz financial statements
Please find below the explanations as requested:
(1) Gain on investment property
The gain recognised of £4 million in respect of the investment property reflects a fair value increase
at 30 September 20X4 on BathKitz's property located in the TarkHill Shopping Centre. This
property is one of three similar properties at the same location. The other two properties were
owned by a company unconnected to BathKitz. This company sold one of the properties for
£9 million in April 20X4 to an investment company based in London and the other property to an
overseas investor for £12 million in May 20X4. The overseas investor was interested in making an
initial purchase in the property market in the UK and was therefore willing to pay a higher price
than local institutions would have been prepared to pay.
In accordance with BathKitz's accounting policy, I have revalued BathKitz's investment property to
a fair value of £12 million. The change in the property's fair value has been recognised in
investment income together with the rental income of £1.2 million.
(2) Increase in revenue
BathKitz supplies flat-pack kitchens and bathrooms to building trade customers. The BathKitz sales
managers are authorised to negotiate a discount with customers on the standard price list.
There are two explanations for the increase in revenue:
(a) Share option incentive scheme
Revenue increased because 100 managers have been motivated by the implementation of a
share option scheme on 1 January 20X4. At that date each manager was granted options over
10,000 shares at an exercise price of £5.80 per share, which was the market price at
1 January 20X4. Each option gives the right to buy one share in BathKitz. The options vest on
1 January 20X7 subject to the following conditions:

 The manager remains in the employment of BathKitz until 1 January 20X7.
 Revenue for their depot increases by an average of 10% per year over the three years of
the vesting period.
The fair value of an option was estimated to be £4.60 at 1 January 20X4 and £4.80 at
30 September 20X4. The price of one BathKitz share at 30 September 20X4 was £5.90.
At 30 September 20X4, all 100 managers were still employed, but the directors estimate that
six managers will leave the scheme before 1 January 20X7 when the options will vest.
As there is no cash cost to the company, no adjustment has been made to the financial
statements for the share options, but the motivational impact has already been seen in the
increase in revenue, particularly in the last three months of the year.
(b) New 'Pick and Collect' sales
Since incorporation, BathKitz has operated only by means of trade counter sales. Trade
counter customers visit a depot to order and collect their goods. The number of depots has
been constant for many years. Customers receive 60 days' credit and BathKitz recognises
revenue on collection of goods by the customer from its depots.
Following an internal review, a new online sales system was developed called 'Pick and
Collect'. The system allows trade customers to order goods online and collect directly from
the depot. To service this system, 10 new depots were opened on 1 July 20X4 in various
locations in the UK. Revenue from these sales is recognised when the order is placed online by
the customer and sales are made at a standard discount of 10% off list price and 60-day credit
terms. An analysis of revenue is as follows:
Year ended 30 September 20X4 20X3
£'000 £'000
Trade counter sales 804,550 737,334
'Pick and Collect' sales 54,560 –
Total trade discounts (242,110) (184,334)
Revenue after trade discounts 617,000 553,000
The 'Pick and Collect' sales have created problems with credit control as existing customers
continue to take 60 days' credit from when they collect their goods, which can be up to
two weeks after placing the order online. Receivables from 'Pick and Collect' customers were
£39 million at the year end, which included £10 million for goods sold and not collected.
(3) Decrease in operating profit margin from 9.5% (20X3) to 6.7% (20X4)
BathKitz installed automated storage and retrieval equipment in its depots. The equipment, which
is highly specific to BathKitz's business, was acquired by means of a lease with EG Capital. The
lease, which commenced on 1 July 20X4, has an implicit annual interest rate of 7%, and BathKitz is
required to make four annual payments of £4.7 million payable in arrears. The equipment could
have been purchased for a cash price of £16 million. A rental expense of £1.2 million, for the three
months to 30 September 20X4, has been included in operating expenses and in provisions. The
equipment has a useful life of six years with a zero residual value.
(4) New depot leases
BathKitz rents its 10 new depots from a property company called HYH on four-year operating
leases which commenced on 1 July 20X4. The total annual rentals have been agreed at £10 million.
However, as an incentive to sign the lease, HYH gave BathKitz an initial rent-free period of six
months, which means that BathKitz will pay £35 million in total. As the rent payment had not been
paid at the year-end, no charge has been made in the statement of profit or loss.
(5) Increase in long-term borrowings
To finance expansion, on 1 October 20X3 BathKitz raised £20 million by issuing, at par, 5% three-
year convertible bonds. The issue proceeds of £20 million have been credited to long-term
borrowings. The coupon interest has been paid to the bond holders on 30 September 20X4 and
has been recognised in finance costs for the year. The annual market rate of interest for a similar
bond with a three-year term, but no conversion rights, is 7%.
At the choice of the holders, the bonds can be either redeemed at par on 30 September 20X6 or
converted into ordinary shares in BathKitz at the rate of one ordinary share for every £10 bond
held.

Audit and integrated questions
20 Dormro
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.
Audit and integrated questions 47

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
Equity
Share capital 200
Retained earnings at 1 May 20X1 1,200
Profit for the year 500
Long-term borrowings 1,400
Current liabilities
Trade and other payables 1,380

Clearance from Harwanian auditors of Klip
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
21 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
The investments in both Cole plc and International Energy plc are designated as available for sale. In
previous years, any fair value gains or losses have been taken to the AFS reserve.
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
classified as held to maturity. 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 June 20X6 140,000 8,022 (7,000) 141,022
31 Dec 20X6 141,022 8,081 (7,000) 142,103
30 June 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
22 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
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

23 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 ten 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
Current service cost for the year 211.2
Contributions paid 192
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?
24 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 some 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

20X8 Draft 20X7 Audited
£'000 £'000 £'000 £'000
ASSETS
Non-current assets
Goodwill 12,000 5,000
Other intangible assets 40,680 28,740
Financial non-current assets 10,260 6,130
515,070 474,380
Current assets
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.
25 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
profit or loss' and are disclosed in a note to the financial statements as 'held for trading'. A gain has
been recognised in profit or loss 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%.

26 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 25th 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 ten-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 ten 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) At 30 April 20X8 an analysis of trade receivables showed the following:
£
Boulogne SA 1,200,000
Cristina 2,000,000
Other receivables 10,800,000
14,000,000
The amount due from Boulogne SA is denominated in Euros. All other receivables are denominated
in pounds sterling.
The £2,000,000 due from Cristina represents an amount due from the government of Cristina
which has been outstanding for some time. Considerable efforts by the sales director and his staff
have been required to recover previous amounts owed by the government of Cristina. However,
the Cristina Government has now agreed with Lyght that the £2 million that it owes will be paid
on 1 May 20X9, together with a late payment charge, in lieu of interest, of £100,000. The effective
interest rate at 30 April 20X8 is 8%.
The allowance for impairment of trade receivables is to be partly calculated using a formula to give
a general allowance. The company is proposing to calculate its year end allowance for receivables
as the £450,000 difference between balances owed and cash expected to be received, plus a
general allowance of 5%.

27 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 for efficiency reasons 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
Deferred income 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.
Deferred income
Deferred income represents 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 release of nearly £4 million of deferred income.
The deferred income 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.
28 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 ten jacuzzis. As the tenth 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 ten 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.
29 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 ten 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)
30 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
Property, plant & equipment 389
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.
31 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.

32 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 ten-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 ten 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
(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%.
33 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 recession. 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 30 9 months to 30 Year ended
June 20X6 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 the recession, 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 we are coming out of the recession).
 There are 80 eligible managers now. It is assumed that ten managers (all of whom are currently in
employment) will leave during each year and ten 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

34 Tawkcom
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 a new standard 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

Freehold Fixtures
land and Leasehold Network and Investment
buildings improvements assets equipment property Total
£'000 £'000 £'000 £'000 £'000 £'000
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 and other comprehensive income.
(3) Tawkcom disposed of land for £1.5 million recognising a profit on disposal in profit or loss of
£750,000. The contract was entered into on 31 July 20X9 conditional upon detailed planning
approval being granted. By 30 September 20X9 outline planning consent only had been granted.
Full planning consent was received on 20 October and the sale was completed on 30 October 20X9.
Sale proceeds were agreed to the cash book and bank statement. The cost of land was correctly
removed from the register of PPE and the profit on disposal correctly calculated.
Transfer from assets held for sale
In the financial statements for the year ended 30 September 20X8, a freehold property, surplus to
Tawkcom's requirements, was transferred out of PPE and shown separately as a non-current asset held
for sale. Our prior year audit files concluded that this treatment was correct on the basis that the
property was being actively marketed and a sale at its carrying amount of £3.9 million was considered
imminent.
This sale was not concluded and management has now decided to retain the property for the time
being until the property market has improved. To generate some return from the property,
management intends to divide the property into small office units which it will rent out as office space
under short-term rental agreements. In order to make this more attractive to prospective tenants,
Tawkcom will provide services such as telecommunications, reception, secretarial support and meeting
rooms. As the property is now being held for its investment potential, it has been transferred back into
PPE and designated as an investment property.
Depreciation charge for the year
The Tawkcom financial statements for the year ended 30 September 20X8 disclose the following
depreciation policy:
Depreciation is charged so as to write off the cost or valuation of assets over the following periods:
Freehold buildings 50 years
Leasehold improvements 20 years (the minimum term of the lease)
Network assets 20 years
Fixtures and equipment 3–10 years
For each category of asset, an expectation for the depreciation charge for the year ended was formed
using the above rates and taking into account the timing of additions and disposals.
The following points were noted:
(1) No depreciation has been charged on freehold buildings as these properties are carried at
valuations which the finance director believes reflect their market value at the reporting date and
the buildings are maintained to a high standard.
(2) The depreciation charge for network assets is considerably lower than expected. This is as a result
of a group wide review of useful lives conducted by head office. This review concluded that the life
of network assets is greater than 20 years and a revised useful life of 22 years has been applied to
all such assets. Calculations of the revised carrying amounts for a sample of assets were reviewed
and verified as accurately reflecting for each asset the unexpired portion of a 22-year life.

Exhibit 2: Extracts from the Group audit instructions for the Colltawk plc group for the year
ended 30 September 20X9
Risk of fraud and misstatement
The following key risks have been identified and should be considered by all subsidiary audit teams:
(1) The group has banking covenants on long-term bank loans requiring it to maintain a certain ratio
of non-current assets to net borrowings (defined as bank borrowings and lease creditors less cash).
As a result, management may have an incentive to overstate non-current assets or to understate
net borrowings.
(2) Subsidiary management participates in the group's bonus scheme. The level of bonus to be paid
depends on the performance both of the individual subsidiary and of the group as a whole.
Management may therefore have an incentive to overstate profit either at a subsidiary or group
level.
Materiality and reporting of misstatements
Pre-tax materiality for the Colltawk group audit is £4 million. All individual misstatements over £200,000
should be reported to the group audit team.
35 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 –
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
36 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 20X9 30 June 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
30
Conway Finance 750
700 28
650 26
Dalton Finance 600 24
550 22
(financial 500 20
450 18
controller) 400 16
350 14
Edwards Finance 300 12
250 10
200 8
Farley Finance 150 6
100 4
Lyndon Sales 50 2
s
ds
Ridley Finance
ay
as
ew
n
n
ar
do
ey
g
y
om
nw
h
lto
dr
le
on
ng
w
dl
n
r
An
Da
Co
Ed
Th
Fa
Ly
W
Ri
Si
Singh Finance
Average £17k £12k £53k £8k £13k £5k £15k £18k £18k £2k
Thomas Finance
Wong Sales
37 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 available for sale investments, including some unquoted shares, and accounts
for these in accordance with IAS 39, Financial Instruments: Recognition and Measurement. 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. He is also aware that the presentation may
change when IFRS 9, Financial Instruments comes into force.
(e) Verloc also disposed of an available for sale investment during the year to 30 September 20X9 for
£630,000, when the carrying value of the investment was £580,000. The gain on disposal of
£50,000 is included in administrative expenses in Verloc's individual financial statements. Previously
recognised gains associated with this investment of £40,000 have been recycled from other
comprehensive income to profit or loss (administrative expenses) in the draft consolidated financial
statements, although it had not been adjusted for in the individual statements of profit or loss and
other comprehensive income above.
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) – 40 recycled (1,797)
AFS gains (W7))
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)
Items that may be reclassified subsequently to profit or loss

Recycling of previously recognised gains on AFS investment (W7) (40)
Other comprehensive income for the year, net of tax 65
Total comprehensive income for the year 1,820
Profit for the year attributable to:

Owners of the parent 1,242
Non-controlling interest (W1) 513
1,755
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 x 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.

(7) Available for sale investment
On disposal (30 September 20X9), previous revaluation gains of £40,000 were reclassified from
other comprehensive income to profit or loss ('administrative expenses').
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.
38 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.
39 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. 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 hi-jacking 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.

40 ETP
You are Steph Carter, an audit senior with J&K LLP, a firm of ICAEW Chartered Accountants which audits
Erskin Technology plc (ETP).
You receive the following briefing from Lauren Haynes, the audit manager responsible for the ETP audit:
Welcome to the ETP audit team. This week you are scheduled to plan the ETP audit for the year ending
30 September 20X4. It's important we get the planning completed so we can focus on updating our
controls work on revenue at our interim audit visit next month.
I'm aware that you have not worked on ETP before, so I have provided some background information
from last year's audit file (Exhibit 1). I've also sent you a working paper setting out the results of
preliminary analytical procedures performed last week by our audit assistant, Joshi Khan (Exhibit 2).
Planning materiality has been set at £850,000.
Yesterday I received an email from the ETP finance director, Mari Johnson (Exhibit 3). She has asked us
for some advice and I'll need your help with my response.
You and I are scheduled to meet up later today. I would like you to do the following in preparation for
that meeting.
(a) In respect of the audit for the year ending 30 September 20X4:
(1) Prepare review notes on Joshi's work (Exhibit 2), which explain the weaknesses and limitations
in the procedures he has performed. Perform additional analysis where you think this is
required. Set out clearly the additional audit procedures you would like him to perform and
the queries you would like him to resolve when he returns to the client later this week to
complete the preliminary analytical procedures.
(2) Identify and explain the financial reporting issues and related audit risks you have identified
from the information provided, and outline, for each, the implications for our audit approach.
Detailed audit procedures are not required at this stage.
(b) Draft a response to Mari's email (Exhibit 3) that explains how a review of the interim financial
statements for the period to 31 March 20X5 would differ from a statutory audit and set out the
benefits of such a review for ETP.
Requirement
Respond to Lauren Haynes' requests. Total: 30 marks
Exhibit 1: Background information on ETP from J&K's audit working papers for the year
ended 30 September 20X3
ETP is a listed company which supplies data storage devices and secure archiving systems.
ETP has three main revenue streams:
Hardware
Hardware revenues are generated by sales of data storage devices which are manufactured for ETP by a
third party manufacturer in Asia. These devices are sold under the 'Stor-It' brand name which was
purchased by ETP for £5 million on 1 October 20X1, at which date the brand had a remaining expected
useful life of 10 years. At the same date, ETP invested £1.6 million in patents for a new range of 'Stor-It'
devices. These costs were capitalised as non-current assets. The new 'Stor-It' devices went on sale on
1 April 20X3 and were expected to have a market life of around four years from that date. Revenue from
sales of hardware is recognised when the hardware is delivered.
Systems
Systems revenue is generated from the sale of complete archiving and data storage systems comprising
hardware, software and related services. System projects typically take 6 to 12 months to deliver and
revenue is recognised on confirmation by the customer that the project is complete.
Services
Service revenue is generated by sales of training and consultancy. This is a very competitive market
segment. It has been historically important for ETP and remains a core part of the company's business
plan. Service revenue is recognised as the service is performed.

Exhibit 2: ETP audit for the year ending 30 September 20X4 – Preliminary analytical
procedures working paper prepared by Joshi Khan
This working paper considers the following key performance indicators identified by ETP:
 Revenue growth
 Gross margin
 Receivables – days sales outstanding (DSO)
This working paper compares actual performance reported in the company's interim financial
statements for the six month period to 31 March 20X4, with:
 the budget; and
 the average performance of a comparator group of companies identified during the audit for the
year ended 30 September 20X3 as being most closely aligned to ETP in terms of activity.
Comparisons are also made if applicable to performance in a prior period. Where actual results appear
out of line with budget or the comparative data, explanations have been sought from Julie Barwell,
Financial Controller, and notes from these discussions are documented below.
(1) Revenue growth
Total revenue for the 6 months ended 31 March 20X4 was as follows:
£m
Hardware 25.4
Systems 100.3
Services 17.9
Total 143.6
Revenue growth for the six months ended 31 March 20X4
Hardware Systems Services
% % %
ETP
Actual growth for six months to 31 March 20X4 (15.0) 25.0 12.0
Budgeted growth for six months to 31 March 20X4 5.0 10.0 1.0
Comparator group of companies

Average growth for six months to 31 March 20X4 5.0 6.0 (2.5)
Note 1 2 3
Notes
1 Hardware sales of Stor-It devices were disappointing in the first half of the financial year
following the introduction of cheaper and more advanced products by ETP's competitors.
From discussions with Julie, sales have continued to decline in the third quarter and storage
space for hardware inventory is becoming a problem.
2 Systems sales were very strong in the first half of the financial year. ETP reviewed its revenue
recognition policy for systems sales in October 20X3 and is now invoicing and recognising
revenue and associated costs as each project progresses. This resulted in the recognition of
additional revenue totalling £30 million on part-completed projects in the six months ended
31 March 20X4. The recognition of revenue on part-completed projects was not foreseen at
the time the budget was prepared and hence actual performance was significantly better than
budget.
3 Services revenues for training and consultancy were strong in the first half of the year despite
an overall decline in this sector of the market. Julie attributes this strong performance to the
introduction of an 'all in' advice package. Customers pay an up-front annual fee and are then
able to access telephone and online advice as and when they need it. They are also entitled to
discounts of up to 20% for the company's training programmes. This new service has proved
very popular and revenues of £5 million were received in the six months ended 31 March 20X4.
The up-front fees are recognised as revenue on receipt as they are not refundable.

(2) Gross margin
Hardware Systems Services
% % %
ETP
Actual margin for six months to 31 March 20X4 31.4 46.0 63.9
Budgeted margin for six months to 31 March 20X4 35.0 45.0 50.0
Actual margin for six months to 30 September 20X3 35.0 44.8 50.1

Average margin for 6 months to 31 March 20X4 42.0 44.7 50.3
Notes 4 5
Notes
4 Gross margin on systems sales for the six months to 31 March 20X4 is higher than budgeted
as the new projects that started during the period have generated margins higher than those
experienced on the older projects which have now been completed. These higher margins
were, however, offset by a loss recognised on a new project for a government department. At
31 March 20X4, this project was approximately 40% complete and revenue of £3.6 million
was recognised in the six months to 31 March 20X4. Costs incurred on this project in the
period amounted to £4.6 million giving rise to a £1 million loss.
5 The gross margin on services revenues is higher than expected due to the recognition of
£800,000 of training revenue relating to training courses held in September 20X3, but only
invoiced in October 20X3. Related costs were recorded in September 20X3.
(3) Receivables – Days sales outstanding (DSO)
ETP Days
Actual DSO as at 31 March 20X4 78.4
Budgeted DSO as at 31 March 20X4 66.0
Actual DSO as at 30 September 20X3 66.2
Average DSO for comparator group as at 31 March 20X4 65.0
Note 6
Note
6 Overall DSO increased to above the industry average and prior year, as customers were
generally slow to pay invoices for stage payments on systems sales. In addition, a number of
distributors for the 'Stor-It' hardware devices struggled to make timely payments as their sales
of the product fell and inventory levels increased.
Exhibit 3: Email from ETP finance director, Mari Johnson
To: LaurenHaynes@JK.com
From: MariJohnson@ETP.com
Date: 21 July 20X4
Subject: Interim audit
Hi Lauren
I was surprised when I joined ETP that we did not ask J&K to complete review procedures on our interim
results. I'd like ETP to do this in future, but I am having some difficulty persuading the board that we
should incur the additional cost. Please therefore provide me with a brief summary of the key benefits
that an interim review and report by J&K would provide.
ETP's budget for the year ending 30 September 20X5 forecasts revenue for the year to be £350 million.
The revenue growth is mostly attributable to a major systems sales contract with an overseas company
which will commence in April 20X5. ETP will prepare interim results to 31 March 20X5 and I think it
would be relevant information for our shareholders to recognise revenue evenly over the year and
therefore reflect half of this new contract revenue in the interim financial statements for the six months
to 31 March 20X5. A review and a report by J&K would add credibility to the interim financial
statements for our shareholders.

41 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 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$20 million.
Due diligence
Due diligence in respect of Couvert's acquisition of Ectal was carried out jointly by PG and Stepalia. The
principal member of PG's staff involved in the due diligence exercise was Mary, the PG audit manager
who has just left the firm.
Exhibit 2: Year-end financial information received from Ectal
The Ectal financial statements have been prepared in compliance with IFRS.
Ectal: Statement of profit or loss for the year ended 31 August 20X4
20X4 20X3
Actual 20X4 Budget Actual
C$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 20X3
Actual 20X4 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 including 8,557
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 available-for-sale financial asset, 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.
42 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 ten 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)
43 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
July 2015 questions 117

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, ten 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
Property, plant and equipment 150
Net current assets 50
Net assets 200
Given the nature of these assets and liabilities, their fair values are equal to their carrying amounts.
Disposal of 75% interest in Tabtop
Tabtop has been making losses for a number of years and is also incurring net cash outflows to an
extent that the Congloma group no longer wishes to fund. Its projected loss for the year ending
31 August 20X4 is £3 million. We have received an offer of £6 million for 75% of the Tabtop ordinary
shares which we believe we should accept. In addition, Congloma will retain a holding of 25% Tabtop's
ordinary share capital, which experts tell us would have a fair value of £1 million. Congloma would
continue to exercise some influence on the business through a seat on the board.
44 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, stating with a brief explanation whether the treatment of the cash flow hedge will
change when IFRS 9, Financial Instruments comes into force; 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)
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 30 June 20X5 5,600 6,000 12,000 23,600
Accumulated depreciation at 1 July 20X4 – (960) (3,400) (4,360)
Depreciation charge for the year ended
30 June 20X5 – (120) (860) (980)
Carrying amount at 30 June 20X5 5,600 4,920 7,740 18,260
Continuing activities:
(ie, the other three divisions)
Carrying amount at 30 June 20X5 32,200 34,700 28,500 95,400
Total carrying amount at 30 June 20X5 37,800 39,620 36,240 113,660
The buildings are being depreciated over a 50-year life to a zero residual value. The plant and
equipment is being depreciated on a 10% reducing balance basis. The company's policy is to
recognise all depreciation charges in cost of sales.
There were no acquisitions or disposals of property, plant and equipment during the year ended
30 June 20X5.
(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. No
accounting entries have been made in the draft financial statements.
45 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 financial
Statement of profit or loss position
Debit Credit Debit Credit
£'000 £'000 £'000 £'000
(1) Over-provision of warranty costs due to – 75 75 –
error in formula used to derive general
provision for warranty.
(2) Estimated over-valuation of inventory 115 – – 115
based on a sample testing of inventory
costs.
(3) Understatement of cost of sales due to 34 – – 34
lease of production machinery (see Note
below).
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 tax working papers. There were no disposals
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
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 2,180
20X5
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)
46 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).
Corporate responsibility disclosure and assurance
The board would like to discuss some proposals for corporate responsibility disclosure 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
November 2015 questions 127

(c) respond to the proposals from the board about corporate responsibility by:
 explaining the responsibilities of the Larousse Group's external auditors in respect of the
proposed corporate responsibility disclosures (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
46.1 Respond to the instructions in Hal Benny's email.
46.2 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 costs (4.7) (0.7) (1.4) (6.8)
Finance costs (1.6) – – (1.6)
Profit before tax 8.6 2.3 0.6 (1.0) 10.5
Income tax expense (1.7) (0.5) (0.2) (2.4)
Profit for the year 6.9 1.8 0.4 (1.0) 8.1

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

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

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 corporate responsibility disclosure 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 well-being 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 its corporate responsibility policies and disclosures.
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 integrated reporting to
stakeholders in a corporate 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.
47 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.

48 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
Number of manufacturing managers 30

Average value per individual order £2,343
Average value of monthly total orders per £45,864
manager
Frequency of managers exceeding 16
£90,000 in any one month
Frequency of managers exceeding zero
£100,000 in any one month (requiring
approval from senior manager)
Outliers
One manufacturing manager, John Fuller, was identified as an outlier showing the following data:
Test Outcome
Frequency of
Average value per individual order £3,246 value of individual
Average value of monthly totals of orders £64,379 orders for John Fuller for
the year
% of individual orders exceeding £4,000 35%
% of individual orders in last three days of 27% 35%
the month 30%
25%
Frequency of John exceeding £90,000 of 7 20%
orders in a month 15%
100%
5%
0%
Test 2: DAACA system - data dashboard
Test Outcome
Top 4 suppliers
Number of orders matched with GRN 13,546 Average no of days
Number of unmatched orders 1,175 delivery terms exceeded
Number of unmatched orders over 22

2 months old Wilson
Number of unmatched GRNs 17

Man Inc
UUP Ltd
Jones plc
-5 0 5 10

49 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.
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.
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.

50 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. HiDef classified its investment in 50,000 EyeOP
shares as an available-for-sale financial asset. 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
statement of 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
51 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.

52 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 20X5 20X5
Forecast Forecast
Ph244 Other PPE Ph244 Other PPE
£m £m £m £m
Balance at 1 November 5.8 10.0 0.3 8.9
Additions 1.8 2.2 6.0 1.5
Depreciation (0.5) (0.7) (0.5) (0.4)
Balance at 31 October 7.1 11.5 5.8 10.0
Intangible asset: research and development (R&D)

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

Recoverable amounts
(1) I believe it is unlikely that impairment losses will arise in respect of 'Other PPE' or 'Other R&D'.
(2) Included in the £7.1 million forecast for Ph244 PPE at 31 October 20X6 is £6.2 million for a
specially-constructed building for the production of Ph244. It is likely that this building could be
sold for £8 million if it were adapted for more general use. Adaptation costs are currently estimated
at £1.5 million. This building could continue to be used in Zego's business if future research and
development projects are undertaken.
(3) A market is likely to continue to exist for Ph244, although at a much reduced level of activity.
Estimated net cash inflows are:
Year ending 31 October 20X7 £1.4 million
We would need to discount these at around 8% per annum. No significant cash flows are expected
to arise after 31 October 20X9.

Exhibit 3: Zego Ltd – Draft financial statements for the year ended 31 October 20X6 –
prepared by Julia Brookes, Zego's financial controller
Zego Ltd: Statement of profit or loss for the year ended 31 October 20X6
20X6 20X5
£m £m
Revenue 24.8 31.4
Cost of sales (15.2) (18.8)
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
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

20X6 20X6 20X5 20X5
£m £m £m £m
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.

53 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
54 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.

55 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 device Konext sells are tablet computers. The following are the operating segments
used by the board to make strategic decisions:
1 Konext develops a software service specific for each client which enables the clients' employees to
access the clients' business processes. In each case, the software service contract includes data
security and storage services.
Konext buys mobile devices to which it uploads software specific to the client business. It then sells
the customised mobile devices to the client together with a software service contract.
2 Konext also sells other mobile devices to customers without customised software services.
3 Mobile device repairs for Konext clients and other customers are undertaken by a division of
Konext called 'Refone' (Exhibit 3).
Exhibit 2: Draft management commentary for the six months ended 30 June 20X4 prepared by
Jacky Jones, finance director
Financial performance
The Konext group had a good financial performance across all operating segments in the first half of
20X4.
Total revenue increased by 54.5% to £66.11 million in comparison with the equivalent six-month
period ended 30 June 20X3. Konext's sales of all mobile devices are seasonal, with 40% of mobile
devices delivered in the first six months of 20X4.
The directors forecast that total revenue for the year ending 31 December 20X4 will grow by 20% in
comparison with the year ended 31 December 20X3.
The directors estimate that the number of devices to be delivered in the year ending 31 December 20X4
will be as follows:
20X4 20X3
Number of devices Number of devices
Customised mobile devices 650,000 636,000
Other mobile devices 392,000 205,000
The combined gross profit margin on sales of customised mobile devices and software services has
increased from the 60% margin achieved in 20X3. The gross profit margins on sales of other mobile
devices and mobile device repairs have remained at 25% and 30% respectively.

Future prospects − New product, the Denwa+
Konext has signed a contract with JUI, a Japanese manufacturer of mobile devices. JUI will sell a new
device called the Denwa+ to Konext. This device will be sold exclusively by Konext to its customers
together with specific software and services where relevant. From August 20X4, sales of the Denwa+ will
gradually replace sales by Konext of its current mobile device.
All the Denwa+ devices will be sold with a guarantee of a replacement device if the original is damaged.
This guarantee will apply regardless of the reason for the damage.
An advertising campaign for the launch of the new Denwa+ device began in May 20X4 in anticipation
of the sales starting in August 20X4.
Information security issue
An information security issue in a Konext subsidiary is under investigation. There is no evidence that
client accounts have been compromised.
Exhibit 3: Summary of financial reporting issues – prepared by Menzie Mees
I have set out below some financial reporting issues. I am not sure that the transactions are correctly
treated in the draft consolidated interim financial statements.
Revenue
In June 20X4, Konext received deposits totalling £2 million from clients for the new Denwa+ device. The
clients will make final payments totalling £13 million on delivery of the devices on 1 August 20X4. These
clients will also receive a software service contract for two years and a free guarantee for replacement
should the device be damaged or faulty. Revenue in relation to these sales has been recognised in full
and presented in the interim financial statements as follows:
£'000
Customised mobile devices 10,000
Software services 5,000
15,000
An estimate of the cost of sales for these devices has been recognised in the interim financial statements,
assuming a gross profit margin of 60%.
Jacky, the finance director, said that we should recognise the Denwa+ sales in full because the contracts
were signed before 30 June 20X4 and are legally binding. Jacky added that, because the devices will be
delivered before 31 December 20X4, it does not make much difference whether we recognise the
revenue in the first or second half of the year.
Impairment of Refone
In January 20X2, Konext bought the trade and net assets of Refone, a mobile device repair business.
Refone's cash flow is independent of other group cash flows and it is regarded as a separate cash
generating unit. At 30 June 20X4, the carrying amounts of the net assets of Refone were:
£'000
Brand name 4,175
Goodwill 1,975
Inventory 225
Receivables 1,950
15,875
Payables and other liabilities (3,425)
Net assets 12,450
Recently Konext received an offer of £8 million after selling costs for the Refone trade and net assets.
Jacky told me that there is currently no plan to sell the business as the budget shows that it can
generate pre-tax cash flows of £1,200,000 per annum for the five years to 30 June 20X9. With a pre-tax
annual discount rate of 5%, Jacky believes this business can be a success. However, I wonder if there
should be an adjustment to reflect the fall in value of the assets.

Deferred advertising costs
In March 20X4, Nika, an advertising company, was engaged to market the new mobile device,
Denwa+. On 30 June 20X4, Konext recorded invoices totalling £1 million from Nika for marketing
services delivered by that date by debiting the statement of profit or loss and crediting the Nika payable
account. Konext has agreed to issue 100,000 of its £1 ordinary shares to Nika, in full settlement of the
£1 million owed to Nika. The date of the share issue is expected to be 1 September 20X4.
However, Jacky has accounted for the £1 million as a prepayment in the interim financial statements for
the six months ended 30 June 20X4 by debiting prepayments and crediting the statement of profit or
loss. She explained to me that the final cost for the marketing services will depend on the share price on
1 September 20X4 and it should, in any case, be matched against the deliveries of the Denwa+, which
start in August 20X4. I am concerned that this treatment is not correct.
Defined benefit scheme
Konext operates a defined benefit pension scheme for its senior executives and a defined contribution
scheme for other employees. Konext's employer contributions to the schemes for the six months to
30 June 20X4 have been charged to the interim statement of profit or loss as follows:
£'000
Defined benefit scheme 900
Defined contribution scheme 3,600
4,500
The service cost for the defined benefit scheme for the year ending 31 December 20X4 is expected to
be £2.8 million. The six-month interest rate to 30 June 20X4 on a selection of corporate bonds is
3.25%. The net benefit pension obligation of £2.3 million reported at 31 December 20X3 comprised
assets at fair value of £12.2 million and the present value of the obligations of £14.5 million. To date
the scheme has not paid out pensions or other benefits to beneficiaries of the scheme.
Jacky did not want to incur the cost of asking the scheme actuary to provide measurements of the
scheme's assets and liabilities at 30 June 20X4 as there have been no significant changes since the
actuarial valuation at 31 December 20X3. For simplicity, Jacky told me to charge the employer
contributions to the interim statement of profit or loss and leave the net pension obligation unchanged.
Exhibit 4: Confidential details about information security issue – prepared by Jacky Jones,
finance director
Last week the Konext IT department emailed me with details of a cyber attack on a Konext data server
in Poland. The data server held clients' business details and bank accounts. It is possible that data from
500 client accounts could have been accessed during the attack.
There is no evidence so far that client accounts were accessed, so we have not informed the clients.
However, there is some risk that clients could suffer a financial loss.
I have included a statement disclosing the security issue in my management commentary in the interim
financial statements. As this is still being investigated, I don't want to say too much publicly about it at
the moment. Further details will be announced in the year-end consolidated financial statements.
56 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) to Fenner 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) to Fenner 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 financial statements.
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.
57 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 to
audited financial statements and so perform audit procedures
Results are expected to be
work will be performed using
material to the Recruit1 group.
component materiality of £300,000
(A$600,000 as at 31 December 20X6).
Other non-UK subsidiaries £500,000 UK audit team to perform
(including R1-Elysia) review procedures for
unexpected fluctuations or
Results are not expected to be
material balances
material to the Recruit1 group.
Exhibit 2: Reporting memorandum received from the Hind audit team in Arca on 14 July
20X7
The table below sets out the audit procedures we have performed on the financial statements of
R1-Arca for the year ended 30 April 20X7 and highlights matters arising. All accounts have been agreed
to the consolidation schedules provided to Recruit1. These are reported in A$. 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, ensuring
expenses 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
(1,715) profit of A$4.9 million at the Arcan corporate tax rate of 35%.
Retained earnings at Reconciled to prior-year financial statements. Retained earnings as
1 May 20X6 reported to Recruit1 as at 30 April 20X6 were A$6,488,000.
The difference of A$2,250,000 is due to the reversal of revenue
which was incorrectly included in the reporting pack for the year
ended 30 April 20X6 as it relates to recruitment services provided in
May and June 20X6.
This error was discovered during the preparation of the financial
4,238 statements for the year ended 30 April 20X7.

Account A$'000 Notes on audit procedures and matters arising
at 30 April 20X7
Property, plant and 1,065 In accordance with group policy, property, plant and equipment is
equipment 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 materiality of
and prepayments A$600,000.
Cash and short- Agreed to bank statements or investment confirmations.
term investments 4,143
Total assets 8,787
Trade payables and 2,218 The only material balance within this account is A$1,715,000
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 incurred 750
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

58 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 twelve 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 made only small impairment allowances for specific trade receivables which it does
not expect to recover in full. Bob has now also asked us to establish a general allowance based on the
ageing of receivables that, at 31 August 20X7, amounts to £1.35 million. A general 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.
59 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: available-for-sale 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 an available-for-sale financial asset at
£430,000. 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. I understand that under IFRS 15, Revenue from
Contracts with Customers, it would be incorrect to recognise the service revenue immediately but
IFRS 15 is not yet mandatory and so I have applied IAS 18, Revenue.
(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%.
60 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 ten 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 an available-for-sale financial asset at its fair value of
£2 million. At 30 September 20X6, the SB board estimated the fair value of the investment to be
£2.5 million and an increase of £0.5 million was recognised in other comprehensive income.
On 1 January 20X7, John offered to sell his 600,000 shares to SB for £15 million. SB bought 40% of
John's shares on 1 January 20X7 for a consideration of £6 million. SB also holds a call option to buy
the remaining 60% of John's shares on 1 January 20X8 for £9 million.
On 1 January 20X7, John resigned as a director of CG. SB appointed two representatives to the CG
board as marketing and production directors. Since they joined the board, CG's performance has
improved significantly and this trend is expected to continue.
In SB's consolidated financial statements for the year ended 30 September 20X7, the investment in
CG is recognised at £8.5 million, as an available-for-sale financial asset, 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 matched 6,884 purchase invoice
to purchase orders
Average number of days from GRN to 10 days
receipt of purchase invoice
MAK Ltd
Number of GRNs not invoiced at 311

30 September 20X7 (GRNI) CG Ltd
Number of GRNs over 2 months old 156 UMD Ltd

not invoiced at 30 September 20X7
Average order value £1,900

Pegs Ltd
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 matched 732 40%
to purchase orders
35%
Average number of days from GRN to 21 days 30%
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%
0
0
40
10
80
50
70
1,
2,
2,
3,
-£
-£
-£
-£
-£
£0
01
01
01
01
£7
,4
,1
,8
£1
£2
£2

Answer Bank
177
178 Corporate Reporting: 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
 IAS 11 6
 FX House disposal 5
 Estate agency buildings 4
 Foreign currency receivable and forward contract 4
 Taxation 3
Total 25
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), IAS 11, Construction Contracts,
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
Financial reporting answers 179

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) 560.0
Cost of sales (322.4 + 18) 340.4
Gross profit 219.6
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 (17.3 + 3.4) (20.7)
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
(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 65.4 167.4
Long-term borrowings 80.0
Deferred tax liability (33 + 3.4) 36.4
Current liabilities
Trade and other payables (54.9 + 17.3) 72.2
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 IAS 11. This appears to be a contract specifically negotiated for the construction of an asset for
which a fixed contract price has been agreed.
IAS 11 requires revenue and costs to be recognised as contract activity progresses. There is a
significant amount of judgement required in determining the appropriate accounting policy and in
the assessment of progress to date.
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 determined.
Using the contract costs as a method of accounting for this contract, the contract is
((£18m/£22.5m) × 100 =) 80% complete. Therefore £27.2 million representing 80% of the
contract revenue would be recognised.
Using the certified sales method, 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:
Contract cost Work certified
basis basis
£m £m
Revenue 27.2 23.8
Cost of sales (18.0) (18.0)
Profit 9.2 5.8

Contract costs 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
Trade receivables (£17.0m – £17.0m) 0 0
An alternative presentation for the work certified method is to include the costs on the basis of the
work certified. This would result in an increase in the amount of profit recognised under this
method.
Work certified
£m
Revenue 23.80
Costs 70% × 22.5m 15.75
Profit 8.05
Work certified
£m
Gross amounts from customers
Costs 18.00
Recognised profit 8.05
26.05
Progress billings (17.00)
9.05
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 contract cost
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
Discontinued operations
Separate disclosure in the statement of profit or loss as 'discontinued operations' may also be
required.
The question of whether the closures are a withdrawal from the market is a question of 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 to be accounted for as a
hedge." 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.
IFRS 9, Financial Instruments has different criteria for hedge accounting. The 80–125% range is replaced
by 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. Otherwise the
accounting for cash flow hedges is unchanged.
Taxation
The following journal is required to adjust for current and deferred tax as noted in the assumptions:
DEBIT Income tax expense £17.3m
CREDIT Current tax obligation £17.3m
Being current tax adjustment – revised profit (86.1 – 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. There are two
possible methods.

One 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.
The other method looks at the substance of the arrangement. It treats the excess profit as a loan
paid back through higher lease rentals. Under IAS 39, Financial Instruments: Recognition and
Measurement the lease rentals must be split between the amount deemed to be a genuine lease
rental and the amount deemed to be a repayment of the loan.
The appropriate treatment here is (see (W1) for detailed calculations):
£
Loan repayment: Capital 33,000
Interest 20,000 Correct to charge
 Lease rental 27,000 to profit or loss
Total rental paid 80,000
The capital repayment element must be eliminated from the profit or loss and offset against the
loan.
Tutorial note:
Either method of recognising the amortised profit is acceptable. The amended profit computation
in (b) below uses figures from the first method, giving the second method based on IAS 39 as an
alternative.
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
2
Most likely 800 1/1.10 661 60% 397
Worst 1,500 1/1.10
3
1,127 15% 169
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:
 it is probable that delivery will take place;
 the goods are available and ready for delivery at the time that title passes;
 the buyer specifies the deferred delivery arrangements; and
 payment is under the usual terms of the seller.
In this case it would appear that these sales are bill and hold sales. There is an established
relationship with the customer and the arrangement has taken place during the year. Therefore the
revenue should be recognised when the title to the goods passes to the buyer which will be when
the goods are ready for delivery and the buyer has been invoiced. 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 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
Alternative calculation – IAS 39 method for sale and leaseback:

£'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)
Rental element treated as capital repayment (W1) 33
Pension contributions 405
Current service cost (374)
Interest cost (253)
Interest on plan assets 216
Share appreciation rights (50)
Transfers (400,000 – 350,000) (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 516
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

For alternative IAS 39 method only:
Loan repayment: repayment  3.791 = £200,000
200,000
Repayment =
3.791
= £53,000 (rounded)
Interest Capital
200,000  = 33,000
10% = 20,000
Remaining £27,000 (£80,000 – £53,000) represents operating lease rental.
(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
£'000
Net pension liability (2,625 – 2,090) (535)
Tax base (no deduction until benefits paid) (0)
(535)
Deferred tax asset @ 23% 123
Deferred tax asset b/f (85)
38
Credited to OCI re losses ((38,000 + 71,000) × 23%) (25)
 Credit to profit or loss for the year 13
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 (0.4)
value  1/3 vested)
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
Cumulative expense (1,000  500  75%  £5 at grant date  2/3) (1.25)
Excess 0.75
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
Tax base – inventories (£5m  ¾) (3.75)
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) 9.6
Deferred grant (£2m – £2m/5) (1.6) 8
Tax base (£12m – £2m) – [(£12m – £2m)  25%] (7.5)
Temporary difference 0.5
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) 4.8
Lease liability (£6m + [8%  £6m] – £1.5m) (4.98) (0.18)
Tax base 0
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
available-for-sale 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
Available-for-sale investments (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 – available-for-sale 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 (revised) 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
3
Deferred cash consideration (£10m/1.1 ) 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 identify

calculations, the appropriate financial implications of crossing control
reporting treatment of goodwill and threshold.
non-controlling interests for Liddle in
 Apply technical knowledge to
Upstart's consolidated statement of
distinguish between and calculate the
financial position as at 30 June 20X5.
deferred and contingent consideration.
Use the proportion of net assets
method to determine non-controlling  Identify the incorrect treatment of the
interests. 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 calculations, 9  Apply technical knowledge to

the appropriate financial reporting determine whether a provision should
treatment for the restructuring plans be recognised and calculate the
and the share options. amount of the provision.
 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 revised
statement of profit or loss for the year consolidated statement of profit or loss.
ended 30 June 20X5, to include Liddle.
Explain (without calculations) the 5 Assimilate information, and apply technical
impact on Upstart's consolidated knowledge to explain that NCI valuation
financial statements if the fair value 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 on-going 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 June 20X5 1 April 20X5 1 Oct 1 Jan
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 1/10/20X4 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 1/10/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)

Liddle
Upstart (9/12) Adjust Group
£'000 £'000 £'000 £'000
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
CR Cash 3,500
DR NCI 1,665
DR 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 1/1/20X3 to 1/10/20X4 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 1.10.20X4 At 30.6.20X5 Movement
£'000 £'000 £'000
2
Deferred cash (£3 million/1.09 ) 2,525 2,694 169
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
= 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 (revised 2011) 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

IFRIC 13, Customer Loyalty Programmes requires that reward points are treated as a separate
component of the sale. They should be measured at the fair value to the customer (effectively the
amount for which they could be sold separately). This amount should be deferred and recognised
in revenue when the reward points are redeemed.
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.
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).
Effectively MaxiMart has sold goods worth £102 million (ie, £100m + £2m) for a consideration of
£100 million. Thus allocating the £2 million between the two elements would mean that
£98.04 million (£100m/£102m × £100m) would be allocated to food revenue and the balance of
£1.96 million (£2m/£102m × £100m) to the reward points. £98.04 million would be recognised as
revenue in year ended 30 September 20X1 and £1.96 million would be deferred in the statement
of financial position until the reward points are redeemed.

(d) Futures contract
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 IAS 39. Hedge accounting can be
applied because the hedge has fallen within the required 80–125% effectiveness range (2/1.9 =
105%).
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
While the accounting treatment of cash flow hedges will not change under IFRS 9, Financial
Instruments, the somewhat arbitrary 80%–125% 'bright line' test of IAS 39 will be replaced with 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.
While the above criteria will certainly involve calculations, the assessment is more sophisticated and
arguably more realistic.
(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 determine
adjustments, with appropriate accounting treatment of the application.
accompanying journal
Identify need for amortisation of development costs.
entries, that are
required to make the Analyse and interpret journal to determine reversal of accrued
accounting treatment production costs required.
comply with IFRS,
Link information to determine the correct accounting treatment for
explaining the
the revenue from the XL5 order.
reasons for your
proposed changes. Apply technical knowledge to determine treatment of bond.

Explain the appropriate treatment required to reflect the share
option scheme and the adjustment required.
Calculate the profit on disposal of the Lopex shares and the
appropriate recognition of the investment in Saltor.
Identify the difference between the fair value and the face value of
the interest-free loan to the employees as being the cost to the
employer, to be treated as compensation under IAS 19.
Apply the IAS 39 rules in accounting for the loan at amortised cost
using the effective interest method.\
Revise the draft basic 8 Assimilate adjustments and prepare revised profit after tax.
earnings per share
Calculate basic EPS and diluted EPS.
figure (Exhibit 2)
taking into account
your adjustments and
calculate the diluted
earnings per share.
Total marks available 34
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 deferred income.
DEBIT Revenue (1,800  £25,000) £45m
CREDIT Deferred income £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.
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 32/39.
Because they were being treated as available-for-sale 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 an available-for-sale reserve 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. The deemed consideration would
be the fair value of the shares in Saltor at the takeover date of £5.5 million (400,000  2.5  £5.50). The
balance in the available for sale reserve should be transferred to profit or loss at the derecognition date.
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) £3.68m
DEBIT Available for sale reserve £1.28m
CREDIT Profit or loss account, gain on disposal £3.10m
At 30 September 20X4 the shares in Saltor should be remeasured at fair value, which per IAS 39 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
IAS 39, Financial Instruments: Recognition and Measurement requires financial assets (except those at
FVTPL) 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,
£'000
Face value of loan at 1 October 20X3 8,000
2
Fair value of loan at 1 October 20X3: (£8m/(1.06) ) 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.
Robicorp wishes to classify the loan under IAS 39 as 'loans and receivables'. It must therefore 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

If Robicorp wishes to continue to hold the loans at amortised cost under IFRS 9, Financial Instruments,
two criteria must be met under IFRS 9:
(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 criteria have been met. Accordingly, following the introduction of IFRS 9, the loan may continue
to be measured at amortised cost using the effective interest method.
Earnings per share
After taking into consideration the above changes basic earnings per share decreases to 83.4 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 82.9 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)
Gain on sale of Lopex 3,100
Fair value loss on Saltor (700)
Employee compensation (loan to employees) (880)
Interest on employee loan 427
Revised totals 33,371 40,000,000
Basic EPS 83.4 pence

(3)
Diluted EPS
£'000
Basic totals 33,371 40,000,000
Convertibles (see below) 2,478 3,000,000
Share options (free shares) – 232,611
Total 35,849 43,232,611
Diluted EPS 82.9 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 less than the basic EPS of 83.4p then the convertibles are dilutive and therefore must 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.
Journal entries are as follows:
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 year ended 31 May 20X6
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 comprehensive 27
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.
(3) Advise on how to account for the impaired receivable under current IAS 18 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
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

1.1.X6 (Kr 6) 30.9.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)

IAS 18 treatment
Under IAS 18, 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. However, no recognition would
be made, under current rules 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, for which current standards make no arrangements.
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 IAS 18 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 IAS 39; 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 the 12
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 set 8
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 comprehensive income.
(5) Director's loan
Given the issues in terms of recoverability of the loan, it should be written off and removed from
receivables. This will also result in an expense in profit or loss.
As the loan is to a director, it is likely to be treated as a related party transaction, and as such should
be disclosed in the notes to the financial statements. The writing off of the loan should also be
disclosed.
There are likely to be current tax implications of this loan write off and the Ruritanian tax treatment
of this would need to be ascertained.

Consolidation of subsidiary
Goodwill
As Excelsior is a subsidiary, goodwill arises at the acquisition date, and is restated at 30 April 20X1 using
the exchange rate at that date. The initial recognition of goodwill does not in itself create a deferred tax
consequence. This is because goodwill is only recognised in the consolidated financial statements.
The assets and liabilities of Excelsior at 30 April 20X1, after any adjustments to align IFRS and Ruritanian
GAAP, should be translated using the closing rate of exchange in the consolidated statement of financial
position, and at the average rate in the consolidated statement of profit or loss and other
comprehensive income. Any gain or loss arising in respect of the movement in exchange rates is taken
to other comprehensive income.
Goodwill should be subject to an impairment review at the end of the first year of acquisition. This is
especially important because of the post acquisition losses generated by Excelsior.
Goodwill with non-controlling 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

CUm
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 assets 71.0 71.0
Current assets
Accounts receivable 35.2 (2.0) 33.2
Cash 12.8 12.8
Total current assets 64.6 62.6
135.6 133.6
Equity and Liabilities
Share capital CU1 10.0 10.0
Share premium account 16.0 16.0
Retained earnings at acq'n 64.0 64.0
Net assets at acquisition 90.0 90
Loss since acquisition (16.0) (1.2) (1.4) 2.0 (2.6) 6.4 (2.0) (14.8)
Deferred tax 4.4 1.2 1.4 (2.0) 5.0
Loans 48.0 2.6 (6.4) 44.2
Current liabilities 9.2 9.2
The subsidiary is translated at the closing rate for the assets and liabilities in the statement of financial
position and average rate for loss for the year.
Statement of financial position for Excelsior
CUm Rate £m
PPE 64 4.5 14.2
Intangible assets 7 4.5 1.6
Current assets
Inventories 16.6 4.5 3.7
Trade receivables 33.2 4.5 7.4
Cash 12.8 4.5 2.8
133.6 29.7
Share capital 10 5 2.0

CUm Rate £m
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
Marking guide
Marks
 Advice, with explanations and relevant calculations, on the appropriate financial 26
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
Per IAS 18, Revenue, in relation to services, revenue should be recognised only when:
 the amount can be measured reliably;
 probable economic benefits will flow to Aytace; and
 the stage of completion at the SFP date can be reliably measured. At 31 May 20X3
Aytace had not provided any services to the broadcaster, and therefore no revenue
should have been recognised.
Therefore revenue should be reduced by £400,000 (£4.8m × 4/12 × ¼).
(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,
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 31/5/20X2) 4,800
Retained earnings to 1/9/20X2 (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 9
Golf/TV Pension accrual Options 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 went into administration shortly after the year-end requiring a write
down of the bond in Razak's financial statements. 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 the 12
financial statements of the Razak group.
Explain any adjustments needed to account for the purchase of the bond in Imposter plc 9
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 20X2 after 9
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
Per IFRS 3 the gains on the available for sale investment of £750,000 previously taken to OCI are now
transferred 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 profit or loss.
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 has been correctly measured at amortised cost of £1.308 million. As only 40% of the bond
will be repaid at 30 September 20X4, the bond must be reviewed for impairment and adjustment of
£832,000 made to impair the bond. This amount is written off to profit or loss (see W6).
Explanation of the adjustments needed to account for the purchase of the bond in Imposter and
evaluation of the ethical issues.
Ethical issues
First of all, both Andrew and Kay are chartered accountants and are both therefore bound by the ICAEW
ethical code.
If it was foreseeable that Imposter would be placed in administration and the bond 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)
Impairment
Other financial assets 1,308 (832) 476 W6
17,433
Current assets
Inventories 1,140 610 1,750

Receivables 960 400 1,360
Bank 0 70 70
2,100 1,080 3,180
Total assets 19,533 4,540 (871) 23,202
Equity
£1 ordinary shares 2,800 500 (500) 2,800
Share premium account 7,400 7,400
(2,740)
Retained earnings 2,510 2,740 192 2,702 W5
AFS 750 (750)
NCI 2,012 2,012 W4
13,460
1,641 + 74
(unwinding
Contingent consideration 1,715 1,715 6/12 months)
Other 2,788 2,788
Loan from Razak 800 (800)
Current liabilities
Bank overdraft 1,220 1,220
Trade payables 865 290 1,155
Tax payable 1,200 210 1,410
3,285 500 3,785
Total equity and liabilities 19,533 4,540 (871) 23,202
Consolidated statement of financial position

£'000
Non-current assets
Goodwill 8,826
Other financial assets 476
Current assets
Inventories 1,750
Receivables 1,360
Bank 70
Total assets 23,202
Equity
£1 ordinary shares 2,800
Share premium account 7,400
Non-controlling interests 2,012

£'000
Contingent consideration 1,715
Other 2,788
Current liabilities
Bank overdraft 1,220
Trade payables 1,155
Tax payable 1,410
WORKINGS
(1) Group structure
Razak's shareholding has increased from 15% to 80% therefore the investment should now be
accounted for as a subsidiary.
(2) Net assets
SFP Acquisition
£'000 £'000
Share capital 500 500
Fair value adjustment 1,400 1,400
Depreciation (six months) (140)
Total 4,500 4,440
Since acquisition (4,500 – 4,440) 60
(3) Goodwill
£'000
Original cost of 15% shares in Assulin 450
Revalue 15% shareholding to £16 per share at 30 Sept 20X1 to
AFS 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
Retained AFS reserve
earnings
£'000 £'000
Razak per draft 2,510 750
Transfer from AFS to RE 750 (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
Imposter – impairment of debt (832)
Total 2,702

(6) Imposter debt write off £'000
Cost 1,200
Interest @15% 180
Interest received @6% (72)
Carrying amount before impairment 1,308
PV of cash flows discounted for two years
at 15% 476
Impairment 832
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
(a) Review the information and 28 Identify the sale to Muzza is revenue and
prepare a briefing note, including finance income.
any relevant calculations, that sets
Identify the impairment of the receivable from
out the financial reporting Muzza in the current financial year.
consequences for the year ended
30 September 20X2 of the issues Deal correctly with the impairment of the other
contained in Attachment 1. trade receivables.
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.
Distinguish between impairment loss and
remeasurement of overseas investment.
(b) Redraft financial statements to 5 Identify how the information affects the
take account of the financial financial statements and revise them accurately.
reporting issues.
(c) Discuss any further financial 4 Communicate in an appropriate manner to
reporting consequences that may given audience.
arise in respect of these issues in
Identify future treatment and issue of
future reporting periods. recoverability of Muzza receivable.
Identify the future impact on profit if the copper
price falls.
Identify future impact due to change in
regulations (IFRS 9).
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) Sale of equipment to Muzza Ltd
The original transaction with Muzza should have been split into two elements, a sale of goods and
the finance income arising from the related financial asset.
The sale of goods should have been measured at the present value of the cash flows discounted at
the appropriate credit rate of 10%.
This would give revenue and initial receivable of £4.68 million (£5m  1.03/1.10) recognised on
1 October 20X1. Finance income of £470,000 (£5.15m – £4.68m) would be credited to profit or
loss, to give a total amount receivable at 30 September 20X2 of £5.15 million.
The problems encountered by Muzza indicate that an impairment review is needed, and the
2
receivable at 30 September 20X2 should be restated to £4.52 million (£1.5m/1.1 + £2m/1.1 +
3
£2m/1.1 ). The impairment of £630,000 (£5.15m – £4.52m) should be charged to profit or loss for
the year ended 30 September 20X2.
The journals are:
DEBIT Receivable £4.68m
CREDIT Revenue £4.68m
DEBIT Receivable £0.47m

CREDIT Finance income £0.47m

CREDIT Receivable £0.63m
Future accounting periods
Muzza is clearly having financial difficulties and therefore the potential for the debt not to be
honoured exists. Therefore each year the asset will be reviewed for impairment and the receivable
would need to be assessed for recoverability.
In addition the finance income will be credited to profit or loss each year on an amortised cost
basis over the period to when the debt is extinguished.
(b) Other trade receivables
IAS 39, Financial Instruments: Recognition and Measurement classifies trade receivables as 'loans and
receivables' since they are non-derivative financial assets with fixed or determinable payments that
are:
 not quoted in an active market
 not designated as at fair value through profit or loss
 not held for trading or designated as available for sale
IAS 39 requires that loans and receivables should be measured at amortised cost using the
effective interest rate method with gains and losses taken to profit or loss. This method, which
spreads the interest income over the life of the financial asset, may not seem appropriate for short-
term trade receivables with no stated interest rate, as they do not normally bring in any interest
income. IAS 39 allows such receivables to be measured at the original invoiced amount, if the
effect of discounting is not material.
As with other financial assets, however, IAS 39 requires an annual consideration of possible
impairment, in order to assess, at each reporting date, whether the receivable may be impaired.
The carrying value of the trade receivable must then be compared with the present value of the
estimated future cash flows. For other assets, the cash flows would be discounted at the effective
interest rate, but this is not normally required for trade receivables. Nevertheless, an estimate is
needed of the cash that will actually be received.
Finney has calculated the impairment using a formulaic approach. This is only acceptable if it
produces an estimate sufficiently close to that produced by the IAS 39 method. It is not acceptable
to use a formula based on possible trends. The general allowance of 2% is not acceptable,
because it is not based on past experience and is unlikely to be an accurate estimate of the cash
flows that will be received.

General allowance
Following the above, the general allowance will not be permitted under IAS 39.
Technica
Where it is probable that payment will not be received in full for a significant balance, an
allowance for impairment must be made.
It looks as if Technica will pay in full plus a penalty. However, the payment will be in a year's time,
and so discounting should be used to calculate any impairment.
Multica
Where, as in the case of Multica, there is no objective evidence of impairment, the individual
asset is included in a group of assets with a similar credit risk, and the group as a whole is
assessed for impairment. Multica has a similar credit risk to 'other receivables' and so will be
grouped in with those.
Allowance for impairment
This is calculated as follows.
Cash to be
Balance received
£m £m
Technica 4 3.9*
Multica and other receivables 7 6.6
11 10.5
*£4.1m discounted at 5%
Finney should reduce trade receivables by £11m – £10.5m = £500,000 (or show a balance of
£500,000 on the allowance account).
An allowance of £520,000 has been made, and this allowance is therefore overstated by £20,000,
so to correct:
DEBIT Receivables £20,000
(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.
For hedging rules to apply, Finney must:
 ensure the hedge relationship is designated;
 ensure the hedge relationship is formally documented at inception; and
 determine that the hedge is highly effective at both inception and throughout its life. For this
to be the case the movement in the fair value of the hedged item must be between 80 –
125% of the movement in the hedging instrument.
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. IAS 39 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.
Future accounting periods

The ability to apply hedging rules is dependent upon the effectiveness of the hedge. Should the
hedge become ineffective and the price of copper fall significantly, it would result in the loss
impacting on the profit in future accounting periods.
(d) UK investment – Coppery plc
These shares would be classified as available-for-sale because they were not being held for trading.
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)

£'000
Gain on derecognition 1,173
Amount recycled from OCI 300
Gain taken to profit or loss 1,473
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 available-
for-sale, 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 other comprehensive income. 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
DEBIT Other components of equity 0.3
CREDIT Gain on disposal 0.3
Gain on AFSFA in the year
£m £m
DEBIT Investment in Zoomla 0.4
CREDIT Other comprehensive income 0.4
Finance income in the year
£m £m
DEBIT Receivable 0.013
CREDIT Finance income 0.013
(e) Overseas investment – Bopara Inc
As the investment is classified as available-for-sale it should be measured at fair value at each
reporting date using the closing rate of exchange. Gains and losses should be recognised in an AFS
reserve in equity, and should be recognised in other comprehensive income.
At the acquisition date the investment in Bopara would have been measured at its cost of
£10 million ($15m/1.5) and restated to £8 million ($12.8m/1.60) at 30 September 20X1. The
decrease of £2 million is debited to other comprehensive income as there was no evidence of
impairment.
Also, IAS 39 para 55(b) states that "a gain or loss on an available-for-sale financial asset shall be
recognised in other comprehensive income except for impairment losses and foreign exchange
gains or losses". However in IAS 39 Appendix A para AG83 it makes clear that only foreign
exchange gains and losses on monetary assets and liabilities should be recognised through profit or
loss and the Bopara investment is an equity instrument and therefore is a non monetary item.
Specifically, para AG83 makes clear that 'For available-for-sale financial assets that are not monetary
items under IAS 21 (for example equity instruments), the gain or loss that is recognised in other
comprehensive income under para 55(b) includes any related foreign currency exchange
component'.
The mine explosion however would be deemed to be an impairment, and so when restated to
£7 million ($11.34m/1.62) at 30 September 20X2 the decrease in value of £1 million should be
charged to profit or loss as an impairment loss.

In addition, there will be a reclassification adjustment, reclassifying losses accumulated in other
comprehensive income to profit or loss in accordance with IAS 39, para. 67. Accordingly, there will
be a reclassification adjustment to profit or loss of £2 million. Together with the additional
impairment in the current year of £1 million, this gives a total charge to profit or loss of £3 million.
The portion of the cumulative net loss in OCI attributable to changes in foreign currency is now
recognised in profit or loss as part of the £2 million reclassification adjustment (per IAS 39,
IG E4.9).
Future reporting periods
The treatment in future reporting periods would depend upon whether falls in share prices are in
respect of impairment to the underlying assets.
The journal in the current period would be:
DEBIT Profit or loss £1 million
CREDIT AFSFA (Bopara) £1 million
New IFRS covering financial instruments: IFRS 9
On recognition, IFRS 9 requires that financial assets are classified and measured at either:
 amortised cost; or
 fair value.
This classification is made on the basis of both:
(a) the entity's business model for managing the financial asset; and
(b) the contractual cash flow characteristics of the financial asset.
In future periods where there is a change in business model the classification of the financial asset
will change. Thus for the investment in Bopara it can no longer be classified as available-for-sale as
this classification will not exist when IFRS 9 is adopted. The fair value treatment through other
comprehensive income will however continue unless the asset becomes held for trading.
On adoption of IFRS 9 the treatment is normally retrospective so if a classification changes then the
recognition is as though it had always been in the new classification. The above treatment may
therefore be altered retrospectively in future years when IFRS 9 is adopted by Finney.
(2) Statement of profit or loss and other comprehensive income for year ended 30 September 20X2
Other
trade Copper Overseas
Draft Equipment receivables contract Coppery Zoomla investment Revised
20X2 20X2
£m £m £m £m £m £m £m £m
Revenue 194 4.68 198.68
Cost of sales (111) (111.00)
Gross profit 83 87.68
Operating costs (31) (0.63) 0.02 (3) (34.61)
Gain on disposal 1.17

– 0.30 1.47
Operating profit 52 54.54
Finance income 3 0.47 0.01 3.48
Hedging loss – (0.05) (0.05)
Interest payable (16) (16.00)
Profit before
taxation 39 41.97
Taxation (8) (8.00)
Profit for the
year 31 33.97

Other
trade Copper Overseas
20X2 20X2
£m £m £m £m £m £m £m £m
Other
comprehensive
income 7 (0.3) 0.4 7.10
Total
comprehensive
income for the
year 38 41.07
Statement of financial position as at 30 September 20X2

Other trade Copper Overseas
20X2 20X2
£m £m £m £m £m £m £m £m
Non-current
assets
Property,
plant and
equipment 84 84.00
Available-for-
sale financial 4.4
assets 36 (3.5) 0.4 (1) 36.30
Other financial
assets 10 0.95 10.95
Inventories 66 (1) 65.00
Receivables 56 4.68 0.02 0.01 60.82
0.47 0.27
(0.63)
Total assets 252 257.07
Share capital:
£1 shares 75 75.00
Retained
earnings 97 4.52 0.02 (0.05) 1.48 (3) 101.97
Other
components of
equity 24 (0.3) 0.4 2 24.10
Non-current
liabilities 27 27.00
Current
liabilities
Trade
payables 18 18.00
Overdraft 11 11.00
Total equity
and liabilities 252 257.07

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%

20X7 20X6
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, making ratios.
adjustments where required and 6 Explain, with supporting calculations, the
explain the financial reporting correct treatment of the share options.
issues.
6 Calculate and show the treatment of the gain
on the AFSFA and related deferred tax.
7 Redraft financial statements and make
appropriate adjustments to ratios.
5 Choose and calculate useful additional ratios.
5 Comment on performance.
5 Comment on position.
4 Identify useful further information.
1 Communicate in an appropriate manner to
given audience.
15.2 Discuss any ethical implications of 3 For Tom Briar, identify issues of professional
the scenario for Tom Briar and his competence and conflict of interest.
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 available-for-sale financial asset, 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
Share AFSFA adj 20X8
20X8 draft option adj adjusted
£m £m £m £m
Revenue 158.4 158.4
Cost of sales (137.3) (137.3)
Other income 0.5 1.5 2.0
Other costs (7.6) (0.5) (8.1)
Profit from operations 14.0 15.0
Profit before taxation 3.6 4.6
Taxation (1.4) (1.4)
Other comprehensive
income (reclassification
adjustment for gains
included in profit or loss,
net of tax (W)) 30.0 (0.4) 29.6
Total comprehensive 32.2 32.8
income for the year
Adjustments to statement of financial position as at 31 October 20X8

Share option AFSFA adj 20X8
20X8 draft adj adjusted
£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 receivables 9.3 9.3
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 other 54.3 (0.5) + 1.1 55.4
reserves 0.5
Equity 109.3 110.4
Borrowings and obligations 150.2 150.2
under finance leases
Maintenance provisions 5.2 5.2
Deferred tax liability 2.1 (0.1) 2.0
157.5 157.4
Current liabilities
Trade and other payables 18.4 18.4
Taxation 1.6 1.6
Borrowings and obligations 8.6 8.6
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% 3.2/110.4 2.9%
funds (ROSF)
Non-current asset turnover 158.4/274.9 0.58 158.4/272.9 0.58
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% 15/158.4 9.5%
WORKING: Profit on sale of available-for-sale financial asset

£m
Proceeds 3.0
Carrying value at 31 October 20X7 (2.0)
1.0
Gains reclassified to profit or loss from other comprehensive income 0.5
Gain on sale 1.5
This figure (gross of tax) will be included in other income. The current tax effect of the gain is
already included in the income tax expense by Sally per the question.
In addition the gain reclassified to profit or loss will appear in other comprehensive income,
net of the deferred tax previously provided:
£m £m
DEBIT Other comprehensive income (0.5  80%) 0.4
DEBIT Deferred tax liability (0.5  20%) 0.1
CREDIT Profit or loss 0.5
(included in
the gain
above)
Other relevant entries are:
£m £m
DEBIT Cash 3
CREDIT AFSFA 2
DEBIT Other reserves 0.4
CREDIT Retained earnings 1.5
Since retained earnings and other reserves are merged in the statement of financial position,
the bottom two entries above give a net credit of £1.1 million.
(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 available-for-sale financial asset. Further
ratios could be calculated. For example:
20X8 20X7
Cost per passenger, excluding interest ((137.3 +
6.1)/3.722) and ((103.8 + 5.2)/3.163) £38.53 £34.46
Cost per passenger, excluding interest and fuel cost
((137.3 + 6.1 – 57.7)/3.722) and ((103.8 + 5.2 –
36.4)/3.163) £23.03 £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 + 6.1) as % of
158.4) and ((103.8 + 5.2) as % of 138.3) 90.5% 78.8%

20X8 20X7
Return on capital employed (15.0 as % of (110.4 +
150.2 + 8.6 – 14.2)) and (29.3 as % of (77.0 + 123.7 +
9.2 – 7.4)) 5.9% 14.5%
ROSF for 20X8 excluding effects of revaluation (3.2 as
% of (110.4 – 30.0)) 4.0%
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 (15.0/10.4) and (29.3/10.0) 1.44x 2.93x
Current ratio (23.5:28.6) 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 2.0% (3.2 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 2.9% 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
£38.53, 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 8p (to
£23.03 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 1.44 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 £3.2 million,
and so there must be at least one other reserve to account for the difference. Although a
movement of £0.2 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 = PBIT/(Debt + 540 + 43 307 + 34
Equity – Investments) = 33.3% = 21.8%
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
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 liabilities 1,715 1,532
= 3.98 = 4.05
431 378
Quick ratio = (Current assets – 1,715  1,260 1,532  1,180
Inventories)/Current liabilities = 1.06 = 0.93
431 378
Inventory days = (Inventories/Cost of sales)  365 1,260 1,180
×365 = 113 days ×365 = 166 days
4,083 2,590
Receivable days = (Receivables/Revenue)  365 455 310

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

×365 = 32 days ×365 = 53 days
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
Marks
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:
No liability Liability of £13m Liability of £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
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)

18 Snedd (July 2014)
Scenario
This question involves adjusting the financial statements of three companies (a parent and two
subsidiaries), and applying the principles of acquisition accounting to produce consolidated financial
statements. The most recently acquired subsidiary is based overseas, and its results and position (in the
form of a trial balance) require translation. Other issues covered include adjustments within and outside
the measurement period, an adjustment to the overseas financial statements in order to comply with
IFRS, payment of a supplier in ordinary shares and deferred tax adjustments.
Marking guide
Marks
 For each of the outstanding issues I have identified, set out and explain the correct
financial reporting treatment, showing appropriate adjustments.
– Acquisition of Bellte 8
– Acquisition of Terald 7
– Share-based payment 3
– Deferred tax 4
 Prepare Snedd's consolidated statement of profit or loss and other comprehensive
income for the year ended 31 May 20X4 and a consolidated statement of financial
position at that date. Take into account any adjustments for the outstanding issues
and set out your workings showing how you arrived at your consolidated figures so
that I can understand them. 8
Explanation of the correct financial reporting treatment, showing appropriate adjustments

(1) Acquisition of Bellte
Goodwill on the acquisition date of 1 June 20X3 was originally calculated as follows:
£'000 £'000
Consideration transferred 800.0
Non-controlling interest (25%  £922) 230.5
1,030.5
Net assets acquired
Net assets at carrying amount 932.0
Less contingent liability at fair value (20.0)
Add fair value uplift in specialist plant (£60,000 – £50,000 (W)) 10.0
922.0
Goodwill on acquisition 108.5
WORKING
Carrying amount of specialist plant at 1 June 20X3: 5/10  £100,000 = £50,000
However, the goodwill amount of £108,500 was based upon provisional values. IFRS 3, Business
Combinations, requires that during the measurement period following acquisition the acquirer
should retrospectively adjust provisional amounts recognised at the acquisition date to reflect new
information obtained about the facts and circumstances that existed at the acquisition date.
In this case, the settlement of the contingent liability occurred within the measurement period
(which cannot exceed 12 months). The valuation of the specialist plant, however, did not occur
until after the 12 months had elapsed, and therefore the provisional fair value cannot be
retrospectively altered.

The recalculation of goodwill is as follows:
£'000 £'000
Non-controlling interest (25%  £902) 225.5
1,025.5
Net assets acquired
Net assets at carrying amount 932.0
Less contingent liability at fair value (40.0)
Add fair value uplift in specialist plant (£60,000 – £50,000 (W)) 10.0
902.0
Goodwill on acquisition 123.5
Goodwill is increased by the group's share of the additional value of the contingent liability
(£40,000 – £20,000)  75% = £15,000. NCI at acquisition is decreased by £5,000.
Tutorial note:
Journal entries are required as follows:
£'000 £'000
DEBIT Goodwill 15
DEBIT Non-controlling interests 5
DEBIT Contingent liability recognised 20
CREDIT Bellte operating expenses 40
Treatment of specialist plant:

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

First, an adjustment must be made in respect of the measurement of the financial asset. The
increase in fair value is D$5,000 which must be recognised as a gain in profit or loss, and as an
increase in the carrying amount of the asset.

Profit for the year in Terald is D$20,000 (Revenue L$150,000 – cost of sales D$112,000 – operating
expenses D$15,000 – tax D$3,000) before accounting for the fair value increase in respect of the
financial asset, all of which is attributable to the post-acquisition period. Of the D$20,000 profit
half is attributable to the pre-acquisition period (first six months of the year) and half is attributable
to the post-acquisition period. Therefore, equity at the date of acquisition, 1 December 20X3, was
D$160,000 (Share capital D$10,000 + Retained earnings at 1 June 20X3 D$140,000 + Pre-
acquisition profit: D$10,000).
The amounts to be consolidated by Snedd are therefore as shown in the table below. In
compliance with IAS 21, The Effects of Changes in Foreign Exchange Rates, profit or loss items are
translated at average rate, and financial position items are translated at closing rate.
Profit or loss
D$'000 Rate £'000
Revenue (150/2) 75 2.1 35.7
Cost of sales (112/2) (56) 2.1 (26.7)
Gross profit 19 2.1 9.0
Operating expenses (15/2) (7.5) 2.1 (3.6)
Other income (fair value increase in financial asset) 5 2.1 2.4
Profit before tax 16.5 2.1 7.8
Tax (3/2) (1.5) 2.1 (0.7)
Profit for the six months ended 31 May 20X4 15.0 2.1 7.1

D$'000 Rate £'000
Non-current assets (160 + 5) 165 2.2 75.0
Current assets 50 2.2 22.7
Total assets 215 97.7
Current liabilities 40 2.2 18.2

Therefore: equity 175 2.2 79.5
215 97.7
Reconciliation of exchange gain/loss

Opening net assets of £80,000 (D$160/2) plus profit of £7,100 = £87,100. Closing net assets at
closing rate = £79,500. Therefore there has been an exchange loss of £7,600 (£87,100 – £79,500):
Exchange loss
£'000 £'000
Opening net assets of L$160 at opening rate of 2.0 80.0
Opening net assets of L$160 at closing rate of 2.2 72.7
7.3
Profit for the six months ended 31 May 20X4 of D$15.0 at average rate of 2.1 7.1
Profit for the six months ended 31 May 20X4 of D$15.0 at closing rate of 2.2 6.8
0.3
Exchange loss 7.6
Goodwill on consolidation is calculated as follows:

D$
Consideration transferred: £100,000  2.0 200,000
Less net assets of Terald at date of acquisition (160,000)
Goodwill 40,000
On 1 December 20X3, the sterling equivalent of goodwill was D$40,000/2 = £20,000.

This is retranslated on 31 May 20X4 at the closing rate of exchange of 2.2 = D$40,000/2.2 =
£18,200 (to nearest £'000). There has therefore been a loss on exchange of £20,000 – £18,200 =
£1,800.
The overall exchange loss of (£7,600 + £1,800) £9,400 is recognised in other comprehensive
income.

(3) Deferred tax
Temporary differences for Snedd at 31 May 20X4:
£'000
In respect of accelerated capital allowances 300
In respect of revaluation surplus 600
900
Deferred tax liability to be recognised: £900,000  22% 198
At 31 May 20X3 Snedd's deferred tax balance was £92,000. A further £106,000 is required to
increase the deferred tax balance at 31 May 20X4 to £198,000. The element of deferred tax
relating to the revaluation surplus must be calculated and presented separately in other
comprehensive income:
£600,000  22% = £132,000. This leaves a credit of £26,000 (£132,000 – £106,000) to be
credited to income tax expense.
Temporary differences for Bellte at 31 May 20X4 are £180,000. Calculated at 22%, the deferred
tax liability to be recognised is £180,000  22% = £39,600. The deferred tax balance at
31 May 20X3 was £46,000, and therefore the adjustment required is to debit deferred tax and
credit income tax expense in profit or loss with £46,000 – £39,600 = £6,400.
The debit to other comprehensive income is £132,000
The total credit to consolidated income tax expense is £26,000 + £6,400 = £32,400
The total credit to consolidated deferred tax is £106,000 – £6,400 = £99,600
(4) Payment of a supplier in shares
The issue of shares to Whelkin Ltd falls within the scope of IFRS 2, Share-based Payment. It is an
equity-settled transaction because, essentially, Snedd has received goods in exchange for an issue
of shares. This type of transaction, with a third party, is normally measured at the fair value of
goods and services received, and should be recorded when the goods are received. The fair value
of the issue of 270 shares to Whelkin is therefore measured at £6,000 which is the value of the
goods provided to Snedd. The consultant's estimate of the fair value of Snedd's shares at
31 May 20X4 is not relevant.
The prescribed accounting treatment is to recognise the fair value of the goods provided in profit
or loss, with a credit to equity. In this case, the fair value of the goods has already been recognised
in profit or loss as part of purchases of goods for production. The adjusting entry is to derecognise
the trade payable of £6,000 from current liabilities, with a corresponding credit to equity.
Snedd Group – Consolidated statement of profit or loss and other comprehensive income for the
year ended 31 May 20X4
£'000
Revenue 10,732.7
Cost of sales (7,170.7)
Gross profit 3,562.0
Operating expenses and finance costs (2,004.2)
Profit before tax 1,557.8
Tax (350.3)
Profit for the year 1,207.5
Other comprehensive income 458.6
Total comprehensive income for the year 1,666.1

Owners of the parent 1,168.4
Non-controlling interests (W1) 39.1
1,207.5

Owners of the parent 1,627.0
Non-controlling interests 39.1
1,666.1

Snedd Group – Consolidated statement of financial position at 31 May 20X4
£'000
ASSETS
Non-current assets
Goodwill 141.7
Property, plant and equipment 5,058.0
5,199.7
Current assets 2,973.7

Total assets 8,173.4

Equity attributable to owners of the parent
Share capital 306.0
Retained earnings (W2) 4,225.4
Other components of equity 458.6
4,990.0
Non-controlling interests (W1) 264.6
Deferred tax 237.6
Current liabilities 2,681.2
Total equity and liabilities 8,173.4
WORKINGS
(1) Non-controlling interests – Bellte
£'000
At 1 June 20X3 (as in revised goodwill calculation) 225.5
NCI share of profit for the year: (£112 + 40 (Contingent liability) – 2 39.1
(additional depreciation) + 6.4 (deferred tax – see section 3)  25%
At 31 May 20X4 264.6
(2) Consolidated retained earnings

£'000 £'000
Snedd: £4,075,000 plus deferred tax £26,000 4,101.0
Bellte: £1,014,000 less pre-acq of £902,000 112.0
Adjustments: (£40,000 operating expenses – £2,000
depreciation + £6,400 deferred tax) 44.4
156.4
Group share: 75% 117.3
Terald: post-acquisition (£75,000 – £67,900 see W4) 7.1
At 31 May 20X4 4,225.4
(3) Snedd Group – consolidation schedule at 31 May 20X4

Snedd Bellte Terald Adj 1 Adj 2 Adj 3 Adj 4
£'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000
Revenue 8,511.0 2,186.0 35.7 10,732.7
Cost of sales (5,598.0) (1,544.0) (26.7) (2.0) (7,170.7)
Gross profit 2,913.0 642.0 9.0 3,562.0
Operating (1,541.0) (502.0) (3.6) 40.0 2.4 (2,004.2)
exps
PBT 1,372.0 140.0 5.4 38.0 2.4 1,557.8
Tax (354.0) (28.0) (0.7) 32.4 (350.3)
Profit for the 1,018.0 112.0 4.7 38.0 2.4 32.4 1,207.5
year
OCI 600.0 (9.4) (132.0) 458.6
TCI 1,618.0 112.0 4.7 38.0 (7.0) (99.6) 1,666.1

Snedd Bellte Terald Adj 1 Adj 2 Adj 3 Adj 4
£'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000
Assets
Goodwill 123.5 18.2 141.7
PPE 3,512.0 1,463.0 75.0 8.0 5,058.0
Investments 900.0 (800.0) (100.0) –
Current assets 2,365.0 586.0 22.7 2,973.7
Total Assets 6,777.0 2,049.0 97.7 (668.5) (81.8) 8,173.4
Equity and
Liabilities
Share capital 300.0 30.0 *4.5 (30.0) (4.5) 300.0
RE 4,075.0 1,014.0 75.0 (902.0) (67.9) 32.4 4,225.4
38.0 (W4) (W5)
(39.1)
Reserves 600.0 (9.4) 6.0 (132.0) 464.6
NCI 225.5 264.6
39.1 (W2)
Deferred tax 92.0 46.0 – 99.6 237.6
Current liabs 1,710.0 959.0 18.2 (6.0) 2,681.2

Equity and 6,777.0 2,049.0 97.7 (668.5) (81.8) – – 8,173.4
Liabilities
* Share capital in Terald, translated at closing rate of 2.2 (10/2.2)
(4) Elimination of pre-acquisition retained earnings in Terald
£'000
Total equity in Terald at 31 May 20X4 (see translation of statement of 79.5
financial position in section 2 of answer)
Less share capital translated at closing rate of 2.2 (4.5)
Retained earnings at 31 May 20X4 75.0
Post-acquisition retained earnings (see translation of statement of profit or (7.1)
loss in section 2 of answer)
Pre-acquisition retained earnings 67.9
Examiner's comments
General comments on candidates' performance
There are examples of overseas subsidiary consolidation in the learning materials. Therefore this
question should not have been unexpected for candidates preparing for this assessment. The question
included a standard consolidation of a UK subsidiary, which is covered in the financial accounting and
reporting paper at professional level. It was very often this basic knowledge which was missing in the
weak candidates. There were plenty of marks to be gained from dealing logically with the specific
financial reporting issues in advance of preparing the consolidation itself.
Detailed comments
Acquisition of Bellte
Well prepared candidates had little difficulty in setting out the required implications of the adjustments
arising from the remeasurement of the liability and the subsequent determination outside of the
measurement period of the fair value of the machine.
It was pleasing to see that candidates appreciated that these issues would impact on the measurement
of goodwill. Although it was not uncommon for weaker candidates to make the wrong assumptions
about the measurement period or to miscalculate the dates (30 June 20X4 – is in fact 13 months after
the acquisition date – 1 June 20X3). Plenty of candidates also went on to calculate the extra
depreciation charge arising on the adjustment to fair value but a significant minority did not appreciate
that this adjustment was for consolidation purposes only. There were also some references to
revaluation reserves which were poorly explained.

Overseas subsidiary
Well prepared candidates were able to produce relevant workings to show how the financial statements
of Terald were to be translated and the calculation of exchange losses and the appropriate accounting
treatment. Goodwill was very often correct and the appropriate exchange adjustment calculated.
Common errors were:
 taking a full year of results for Terald instead of 6 months
 not adjusting for the fair value adjustment for the financial asset
 using inappropriate rates
 recognising exchange adjustments in profit for the year instead of OCI
Deferred tax
Candidates were aware of deferred tax which was a positive point. There seemed to be little difficulty in
calculating the in-year timing differences and appreciating that these would impact on the profit or loss
(and OCI in respect of the revaluation). However, even the better candidates sometimes failed to spot
the brought forward deferred tax liabilities on the respective balance sheets and therefore processed the
whole timing differences as a movement to profit or loss and OCI instead of calculating the movement
between the closing and opening liabilities. Also worrying to see was that sometimes all three
companies were adjusted on a group basis instead of identifying deferred tax for the individual
companies prior to consolidation. Deferred tax and current tax are key advanced level topics and the
coverage in the learning materials is extensive. Candidates would be advised to prepare well for
this topic.
Payment of a supplier in shares
Most well prepared candidates scored maximum marks for this and this issue presented little difficulty.
Poorly prepared candidates scored very little.
Preparation of consolidation
If the ground work was done carefully and with clear workings, some candidates produced consolidated
SOFP and statement of profit or loss. Weaker candidates demonstrated large holes in prior knowledge.
For example – it was not uncommon to see candidates taking a 75% share of Bellte's results and assets?
Or fail to cancel cost of investments with pre-acquisition reserves and share capital. Questions at
advanced level assume basic understanding of technical topics and will continue to progress from these
skills and technical issues acquired in earlier studies.
19 BathKitz (November 2014)

Scenario
The candidate in this question is working as an analyst for a private equity firm and is required to
explain the financial reporting implications of a number of transactions in the year. The candidate is also
required to redraft the statement of cash flows and provide a reconciliation of profit before tax to cash
flow from operations. Finally the candidate is required to explain why the increase in revenue is not
manifesting into an increase in cash.
Marking guide
Marks
Explain the appropriate financial reporting treatment for each of the matters in the 16
email (Exhibit 2) showing journal entry adjustments where possible. I will have the tax
looked at separately, so please ignore any current or deferred tax adjustments
Prepare a revised statement of cash flows, after recording your correcting journal 6
entries. Include a note reconciling profit before tax with cash generated from
operations.
Explain briefly why the revised statement of cash flows shows a net cash outflow from
operating activities despite an increase in revenue 4
Total marks 26

Briefing note to Manager
(a) Identify incorrect financial reporting treatments and recommend and set out appropriate
adjustments required to the draft extracts
Investment property
The fair value of the investment property should reflect the market conditions at the reporting
date. The valuation of £12 million should not be used as a fair value because the sale transaction
appears to have been made with a buyer who was not knowledgeable of local market conditions
and therefore not a market participant. The valuation of £9 million would better reflect market
conditions. Therefore an adjustment is required to the financial statements to reflect the fair value
of £9.0 million which reduces profit by £3 million.
The revaluation will not impact on cash flow from operating activities. However, the company has
not adjusted the rental income to show this as part of cash flows from investing activities which will
decrease cash flow from operating activities and increase cash flow from investing activities.
Correcting journal:
£'000 £'000
DEBIT Investment income 3,000
CREDIT Investment property 3,000
Share options
The 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 non-market based. The fact that the share price has increased since the
grant date is ignored when determining the charge to profit or loss. The continuing employment
condition should be based on the best estimates at the statement of financial position date, which
in this case is for 6 managers to leave and therefore only 94 to be employed at the vesting date.
The charge to profit or loss is therefore £1.08 million (10,000 × 94 × £4.60 × 1/3 × 9/12). 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.
£'000 £'000
DEBIT Operating profit 1,081
CREDIT Equity 1,081
Revenue recognition
Revenue would appear to be overstated by £10 million. However, I do not have enough
information to propose an adjustment as I would need further information regarding the gross
profit percentage on these goods.
Lease of equipment
The lease should have been treated as a finance lease since the equipment is specialised and
specific to BathKitz business. Also the PV of MLP is substantially all of the cash price. Therefore the
equipment should be recognised as an asset at the lower of PV of MLP and the fair value which is
£16 million. The implicit interest rate in the lease is 7% and therefore the asset and the obligation
should be recognised on the SOFP at £16 million (£4.7m  3.387 = £16m). A finance cost of
(£16m  7%)  3/12 = £0.28 million and depreciation of £1m/4  3/12 = £1 million will be
recognised in profit or loss. The operating lease charge of £1.2 million will be reversed out of the
statement of profit or loss and debited to provisions.
This adjustment will also affect the cash flow statement. The interest element will be added back to
cash flow from operating activities. However, no interest paid will be shown in respect of the
finance lease as no payment has yet been made. The repayment of the capital element should be
shown as part of financing activities.

£'000 £'000
DEBIT Assets under finance obligations 16,000
CREDIT Finance lease obligations 16,000
Being recognition of equipment as asset acquired under finance lease
£'000 £'000
DEBIT Depreciation 1,000
CREDIT Assets 1,000
Being depreciation of equipment over the lower of lease term and useful life (4 years)
£'000 £'000
DEBIT Finance interest 280
CREDIT Obligations under finance leases 280
Being recording of 3 months interest
£'000 £'000
DEBIT Provisions 1,200
CREDIT Operating profit 1,200
Being reversal of provision for rental incorrectly made
Lease of warehouses
BathKitz should recognise the aggregate benefit of incentives as a reduction of rental expense over
the lease term on a straight line basis. Therefore the amount of rental expense to be included
should be:
Total rent expense over 4 years = ((£10m  3) + £5m = 35m over 4 years = £8.75 million, therefore
three months = £2.2 million.
Journals
£'000 £'000
DEBIT Operating profit 2,200
CREDIT Payables 2,200
Being an accrual for the warehouse rent taking into account the lease incentive.
Bonds
The convertible bond is a compound financial instrument per IAS 32, Financial Instruments: Presentation.
IAS 32 para 28 requires separation of the equity and liability components. This has not been done
in the financial statement extracts of BathKitz.
The liability component should be measured first at the present value of the capital and interest
payments. The discount rate used should be the prevailing market interest rate for an instrument
with the same terms and conditions except for the ability to convert to shares. At the date of issue
the value of the liability is therefore:
Cash flow
DF @ 7% £'000
£'000
30.09.20X3 1,000 1/1.07 0.935 935
2
30.09.20X4 1,000 1/1.07 0.873 873
3
30.09.20X5 21,000 1/1.07 0.816 17,136
18,944
The equity component is then the residual amount: being the difference between the liability and
the value of the bond:
£20m – £18.944m = £1.056m
In the cash flow statement, the finance charge is added back and is replaced by the coupon
interest in the cash flow from operating activities. The proceeds from the issue of the bonds is
shown in cash flows from financing activities.

Journals
£'000 £'000
DEBIT Bond 1,056
CREDIT Equity 1,056
DEBIT Interest costs (18,944  7%) 1,326
CREDIT Bond 1,326
DEBIT Bond 1,000
CREDIT Interest cost 1,000
(b) Draft statement of cash flows at 30 September 20X4
£'000
Profit before taxation (see W1) 36,052
Adjustments for:
Depreciation (10,631 + 1,000) 11,631
Increase in provisions 2,050
Gain on investment property (4,000 -3,000) (1,000)
Investment income (Rental income - see below) (1,200)
Share option expense – non cash investment 1,081
Interest expense (3,500 + 280 – 1,000 + 1,326) 4,106
52,720
Increase in trade receivables (53,978)
Increase in payables 29,600
Interest paid (see W2) (3,500)

Net cash used in operating activities (10,248)

Rental income 1,200

Dividends paid (5,000)
Proceeds from issuing bonds 20,000
Net cash from financing activities 15,000
Net increase in cash and cash equivalents 5,952

Cash and cash equivalents at beginning of period 12,670
Cash and cash equivalents at end of period 18,622
WORKINGS
(1) Adjusted profit
£'000
Profit per the question 42,739
1. Investment gain (3,000)
2. Share option (1,081)
3. Depreciation on equipment (1,000)
Reverse rent 1,200
Finance lease interest (280)
4. Warehouse lease cost (2,200)
5. Bond – actual coupon interest (1,326)
Revised finance cost 1,000
Revised profit before tax 36,052

(2) Interest paid
£'000
Revised charge 4,106
Less finance lease interest (280)
Less finance charge for bond (1,326)
Add coupon interest on bond 1,000
Cash flow statement – interest paid 3,500
(c) Explain briefly why the revised statement of cash flows shows a net cash outflow from
operating activities despite an increase in revenue.
Revenue has increased but this is not feeding through to an increase in cash for the following
reasons:
Comparison of 'like for like revenue' – ie, excluding Pick and Collect sales
£'000 £'000
Trade counter sales 804,550 737,334
Total trade discounts (242,110 – (54,560  10%)) (236,654) (184,334)

Revenue 567,896 553,000
Managers have the ability to negotiate discounts locally – the % of discounts to gross revenue has
increased from 25% to 29%. As managers are motivated with the share option scheme to meet
agreed growth targets in revenue, this could have resulted in higher discounts being offered and a
fall in operating profit. This will ultimately have an impact on the company's cash flow position.
Revenue has increased because of the new revenue stream. However there are inevitably upfront
costs associated with this stream which may result in higher cash flows in the future. Also
customers are taking longer to pay which will worsen cash flow.
Receivables days Receivables days
Trade counter sales
61 days 53 days
(£134.5m – £39m)/£567.896m  365
'Pick and Collect' sales
72 days N/A
(£39m/(£54.56m  90%)  365)  3/12
As discussed above in part (a), the revenue recognition policy on Pick and Collect is inappropriate
for this business and revenue may be overstated – customers are also taking longer to pay which
has affected cash flow.
Examiner's comments
Financial reporting issues
The first part of this question required candidates to explain the appropriate financial reporting
treatment of several matters set out in the question. Well-prepared candidates often scored full marks on
this element of the question, producing impressive and comprehensive answers. Weaker candidates,
however, revealed significant gaps in their knowledge of financial reporting. While many candidates
produced the correct calculation for recognising the effects of the share option incentive scheme, it was
common to find straight forward errors in the calculation.
The investment property issue was answered well and it was very common to see the correcting journal.
The share options expense was also extremely well dealt with as were both the leases. Some candidates
wasted time trying to make complex adjustments to revenue and costs for the new pick and collect sales
when there was insufficient information to do more than highlight that revenue and receivables were
both overstated.

Where errors were made they often included:
 Taking the change in value of the investment property to equity rather than to profit and loss.
 For the share options – failing to time apportion the current year expense/not adjusting correctly
for the managers expected to leave/using the fair value of the option at the year-end rather than
the grant date.
 For the finance lease – failing to capitalise at the lower of fair value and present value of minimum
lease payments/depreciating over useful life rather than lease term/failing to time apportion both
interest and depreciation.
 For the operating lease – failing to time apportion the current year expense.
 For the compound instrument – making errors in the calculation of the discounted cash
flows/preparing journals as if no entries had currently been made rather than correcting for the
errors made.
Statement of cash flows
The second part of the question required a revised statement of cash flows. Some candidates, and not
just the weaker ones, missed out this requirement altogether. Omitting parts of questions is risky and is
not advised. Others produced only a very sketchy attempt at an answer and limited themselves to just
making adjustments to profit. Candidates at Advanced Level are expected to be able to prepare, amend
and interpret cash flow statements.
Explanation
The final part of the question required a brief explanation of why the cash flow statement showed a net
cash outflow despite an increase in revenue. This part of the question was sometimes omitted. Those
who did attempt it scored few marks because the answers mostly were generic in nature and not
tailored to the specific circumstances of BathKitz.
Answers were very disappointing and often very brief. Most candidates simply wrote generally about
why cash outflows might arise often relating this to positive operating profits rather than the increase in
revenue. Very few made use of the specific information in the question.

Audit and integrated answers
20 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 IAS 39) 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.
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.
Audit and integrated answers 269

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 IAS 39, 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
Finance Interest
Instalment 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 a significant material risk of misstatement to
the group. Depending on 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
21 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
(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
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
AFS reserve.

 As the investment was classified as available-for-sale (AFS), 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 gain on disposal of £12,000 (£242,000 – £230,000).
However, holding gains of £67,000 remain in the AFS reserve. These need to be reclassified from
the reserve to profit or loss, giving a total profit or loss impact of £79,000 (£67,000 + £12,000).
The following journal is required to transfer the holding gains from the AFS reserve to profit or loss:
£'000 £'000
DEBIT AFS reserve 67
(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 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, IAS 39 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. IAS 39 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
 Since hedge accounting has been applied, the loss on revaluing the investment has been
charged to profit or loss. Reversing hedge accounting would require an adjusting entry to
transfer the loss to the AFS reserve.
 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 AFS
reserve in the statement of equity, as follows:
£'000 £'000
DEBIT AFS Reserve 27
CREDIT Investment 27
The journal required to reverse the hedge accounting is:
£'000 £'000
DEBIT AFS Reserve 27
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).
 The £12,000 fair value gain is recorded in profit or loss irrespective of the application of hedge
accounting rules:
£'000 £'000
DEBIT Derivative asset 12
No adjustment is required.
(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
Tainting of remaining holding
 The tainting of the remaining holding as a result of the disposal at the year end has not been
recorded or considered.
 The disposal of a significant proportion of a held-to-maturity (HTM) asset before maturity
results in the entire HTM category becoming tainted for the next two years.
 The remaining debt investment must be transferred from HTM to the available-for-sale
category.
 This results in the remaining investment of £72,200 being fair valued to £83,000, with the
corresponding gain being recognised in equity.
£'000 £'000
CREDIT AFS reserve 10.8

(5) Loan note and interest rate swap
 The treatment of the interest rate swap appears to be correct. However, the accounting note
made no mention of the effectiveness of the swap, a factor upon which the appropriateness of
hedge accounting depends. (Please see Audit evidence section below.)
Hedge accounting rules and hedging principles
Hedging principles
 The fair value of the derivative is comprised of an intrinsic value (exercise price less share price) and
a time value, based on the period to expiry of the option.
 Where the share price is higher than the exercise price, the intrinsic value is zero as the put option
is out-of-the-money and will not be exercised.
 At acquisition, the share price was £9 (30,000 shares with a total cost of £270,000). The exercise
price of the put option was also £9. The intrinsic value is therefore zero.
 At the year end, the fair value of an option is £2.40 representing an intrinsic value of £1.40 (£9–
£7.60) and a time value of £1.
 The share price has fallen by £1.40 since acquisition and this is exactly matched by the increase in
the intrinsic value of the options from zero to £1.40. Hence it can be seen that the intrinsic element
of the option provides a highly effective hedge for the change in fair value of the share price below
£9.00.
 It can be seen that the hedge constitutes a 'fair value hedge' as the option is protecting against
movements in the fair value of the recognised equity investments below £9.
Tutorial note:
The company does not have to designate only the changes in the intrinsic value of the option as the
hedging instrument: it could in fact designate the changes in the total fair value of the option as the
hedging instrument instead. However, in this case the hedge would not be effective.
Fair value hedge accounting

Without applying hedge accounting, a mismatch would arise: the gain on the options and the loss on
the associated investment are not recorded in the same financial statement. While the gain on the
options is recorded in profit or loss, the loss on the investment is charged to other comprehensive
income. Hedge accounting prevents such a mismatch.
 The derivative would be accounted for as normal ie, fair valued through profit or loss resulting in a
gain of £12,000. This 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.
 Special hedge accounting rules would therefore require this loss on the shares to be matched in
profit or loss against the gain on the intrinsic element of the options, rather than being recorded in
the AFS reserve in equity.
 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 risk. We should explain to the client that due to our obligation
to remain independent, we are unable to prepare supporting documentation for the financial
statements.
Risks from derivatives trading:
Key risks
There are a number of concerns that we should address as auditors.
 Credit risk is the risk that a customer or counterparty will not settle an obligation for full value. This
risk will arise from the potential for a counterparty to default on its contractual obligations and it is
limited to the positive fair value of instruments that are favourable to the company.
 Legal risk relates to losses resulting from a legal or regulatory action that invalidates or otherwise
precludes performance by the end user or its counterparty under the terms of the contract or
related netting agreements.
 Market risk relates to economic losses due to adverse changes in the fair value of the derivative.
These movements could be in the interest rates, the foreign exchange rates or equity prices.
 Settlement risk relates to one side of a transaction settling without value being received from the
counterparty.
 Solvency risk is the risk that the entity would not have the funds to honour cash outflow
commitments as they fall due. It is sometimes referred to as liquidity risk. This risk may be caused
by market disruptions or a credit downgrade which may cause certain sources of funding to dry up
immediately.

Necessary general controls and application controls
Tutorial note:
This answer assumes that a computer system is used in processing trades involving derivatives.
General controls
A number of general controls may be relevant:
 For credit risk, general controls may include ensuring that off-market derivative contracts are only
entered into with counterparties from a specific list and establishing credit limits for all customers.
 For legal risk, a general control may be to ensure that all transactions are reviewed by properly
qualified lawyers and regulation specialists.
 For market risk, a general control may be to set strict investment acceptance criteria and ensure
that these are adhered to.
 For settlement risk, a general control may be to set up a third party through whom settlement
takes place, ensuring that the third party is instructed not to give value until value has been
received.
 For solvency (liquidity) risk, general controls may include having diversified funding sources,
managing assets with liquidity in mind, monitoring liquidity positions, and maintaining a healthy
cash and cash equivalents balance.
Application controls
These include the following:
 A computer application may identify the credit risk. In this case an appropriate control may be
monitoring credit exposure, limiting transactions with an identified counterparty and stopping any
further risk-increasing transactions with that counterparty.
 For legal risk, an application control may be for the system not to process a transaction/trade until
an authorised person has signed into the system to give the authority. Such an authorised person
may be different depending on the nature and type of transaction. In some cases it may be the
company specialist solicitor, or the dealer's supervisor.
 For market risk, an application control may be to carry out mark-to-market activity frequently and
to produce timely exception management reports.
 For settlement risk, an application control may be a computer settlement system refusing to release
funds/assets until the counterparty's value has been received or an authorised person has
confirmed to the system that there is evidence that value will be received.
 For solvency risk, an application control may be that the system will produce a report for
management informing management that there needs to be a specific amount of funds available
on a given date to settle the trades coming in for settlement on that date.
In addition to the above, a fraud risk arises because the Financial Director – who has maintained the
accounting records for the derivatives almost single-handedly – also appears to be the only person
within the company familiar with the accounting treatment for the financial instruments (including the
derivatives). An effective system of internal controls will go some way to mitigate the fraud risk, but an
informed management with an adequate understanding of derivatives and hedge accounting is crucial.
Audit evidence:
The additional audit evidence that we will need to obtain with regards to the financial instruments
includes the following:
Equity investments
 Confirmations from management regarding the basis on which the year end valuation of the
equity investments were made.
 Information from third-party pricing sources regarding the fair value of the investments (including
details of valuation techniques, assumptions and inputs).

 Observable market prices at the year end for comparison.
 Supporting documentation (board meeting minutes, accounting notes produced by the Treasury
department) to support the classification of the investments in Cole plc and International Energy
plc as AFS.
 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 supporting the classification of the bonds as held to
maturity.
 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.

22 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

PPE Total
properties assets construction
£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 £235m 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, a qualified opinion should be issued, on
the basis that the misstatements are material, but not pervasive.
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.
23 Button Bathrooms
Marking guide
Marks
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
E-commerce and service provider – audit risks 7
Outsourcing of payables ledger 5
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. Revenue
should be recognised for the sale of goods when risks and rewards pass. 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
 Considering 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
2
Balance (468,000 × 1/1.1 ) 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.
 Discuss with 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.
Discontinued operations
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 co-ordinated plan to dispose of a separate major line of the business or
geographical area of operations; or
(c) is a subsidiary acquired exclusively with a view to resale.
Thus, in this case, IFRS 5 para 32(b) may apply as the closure is part of the single co-ordinated 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
 Review contract terms of the sale of the Bradford showroom.
 Review legal and other correspondence in respect of the sale of the Bradford showroom.
 Obtain an independent valuation of Bradford and Leeds sites.
 Review the probability of sale of the Leeds site up to the audit completion date.
 Review advertising and any correspondence in response of this.
 Review reorganisation plan for evidence of a coherent and co-ordinated plan.
 Review 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 reviewed for
impairment.
 Examine costs capitalised to ensure they are attributable to website development.
 Consider 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 (as revised in 2011).
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
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.
 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
 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)
24 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. We will also have to pay attention to any adjustments that are proposed to the draft
accounts that have the effect of increasing the reported profit.
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% and whereas this is not materially out of line, it would be useful to look at expenses
more closely by carrying out some analytical procedures.
Cost of sales
In 20X8 cost of sales has increased by 11.5% over 20X7, compared with a 10% increase in
revenue. As part of the analytical procedures we should be looking at the possibility of increases in
costs which have not been reflected in higher sale prices.
Administrative expenses
In spite of the 10% increase in revenue, administrative expenses (excluding amortisation) have
increased by only 1.2%. We need to look into this to ensure that expenses relating to continuing
operations have not been incorrectly allocated.
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? Further investigation is needed.
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.
(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 co-ordinated 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 co-ordinated disposal plan
based on the information provided.
Despite meeting two of the criteria to be classified as a discontinued operation, the Scottish depots
have not been disposed of by the reporting date and do not appear to meet the definition of 'held
for sale' at this date.
A disposal group is classified as held for sale only if its carrying amount will be recovered primarily
through a sales transaction rather than through continuing use. The following criteria must be met
in order for this to be the case:
 The depots must be available for immediate sale in their present condition. In this case the
depots are not available for immediate sale as they are still in use and no alternative
arrangements have been made to store the vehicles currently held at these depots.
 The sale must be 'highly probable', that is:
– being actively marketed at a reasonable price;
– changes to the plan are unlikely;
– management must be committed to the sale;
– there must be an active programme to locate a buyer; and
– the sale must be expected to be completed within one year from the date of
classification.
From the information currently available, whilst management appear committed to the sale,
indicated by the recording of the decision in the board minutes, there is currently no active
programme to locate a buyer. Marketing of the properties is not due to start until May or June of
20X8.
On this basis the Scottish depots should not be classified as either held for sale or discontinued
operations and the loss for the year in respect of this group of depots should not be separated from

the results of the continuing operations of the business in the statement of profit or loss and other
In the statement of financial position, the depots should not have been reclassified as held for sale
on 1 January 20X8 but should have been retained in property, plant and equipment and
depreciated for the remainder of the year.
From the draft financial statements we can see that on transfer to held for sale, the depots have
been measured at the lower of carrying amount and fair value less costs to sell. Therefore, the
following journals are required to reverse this transfer and record depreciation for the three months
to 31 March 20X8:
DEBIT Property, plant and equipment £44,520,000
CREDIT Profit or loss – discontinued operations £4,390,000
CREDIT Assets held for sale £40,130,000
and:
(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.
Enquire of directors as to the progress of the planned sale of the depots.
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.
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
(4,000,000/10)
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 IAS 39. We need to confirm that:
 the interest rate swap was designated as a hedge at inception and this strategy is fully
documented;
 the hedge is 'highly effective' (ie, the ratio of the gain or loss on the hedging instrument
compared to the loss or gain on the item being hedged is within the ratio 80% to 125%), and
this is subject to continuous assessment; and
 the hedge effectiveness can be reliably measured.
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
IAS 39 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 disclosed 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 IAS 39.
 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
£ £
DEBIT Profit or loss 15,000
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 a self-review threat, especially if in future years the firm
was to place reliance on controls in gathering their audit evidence.
25 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:
 At inception of the hedge there is a formal designation and documentation of the hedging
relationship and the entity's risk management objective and strategy for undertaking the
hedge.
 The hedge is expected to be highly effective.
 The effectiveness of the hedge can be reliably assessed.
 The hedge is assessed for effectiveness on an ongoing basis.
 In respect of a cash flow hedge the forecast transaction is highly probable.
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 and 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 profit or loss on the basis that it is held for trading. In accordance with IAS 39,
Financial Instruments: Recognition and Measurement this categorisation is only appropriate if it
is:
 acquired principally for the purpose of selling in the near future;
 part of a portfolio of identified financial instruments that are managed together and for
which there is evidence of a recent actual pattern of short-term profit taking; or
 a derivative.
Whilst it is not impossible for a held for trading investment in equity to be a non-current asset,
it would be more usual for such items to be current. This fact raises the risk of inappropriate
disclosure.
There is a risk that the investments have been incorrectly valued. Financial assets at fair value
through profit or loss 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
profit and loss. 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 held for trading eg, enquire of management of their intention to sell in the short term
corroborated by a review of events after the end of the reporting period, review of portfolio for
evidence of short-term trading.
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 twelve 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 financial
statements.
Review financial statements of Bourne Ltd to establish that it recognises that it has a liability to
Hopper and assess the ability of the company to repay the debt.
Obtain general representation from management confirming that they have disclosed all related
party transactions to us and that they are appropriately accounted for and disclosed.
Obtain further specific written representations regarding the receivable due from Bourne Ltd
including details of the control which Jack Maddison has over Bourne Ltd, confirmation that
management believes the debt to be recoverable and the date on which it will be repaid.
(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.
26 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 available 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
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 financial statements.

 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 twelve 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 available 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 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 available 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.
 Check 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.
 Consider 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
 IAS 39 requirements
IAS 39 classifies trade receivables as financial assets, under the heading of loans and
receivables.
IAS 39 requires that loans and receivables should be measured at amortised cost using the
effective interest rate method. However it allows short-term receivables with no stated interest
rates to be measured at the original invoiced amount, if the effect of discounting is not
material.
IAS 39 also requires an annual exercise, in order to assess, at each reporting date, whether
there is any objective evidence that the receivable is impaired. If so, then the carrying amount
of the trade receivable must be compared with the present value of the estimated future cash
flows.
Lyght has calculated the impairment partly using a formulaic approach. This is only
acceptable if it produces an estimate sufficiently close to that produced by the IAS 39 method.
The general allowance of 5% is not acceptable, because it is not based on past experience and
is unlikely to be an accurate estimate of the cash flows that will be received.
 Cristina
Where it is probable that payment will not be received in full for a significant balance, an
allowance for impairment must be made. It looks as if Cristina will pay in full plus a penalty.
However, the payment will be in a year's time, and so discounting should be used to calculate
its present value and hence any impairment. The receivable should be recorded at
30 April 20X8 as £1,944,444 (2,100,000 × 1/(1.08)).
As the receivable is not due to be paid until 1 May 20X9 the asset is recoverable after more
than one year from the date of the statement of financial position. However in accordance
with IAS 1 it will still be classified as a current asset as current assets include assets that are
sold, consumed and realised as part of the normal operating cycle even where they are not
expected to be realised within 12 months.
 Foreign exchange translation
As with inventories, there is also the issue of translating foreign currency items in accordance
with the requirements of IAS 21. The receivables balance due from Boulogne SA is a monetary
item, so must be shown in the statement of financial position translated at the exchange rate
at the reporting date. Any exchange gain or loss on retranslation will be recognised in profit
or loss.
(2) Audit issues
We would carry out the following audit procedures in connection with the allowance:
 Review correspondence with the Cristina government and assess whether its commitment
appears legally binding.
 Consider whether external factors may result in the monies owed by Cristina not being paid,
such as a likely change of government in the next year.
 Determine the basis on which the 8% effective interest rate has been calculated (In
accordance with IAS 39 the effective interest rate is the rate that exactly discounts estimated
future cash payments or receipts through the expected life of the financial instrument to the
net carrying amount of the financial asset).
 For other receivables, examine customer files on overdue debts, and assess whether additional
allowances are required.
 Ensure that the allowance made in the accounts relates to specific receivables, and does not
include any general allowance.
 Confirm that all other receivables (apart from Boulogne SA) are denominated in sterling.
 Assess the need to recognise any impairment of the value of material balances if the exchange
rate weakens materially between the date of the year-end and the audit.
 Review any significant changes in circumstances occurring between the interim audit and the
final audit.

27 Maykem
Marking guide
(a)(1) Review of assistant's 11 Write in a clear and concise style appropriate to a file
work: key weaknesses 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 audit
procedures work to address the identified weaknesses.
(b) Financial reporting issues Write in a clear and concise style appropriate to a 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) Deferred income 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 and
other comprehensive income.
(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.
Deferred income
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 IAS 39 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.
Deferred income
Deferred income change seems odd and inappropriate – split between various elements of a multi-
element sale should be on the basis of fair value.
Since Maykem do sell product separately, have evidence of the fair value of product by reference to
what a customer will pay for it. Same true of additional amount customer chooses to pay for
maintenance contract. To split on any other basis seems unusual and inappropriate.
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 will require disclosure and
might be regarded as a change in policy (if valid at all).
No requirement that all elements of a multi-element sale should give same margin – what matters is
appropriate fair value allocated to revenue.
As maintenance contracts are for three years, surely part of deferred income should be in payables
falling due after more than one year.
Disposal of business
Seem to have considered only some of the costs might expect:
 What about dilapidations for property as in bad state?
 Do plant and machinery or leasehold improvements have a NBV which is impaired and should be
written down or even written off completely? What proceeds, if any, are expected for such items?
 What has happened to any receivables balances relating to domestic customers? Have these all
been collected or is collectability in doubt given sale of business?
 Does Maykem have any ongoing warranty or other obligations under terms of deal which should
be provided for?
Need also to consider whether domestic market is a separate business segment and therefore should be
disclosed as a discontinued operation within the accounts.
May also be assets held for sale which should be reclassified.
Need to ensure gain or loss is properly described within statement of profit or loss and other
comprehensive income as should probably be regarded as an exceptional item.
Does sale of inventory suggest that other inventory provisions within Maykem might be inadequate?
Need to understand more fully what profit or loss was made on sale of inventory.
Should consider discounting in calculating surplus property provision.
Pension scheme
The directors are not correct. The contributions to the scheme are not recognised in profit or loss but
are treated as a debit to plan assets. The accounting entries relating to the contributions should be:
DEBIT Plan assets £306,000
CREDIT Cash £306,000
According to IAS 19, Employee Benefits (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 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.
28 Sunnidaze
Marking guide
Marks
(a) Prepare a memorandum setting out and explaining the additional audit adjustments 21
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 have in 11
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 give 8
(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 ten 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:
DEBIT Revenue £9,000
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 the appendix to IAS 18, point 2, revenue
should not have been booked until the installation was complete. However, not so clear that this
should be recorded as an exceptional item. The amount must be reversed from revenue.
Hence:
DEBIT Revenue £42,000
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 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 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
evidence 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 significant 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 report 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 auditor's report to fact 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.

29 Tydaway
Marking guide
Marks
(a) Follow up work from inventory count 12

(b) Audit work arising from concerns and need to address financial 13
statement assertions
(c) Financial reporting effects of four hedging options 10
(d) Explanation and comparison of the alternative financial reporting 4
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 risks and rewards would have passed from the seller to Tydaway. The
firm commitment would not therefore be recognised.
On 15 December 20X1, the purchase takes place and the transaction would be recognised at the
exchange rate on that day at a value of £354,409 ($500,000/1.4108) as follows:
DEBIT Inventory £354,409
This cost of inventory (which is £44,004 greater than at the time the contract was made) would
then be recognised in cost of sales and impact on profit in the year ending 31 July 20X2.
Hedging with forward contract – but no hedge accounting
At 31 July 20X1:
DEBIT Forward contract – financial asset £20,544
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 (IAS 39 para 87) 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. (IAS 39 para 89)
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 (IAS 39 para 89).
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 (IAS 39 paras 95–96).

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) (IAS 39 paras 95–
96).
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 IAS 39 para 89. 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 (IAS 39
paras 95–96). 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 (IAS 39 para 96).
(e) Documentation
For audit purposes and to meet the requirements of IAS 39, 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

30 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
IAS 39. 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 x 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 checked 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.
 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 co-operate 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 co-ordinating 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. IAS 39, Financial
Instruments: Recognition and Measurement states that the use of a foreign currency loan to hedge an
overseas investment can only be used where strict conditions are met:
 The hedge has been designated and documented at inception.
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 calculated.
– Statement of the entity's risk management objective and strategy for undertaking the
hedge.
 The hedge must be highly effective. We would need to confirm that the exchange difference
on retranslation of the net investment in the subsidiary compared to that of the loan falls in
the 80%–125% band. Based on the information available this does appear to be the case.
– 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 91.7% effective and hedge accounting rules may be applied provided that
the first condition has 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 IAS 39 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
31 Jupiter
Marking guide
(a) Accounting treatment of 11 Consider how each development project meets IAS 38
development costs criteria for deferral.
Identify the inter-relationship of the two projects and how a
successful outcome of the engine project could shorten the
useful life of the fuel converter.
Calculate the impairment loss 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 ethical 4 Identify ethical and legal implications of industrial
implications espionage to the company.
Demonstrate awareness of how the lack of integrity of
directors affects the auditor's position.
(d) Audit of trade payables 12 Identify practical alternative forms of evidence in face of the
inability to obtain confirmation or statements from Myton.
Recognise the risk of dependence on Myton as a supplier.
Identify the potential implications of the retention of title
clause.
Identify the risks arising from the non-replacement of the
clerk.
Demonstrate understanding of the risks relating to overseas
suppliers.
Identify practical level of testing for the other balances.
Recognise the implication of debit balances and the
increasing level of goods received not invoiced.
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 the risks and rewards 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.

32 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. If future revenues from the residual rights are not forthcoming, this may
result in excess costs needing to be written off as incurred in the financial statements
rather than being carried forward. 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 valuation
of work in progress. According to IAS 18 we will need to be able to measure the
outcome reliably in order to be able to recognise any excess costs as an asset at the year
end.
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 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.
 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:
 review management's calculation of the profit or loss on disposal of the shares;
 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.
 Check insurance documentation to assess the extent that any liability may be covered by
insurance.
 Review any correspondence with insurers over whether any claims would be fully
covered.
 Review 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.
 Review 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.
 Ensure that we obtain written representations from management on the level of claims
included within the financial statements and review any payments made in respect of the
incident both before and after the year end.
 Assess impact on company's reputation from a review of reports in the media.

Directors' emoluments
Directors' emoluments exceeding £350,000 are to be excluded from the calculation.
Management may seek to report a lower emoluments figure by excluding benefits in kind or
use share based payments according to IFRS 2. Only those emoluments over £350,000 are to
be excluded, therefore management may defer payment of a portion of their salary below this
figure until the following year in order to reduce pre-tax profit. Similarly, any bonuses to
which the directors are entitled may not be provided for by management, or may be deferred
or waived for this year.
Audit procedures
The major issue with respect to the directors' emoluments is their impact on the contingent
consideration. The key risk therefore is the extent to which directors' emoluments are
understated below the benchmark of £350,000 in year to 28 February 20X7. Audit tests
should therefore focus on this shortfall risk and may include the following:
 Assess whether there is a clear definition of 'directors' emoluments' in the contingent
consideration contract. Areas of doubt may be the following:
– whether they are determined for the purposes of the contract on a normal IAS 19
accruals basis;
– whether bonuses are included;
– whether share-based payments are included and if so whether they are measured
for the purposes of the contract on an IFRS 2 basis;
– assess the treatment under the contract of any other payments to directors
(eg, pension payments); and
– whether any actions by the new Scherzo directors are forbidden under the contract
(eg, waiving or deferring emoluments).
 Obtain a list of all directors and verify that both executive and non-executive directors
are included in the contract.
 Ascertain from the contract that all directors are included (ie, anyone who was a director
at any time during the year).
 Attest all payments made and owing to directors at any time during the year.
 Ensure 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 £5.6m (£8m – (£8m – £2m) × 4/10)
which was well in excess of its fair value at that date of £4m. 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.
 Review the estimate of future cash flows prepared by management, ensuring they are
based upon reasonable assumptions.
 Check the calculations of the possible impairment, including an assessment of whether
the pre-tax discount factor used is reasonable.
 Ensure 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 (for instance in the case of available for sale financial assets). 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 (£4m plus £0.25m) 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.
33 Precision Garage Access
Marking guide
Marks
Carry out revised analytical procedures identifying any unusual patterns and 18
trends in the data which may require further investigation.
Outline the audit risks that arise from the patterns and trends identified in the 8
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
30/6/20X6 30/6/20X5
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
 Verify the data provided by Claire which was used to make the predictions in the
analytical procedures.
 Agree standard prices to price lists and time of price change.
 Test standard prices against sample of invoices.
 Review inventory records against inventory count information or continuous inventory
records.
 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 examine 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 assess whether the
threshold level of sales to trigger the bonus has been achieved. For the final audit this figure
will be known but for the purpose of reviewing the interim financial statements a combination
of the latest actuals and the budget would be needed.
Examine the terms of the bonus agreement and of any announcement or other undertakings
with staff regarding the possible payment of the bonus.
(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 in a recession). 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 financial statements.
Impairments of PPE
The Gold product looks to be performing poorly in making losses and the estimate is that
"sales of Gold doors are not expected to increase in the foreseeable future".

Gold doors production seems likely to be a cash generating unit as the assets to make the
Gold doors are separately identifiable from the Monty assets. Similarly, the revenue streams
are also separately identifiable.
As a consequence the value in use of the PPE used on the Gold production line (and other PPE
specifically associated with the Gold product) seems likely to be low.
Also the fair value less costs of disposal also seem to be low as the "production equipment is
specialised and highly specific to each of the separate production processes".
In such circumstances the sharp downturn in Gold sales could represent an impairment event
and therefore an impairment review of the Gold assets should be carried out.
Receivables
The amount for receivables is a monetary asset and so should be translated at the year end
exchange rate.
If in the recession bad debts are increasing then an impairment charge should be considered.
(2) Response to David May's request
Proposal A – equity settled
Equity
Scheme Expense impact
commencing Computation of annual expense for each scheme each year each year
£ £
1/10/20X6 600  £8  1/3  (80 – [3  10]) 80,000 80,000
1/10/20X7 600  £10  1/3  50 100,000 100,000
1/10/20X8 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 1/10/20X6
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
£ £ £
1/10/20X6 100,000 140,000 192,000
1/10/20X7 120,000 168,000
1/10/20X8 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 ten 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.
34 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 to 9
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 the tolerable mis-statement 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 £7–8m 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 downturn. 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 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 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 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 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 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 701 (UK). 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 701.13R-1).
35 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 (market-based evidence of fair value)

Ensure 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).
Check that disclosures are adequate in accordance with IAS 16 and IFRS 13. These should include the
following:
 Effective date of revaluation.
 Whether an independent valuer was involved.
 The methods and significant assumptions applied in estimating fair value.
 The extent to which fair values were determined by reference to market transactions or other
valuation techniques.
 The carrying amount that would have been recognised had the land not been revalued.
 The change for the period in the revaluation surplus and the restrictions on the distribution of the
balance to shareholders.
Debenture loan
In accordance with IAS 39, Financial Instruments: Recognition and Measurement a debenture initially
should 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
 Agree the details of the debenture to the debenture documentation ie, issue date, coupon rate,
premium.
 Agree the receipt of cash to the cash book/bank statement.
 Check the nature of the costs and confirm that they are directly attributable to the issue of the
debenture.
 Check calculation of 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.
 Agree the change in the accounting treatment of the interest charge and the liability in the
statement of financial position with the client.
 Check 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 IAS 39 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
 Agree 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%.
 Check 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.
 Agree 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 –
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 –

Period end date 30/06/20X7 30/06/20X6
(draft) (audited)
£'000 £'000
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
36 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. 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 established 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
37 Verloc Group
Marking guide
Marks
(a) Identify financial reporting issues, explain the correct accounting treatment and 18
describe audit response.
Identify audit issues and describe the actions required. 10
(b) Draft revised consolidated statement of profit or loss. 18
Total marks 46
Maximum marks 30
(a) Financial reporting issues

Based on the draft consolidated statement of profit or loss 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 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:
 Discuss with the Finance Director to understand the reason why Stevie has continued to be
accounted for as a subsidiary at the end of the year.

 If the error in 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.
Fair value adjustment in respect of property
From the consolidation workings provided, no adjustment appears to have been made with respect
to the uplift in value in the depreciable property. We will need to determine whether the fair value
adjustments have already been made to Winnie's individual financial statements. If no such
adjustments have been made, non-current assets in the draft consolidated statement of financial
position would be understated by £950,000 (£960,000 less the effect of one year's depreciation on
the uplift in value), goodwill would be overstated by the same amount, and the draft consolidated
statement of profit or loss would be overstated by £10,000.
While the impact on the consolidated statement of profit or loss is unlikely to be material, the
overstatement in the statement of financial position is very likely to be – based on the materiality
threshold for the previous year's audit. We therefore need to request the management of Verloc
Group to put through the fair value adjustment.
Other issues to consider in relation to the property:
 The property is classified as investment property, and has been owned by Winnie for ten
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 available for sale investments
IAS 39 requires gains arising on the subsequent measurement of available for sale financial assets to
be recognised in other comprehensive income, to be reclassified to profit or loss when the financial
asset is sold.
The £46,000 gain on available for sale investments should therefore be recorded in other
comprehensive income in the consolidated statement of profit or loss and other comprehensive
income. As this has not been done, the total consolidated 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 available for sale investments are unquoted equity. Unquoted
equity should be recorded at cost if their fair value cannot be reliably measured. No gain should
arise on their subsequent measurement. It will be necessary to identify the investments in respect
of which the £46,000 gain has arisen – any portion related to unquoted equity should be
examined carefully.
The £40,000 gain associated with the available for sale investment which has now been sold has
been correctly recycled to profit or loss in the consolidated financial statements. However, the
same adjustment must still be made to Verloc's individual financial statements.

Other issues to consider:
 Determine what other financial assets and liabilities are held by Verloc, and by the group, and
evaluate their accounting treatment. The fact that the financial controller is unsure how to
account for the subsequent gain arising on the available for sale investments indicates a
higher risk of material misstatement in this area.
 Review the purchase contracts for the available for sale investments as well as other financial
assets, and discuss with management to understand the nature of the investment held.
Evaluate whether the financial assets have been classified correctly.
 For investments trading 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.
IFRS 9 treatment
Under IFRS 9, Financial Instruments, the category of available-for-sale financial asset will no longer
exist. All equity investments in the scope of IFRS 9 are to be 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 report value changes in 'other comprehensive
income'. 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.
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 he/she is 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 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 by the audit team of the risk of fraud-related misstatements
 Inquiries of management
 Obtaining an understanding of the controls in place to identify 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.
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 AFS investments, 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) + (1,549)
10 (W5) – 40 recycled AFS gains (W9))
Distribution costs (800 + (700  5/12) + (550  9/12)) (1,505)
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  2
35%)
Items that may be reclassified subsequently to profit or loss
Recognised gains on AFS investments (Note) 46
Recycling of previously recognised gains on AFS investments (W9) (40)
Other comprehensive income for the year, net of tax 107
Profit for the year attributable to:

1,892
Total comprehensive income for the year attributable to:

1,999

WORKINGS
(1) Group structure and timeline
Verloc
1.11.X6 Buy 75/100 = 75%
1.5.X9 160/200 = 80% 1.7.X9 Sell 40/100 = (40%)
Have left 35%
Winnie Stevie
Timeline
1.10.X8 1.5.X9 1.7.X9 30.9.X9
Winnie
Subsidiary – consolidate 5/12
Acquired
160,000 shares
= 80% of Winnie
Stevie
Subsidiary – 9/12 Associate – 3/12
Held 75,000 Sells 40,000 shares Equity

shares = 40% account in
= 75% of Stevie SOFP
Group gain on
(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
Consideration transferred 2,800
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 Movement At year end
1.5.X9 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) Available for sale investment
On disposal (30 September 20X9), reclassify previous revaluation gains of £40,000 from other
comprehensive income to profit or loss ('administrative expenses').
Note: The draft revised consolidated financial statements assume that the £46,000 gain arising on
subsequent measurement of available for sale assets is calculated correctly based on IAS 39. This is
subject to further review.
38 KK
Marking guide
(a) For each of the issues in

Exhibit 2:
 describe the appropriate
financial reporting
treatment in the KK
consolidated financial
statements. Explain and
justify whether or not
disclosure of any related
party transactions needs
to be made in the
individual financial
statements of the
companies concerned for
the year ended
30 June 20X4; and
 explain the key audit
issues and the audit
procedures to be
performed.
(1) Seal sold £12 million of 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 Seal 7 Apply technical knowledge of IFRS 10 to the scenario to
to Moose 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.

(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 Crag 7 Determine that the sale of goods from Crag to KK is an
to KK 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.
(b) Identify and explain the key 5 Identify and explain the key audit issues surrounding the
audit issues which arise from acquisition of a controlling interest in Crag during the
the acquisition by KK of shares year.
and options in Crag.
(c) Explain the ethical 5 Identify the issue as an advocacy threat arising from the
implications for WJ of Mike's provision of non-audit services.
suggestion that WJ carry out
Assimilate information to identify intimidation and self-
review work in respect of the review threats.
due diligence assignment
performed by TE. Provide a recommendation of appropriate action.

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 financial
statements.
Regardless of whether there have been transactions between a parent and a subsidiary, IAS 24
requires an entity to disclose the name of its parent and, if different, the ultimate controlling
party. Crag must therefore disclose the fact that KK is now its parent in its financial
statements.
Treatment and disclosure of the goods sold to Crag by Seal
KK has significant influence over Seal and it is therefore a related party of KK. In accordance
with IAS 24, Related Party Disclosures, disclosure of the aggregate amount of the transactions
occurring between Crag and Seal between 1 August 20X3 and 30 June 20X4 is required in
the consolidated financial statements of the KK group as they are related parties. (Crag is a
subsidiary of KK and Seal an associate of KK.) Disclosure is also required in the individual
company financial statements of Seal and Crag. No disclosure is required in KK's individual
company financial statements (even though Seal and Crag are both related parties of KK) as
the transaction does not impact on its individual company financial statements.
Transactions before the acquisition date do not require separate disclosure in any company's
financial statements as the parties were not related during this period.
Any outstanding balances and any bad or doubtful debts must also be disclosed in
accordance with IAS 24.
Audit issue
The key audit issue is the nature of the relationship between KK and Crag which determines
whether related party disclosures are required or not.
KK appears to have transactions with a number of related parties. Related party transactions
are particularly difficult to audit, not least because they depend upon management providing
the auditor with complete and correct information. This is an area that the audit team will
need to focus on, both to ensure that appropriate disclosure has been made in the financial
statements, and as part of considering the risk of fraud.
The auditors must remain alert for circumstances which might indicate the existence of
related party relationships or transactions. Where transactions outside the entity's normal
course of business are identified the auditors must discuss them with management, in
particular inquiring about the nature of the transactions, whether related parties are involved
and the business rationale (or lack of) of those transactions.

Audit procedures
Sales transactions
 Agree the total of post-acquisition transactions to supporting sales and purchases records
of the two companies.
 Inspect a sample of delivery notes around acquisition date for cut-off to ensure
consistency of treatment between the two companies.
 Verify amounts of intra group goods held in inventory at year end against inventory
count records.
Related parties
 Establish 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, Related Party Disclosures, 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
 Establish 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
 Review provisions in Articles of Association and any shareholder agreement regarding
directors' contracts with the company.
 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.
 Agree the amounts to the underlying contract for sale of the machine to Mike.
 Establish carrying amount from accounting records.

 Establish fair value to third party evidence (eg, trade guides if there is an active second
hand market).
 Consider 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.
 Recognise 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 ensure unwinding of
the discount is charged to profit or loss.
 Agree 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
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 non-
controlling interest has been correctly accounted for.
Audit procedures
 Agree the cost of the goods sold to KK to Crag's inventory records.
 Agree 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.
39 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 lease back arrangement – the lease back is on the cusp of being treated as either an operating lease
back 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 20
handover notes. Make recommendations on the appropriate financial reporting
treatment where relevant.
(b) Using your recommendations above, evaluate and explain the impact of your 6
adjustments on the gearing ratio and the interest cover ratio in accordance with
the bank's loan covenants (Exhibit 1).
(c) Outline the key audit risks we need to address before signing our audit opinion 9
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 5
and make appropriate recommendations
(e) Prepare a file note explaining the ethical implications for our firm if we decide to 5
tender for and, if successful, accept this one-off assurance assignment.
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 lease back 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 Deferred income more than 1 year (£3.04m  19/20) 2,888
CREDIT Deferred income 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
b/f Lease payment Finance charge c/f Due > 1 year Due < 1 year
due on 8% in arrears
31.3.20X5
£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 IAS 39/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 the income statement 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.

Therefore the hedge is effective 1.768m/2.000m = 88.4%
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 £'000
(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
Equity = 226%
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 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 lease back (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 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 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.
40 ETP (July 2014)

Scenario
The candidate is the audit senior planning aspects of the audit of a listed company which supplies data
storage and secure archiving systems.
The planning aspect of the scenario requires the candidate to identify and explain risks arising from a
number of new and complex revenue streams and also from diminishing performance in other areas of
the business. The candidate is also required to critique and raise review notes on a rather high level and
inadequate preliminary analytical review prepared by an inexperienced assistant. The relevant
information needs to be pulled together to draw conclusions and the explanations gained by the
assistant should not be taken at face value.
The candidate is asked to comment on the benefits arising from an auditor's review of the interim
financial statements. Key in this response is the candidate's ability to link errors identified in the current
period and the potential recognition error of revenue in the next interim reporting period to identify
that a key benefit for the company of the assurance review procedures would be to protect the directors
from issuing incorrect interim financial reports.

Marking guide
Marks
(a) (1) Prepare review notes on Joshi's work (Exhibit 2), explaining the weaknesses 12
and limitations in the procedures he has performed and performing additional
analysis where you think this is required. Set out clearly the additional audit
procedures you would like him to complete and the queries you would like
him to resolve.
(2) Identify and explain the further financial reporting issues and related audit 10
risks you have identified from the information provided, and outline for each
the implications for our audit approach.
(b) Explain how a review of the interim financial statements for the period to 31 March 8
20X5 would differ from a statutory audit and set out the benefits of such a review
for ETP.
(a) (1) Review notes on Joshi's work explaining weaknesses and limitations in his procedures;
my additional analysis and additional audit procedures for Joshi to complete on
analytical review
While it is relevant to look at the KPIs ETP has identified we also need to think about whether
there are any other indicators we should be considering in our preliminary analytical review
procedures. One would normally expect these to cover all significant balances as well as the
key ratios so there is more work to be done.
Additional procedures
 Consider KPIs used in Board reporting and ensure that all relevant KPIs are included in
our analysis.
 Complete analytical review of all significant balances.
Joshi has used comparator companies that were used in last year's audit working paper. We
need to assess whether the comparator group of companies remains relevant and the best
indicator of overall market performance. We should also consider whether the same group has
been used for all revenue streams and, if so, whether this is appropriate or whether a more
focused comparator group would give a better comparison against which to assess ETP's
performance.
• Using discussions with client and industry knowledge, determine whether there are other
groups of comparator companies which would give a better comparison.
Explanations have only been sought from the financial controller, Julie Barwell who may not
be in the best position to understand the performance of the company and the relevant
factors.
 Extend our discussions to other more senior management, including those responsible
for the relevant area such as sales or divisional management.
 Seek to corroborate explanations received by looking at corroborative evidence wherever
possible.
Declining sales in Stor-It devices may lead to an obsolescence problem and increased storage
costs. Procedures will be required on inventory valuation.
Systems sales growth – your analysis shows a 25% growth rate, indicating that sales for the
comparative prior year period which were recognised on a completed contract basis were
£80.2 million. Looking at current year sales on a comparable basis, they would amount to
£70.3 million (£100.3m – £30.0m (the revenue from part completed contracts)) which is a

decline of 12%. This is against market trends and considerably poorer than the budgeted
growth figure of 10% which does appear aggressive compared to market. Your analysis does
not explain this decline at present.
• Obtain further explanation and analysis.
Excluding revenue from the new 'all-in' package, sales of training and consultancy have
declined. Possible that customers have switched from previous billing arrangements to 'all-in'
package but would be useful to have further analysis.
• Obtain further analysis, showing, in particular, split between training and consultancy
and how each revenue stream has moved as level of detail we have at present may not
be sufficient to understand underlying trends and fluctuations. This applies to margin
and debtor analysis as well.
• Ensure that the revenue recognition policy is appropriate and assess whether income
should be prepaid.
In gross margin analysis there is no comment on the lower margin for hardware – this is out
of line with budget and prior year and might imply that additional discounts are being
offered.
• Obtain explanation of fall in margin.
• Obtain management perspective on why margin achieved is so much lower than that for
competitors – this may well be due to decline in market for ETP Stor-It products and/or
mix of products sold. Prior year margin was also much lower so worth understanding
reasons we were given last year.
Systems gross margin – analysis is incomplete at present. It would be helpful to show more
detailed analysis between margins on completed and partially completed projects so can
understand fully the extent of the distortion arising. Overall margin amounts to £100.3 @
46% = £46.1m. Assuming margins on completed projects remained as in prior year at 44.8%,
that accounts for 70.3 @ 44.8% = £31.5m, meaning that £14.6 million relates to the partially
completed projects. Of that a £1 million loss was made on one project with revenue of £3.6
million, meaning that a margin of £15.6 million (59%) was made on the remaining new
project revenue of £26.4 million which appears high.
• Request more detailed analysis from client.
Additional overall margin on services is £17.9 million @ (63.9 – 50.1) = 13.8% = £2.5m, much
higher than would arise on the £800,000 training revenue recorded in the wrong period
explained by the assistant. It seems likely that some of this is due to up front recognition of
revenue for 'all-in' advice packages where costs may not be matched with revenue.
• Obtain further explanation/investigation of the margin from the client.
DSO analysis is for overall company only and therefore gives limited information. It is not clear
on what basis the budget has been prepared. There has also been no attempt to explain the
impact on the budget of the change in revenue recognition policies. Therefore the
comparison to the budget is of little value.
• Request more detailed divisional analysis to support the explanations given.
• Discuss the basis of preparation of the budget with management and if necessary
prepare further analysis to enable valid comparisons to be made.

(2) Further financial accounting issues and associated audit risks identified from planning
work performed and implications for audit approach.
Revenue recognition – systems projects
The historical revenue recognition policy for system projects has been very prudent with all
revenue and margin recognised only on customer acceptance. Accounting standards require
recognition based on the stage of completion where the outcome can be assessed reliably.
Hence the historic policy adopted by ETP must have been on the basis that reliable assessment
of the outcome was not possible.
The new revenue recognition policy adopted in the 6 months to 31 March 20X4 is more in
line with expected practice but is inherently more judgmental and has had a very significant
effect. It is concerning that the margins anticipated on partially complete projects exceed
those on completed projects and this could be indicative of over optimism, deliberate
distortion of results or simply the continuing difficulty in estimating the outcome with any
certainty.
The fact that debtor days have lengthened due to delays in payment of stage invoices
suggests that customers may not be happy that they have received deliverables for which they
are not happy to pay or that the stage payments are not a true reflection of the stage of
completion and therefore not a valid basis for revenue recognition.
There is therefore an audit risk that:
 the new basis for revenue recognition is not appropriate; and
 judgments made in assessing out-turn margins and stage of completeness are not correct
or appropriate.
In addition, if the new policy is found to be appropriate, there is a financial reporting issue in
that a change in revenue recognition policy would normally give rise to a restatement of prior
year revenue and margin. This would however not be the case were the company to argue
that it is their ability to assess the outcome which has changed rather than the policy.
The new policy will mean changes to our audit approach in that our controls work will need
to focus on new control objectives around estimating costs and assessing percentage
completion. In addition our substantive work will need to consider carefully the judgments
made and the evidence available as to progress on the projects and customer acceptance of
obligations for the invoices issued. Immediate discussions should be held with the client
around the reasons for the change in policy and ETP's own consideration of the impact, if any,
on the prior year.
Declining sales of Stor-It devices
The declining sales and margins on Stor-It devices give rise to a number of risks:
 The risk that there is excessive inventory of the products and obsolescence provisions
need to be increased. The financial controller's comments make it clear that inventory
levels are increasing significantly.
 The risk that more attractive sales terms will need to be offered to ensure that the devices
are sold. To some extent this may already be happening at least in practice as
distributors are delaying payment for the product on the basis that they have not sold it
on. In addition margins are lower which may indicate additional discounts.
 The risk that the carrying value of the associated brand and/or tooling may be overstated
given future anticipated sales and margin to be earned from the product.
 The risk that even if the carrying values can be supported, the useful economic lives may
need to be reassessed as a shorter life may be more realistic.
Implications for our audit approach are that we will need to include additional procedures to
address the impairment and useful lives risks and to look carefully at judgments in these areas
and around inventory obsolescence. We will also need to consider carefully whether there
have been changes in formal sales terms or those allowed in practice, such as increased

acceptance of returns from distributors or volume incentives, and to ensure that all such
matters are accounted for correctly.
'All-in' advice packages – revenue recognition
Revenue for the 'all-in' advice packages is being recognised up front. While such revenue is
not refundable, it seems likely that ETP has an ongoing obligation to provide a service
throughout the period and that a more appropriate revenue recognition model would be to
recognise revenue ratably throughout the relevant period. In addition, we need to consider
whether revenue is being deferred to cover the right to future discounts on training
programmes. The fact that margins have increased considerably also suggests that the present
recognition model may not be achieving appropriate matching of costs and revenues. There is
therefore a risk that the policy adopted for revenue recognition on these projects is
inappropriate and considering it further must be a focus area for our audit.
Accounting for loss on government contract
Whilst a loss has been recognised on the government contract there is a risk that the element
recognised relates only to the proportion of the contract completed to date as it appears to
include only incurred costs. Provision should be made for the entire anticipated loss and we
should include audit procedures to ensure that this is the case.
Cut-off error on training revenue
Error identified to date is not material but it is possible that the total extent of the error has
not been identified. Our audit will need to include procedures to look in detail at cut-off at
both the beginning and end of the year as, if the prior year error were material, a prior year
adjustment would need to be made. In addition we need to revisit our work on controls as the
controls operated in the previous year were clearly not operating effectively. Unless significant
changes to controls have been made, we may conclude that controls reliance in this area is no
longer possible.
(b) Response to email – assurance on interim financial reporting.
A review of ETP's interim financial statements would provide a lower level of assurance than an
audit but is still designed to provide assurance to the board on the company's published financial
statements. The amount of work performed by J&K would be less than that for a statutory audit
and would involve primarily analytical review procedures rather than detailed substantive testing.
Performing an interim review would mean that we, as auditors, performed analytical review
procedures and other procedures prior to the publication of your interim financial statements
rather than after that publication as part of our planning procedures. Many of the procedures
would be similar to/the same as those we would perform as part of our audit – eg, review of
minutes etc. but they would be performed on a more timely basis allowing us to let you know of
any errors/omissions before the data is made public.
This would be of benefit to the whole Board who take responsibility for the financial statements in
providing assurance that those statements have been subjected to a review process. This would
help to avoid issues/errors coming to light at a later date – our review for planning purposes has
identified a number of potential risks and issues which should have been considered as part of the
interim reporting.
Interim review procedures also provide additional assurance to investors about the degree of
reliance they can place on the interim financial information and thus is of value in investor relations
and also potentially attracting additional investment. Mari is therefore correct in her assertion that
the review procedures would add credibility to the figures for the shareholders.
While an interim review is an additional report and there will be an additional fee, the extent of this
can be mitigated as some of the procedures are ones which would have been performed in any
event and it is only the timing which will change. Other procedures such as review of the reporting
document itself and reporting to management will be additional and some, such as analytical
review, will be extended.

Revenue recognition – Interim financial statements
J&K's procedures would prevent ETP publishing misleading interim financial statements which
would be the case if the revenue for the new overseas contract is recognised evenly over the year
as Mari proposes.
It appears that the loss on the government contract has been understated in the interim financial
statements for the period to 31 March 20X4. In addition the interim financial statements for this
period may have been incorrectly stated due to cut off and revenue recognition policy changes in
respect of systems and 'all-in' packages for service revenues. These errors would have been
identified by J&K if review procedures had been carried out on the interim results for the period to
31 March 20X4 on a timely basis prior to publication of the results.
IAS 34.37 requires that revenue should not be anticipated at the interim date if anticipation would
not be appropriate at the year-end date. The revenue from the new overseas contract should not
therefore be included in the interim results to 31 March 20X5.
Examiner's comments
General comment on candidates' performance
Requirements (a)(1) and (a)(2)
A significant majority of candidates failed to appreciate that there were in fact three requirements to this
question and ignored the requirement to review and identify weaknesses in the analytical procedures
performed by the junior member of staff. At this level candidates are required to demonstrate the ability
to review the work of others and identify the weaknesses in the procedures performed. Similar style
questions are available in the learning materials.
The good candidates followed the format of the question and identified weakness in the work
performed to date. Doing so provides gateway points to then drill down further into the errors in the
financial reporting treatment for revenue, and also identifying other financial reporting implications in
relation to potential impairments of patents and inventory. Technically the topics are not challenging; in
terms of interpreting the information by applying fairly straightforward analysis, most candidates
demonstrated severe weaknesses in this area. Very little was offered in terms of analysis – financial
statement analysis is a key part of the syllabus for this paper and candidates need to be prepared to
analyse and interpret financial information in different scenarios including in the auditing context of
analytical procedures.
The question was often not attempted by weak candidates.
Good candidates identified the impact of the changes in revenue recognition policies although it was
not uncommon for candidates to fail to appreciate that these had changed from the file note presented
in exhibit 1 which related to the year ended 30 September 20X3.
Requirement (b)
Unfortunately for some candidates who copied out IAS 34 requirements instead of answering the
question which asked for how a review of the interim financial statements would differ from an audit
and the benefits of such a review, there were limited marks available for this section. Candidates who
discussed the value of interim financial statements were not answering the question. Candidates are
expected to apply to the scenario and not use the open book policy as an opportunity to write out
sections of the standards.
For the better candidates this section presented no difficulties and many scored maximum marks.
41 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 15
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 9
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: 8
 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 8
Couvert's finance director (Exhibit 3).
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 & WIP used (192.8) (205.7) (194.1)
(186.9) (214.0) (212.7)
Revenue for 20X4 is very much lower than both prior year and budget figures, which may suggest
a downturn in trade. However, it is also possible that cut-off at the beginning of the year was
incorrect, and that revenue was recognised too early in order to manipulate profits immediately
prior to takeover and to improve the price paid for the acquisition. This factor could have affected
many of the figures in both the performance and position statements, and if so, the consequences
for the audit and for the client would be very significant. It would be helpful to undertake some
trend analysis of Ectal's results, going back over three or four years, and also to look at the extent to
which their budgeting has deviated from actual results in the past. We should be able to obtain this
information from the due diligence files.
Employee expenses are higher than budget, and much higher than in the previous year. The
increase appears to have been expected in that the 20X4 budget figure is substantially increased
compared to 20X3 actual figures. It may indicate a significant planned pay increase for staff, but it
is difficult to tell without further information. Other expenses have increased even more, both
against budget and prior year. Again, more information would be required. It is possible that
expenses have been misallocated, and that the totals that we are currently examining are not
accurate comparators.
Depreciation, on the other hand, is much lower than planned, and much lower than in the prior
year. However, the C$60 million impairment, which is material, has had a significant impact on the
PPE balance. More information would be required about the timing of this impairment. If it
occurred and was recognised at the year end, as seems likely, then it does not explain the drop in
depreciation which should have been recognised in full before the amount of the impairment was
calculated. It is impossible to reconcile the movement in property, plant and equipment without
further information on acquisitions and disposals. The carrying amount of PPE at 31 August 20X3
was C$603.7 million, which reduced to C$551.3 million at 31 August 20X4. The difference
between the two figures is C$52.4 million, exactly the amount of the depreciation charge for the
year ended 31 August 20X4. It appears, therefore, that net acquisitions amounted to exactly
C$60 million, balancing the amount of the impairment. The note to the financial statements on
PPE and the cash flow statement would help in providing explanations.

Profitability
Because of the classification of expenses by nature, no figure for gross profit is disclosed. However,
gross profit can be estimated by deducting change in inventory, RM and WIP used, employee
expenses and depreciation expenses from revenue, as follows:
20X4 Actual: 305.4 + 5.9 – 192.8 – 26.3 – 52.4 = 39.8 (ie, excluding impairment)
20X4 Budget: 358.6 – 8.3 – 205.7 – 25.8 – 60.8 = 58.0
20X3 Actual: 350.4 – 18.6 – 194.1 – 21.0 – 59.4 = 57.3
Margins can then be calculated as follows:
Gross profit margin 13.0% 16.2% 16.4%
Operating profit margin (14.8%) 10.3% 10.3%
(operating profit = (loss)/profit before
tax + finance costs)
Net pre-tax margin (16.4%) 8.9% 8.9%
Note: All calculations exclude other income, which was not budgeted. There is no indication of
what this might be, but audit work will be required on this figure.
Gross margin has suffered a significant decline. This may possibly be the result of a change in sales
mix, but the decline requires further explanation.
Finance costs
Linking finance costs to the statement of financial position, the principal liability at the 20X4 and
20X3 year ends was the loan from director. It appears that the director is earning approximately
10% pa from this loan. Whether or not this is a reasonable return depends to some extent upon
interest rates in Celonia, but the interest rate may be excessive.
Other issues
Return on capital employed (7.7%) 5.6% 5.6%
Return on capital employed is negative in 20X4. Budgeted and 20X3 actual ROCE are both
relatively modest figures. It could be helpful to compare these and other performance ratios with
industry averages, both within Celonia and globally.
There is no tax 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 co-operation 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 600 (UK)
(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 of 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 IAS 39
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
Available-for-sale financial assets 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.

42 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 10
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.
(b) Identify and explain the financial reporting issues. Recommend appropriate 12
adjustments.
(c) Summarise on a schedule of uncorrected misstatements the adjustments that you 6
have recommended. Explain the further action that we should take in respect of
the uncorrected misstatements.
(d) Identify and explain any ethical issues for HH, and recommend any actions for HH 6
arising from these issues.
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 500 (UK) 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 year  Re-perform a sample of supplier statement
end trade payables. reconciliations based on throughput, obtain
explanations for all reconciling items and
recommend appropriate adjustments.
 Perform cut off procedures on supplier
invoices, accruals – directional testing in both
directions, both pre and post year end.
 Obtain explanation for debit balances and
ensure recoverable.
 Obtain a list of credit notes after date and
consider whether further adjustments are
required.
 Obtain documentation in respect of disputed
Medex invoices and assess appropriateness of
the credit note accrual.
 Quantify the total cash-in-transit and
determine whether adjustment is required to
eliminate window dressing.
 Obtain permission from those charged with
governance to contact Mesmet. If permission
refused consider whether alternative
procedures are possible to confirm the balance.
Document for audit completion meeting the
ethical implications of the invoices on 'hold' see
below.
Foreign exchange
 There is a clear risk that there may be other  Review the list of trade payables for other
misstatements of Forex balances. currency balances and reperform 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 NRV
inventory at year end. for inventory.
 There may also be missing balances in respect  Enquire whether there have been any forward
of derivatives. 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.

Audit risks Procedures
Provisions
 There is a risk that there may be other similar  Review accruals schedule for other accruals
balances that required discounting which may which may need discounting and quantify the
cumulatively be material. impact of such an adjustment.
 There is a risk that impairments of assets in the  Confirm with other audit team members that
factory have not been correctly assessed adequate testing has been performed on
therefore non-current assets will be overstated. impairments of receivables and non-current
assets.
 Receivables relating to the division may also
not be correctly stated.
 There could be additional liabilities which have  Review payments after date and ensure that
arisen which were not originally in the budget. the provision is fairly stated. Agree to
supporting third party documentation.
Legal claim
 The financial statements may not be fairly  Make appropriate enquiries of those charged
stated if the legal claim is not disclosed. with governance including obtaining
representations.
 Review board minutes and correspondence
with ERE's legal advisers.
 Ask for permission from those charged with
governance to communicate directly with ERE's
lawyer by means of a letter of enquiry with the
reply sent direct to HH.
 Consider all matters pertaining to the legal
case up to the date of signing the auditor's
report.
Deferred tax
 There is a risk that the client lacks the  Review the current tax computation for any
appropriate financial reporting knowledge to temporary differences not accounted for as a
prepare accurate deferred tax computations deferred tax adjustment.
resulting in a misstatement of the financial
 Obtain a reconciliation of profit per the
statements.
financial statements to taxable profit and
ensure that deferred taxation has been
appropriately provided for temporary
differences only.
 Verify that the tax rate at which the liabilities
and asset unwind is in line with tax legislation
enacted.
 Agree the opening position of the deferred tax
liability to the prior year financial statements.
 Consider whether it is appropriate for the
company to recognise deferred tax assets and
liabilities given future forecasts of taxable
profits.
(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
2
used an annual discount rate of 5% for two years (1/1.05 ) 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
(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 of 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 into 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 ethical code 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. 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 material risk of
misstatement of 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.

43 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 (Exhibit threshold not being crossed in respect
3). In your response you should: of the acquisition of Oldone shares.
(1) Set out and explain, for each of the  Apply technical knowledge to
transactions she identifies, the determine the split of equity and
correct financial reporting liability in respect of the bond.
treatment in Congloma's
 Apply IFRS 10 to determine whether
consolidated financial statements
control exists in respect of the Neida
for the year ending 31 August
investment.
20X4. Recommend and include
appropriate adjustments and  Explain the implication of unidentified
calculations. 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 adjustments
before taxation for the year ending and prepare a revised profit before
31 August 20X4, taking into taxation.
account the adjustments you have
identified.
July 2015 answers 415

(b) Set out in a working paper the 15  Determine relevant audit procedures to
additional audit procedures that we will the transactions identified.
need to perform as a result of the
 Identify the potential to manipulate
transactions Jazz has identified. Include
profits in arising from the sale of the
an explanation of the impact that the
Oldone CEO's shares – link relevant
transactions will have on the scope of
procedures to this risk.
our audit procedures and the
components that we consider to be  Apply concept of materiality to
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%:
Year Cash flow Discount factor PV
£'000 8% £'000
1 500 0.926 463
2 500 0.857 429
3 10,500 0.794 8,337
9,229
Hence of the £10 million gross proceeds, £9.229 million should be shown as a liability payable
(on issue). The split between the short and long term elements will need to be redetermined
at the year end of 31 August. The remaining balance of £771,000 should be shown as equity.
The effect on profit before taxation will be a charge of three months' interest on the bond.
This will be £9,229 @ 8%  3/12 = £185,000.
Neida
IFRS 10 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
and (paragraph 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 profit 0
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' interest on –185
the bond. This will be £9,229 @ 8%  3/12
Acquisition of Neida – as Neida is accounted for as a subsidiary, its loss for the –75
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 £3m  2/12 = 375
£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.
44 Heston
Scenario
Heston is a listed company which manufactures engines. It has four autonomous divisions operating
from separate factories. The candidate has recently joined Heston as deputy to the finance director.
Heston has had some difficult years recently but a new chief executive is beginning to turn the company
around. It has been decided to close the lawnmower division but at the accounting year end under
consideration it has not yet been sold. In order to boost sales volumes in the other three divisions,
selling prices were reduced by 10% at the beginning of the current financial year. Steel is a significant
raw material used in production. Fluctuations in steel prices are a major risk so the company has entered
into a cash flow hedge for a highly probable purchase of steel. Candidates are required to:
 set out the financial reporting adjustments for the decision to dispose of the lawnmower division
and for the cash flow hedge;
 redraft the draft financial statements including comparatives; and
 analyse Heston's performance and position for the current year using the redrafted financial
statements.

Marking guide

I would like you to: 14  Apply technical knowledge to determine the
Set out and explain the financial reporting adjustments required for the discontinued
adjustments required in respect of the operation, including assets held for sale.
issues in Exhibit 3.  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 or 8  Assimilate adjustments and prepare in
loss for the year ended 30 June 20X5 and appropriate format.
an adjusted statement of financial position
 Identify separate disclosure of continuing and
at that date in a form suitable for
discontinued activities.
publication, including comparatives.
Analyse Heston's performance and 8  Identify causal factors for changes.
position for the year ended 30 June 20X5.
 Communicate in an appropriate style relevant
Include calculations and use the adjusted
to the context of the FD's section on the
financial statements. Outline any further
annual report and analysts' questions.
information needed, so I can ask
somebody to investigate.  Identify separately the performance of
continuing and discontinued activities,
explaining the significance of each for
shareholders and other stakeholders.
 Link price decrease to revenue increase and
provide reasoned explanation highlighting
changes in sales volumes.
 Extrapolate results of analysis to infer reasons
for GP and profit changes.
 Identify liquidity as an issue and explain main
factors affecting liquidity.
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
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.
IFRS 9, Financial Instruments will not change the accounting, but the criteria for hedging will change. In
particular, the 80–125% hedge effectiveness range will be replaced by 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.

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)
Income tax expense (4,420 + 2,600)/(6,060 – 1,400) (7,020) (4,660)
Profit for the year from continuing operations 27,984 18,440
(Loss)/Profit from discontinued operations (W1) (12,274) 5,800
Cash flow hedge (W4) (42) –
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
Adjustments for:
Depreciation (120,400 – 113,660) 6,740
Provision 3,800
Increase in receivables (5,700)
Decrease in payables (7,800)
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.
45 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 have reporting treatment of lease.
identified and recommend
 Apply technical knowledge of IAS 17 to
appropriate adjustments.
recommend treatment.
 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 schedule 4  Assimilate adjustments and prepare schedule
of all uncorrected of uncorrected misstatements.
misstatements (Exhibit 1),
 Apply materiality to the adjustments to
including your
determine which should be adjusted.
adjustments from (a)
above. Identify and  Identify and explain need for further work
explain the misstatements, arising from the nature of the errors identified.
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 balances.
performed on opening 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 this 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
CREDIT Equity 45,000
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
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 forward 35

(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 – 75 75 –
error in formula used to derive general
provision for warranty
Tax effect 15 – – 15
(2) Over-valuation of inventory projected due 115 – – 115
to sample testing of inventory costs
Tax effect – 23 23 –
Further adjustments
(3) Effect of prior year over-provision of – 60 60 –
warranty provision
(4) Net effect of lease 14 – – 14
(5) Current year tax liability – correction for 60 – – 60
share option and warranty
(6) Prior year tax liability – disallowable 68 – – 68
expenses
(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.

46 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 corporate responsibility, 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

46.1 (a) Prepare the consolidated 18  Assimilate and demonstrate understanding
financial statements for of a large amount of complex information.
Larousse for the year ended
 Identify errors in the partially prepared
30 September 20X5,
consolidation schedule, and related
correcting any errors. Provide
information.
explanations and journal
entries for any adjustments  Identify appropriate accounting treatments
you make. 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 appropriate
analysing the performance measurements such as gross profit margin.
and profitability of each of the
 Demonstrate understanding of the
two subsidiaries.
importance of intra-group trading on the
results.
 Identify transfer pricing issue.
November 2015 answers 439

(c) Respond to the proposals 9  Apply knowledge of the scope of external
from the board about auditors' responsibility in respect of
corporate responsibility by: voluntary disclosures.
 explaining the  Identify issue of auditor firm competence to
responsibilities of our produce additional assurance report.
external auditors in
 Identify likely contents of additional report.
respect of the proposed
corporate responsibility  Assimilate knowledge, drawing upon
disclosures (Exhibit 3); question content, to describe type of work
and required to provide verification evidence.
 evaluating the 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).
46.2 Identify any potential ethical 6  Discuss appropriate responses and actions in
issues arising for you and for respect of the apparent ethical dilemma.
Dennis Speed from the
 Identify potential money-laundering issue.
information in Exhibit 4,
describing the actions that you  Recommend caution in taking action.
should take.
Total marks 40
46.1 (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
First draft Adjustment Ref to Revised draft
Working
£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

Working
£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
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

Working
£m £m £m
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 corporate responsibility disclosures
External auditors' responsibilities in respect of corporate responsibility disclosures
Even though the proposed disclosures are 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 be concerned to ensure that any
disclosures related to corporate 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 720.22(e)).
The additional disclosures 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.

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 disclosures, 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 the disclosures, 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 AA1000AS issued
by AccountAbility, a non-profit network that works with business and governments to
promote sustainable development. The additional assurance report might include the
following:
 Intended users of the report
 Description of the scope of the report, including any limitations
 Description of the disclosures covered and the methodology used in verifying them
 Statement on level of assurance
 Finding and conclusions
 Recommendations
Where there is objective, third-party, evidence about progress towards the targets, 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 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 disclosures, as these
would be the starting point for any additional assurance report.
46.2 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
he/she is 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
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 46.1 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 corporate social responsibility
aspect of the question.
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.
Corporate responsibility proposals
Answers to this requirement relating to corporate governance 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.
47 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 financial 22  Assimilate complex information in order to
reporting treatment of the produce appropriate accounting
outstanding issues, setting out the adjustments.
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 profit 8  Assimilate and use adjustments identified
or loss and other comprehensive in (a) in drafting the two financial
income for the year ended statements requested.
31 August 20X5, and a statement
 Use knowledge of financial statement
of financial position at that date,
presentation to present the financial
including your adjustments.
statements in appropriate format.
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

£'000
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.
48 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 to
providing, with explanations, the 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 will 22  Apply technical knowledge to explain
help me to consider Rosa's assertions relevant to the scenario.
suggestion that we should place
 Assimilate information to identify control
more reliance on internal controls in
activities relevant to audit assertions.
our audit of Newpenny's trade
payables and accruals for the year  Identify weaknesses in control and impact
ending 31 December 20X5. 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 manufacturing 30 Only one of the 30 managers has been identified as an

managers outlier.
This provides some assurance about the processes and
controls for a large majority of manufacturing managers.
Average value per £2,343 The average value per individual order is less than half
individual order (47%) the maximum of £5,000. This indicates that the
limit is well within manager's normal operating limits
and does not constrain most managers making orders
without the need for authorisation.
There is the risk of split orders however to avoid the
need for authorisation. For example, managers may split
an £8,000 order into two orders for £4,000.
Average value of monthly £45,864 The average monthly value of orders is less than half
total orders per manager (46%) the maximum of £100,000. This indicates that
the limit is well within manager's normal operating
limits and does not constrain most managers making
orders without the need for authorisation.
There is the risk of managers early ordering to avoid the
need for authorisation. For example: if July is a peak
month then they could order more at the end of June
than is needed, so there is enough inventory to avoid
£100,000 being exceeded in July orders. Patterns of
orders late in the month preceding a peak month could
be investigated.
Frequency of managers 16 There are no instances of managers exceeding £100,000
exceeding £90,000 in any in a month (which would have required authorisation)
one month but a number of instances where managers came close
to this limit.
Frequency of managers zero Investigate where managers have been near limit and
exceeding £100,000 in investigate behaviour around limit. eg, delaying orders
any one month (requiring at the end of the month and making early orders at the
approval from senior end of the previous month.
manager) Understand role of managers. Some managers may be
responsible for higher value/volume orders. Understand
why a flat limit for all managers has been applied if this
is the case.

Dashboard data: Data Comment
Outlier – John Fuller

Average value per £3,246 The average order is 39% higher than the average order
individual order for all managers and 65% of the maximum for a single
order.
This places John Fuller as a high risk item in ordering
more than other managers.
This may mean a build-up of inventory arising from
excessive orders or inefficient usage.
An alternative explanation is that John may work in a
high cost area. He may therefore need a higher limit
than other managers.
Average value of monthly £64,379 The average monthly total of orders is 40% higher than
total orders the average monthly order total for all managers and
64% of the maximum for a single month. Investigate
the price and volume causes of the high average value.
% of individual orders 35% A high proportion of John's orders were near the £5,000
exceeding £4,000 limit yet the next most frequent incidence is 0-£1,000.
This may be regarded as an unusual pattern.
Benford's Law (First digit law) is that numerical data sets
frequently show that the leading digit is likely to be the
most common. (ie, in this case there should be more
small orders than large orders). This is true in other
sections of John's distribution but not of the highest
grouping of £4,001– £5,000.
This may be a risk of excessive ordering or possibly
fraud.
% of individual orders in 27% A significant proportion of orders occurred in a short
last three days of the period of time at month ends. If this does not reflect the
month pattern of usage then it may be a behavioural response
by John to circumvent monthly maxima for ordering
without authorisation (see above).
Investigate the reasons why this pattern of ordering
should have occurred and whether there is any
commercial rationale.
Compare with other managers whose order patterns
have not been extracted by DAACA analytics as outliers.
Frequency of John 7 There were only 16 occurrences of orders exceeding
exceeding £90,000 in any £90,000 by 30 managers and John made 7 (almost half)
one month of these.
Despite this, on no occasion did his monthly order total
exceed £100,000, thereby requiring authorisation.
There may be a risk he is avoiding authorisation and any
scrutiny.

Test 2
Dashboard data:
Number of orders 13,546 The norm is that orders should be matched with GRNs.
matched with GRN This total figure should be reconciled with the total
number of orders and GRNs issued in the period.
Number of unmatched 1,175 This could be a timing difference between the order
orders being made and the goods arriving.
Analyse by each individual supplier and assess whether
the time delay is normal for each supplier's delivery
terms.
Predict number of outstanding unmatched orders based
on totals of orders made and usual time delay for each
supplier.
Number of unmatched 22 Two months seems excessive for a delayed delivery. This
orders over 2 months old is a small number so all 22 could be investigated in case
they reveal a control weakness (eg, undelivered orders
not been followed up; inability of supplier to deliver).
Number of unmatched 17 The goods received department staff are instructed that
GRNs if there is no matching purchase order on the system,
materials should not be accepted.
If this instruction had been fully applied, then this
number should be zero. This suggests a control
weakness in that goods may have been received and
delivery accepted for goods not ordered.
There may be a further risk that an invoice has been
received and paid which would be a more serious
control weakness.
Investigate all 17 items and establish the causes.
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.

49 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 understanding
implications of each of the of a large amount of complex information.
transactions noted from the board
 Identify appropriate accounting treatments
minutes by Greg (Exhibit 2 and 3).
for complex transactions including an
Recommend appropriate accounting
interest free loan in a foreign currency to a
adjustments. Please ignore any tax
supplier; equity investment in a foreign
implications of these adjustments.
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 risks.
(Exhibits 2 and 3) and recommend
 Describe relevant audit procedures required
the audit procedures we will need to
to provide verification evidence for each
complete to address each risk.
risk.
(c) Prepare a revised draft statement of 5  Assimilate adjustments to prepare draft
financial position at 30 June 20X6 statement of financial position.
(Exhibit 1). This should include any
adjustments identified in (a) above.
(d) Explain any corporate governance 7  Assimilate information to identify potential
issues for Earthstor that you identify problems with the governance of Earthstor.
from Greg's file note (Exhibit 2). Also
 Identify potential ethical and money-
explain any ethical issues for our
laundering issues.
audit firm and set 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. IAS 39 para 43 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 IAS 39 AG 64 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 fall within IAS 39's definition of loans and receivables and should be
subsequently measured at amortised cost.
The initial fair value of the loan when issued on 1 July 20X5 is therefore:
2
MYR20m/(1.06) = 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 Loans and receivables 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 risk as creditworthiness of the supplier when the loan was
there are no cash interest payments to observe originally extended.
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 risk Compare rates to corporate loans to similar
equivalent in which case the measurement of the companies where interest is paid in full.
loan and the interest payments would be
incorrect.
Classification of the loan as loans and receivables Confirm terms by examining the loan agreement.
may be inappropriate.
Examine correspondence for any possibility of
early repayment.
There is a control risk in authorising a large loan Review level of authorisation of loan (main board).
on favourable terms.
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 between Examine the contractual supply agreement with
the provision of the loan and the cost of goods TraynerCo for example deep discounting of
from TraynerCo – the CEO has referred to a deal purchase cost of goods as part of loan agreement.
on the rent and this may also 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 and should be categorised as available for sale
because it is for the long term and not intended for immediate sale. The movement in the fair value of
an AFS asset is taken to other comprehensive income including foreign currency exchange gains and
losses (except in the case of an impairment).
IAS 39 para 43 states that (unless the financial asset is measured at FVTPL) 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 may have changed at 30 June
20X6. Where no active market exists and no reliable fair value is available, equity investments, such as
the unquoted equity investment in TraynerCo can be measured at cost less impairment.
The exclusion is only appropriate for financial instruments linked to unquoted equity investments such
as TraynerCo.
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.
There is also a question of whether the valuation is reliable – If the valuation is not reliable the
investment should be continued to be recognised at cost.
If the fall is due to market conditions, then the loss including the exchange difference is taken to OCI. If
the asset is subsequently determined to be impaired, the loss previously recognised in other
comprehensive income should be reclassified to profit or loss, even though the asset has not been
derecognised. The impairment loss to be reclassified is the difference between the acquisition cost and
current fair value.
There is insufficient information to determine whether the fair value of TraynerCo has been impaired or
whether the movement represents a change in the fair value. Or whether the transaction was not at fair
value originally.
Until further information is obtained I have assumed that the value has fallen due to market conditions
and therefore the following adjustments are required:
(Alternative assumptions are also acceptable.)
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
Assuming that the loss should be recognised in other comprehensive income therefore an adjustment is
required as follows:
£'000 £'000
DEBIT AFS – TraynerCo 1,500

CREDIT Translation reserve 1,500
CREDIT AFS – TraynerCo 3,500
DEBIT OCI/AFS reserve 3,500
Being reversal of translation of AFS asset 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 of
understood the significance of fall in price for the audit procedures set out in IAPN 1000.
shares in relation to this equity instrument and the
Review and assess the valuations made by the
additional disclosure required under IFRS 7
directors.
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 be Obtain third party evidence of the valuation at
available in respect of the valuation as the shares 30 June 20X6.
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 between Examine the contract for the acquisition of the
the provision of the equity finance and the cost of shares and ensure that this is not related to the
goods from TraynerCo – the CEO has referred to a supply agreement for goods.
deal on the rent and this may also apply to the
Prepare analytical procedures on history of cost of
equity finance.
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 may Check that fair value has been measured in
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
 Consider the use of an auditor's expert to
perform valuation.
There is a risk that management lack of expertise Confirm compliance with IAS 40/IFRS 13, for
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 during Obtain details of internal software development
the year there is a risk that both external and costs and agree to:
internally generated expenditure relating to the
 invoices from third parties; and
website have been incorrectly capitalised instead
of being written off to profit or loss.  where the costs relate to staff costs, agree to
There is a risk that the useful life of seven years time records.
may be excessive given the nature of the Ensure that costs capitalised are incremental costs
expenditure. relating to the project and not time spent on
management.
Consider the appropriateness of the useful life,
enquire of appropriate management and past
history of similar projects.
Related party transactions

TraynerCo
TraynerCo is a supplier and although there is significant interdependence between Earthstor and
TraynerCo, TraynerCo is not a related party of Earthstor.
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
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
AFS reserve (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, 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, however, did manage to
correctly classify this as an AFS investment and most (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 AFS investment 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 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.

50 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 the 4  Use technical knowledge to calculate the
proposed purchase of 650,000 goodwill on consolidation.
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 order to
outstanding financial reporting issues recommend appropriate accounting
(Exhibit 1) on EyeOP's forecast adjustments.
financial statements for the year
ending 31 December 20X6.  Apply technical knowledge to the
Recommend appropriate adjustments information in the scenario to determine the
using journal entries. appropriate accounting for pension
accounting, development costs and revenue
recognition.
accounting journals.
(c) Prepare a revised forecast consolidated 6 • Assimilate and use adjustments identified in
statement of comprehensive income (b) in drafting the statements requested.
for HiDef for the year ending 30
• Use knowledge of financial statement
November 20X6. Assume that HiDef
acquires 650,000 shares in EyeOP on
1 August 20X6 and incorporate any
adjustments you recommend in • Appreciate that control threshold passed
respect of the outstanding financial and therefore a gain on re-measurement to
reporting issues (Exhibit 1). fair value arises which is recognised in profit
or loss.
• Appreciate that previous gains are also
reclassified to profit or loss.

(d) Analyse the impact of the acquisition 8 • Analyse information to determine EyeOP's
of 650,000 shares in EyeOP on HiDef's impact on the performance ratios.
key performance targets (Exhibit 2) for
• Determine the predicted impact for 20X7.
the year ending 30 November 20X6
and, where possible, for the year • Conclude on the extent to which
ending 30 November 20X7. 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) 18.9
30%  £63 million
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 (W1)
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 December 20X5 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 30 November 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 (W2)
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 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
Revenue should only be recognised once the risks in relation to the orders for the cameras have
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 deferred income.
The adjusting journal is therefore:
£m £m
DEBIT Revenue 33.00
CREDIT Receivables 24.75
CREDIT Deferred income 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 profit or loss in the
period.
One of the consequences of the previously held equity being treated as disposed of is that any
unrealised gains in respect of it become realised at the acquisition date.
As the shares in EyeOP were previously classified as an available-for-sale financial asset, any gains in
respect of it which were previously recognised in other comprehensive income should now be
reclassified from other comprehensive income to profit or loss.
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 £0.7m + £1.8m = £2.5m to increase 3.7
to £6.2m
DEBIT Other comprehensive income and AFS reserve – recycle to 1.8
P or L
To recognise the gain on the deemed disposal existing 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 on EyeOP investment 5.5 5.5
Profit from operations 22.3 25.2 8.4 30.7
Finance costs (5.5) (14.1)  4/12 (4.7) (10.2)
Profit before tax 16.8 11.1 3.7 20.5
Income tax (2.3) (4.8)  4/12 (1.6) (3.9)
Profit for the year 14.5 6.3 2.1 16.6
Other comprehensive income for (1.8) 1.7 1.7 (0.1)
the year
Total comprehensive income for 3.8 16.5
12.7 8.0
the year

Owners of HiDef 16.0
Non-controlling interest 0.6
Consolidated statement of other comprehensive income

Reclassification of gain on available for sale investment (1.8)
Re-measurement gains on defined benefit pension plan 1.7

Owners of HiDef 15.4
Non-controlling interest (3.8  30%) 1.1
16.5
(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 of 35%
This target is currently not predicted to be achieved either with (32.5%) 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 cameras 52.5 19.3

Projected for year ending 31.12.20X7 195.4 98.7
Add HiDef 383.0 264.2

Group revenue 578.4 362.9
Group cost of sales (362.9)
Gross profit 215.4
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 9.6 times and therefore the target of 12 times will not be met.
EBITDAR after consolidation of EyeOP £m
Group profit from operations 30.7
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 = £0.06m 0.1
97.6
Interest 10.2
EBITDAR/Interest 9.6 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 deferred income 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;
 not recycling gain on AFS £1.8 million to P or L; 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.
51 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 for 6 • Assimilate complex information in order to
advice on the financial reporting produce appropriate accounting
implications of the proposed adjustments.
agreement with Beddezy on the TT
• Apply knowledge of relevant accounting
financial statements for the year
standards to the information in the scenario
ending 31 August 20X6 (Exhibit 3).
to appreciate that the rights of use of the
You 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 risks
control and detection audit risks relevant to the scenario.
associated with our audit of the PPE
• Assimilate information to identify control
balance in TT's financial statements for
activities relevant to audit assertions.
the year ending 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 for 12 • Appreciate that evidence of good controls
TT's PPE balance at 31 August 20X6 over additions last year should again be
which explains those aspects of our tested for effectiveness and informal nature
audit of PPE where: of recording system indicate controls would
not be effective.
(1) we are able to test and place
reliance on the operating • Identify the need for an auditor's expert in
effectiveness of controls; terms of valuations.
(2) we will need expert input; • Identify specific areas for audit software for
depreciation arithmetic, samples for control
(3) audit software can be used to
testing, to identify unusual journal entries.
achieve a more efficient audit;
• Appreciate that substantive analytical
(4) substantive analytical procedures
procedures over depreciation calculations
will provide us with adequate
will be effective.
audit assurance; and
• Determine areas where tests of control
(5) tests of details can be performed
would be required – eg, additions,
during our interim audit visit.
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 lease back 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 information
in the scenario.

(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.

52 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 possible, 18  Assimilate and demonstrate understanding
calculating adjustments that are of a large amount of complex information.
required to Zego's draft financial
 Identify appropriate accounting treatments
statements for the year ended
for complex items including PPE/Intangible
31 October 20X6 (Exhibit 3).
impairments and deferred taxation.
Do not prepare revised financial
statements, but you should clearly
inappropriate accounting adjustments.
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 work
Include relevant calculations and required to provide verification evidence.
explanations. Your calculations should
 Prepare analytical procedures having made
take into account any adjustments
assimilated adjustments and restated
that you have proposed to the
relevant account balances.
 Identify areas for further investigation and
areas of audit risk.

(c) A memorandum explaining the key 10  Link analytical procedures to relevant audit
audit risks for Zego. Set out the risks
implications of these risks for the • Use the information in the scenario from
financial statements for the year different sources to identify audit risks
ended 31 October 20X6 of: • Apply scepticism to the information
• Zego provided by inexperienced financial
• Lomax plc controller
• The Lomax Group • 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 £6.9m, 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
2
31.10.X8 1.0 1/ (1.08) 0.9
3
31.10.X9 0.5 1/ (1.08) 0.4
Total 2.6
488 Corporate Reporting

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 = 38.7% (12.6/31.4) × 100 =
(Gross profit/revenue) × 100 40.1%
Gross profit margin after impairment (3.4/24.8) × 100 = 13.7% N/A
adjustment
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 = 29.0% (8.8/31.4) × 100 =
(Operating expenses/revenue) × 100 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 impairment ((3.8)/(14.8 + 20.6 + N/A
losses 3.2)) × 100 = (9.8%)
Cash from operations compared to profit from (3.0/2.4) × 100 = 125% (7.3/3.8) × 100 =
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
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
 Having calculated impairment losses in the first part of the question, a lot of candidates then
speculated upon the need for impairment losses in the second and third parts, disregarding the
fact that they had already calculated them.
 Layout of candidates' answers was often messy and discussions were incoherent.
 Some candidates majored on speculations about, for example, assets held for sale while ignoring
the key points about impairment.
 Some candidates, evidently spotting the key words 'development expenditure' gave lengthy
descriptions of the IAS 38 criteria for capitalising development costs. Although the question clearly
stated that the criteria for recognition had been fulfilled, weaker candidates spent time on
reproducing the IAS 38 criteria, while ignoring the key issue of impairment.

Analytical procedures
The answers for the analytical procedures were very mixed. Good candidates focused on the two key
ratios which were 'flagged up' in the question ie, interest cover and gearing and did make adjustment to
the numbers given for the issues identified in part (a). These candidates also tended to focus on the
obvious cash flow problems, the high level of inventories and the quick ratio. Weak candidates
calculated numerous ratios and then simply repeated facts such as 'revenue has fallen' without making
any attempt to relate this to other information in the question ie, the launch of a rival product and the
fact that underlying revenue had also fallen.
Candidates also wasted time discussing audit issues not arising from the analytical review which were
more relevant to Part (c) of the question.
Improvements to marks could have arisen from simple presentation of a working paper as requested
and using adjusted figures from the financial reporting treatment in Part (a).
The calculation of gearing was often inept. The question clearly stated that gearing in this case was to
be calculated as net debt/equity, but many candidates used D/D+E and/or ignored the 'net' element of
net debt (some even missed out the share capital from equity).
Key audit risks
Weak candidates failed to focus on key risks such as going concern and instead spent time discussing
relatively low risk areas such as having to contra out intra-group balances. Where candidates identified
the key audit risk as going concern and focussed on the analysis on the breaching of the gearing and
interest cover, the operating performance and its anticipated further decline were often neglected.
However nearly all candidates did refer to the implications in the three sets of financial statements and
correctly discussed the use of the break up basis and impairments to the investment, loan and goodwill.
Worryingly it was clear that some candidates believed that goodwill was recognised in the individual
financial statements of the parent rather than in the consolidated financial statements.
53 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 appropriate 18  Apply technical knowledge to the
adjustments for the outstanding information in the scenario to determine
financial reporting issues (Exhibit) for the appropriate accounting for intragroup
the year ended 30 September 20X6 trading, pension accounting, deferred tax
for: and the loan.
(1) the individual company  Appreciate that the accounting for the
financial statements of Trinkup loan represents a net investment in a
and ZCC; and foreign operation and recommend
appropriate accounting treatment.
(2) the consolidated financial
statements.

You should assume that the current  Demonstrate high level technical
tax charges are correct, but you knowledge by explaining how the
should include any deferred tax adjustments impact on the financial
adjustments. statements for the group, parent and
subsidiary.
(b) Prepare Trinkup's consolidated 8  Assimilate complex information to
statement of comprehensive income produce financial statements.
for the year ended 30 September
20X6. Please use the adjusted
individual company financial
statements.
(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 30 September consolidation of the overseas subsidiary.
20X6. Show your 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
deferred tax adjustments.
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).
The unrealised profit is calculated as follows:
£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:
£m
Carrying amount of inventory in the consolidated financial statements
£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 £38.1
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 £
Revenue (Note 1) 189.2 103.0 292.2 (61.3) 230.9
intragroup
sales
(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
Operating income 15.7 15.7 (15.7)

Management
charge
Operating expenses and 1.7 exchange
finance costs gain on loan
(£35m – £1.7m (exchange to OCI
gain – £1.0m interest) (32.3) (52.0) (84.3) 15.7 (1) 1 interest (70.3)

Before
ZCC consol.
Trinkup Working 1 adjust. Adjustments
£m £m £m £m £m £
Profit/loss before tax 48.6 (22.8) 19.9
0.8 deferred
tax on
Taxation (9.0) 3.4 (5.6) unrealised (4.8)
profit
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% = £0.7 m) (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
Non-controlling interest
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.
54 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 in 21  Apply knowledge of relevant accounting
Carey's file note (Exhibit 2) taking into standards to the information in the
account the procedures already scenario to appreciate financial reporting
undertaken by Kevin (Exhibit 3) and adjustments arising from errors, omissions
Max's email (Exhibit 4) identify and and incorrect application of financial
explain:
reporting standards.
(1) any additional financial reporting
 Assimilate complex information to produce
adjustments, including journals; and
appropriate accounting adjustments.
(2) any auditing issues and the
 Apply scepticism to identify potential for
additional audit procedures
fraud.
required in order to complete our
audit and reach a reasoned  Identify the need for further information
conclusion on the unresolved needed to conclude on whether the related
matters. Identify any further parties are appropriately disclosed.
information required from
Key4Link.  Link information on related parties to
additional audit procedures on creditors
You do not need to consider any tax or (Farnell creditor).
deferred tax adjustments.
 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 HJM to appropriate analysis of the ethical code.
bid for Key4Link's tax advisory work
• Apply judgement in terms of the level of
(Exhibit 4). Set out any actions that errors and misstatements in the scenario to
HJM should take. 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 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 available 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 available 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.

55 Konext
Scenario
The candidate is asked to assist in the preparation of an assurance report on the interim financial
statements for Konext plc a company listed on the AIM. The financial controller Menzie Mees has
identified some transactions which he believes may have been treated incorrectly for financial reporting
purposes by the finance director, Jacky Jones. These transactions involve potential financial reporting
issues around revenue recognition, deferred advertising costs, pension schemes and the impairment of a
CGU. To prepare a good answer to this question the candidate needs to appreciate the requirements of
IAS 34. Also, that the audit procedures required may be different when reporting on the interim
financial statements and the year-end financial statements.
The candidate was also asked to comment on the adequacy of management's comments in the interim
financial statements regarding a suspected cyber attack. Also, to explain any ethical issues for Noland,
the auditor, and set out the actions Noland should take.
Marking guide
(a) Explain the appropriate financial 15  Assimilate and demonstrate understanding of a

reporting treatment of the issues in the large amount of complex information.
summary provided by Menzie
(Exhibit 3). Recommend appropriate  Identify appropriate accounting treatments for
adjustments to the draft consolidated complex transactions including revenue
interim financial statements for the six recognition, the impairment of a CGU, deferred
months ended 30 June 20X4. advertising costs and pension schemes.
 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 out
the relevant analytical procedures on  Use financial statement analysis to prepare
the revenue and gross profit in the relevant analytical procedures.
revised statement of profit or loss.  Assimilate knowledge, drawing upon question
Identify potential risks of material content and own procedures to identify key
misstatement. risks of misstatement.
(c) Set out briefly the key audit 5  Describe relevant audit procedures required to
procedures required to address any provide verification evidence for each risk.
risks of misstatement of revenue you
have identified. For these risks, set out  Apply technical knowledge to determine the
separately the audit procedures for: procedures relevant to the interim financial
statements and the financial statements for the
 the interim financial statements; year ending 31 December 20X4.
and
 Present information in accordance with
 the financial statements for the instructions.
year ending 31 December 20X4.

(d) In respect of the details you receive 8  Assimilate information to identify adequacy of
from Jacky about the information the disclosure.
security issue (Exhibit 4):
 Identify potential ethical and reputational issues
 evaluate the adequacy of the for Noland.
management commentary
disclosure in relation to the  Discuss appropriate responses and actions for
information security issue the firm in respect of the potential 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  Demonstrate understanding of the importance
Noland should take. of contributing to the culture of the profession.
Total 40
(a) Financial reporting treatment and adjustments

Revenue recognition
Per IAS 18, Revenue, the sale of the Denwa+ devices cannot be recognised until the risks and
rewards of ownership of the devices have passed.
The deposits should be recognised in cash and included as deferred income. 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.
Also, 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.
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
Deferred income 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
Dr Profit or loss 4,450
Cr Property plant and equipment 1,594
Cr Brand name 881
Cr 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
Dr Profit or loss 1,000
Cr 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
Dr Profit or loss – administrative expenses service cost 1,400
Cr Profit or loss – administrative expenses – contribution paid 900
Dr Finance costs 75
Cr 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 Year ended
30.6.20X4 6 months to revenue to 31.12.20X3
Restated 30.6.20X3 31.12.20X4
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 15,700 6,100 157% 39,250 20,500
services
Total 51,110 42,800 127,775 105,900
x120% 127,080
The projected revenue to 31.12.20X4 has been calculated by considering the seasonality of the
business by multiplying the results to 30 June 20X4 by 100/40.
If the business remains seasonal and 60% of revenue is generated in the second half of the year
and after adjusting for the error in recording the revenue for the new Denwa+ deposits, the
directors' prediction of an increase in revenue of 20% by 31 December 20X4 is achievable overall
based on the performance to 30 June 20X4.
Sales of other mobile devices have increased by 157% – although this increase is in line with the
figures estimated for the number of devices to be delivered in 20X4 as per the management
commentary, the increase could be indicative of a revenue recognition risk of misstatement – see
later conclusion.
The above analysis reveals some unusual trends which could be linked to a risk of material
misstatements as follows:
The revenue from sale of customised mobile devices is not predicted to increase in absolute terms.
The above analysis indicates that revenue will fall by 2%.

Using the above analysis and adjusted revenue figures, the estimated selling price of Konext
devices appears to have fallen whereas the sales price of third party devices appears to be
remaining constant.
Also, the software service element has increased from £41 to £50.
Konext devices and software
Number Selling price device only Software
650,000 × 40% = 260,000 260,000 20,300,000/260,000 = 13,010,000/260,000
£78.08 = £50
12 months to 31 December 636,000 51,700,000/636,000 = 25,900,000/636,000
20X3 £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 205,000 20,500,000/205,000 =
20X3 £100
Gross profit
An analysis of the gross profit margins also reveals some unusual relationships:
6 months to 6 months to Year ended
30.6.20X4 30.6.20X3 31.12.20X3
Gross profit analysis As originally Revised
stated
£'000 £'000 £'000 £'000
Customised mobile Balancing 34,986 25,986 18,540 46,560
devices and software figure
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 the risks and rewards 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 service is provided.
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 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 deferred income;
• review of amounts held in deferred and accrued income and agreement to contracts to
ensure the amount deferred follows IAS 18; 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
this respect.
There were some very good answers to this question, producing clear, rational and concise figures,
discussions and conclusions.
This question asked for journal adjustments. Where a question does this, marks are specifically awarded
for the journals. Candidates should not ignore the requirement.
Some common errors occur in respect of journal adjustments:
• Failing to provide them at all
• One-legged adjustments
• Journals that do not balance
• Adjusting journals that have an impact on cash
It was quite clear that some candidates are still having trouble with debits and credits.
Part (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.

56 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 the recommend appropriate accounting
matters described in the briefing adjustments.
papers prepared by Elac's finance
director (Exhibits 1 and 2). Include  Apply technical knowledge to the
relevant journal entries. Identify any information in the scenario to determine
further information required. Ignore the appropriate accounting for the
the effects of accounting adjustments acquisition of shares in Fenner.
on taxation.  Identify further information required to
recommend appropriate financial
reporting treatment.
(b) Prepare Elac's revised consolidated 10 • Assimilate and use adjustments identified
statement of profit or loss for the year in (a) in drafting the statements
ended 31 May 20X7 and consolidated requested.
statement of financial position at that
• Use knowledge of financial statement
date. These should include any
adjustments identified in (a) above.
Total 30
(a) Elac's investment in Fenner Ltd

Until 1 February 20X7, the investment in Fenner was correctly 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
Jnl ref Adjustment Adjusted
£m £m £m
ASSETS
Non-current assets
Tangible assets 1,799.7 1,799.7
Investments 456.0 1 (50.0) 406.0
Investment in associate 1 350.0 395.1
1 50.0
1 (3.9)
1 (1.0)
Suspense account 350.0 1 (350.0) –
Current assets
Inventories 243.8 2 (1.5) 242.3
Trade receivables 238.9 4 (0.6) 238.3
Cash 16.4 16.4
Total assets 3,104.8 (7.0) 3,097.8
Equity
Ordinary share capital
(£1 shares) 150.0 150.0
Reserves 2,255.4 4 (0.6) 2,253.1
5 (0.8)
1 (1.0)
3 5.5
1 (3.9)
2 (1.5)
Long-term liabilities 388.3 388.3
Current liabilities
Trade payables and accruals 305.6 305.6
Provision 5.5 3 (5.5)
5 0.8 0.8
Total equity and liabilities 3,104.8 (7.0) 3,097.8

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 focussed 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.

57 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 memorandum 18  Identify weaknesses in the audit procedures
from the Hind Arcan audit team performed at subsidiary level.
(Exhibit 2) and for each account
 Critically review the work of the junior and
identified:
prioritise key issues.
 describe any weaknesses in the
 Distinguish and explain the additional
audit procedures;
procedures required at group and subsidiary
 explain any potential financial level.
reporting and audit issues; and
 Appreciate and apply the concept of materiality
 set out further audit procedures in relation to group and subsidiary.
that either the UK group audit
 Appreciate and demonstrate technical
team or the Hind Arca team
understanding of the role of component auditors.
should perform, together with
any additional information for  Relate different parts of the question to identify
these procedures. critical factors.
(b) In respect of R1 – Elysia's property 12  Assimilate complex information to produce
Transaction and loan, review the appropriate accounting adjustments.
additional information provided
 Apply knowledge of relevant accounting
(Exhibit 3) and:
standards to the information in the scenario.
 explain the financial reporting
 Identify the need for further information.
implications for the consolidated
financial statements of Recruit1  Clearly set out and explain appropriate
for the year ended 30 April accounting adjustments.
20X7. Recommend appropriate  Appreciate when expert help may be required in
accounting adjustments determining deferred tax 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 reporting treatment.
Classification of property
The property has been treated as an investment property in Elysia but is unlikely to qualify as such
under the provisions of IAS 40. This is because R1-Elysia uses the building for its own training
courses and provides services to the lessees of the property in the form of administrative support
and catering. Such services are unlikely to be insignificant to the rental arrangement.
As a result, the building should be included within PPE in the Recruit1 consolidated financial
statements and stated not at fair value but at depreciated cost in line with Recruit1's accounting
policies. The revaluation gain of E$500,000 should therefore be reversed.
Audit procedures: further information should be requested on the extent to which R1-Elysia
intends to use the property to ensure that this cannot be regarded as insignificant and examine
further the total rental package and terms for external tenants to ensure that the services provided
by R1-Elysia could not be regarded as incidental.
Accounting for 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$6.350 million) and its carrying amount. A deferred tax asset arises on the accrued
interest cost as tax relief is only available when the interest is paid on 30 September 20X7.
Audit procedures: As the Elysian tax regime is unlikely to be familiar to the group team, expert
advice should be sought to ensure that the information provided regarding the tax treatment of the
property investment and income is correct. The team should question whether the additional costs
capitalised for the contractor, salary and marketing really qualify for capital expenses. The tax
computation should also be requested so that the treatment within the current tax charge can be
confirmed.
There may also be other deferred tax implications from other items within the financial statements
but these are unlikely to be material.
Carrying amount Tax base Timing difference DT at 35%
E$m E$m E$m E$m
Property (excluding 10.165 6.350 3.815 1.335
capitalised interest)
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.

58 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  Identify appropriate accounting
20X7. Identify any additional treatments for complex transactions
information you need to finalise the including recognition of intangible
accounting entries required. Ignore assets, the difference between
any adjustments for current and recognition of intangibles on
deferred taxation. consolidation and in the subsidiary
financial statements, investment
properties and IAS 40, and allowances
for bad debt.
adjustments.
(b) Identify and explain the changes that 14 • Appreciate and demonstrate technical
we need to make to each element of understanding of the role of component
the planned audit approach auditors.
summarised in the file note (Exhibit 1).
 Relate different parts of the question to
You should also consider any
identify critical factors.
additional key areas of audit focus and
risk using all the information available.  Be able to respond to changes in the
audit plan due to changes in the business
environment.
 Identify key judgement areas from a
complex scenario and different sources in
a changing time frame.

 Identify gaps and where more

information is required to develop a
revised plan.
 Appreciate the impact on materiality
level due to changes in the business
operations.
 Understand the difference between
component and planning materiality.
 Identify the risk of management override
of controls and the potential for
manipulation of judgement areas.
(c) Explain any ethical matters which 8  Demonstrate understanding of the
MKM now needs to consider in respect importance of contributing to the culture
of the 20X7 EF audit and any actions of the profession.
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 financial statements.
In addition, to recognise an intangible, EF would need to be able to measure its cost reliably.
It could subsequently choose to adopt a revaluation model for 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
The trade receivable allowance is an estimate and it is both correct and legitimate to
reconsider the basis for that estimate if the new basis provides a more accurate assessment.
That is a judgement for the EF directors. Trade receivables qualify as financial assets and would
be considered impaired if the carrying amount exceeds the recoverable amount.

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. A general 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
this respect.
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 a
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.
59 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 AFS asset 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 the similarities
between IAS 18 and 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 the recommend appropriate accounting
issues identified in Jenny's handover adjustments.
notes (Exhibit 3). Include journal
 Apply technical knowledge to the
entries.
information in the scenario to determine
the appropriate accounting for the AFS
investments and revenue.
 Understand the similarities of accounting
treatment between IAS 18 remains and
IFRS 15.
 Identify the different treatment in
deferred tax adjustments arising from the
classification of the AFS investments and
the accounting treatment of revenue.
 Identify further information required to
recommend appropriate financial
reporting treatment.
(b) Prepare a revised information schedule 8  Assimilate and use adjustments identified
for the bank (Exhibit 1) including all in drafting the schedules requested.
relevant adjustments.
(c) Prepare a report for the board in which 7  Use financial statement analysis to
you analyse and interpret the financial prepare relevant analysis.
position and performance of Wayte
 Apply skepticism to the payment of a
using the revised information schedule
dividend of £4 million when the directors
and other available information.
are seeking further bank finance.
Provide a reasoned conclusion on
whether the bank is likely to advance  Assimilate knowledge, drawing upon
the £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
(i) The investment in PSN, held as available-for-sale, 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
DEBIT AFS reserve 43
CREDIT AFS financial asset 43
(ii) The investment in LXP is classified as 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.
£'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
It is true that IFRS 15, Revenue from Contracts with Customers, is not yet mandatory. IFRS 15
clearly 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. IFRS 15 represents a
significant improvement over IAS 18, but it is not true to say that separation of performance
obligations is therefore not recognised under IAS 18. IAS 18 requires that revenue recognition
criteria should be applied to separate identifiable components of a transaction.
In this case, 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 deferred revenue, to be recognised in the future in the
period(s) in which the service is carried out. The value of the service element to be deferred is
£750,000.
£'000 £'000
DEBIT Revenue 750
CREDIT Deferred revenue 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.
(i) 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.

(ii) 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 as
available-for-sale. This is recognised in other comprehensive income in the year ended
30 September 20X7. As the movement in value is not brought into the charge to tax
until the investment is sold and the reserve recycled to profit and loss, there will be a
deferred tax effect. The tax base of the asset is £430,000, but the carrying amount is
£387,000. The deductible temporary difference is therefore £43,000. At an income tax
rate of 20% this creates a deferred tax asset of (£43,000  20%) £8,600, rounded to
£9,000. This amount is recognised as a deferred tax asset and is credited to the available-
for-sale reserve.
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.
(iii) Temporary differences arising in respect of deferred income.
The service income has been received. But, because it is now being treated as deferred
income, 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
CREDIT AFS reserve (ii PSN) 9
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 – (ii PSN) 9) 351
515 515
Note. The deferred tax asset and liability have been offset. This is recommended
presentation where the entity has a legally enforceable right to set off current tax assets
against current liabilities and where the income taxes are levied by the same taxation
authority. Both conditions are assumed and are likely to be the case here.
(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 + £351 – £145) 9,446 8,730
Equity 26,208 24,830
Net debt 450

Non-current assets available as security at 30 September 20X7
20X7
£'000
Land 1,000
Buildings 18,200
Financial assets: available for sale 387
Financial assets: fair value through profit or loss 219
Plant and equipment 8,678
28,484
Key ratios
20X7
£'000
Gearing (Net debt/equity)  100
20X7 (450/26,208)  100 1.7%
Gross profit margin (9,270/34,650)  100 26.8%

Return on capital employed (operating profit/net debt +
equity)  100
20X7 (3,660/ [450 + 26,208])  100 13.7%
(Operating profit: 4,440 – 30 – 750)
WORKING:
Summary of amendments required in journal entries above:
As stated JNL 1 JNL 2 JNL 3 Total
£'000 £'000 £'000 £'000 £'000
Revenue 35,400 (750) 34,650
Gross profit 10,020 (750) 9,270
Operating profit 4,410 (750) 3,660
Profit before tax 4,440 27 (750) 3,717
Total assets 35,670 (43) 35,654
27
Total liabilities 8,490 750 5 9,446
351
(150)
The adjusted figure for equity is (£35,654 – £9,446): £26,208
(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 26.7% which is quite a
significant fall. Return on capital employed has also fallen between the two years, once the
adjustments are considered.
The issues that are likely to emerge in discussion with the bank are as follows:
(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])/26,208)  100 24.2%
Capital employed = £26,208 + £450 = £26,658 - 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.
Candidates illustrated a firm understanding of the treatment of AFS and the matching deferred tax
treatment within 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.
60 SettleBlue
Scenario
The candidate is in the role of an audit senior who is required to evaluate whether an AFS 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 indicates 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
(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 financial
statements for the year ended 30  Apply knowledge of relevant accounting
September 20X7. Set out appropriate standards to the information in the
adjustments. Ignore any potential scenario.
adjustments for current and deferred  Identify the need for further information.
taxation.
(b) Review the file note prepared by Ann 18  Identify weaknesses in the audit
(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 by
the audit team on the two issues  Distinguish and explain the additional
identified; procedures required.
 analyse the information provided  Appreciate and apply the concept of

in the dashboard to identify the materiality.
audit risks; and  Relate different parts of the question to
 set out any additional audit identify critical factors.
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 parties.
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 focussed 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 dash board 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 the risks and rewards are
transferred to SB, no accounting
adjustment is required.
This percentage does however
provide some comfort that goods
received are authorised by a
purchase order and reduces the
audit risk of misstatement due to
authorisation.

Dashboard data: Data Analysis of data
Average time from GRN to receipt 10 days The audit team reported that
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.
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 = 22.7%
invoice over 2 months
22.7% of GRN unmatched are over
2 months old.
Average order £1,900

Test for MAK Ltd Data
Number of purchase orders 771 732/771  100 = 95%

Number of purchase orders 732 95% of MAK purchases orders are
matched with GRN 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 receipt 21 days The analytics supports the
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.
Number of GRNs not invoiced at 142 142/732  100 = 19%
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 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.

Notes
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The Institute of Chartered Accountants in England and Wales

For exams in 2018

First edition 2014

All rights reserved. No part of this publication may be reproduced, stored in a

British Library Cataloguing-in-Publication Data

Originally printed in the United Kingdom on paper obtained from traceable,

The International Accounting Standards Board (IASB)

Disclaimer: The IASB, the International Financial Reporting Standards (IFRS)

Copyright © IFRS Foundation

Financial reporting questions

Audit and integrated questions

July 2015 exam questions

November 2015 exam questions

July 2016 exam questions

November 2016 exam questions

July 2017 exam questions

November 2017 exam questions

Your exam will consist of:

Financial reporting questions 3

At 30 June 20X1 34.0 33.6 67.6

4 Corporate Reporting: Question Bank

Financial reporting questions 5

6 Corporate Reporting: Question Bank

Financial reporting questions 7

8 Corporate Reporting: Question Bank

Long-term debt 16.34

Accounts payable and accruals 7.91

Share capital 2.50

Financial reporting questions 9

10 Corporate Reporting: Question Bank

Financial reporting questions 11

12 Corporate Reporting: Question Bank

Retained earnings at 1 July 20X4 15,840 9,000

Exhibit 3: Outstanding financial reporting issues

Financial reporting questions 13

14 Corporate Reporting: Question Bank

Financial reporting questions 15

To: Marina Nelitova

DEBIT Cash £75m

DEBIT Cost of sales £33m

16 Corporate Reporting: Question Bank

DEBIT Finance costs £0.9m

Share capital Number of £1 ordinary shares

At 1 October 20X3 40m

Financial reporting questions 17

18 Corporate Reporting: Question Bank

Note: All calculations should be to the nearest £'000.

Financial reporting questions 19

To: Anita Hadjivassili

Other financial information

20 Corporate Reporting: Question Bank

Financial reporting questions 21

22 Corporate Reporting: Question Bank

Exhibit 2: Exchange rates

Financial reporting questions 23

To: Frank Brown

Notes on outstanding matters

24 Corporate Reporting: Question Bank

Financial reporting questions 25

To: Kay Norton

26 Corporate Reporting: Question Bank

Financial reporting questions 27

28 Corporate Reporting: Question Bank