ADVANCED LEVEL EXAMINATION

TUESDAY 23 JULY 2019

(3½ HOURS)

STRATEGIC BUSINESS
MANAGEMENT
This exam consists of two questions (100 marks).

Marks breakdown

Question 1 58 marks
Question 2 42 marks

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The questions in this paper have been prepared on the assumption that candidates do
not have a detailed knowledge of the types of organisations to which they relate. No
additional credit will be given to candidates displaying such knowledge.

@ICAEW
Question 1

Motor Vehicle Software Ltd (MVS) was established in 1985. It develops, sells and supports
software for motor vehicles through two separate divisions:

 In-vehicle Systems Division (customers are motor vehicle manufacturers)

 Vehicle Compliance Division (customers are governments)

You work in the business advisory department of Nathan and Norton LLP (N&N), a firm of
ICAEW Chartered Accountants. MVS is a client of N&N, but not an audit client. MVS’s
accounting year end is 30 June.

The engagement partner for MVS, Hannah Harris, has provided background information
about the company (Exhibit 1). She has also forwarded you an email from MVS’s chief
executive, Shusil Sen:

To: Hannah Harris – N&N partner

From: Shusil Sen – MVS chief executive
Date: 19 July 2019
Subject: MVS – advice required

The MVS board would like N&N’s advice on some key issues.

In March 2018, the entire ordinary share capital of MVS was acquired by Technology
Solutions International Inc (TSI), a large, listed company with international operations.

It was agreed that the MVS board could act autonomously, but it would be accountable to the
TSI board.

The TSI internal audit team made an initial visit to MVS in April 2018 and made a number of
recommendations. It also required MVS to adopt TSI’s integrated management accounting
and communication system.

MVS’s performance was poor in the year ended 30 June 2019. Also, financial journalists
have suggested that TSI overpaid for the acquisition.

On 4 July 2019, the TSI internal audit team made a further visit to MVS and raised the
following concerns:

 On 1 July 2018, the Vehicle Compliance Division adopted a cost-plus pricing policy for
government tenders, on the recommendation of the internal audit team. However, the
internal audit team is concerned about the way this pricing policy has been implemented
and about its impact on the number of successful tenders achieved. The MVS financial
controller has prepared information about tender pricing (Exhibit 2).

 The TSI internal audit team is concerned that MVS’s costs are too high, particularly for
research and development (R&D) expenditure, and it recommends a cost reduction
strategy to increase profit. I have provided further information (Exhibit 3).

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 The development of MVS’s new software platform, SoftTech II, has been delayed. The
TSI internal audit team raised concerns about the business consequences and financial
reporting implications of this delay. Further information is provided (Exhibit 4).

 MVS’s liquidity has become an issue following poor performance. The TSI internal audit
team is concerned that MVS’s response has been inadequate. The MVS management
accountant provided further information (Exhibit 5).

Partner’s instructions

Hannah Harris gives you the following instructions:

“Please respond to MVS’s ‘requests for advice’ (Exhibits 2, 3, 4 and 5).

“An ethical matter has also arisen following a confidential conversation with Mike Andrews,
one of MVS’s quality control software engineers. I have provided notes on this matter, which
need careful consideration (Exhibit 6). Please set out any ethical issues for N&N, MVS and
Mike which arise from this matter. You should also recommend actions that N&N should now
take.”

Requirement

Respond to the instructions from the partner, Hannah Harris.

Total: 58 marks

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Exhibit 1: Company background – provided by Hannah Harris

In-vehicle Systems Division

The In-vehicle Systems Division develops and sells software systems to motor vehicle
manufacturers for installation in individual vehicles. These software systems process,
transmit and store electronic information relating to the vehicle operations.

Each software system performs different functions, such as in-vehicle fault diagnosis and
emissions monitoring. Frequently, motor vehicle manufacturers buy software from different
providers for each function. MVS sets its prices by negotiation with each customer.

Each MVS software system has a standardised element, common to systems supplied to all
motor vehicle manufacturers. MVS then carries out modifications to make the software
system bespoke to the needs of each manufacturer.

Vehicle Compliance Division

The Vehicle Compliance Division develops integrated software systems for motor vehicle
compliance, which it sells globally to government departments. Separate software systems
are developed for each compliance function, such as vehicle number plate recognition and
vehicle registration.

Each compliance software system has a standardised element and additional programming
work is then undertaken to make the system bespoke to each government’s technical and
legal requirements. Further software support and maintenance is provided over the life of the
tender contract.

Government departments purchase compliance software systems using a competitive tender

process.

Typically, between two and four software companies are invited to submit a confidential
tender proposal, including a price for the bespoke compliance system. MVS is normally in
competition with software companies of similar size.

Research and development (R&D)

R&D activity is important to MVS, as competitors’ software is constantly improving and this
raises customer expectations for both divisions. An MVS software system will, on average,
be commercially viable for four years before needing fundamental change or replacement.

MVS’s accounting policy is to capitalise development costs for software systems, where
permissible, and then amortise them over their useful lives (four years on average). Research
costs are expensed as incurred.

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Exhibit 2: Tender pricing – prepared by MVS financial controller

Pricing tenders - Vehicle Compliance Division

Prior to the acquisition by TSI, tender prices were determined by MVS management based
on informal methods and judgement. MVS attempted to “set the highest price possible, whilst
still making it probable that the contract would be won”.

The initial visit by the TSI internal audit team in April 2018 expressed disapproval of this
informal method of tender pricing. The head of the internal audit team stated in her report at
that time:

“Whilst MVS has been successful in the past at winning tenders, it is not clear that it has
made adequate profit on these contracts. If MVS adopts cost-plus pricing, at least it is
assured of making some profit when it wins a contract. The measure of success should not
be how many tenders MVS wins, but how much profit it makes on each contract.”

On 1 July 2018, MVS implemented the internal audit team’s recommendation to adopt a
more formal cost-plus method when determining tender prices. Under this new method, MVS
estimates the expected direct costs of any bespoke software programming and subsequent
software support and maintenance for the contract. It then adds an amount equal to a
multiple of five times the direct cost estimate to attempt to recover the initial cost of
developing the software.

At its recent visit in July 2019, the internal audit team commented that:

“Whilst we still believe that cost-plus pricing is the preferred method for tender pricing, it is
clear that the way in which costs have been allocated and apportioned has had an
unfavourable result on tender success. The manner in which cost-plus pricing for tenders has
been implemented should be reviewed as a matter of urgency.”

Two examples of MVS tender pricing

To address the internal audit team’s comments, I have provided two examples of tender
proposals during the year ended 30 June 2019. These proposals were for vehicle number
plate recognition software for the state governments of Texas (in the US) and Victoria (in
Australia). Each proposal uses standardised number plate recognition software (SNPRS),
with some added bespoke software modifications to meet local needs.

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Tender prices for the two proposals were calculated as follows:

Texas Victoria
£’000 £’000
Bespoke programming costs (including 1,280 320
learning time)
Support and maintenance costs 640 160
Total direct costs 1,920 480
Add: SNPRS development costs 9,600 2,400
Total estimated cost 11,520 2,880
Mark-up 15% 1,728 432
Tender price 13,248 3,312

The Texas government stated that it would require significant bespoke modifications to the
SNPRS to satisfy local data protection laws. MVS software programmers anticipated that this
would need some learning time, as they had not made this type of modification before. They
therefore added a contingency of 45% to the bespoke programming costs to allow for the
learning time.

Including MVS, four software companies tendered for the Texas contract and two for the
Victoria contract. MVS was successful in obtaining the Victoria contract, but not the Texas
contract. After the tender process was completed, MVS discovered that its tender price for
the Texas contract was 20% above the price of the successful tender.

MVS’s tender price for the Victoria contract was 30% below that of the other company
tendering for the contract.

SNPRS development costs

The SNPRS was launched on 1 July 2017 and is expected to have a useful life of four years.
Total development costs of £96 million were all capitalised. These costs were significantly
greater than budgeted because of some initial programming problems. Ultimately, however,
the software works as intended in the original specification.

I have prepared some calculations to show the amount of SNPRS development costs
recovered in the two years since launch. These are based on the assumption that SNPRS
development costs were recovered at 5 times the direct cost estimate.

On this basis, SNPRS development costs included in tender costs for the two years ended 30
June 2019 were:

All number plate recognition tenders £109.4m

Successful number plate recognition tenders £36.7m

Tender experience

MVS’s tender experience for the number plate recognition software since launch has been:

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 Years ended 30 June 2019 2018

Number of tenders made 16 12

Number of successful tenders 4 6
Value of tenders made £80m £72m
Value of successful tenders £15m £36m

Request for advice

In relation to tendering by the Vehicle Compliance Division:

(1) Evaluate the cost-plus method of tender pricing and the manner in which MVS has
implemented it, suggesting alternatives. Appraise the two examples provided (Texas
and Victoria) describing, with supporting calculations, any weaknesses in our approach
to pricing these tenders.
(2) Explain the financial reporting implications of MVS’s tender performance for the carrying
amount of SNPRS development costs in MVS’s financial statements for the year ended
30 June 2019. Show supporting calculations.

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Exhibit 3: Cost reduction strategy – provided by Shusil Sen
Following its visit to MVS in July 2019, the internal audit team commented in its report:

“Profit must increase and a significant cost reduction strategy is needed to achieve
this.

“A key element of this strategy should be a reduction of at least 12% in overall R&D
expenditure for the year ended 30 June 2020. Management should also reassess the
way in which the total annual R&D budget is determined.”

To help address these comments, I have provided some key financial data for MVS for the
years ended 30 June:

2019 2018
£m £m

Revenue 2,000 2,100

R&D expense (written off in year) (150) (158)
R&D amortisation & impairment (160) (165)
Other operating costs (1,632) (1,540)
Operating profit 58 237

Cash spent on R&D 300 315

Carrying amount of development costs

- intangible asset at 30 June 302 312

Current R&D projects

2019 2018
Number of R&D projects 7 8

Capitalised R&D costs are amortised over an average period of 4 years. On individual R&D
projects, this ranges from 3 to 5 years depending on an evaluation of market conditions.

R&D is a major cost and is key to developing new products in a rapidly changing industry.

The total annual R&D budget is determined as 15% of last year’s revenue.

Two alternative methods of reducing R&D expenditure have been identified. Each method
would give a saving of 12% of the overall R&D expenditure in the year ended 30 June 2020,
compared with the previous year. The two alternative methods are:

(a) Reduce total R&D expenditure by making some savings on all R&D projects.
(b) Cancel the R&D project on software for autonomous (ie self-driving) cars. This project
commenced two months ago.

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Request for advice

Please:

(1) Explain and justify the key factors that MVS should consider in deciding which of the
two alternative methods of reducing R&D expenditure by 12% to implement. Include
financial reporting considerations.

(2) Evaluate whether determining the total annual R&D budget by using a percentage of
revenue is appropriate for MVS.

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Exhibit 4: SoftTech II development delay – provided by Shusil Sen

The In-vehicle Systems Division is developing the next version of its car emissions software
(SoftTech II), which it originally intended to launch on 1 July 2019. MVS intended to stop
selling the existing version of car emissions software (SoftTech I) on 30 June 2020, at which
time the capitalised SoftTech I development costs would be fully amortised.

However, very recently, problems were detected in SoftTech II and, as a result, its launch will
be delayed until July 2021.
The development costs for SoftTech II capitalised at 30 June 2019 amount to £22 million,
with no amortisation. Further development costs continue to be incurred.

Following its visit in July 2019, the internal audit team expressed concerns about the
business consequences and financial reporting implications of the delay.

Request for advice

With respect to the delay in the development and launch of SoftTech II:

(1) Set out the strategic and operational issues that may arise.

(2) Explain the financial reporting issues.

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Exhibit 5: Liquidity – prepared by MVS management accountant

Following its July 2019 visit, the internal audit team expressed concerns about MVS’s
liquidity, arising from its recent poor performance.

The head of the In-vehicle Systems Division has agreed to consider new terms for customers
to improve cash flow. In future, customers will be invoiced a single sum for software systems,
together with support and maintenance, payable at the beginning of the contract.

Over the past year, the In-vehicle Systems Division has experienced customer complaints
about prices.

A case example

The In-vehicle Systems Division is currently negotiating with a motor vehicle manufacturer for
the sale of a software system for £2.4 million, payable on delivery.

Software support and maintenance would normally be available for three years following
delivery, for annual payments in arrears of £240,000 over the three-year period.

As an alternative, the customer will be offered the software system and three years’ support
and maintenance for a single payment on delivery of £3 million.

Request for advice

Evaluate the financial implications for MVS of the proposed new payment terms for its
customers. Use the case example and include calculations. Ignore the financial reporting
implications.

Exhibit 6: Notes on an ethical issue – prepared by Hannah Harris

When I visited MVS recently, a software engineer, Mike Andrews, asked for a confidential
chat.

He told me that a software system for a small motor vehicle manufacturer has just been
completed by MVS to make it bespoke. In final quality control testing, Mike said he noticed a
minor fault in the programming. To fix the problem he estimated that it would take
approximately four weeks and so MVS would miss the agreed delivery date.

According to Mike, it is probable, but not certain, that the fault will cause a reduction in the
fuel efficiency of the customer’s vehicles. The problem is unlikely to be immediately apparent
to the customer, but it may emerge over a number of years.

Mike reported this matter to the head of quality control, who said she would look into the
issue and deal with it. This was a month ago and Mike heard no more, until last week, when
he became aware that the software had been delivered to the customer.

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Question 2

Contacta plc is a UK listed company which operates in the eyewear business. It designs,
manufactures and distributes high-quality lenses for glasses. Sales are mainly in the UK.

You are a senior working for Doille, Drabe & Dewie LLP (DDD), a firm of ICAEW Chartered
Accountants. DDD provides business advice and assurance services to Contacta, but
Contacta is not an audit client.

The DDD engagement manager, Claire Mallary, attended a meeting last week with the
Contacta board. After the meeting, Claire gave you the following briefing:

“I would like you to work on the Contacta engagement with me.

“The Contacta board is keen to expand and has asked DDD to provide advice on a number
of issues relating to: financing; financial risk management; and other matters. I have provided
you with background information about Contacta and its proposed expansion (Exhibit 1).

“To finance the expansion, Contacta needs to raise £15 million. The finance director, Ron
Steven, has provided details (Exhibit 2).

“Catherine Greggs, the chief executive, has been notified of a significant unhedged position,
which was entered into recently by the treasury department. The Contacta board would like
DDD to carry out an assurance engagement to assess the risks and recommend actions.
Catherine has provided some notes on the treasury transactions (Exhibit 3).

“Finally, the chairman, Kieran Magrice, who is a non-executive director, raised concerns
relating to gearing and executive options. He has provided a memorandum outlining these
issues (Exhibit 4).

“I would like you to draft a report for the Contacta board. I have set out instructions in a
separate document (Exhibit 5) explaining what I would like you to do.”

Requirement

Draft the report requested by Claire Mallary, the engagement manager (Exhibit 5).

Total: 42 marks

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Exhibit 1: Background information – prepared by Claire Mallary, engagement manager

History

Contacta was founded 25 years ago. Having grown gradually over time, it obtained a listing
on the London Stock Exchange in 2007.

The board and corporate governance

Up to 2016, the company had experienced a 10-year period of near-zero growth. As a

consequence, the executive directors were removed and a new group of executive directors
appointed.

The board now comprises four executive directors and three non-executive directors. The
chairman is a non-executive director and has been in that post for 10 years. The other two
non-executive directors have been in post for six years.

The shareholders are mainly financial institutions. No single institution holds more than 3% of
Contacta’s ordinary share capital. There are good communications with shareholders, but
they are not active in governance issues.

Sales and markets

Sales are mainly to opticians’ outlets throughout the UK. However, about 2% of sales are
outside the UK and these are almost entirely to eurozone countries.

There is increasing competition in the UK market with many new entrants.

Expansion

After recently carrying out market analysis and competitor analysis, the board decided to
expand Contacta’s existing business by manufacturing contact lenses as well as lenses for
glasses.

There will be no new production site, as the existing factory can be scaled-up to utilise spare
capacity. However, £15 million short-term finance is required for initial set-up costs, a
marketing campaign and working capital.

Expansion will commence on 1 November 2019 and the finance will be needed on this date.

Financial statements

Summary statement of profit or loss for the year ended 30 June 2019

2019 2018
£’000 £’000
Revenue 63,000 59,600
Cost of sales (43,400) (41,800)
Gross profit 19,600 17,800
Distribution and administration costs (13,400) (12,200)
Operating profit 6,200 5,600
Finance costs (3,500) (3,500)
Profit before tax 2,700 2,100

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Summary statement of financial position at 30 June 2019

£’000
Non-current assets
Property, plant and equipment
Cost 113,750
Accumulated depreciation (20,000)
93,750

Current assets
Inventories 7,200
Trade and other receivables 6,000
Cash 500
Total assets 107,450

Equity
£1 ordinary shares 5,000
Share premium 1,000
Retained earnings 8,200

Non-current liabilities
4% loan notes 2022 87,500

Current liabilities
Trade and other payables 5,750
Total equity and liabilities 107,450

Contacta’s share price at 30 June 2019 was £8.32 per share.

The 4% loan notes are secured by a fixed charge over property.

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Exhibit 2: Financing the expansion – prepared by Ron Steven, finance director

The Contacta board has decided to raise a £15 million fixed interest loan to finance the
expansion.

I am now making plans to raise the £15 million on 1 November 2019. The loan would be
short-term for 9 months from that date.

However, I am concerned that market interest rates will rise over the three months to
1 November 2019 and that the fixed interest loan will therefore become more expensive by
that date. I therefore want to hedge this interest rate risk using interest rate futures.

We can assume that the hedging transaction will take place on 1 August 2019.

I would like to present an illustrative example to the board to show how a futures contract can
be used to mitigate the risks of a change in interest rates in the three months to
1 November 2019 and I would like your help to do this. Illustrative data and assumptions are
set out below.

Illustrative data and assumptions for an interest rate hedge

At 1 August 2019, the futures prices (for standard 3-month, £1 million contracts) can be
assumed to be:

September 2019 delivery 98.40

December 2019 delivery 98.50
March 2020 delivery 98.60

These contracts will expire at the end of each of the above months.

The 12-month LIBOR rate at 1 August 2019 will be 1.5%. Contacta can borrow at LIBOR +
2.5%.

Working assumptions are:

 At 1 November 2019:
o The price of the December futures contract will be 98.00
o The price of the March futures contract will be 98.10

 The 12-month LIBOR rate at 1 November 2019 will be 2%.

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Exhibit 3: Treasury transactions – prepared by Catherine Greggs, chief executive

The treasury department of Contacta is a profit centre. Its key objective is: “to manage
Contacta’s financial strategy, including the mitigation of financial risks”.

A few days ago, a routine internal audit inspection of the treasury department found that the
head of treasury, Paula Boothby, had recently authorised a series of foreign currency
transactions. This series of transactions involved:

 borrowing a significant amount in Swiss Francs (CHF) at a low interest rate;

 converting this amount to £ sterling; and
 depositing it at a higher sterling interest rate in order to make a profit on the interest rate
differential.

All Contacta staff, with experience of foreign currency transactions, work within the treasury
department and are not sufficiently independent to investigate this matter further. I would
therefore like to engage DDD to undertake a risk assurance engagement and make an
independent report to the board.

In respect of the above series of transactions, the board is concerned about:

 the financial impact of the transactions.

 the risks to which we are now exposed and how to mitigate those risks.
 the financial reporting impact.
 the weaknesses in our control environment and the required improvements.

Pending your report, I have put Paula Boothby on paid leave.

I have set out below extracts from the treasury team notes on the series of transactions. This
was all the supporting information available.

Treasury team notes

On 8 July 2019, the treasury team borrowed CHF4 million on money markets at 0.5% fixed
annual interest rate, with maturity in 6 months.

On the same day, the CHF4 million was converted to £ sterling at the spot rate and this
amount was placed on a 6-month £ sterling deposit.

Money market rates at 8 July 2019

6-month sterling deposit rate (annual rate) 0.72%
£/CHF spot exchange rate £1 = 1.295 – 1.305
6-month £/CHF forward premium 0.0038 – 0.0033

Working assumption by treasury team:

The £/CHF spot rate in 6 months will be: £1 = 1.315 – 1.325

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Exhibit 4: Gearing and executive options – prepared by Kieran Magrice, chairman

For some time, I have had concerns about the following issues:

 Gearing
 Executive share options and their impact on board decisions

Gearing

There has been some dispute at recent board meetings about the most appropriate long-term
financing structure for Contacta. Since they were appointed, the four executive directors have
favoured borrowing and increasing gearing. Catherine Greggs expressed their opinion as
follows:

“It is clear to us as executive directors that Contacta can borrow at around 4% pa

whereas, if we raised equity in future, shareholders would require a return on their
investment of over 10% pa. Borrowing is clearly much cheaper than raising equity.”

In contrast, the three non-executive directors are concerned that gearing is too high and
therefore they favour raising new equity for any further long-term capital requirements.

I, as chairman, and the other non-executive directors believe the Contacta board needs
expert, independent advice on this matter.Executive share options and their impact on board
decisions

On 30 June 2017, the remuneration committee (comprising myself, as chairman, and the
other two non-executive directors) granted each executive director 100,000 share options in
Contacta shares. Each option entitles the directors to purchase one share in Contacta.

At 30 June 2017, Contacta’s share price was £8.50. The exercise price of the options is also
£8.50. The fair value of the options at the grant date was estimated to be £1.20 per option.
The option exercise date is 30 June 2021, but directors are required to remain as directors
until that date in order to be able to exercise the options. These are the only share options
held by the directors. The current share price is £8.32.

I have become concerned about the impact that these options may be having on the
executive directors’ decision making and whether they are creating inappropriate incentives.

For example, I am concerned that the options may be acting as an incentive for the executive
directors to favour debt over equity in Contacta’s long-term financing structure. I need to
understand why this may be the case.

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Exhibit 5: Instructions – from Claire Mallary, engagement manager

(1) Explain how the proposed interest rate futures could hedge the interest rate risk arising
in respect of the £15 million loan.
Illustrate your explanation with calculations, using the illustrative data, working
assumptions and other information provided by Ron Steven (Exhibit 2).

State any additional relevant assumptions.

(2) Regarding the treasury transactions (Exhibit 3):

 Explain, with supporting calculations, the potential financial impact of the series of
transactions. Use the information and the working assumption provided. Briefly
discuss the appropriateness of the working assumption.

 Identify and explain the financial risks to which Contacta is exposed. Explain how
these risks can be mitigated using a forward rate agreement and illustrate with
supporting calculations.

 Briefly explain whether there is any benefit from applying hedge accounting for
financial reporting purposes.

 As part of a risk assurance engagement, set out key controls that could be
introduced by the Contacta board to improve the control environment for these
types of treasury transactions.

(3) Regarding the concerns of the chairman (Exhibit 4):

(a) Explain, with supporting calculations, the factors to be considered by the

Contacta board in deciding whether to raise debt or equity for future long-term
finance. Evaluate the opinion of the executive directors as expressed in the quote
from Catherine Greggs.

(b) Evaluate:

 how the executive share options may influence the executive directors’
decision making.

 the probable impact of raising more debt in future on the value and risk of the
executive share options.

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