AAA - Revision Material

Dec 2013 Q5 - Burford Co

QUESTION

(a)

You are the manager responsible for the audit of Burford Ltd, a company which designs and manufactures
engine parts. The audit of the financial statements for the year ended 31 July 2013 is nearing completion and
you are reviewing the working papers of the going concern section of the audit file. The draft financial statements
recognise a loss of £500,000 (2012 – profit of £760,000), and total assets of £13·8 million (2012 – £14·4 million).

The audit senior has left the following note for your attention:

‘I have performed analytical review on Burford Ltd’s year-end financial statements. The current ratio is 0·8 (2012
– 1·2), the quick ratio is 0·5 (2012 – 1·6). The latest management accounts show that ratios have deteriorated
further since the year end, and the company now has a cash balance of only £25,000. Burford Ltd has a long-
term loan outstanding of £80,000 with a covenant attached, which states that if the current ratio falls below 0·75,
the loan can be immediately recalled by the lender.’

You are also aware that one of Burford Ltd’s best-selling products, the QuickFire, has become technically
obsolete during 2013 as customers now prefer more environmentally friendly engine parts. Historically, the
QuickFire has generated 45% of the company’s revenue. In response to customers’ preference, £1·3 million has
been spent on designing a new product, the GreenFire, due for launch in February 2014, which will be marketed
as an environmentally friendly product.

A cash flow forecast has been prepared for the year to 31 July 2014, indicating that based on certain
assumptions, the company’s cash balance is predicted to increase to £220,000 by the end of the forecast period.
Assumptions include:

1. The successful launch of the GreenFire product,

2. The sale of plant and machinery which was used to manufacture the QuickFire, generating cash
proceeds of £50,000, forecast to take place in January 2014,
3. A reduction in payroll costs of 15%, caused by redundancies in the QuickFire manufacturing plant, and
4. The receipt of a grant of £30,000 from a government department which encourages innovation in
environmentally friendly products, scheduled to be received in February 2014.
Required:
Explain the matters which cast doubt on the going concern status of Burford Ltd and explain the audit
evidence you should expect to find in your file review in respect of the cash flow forecast.

(14 marks)

(b)

Having completed the file review, you have concluded that the use of the going concern assumption is
appropriate, but that there is significant doubt over Burford Ltd’s ability to continue as a going concern. You have
advised the company’s audit committee that a note is required in the financial statements to describe the
significant doubt over going concern. The audit committee is reluctant to include a detailed note to the financial
statements due to fears that the note will highlight the company’s problems and cause further financial
difficulties, but have agreed that a brief note will be included.

Required:

In respect of the note on going concern to be included in Burford Ltd’s financial statements, discuss the
implications for the audit report and outline any further actions to be taken by the auditor.

(6 marks)

(20 marks)
 AAA - Revision Material
Dec 2013 Q5 - Burford Co

SOLUTION

(a)

Going concern

The company is making a loss of £500,000 compared with a profit of £760,000 last year. This is a very
significant decline in performance which ultimately results in a cash outflow from the business which the
company may not be able to sustain.

The value of assets has declined from £14.4m to £13.8m. Whilst this is not a problem in itself, it could be
necessary to replace assets at a certain point which may create an additional risk from a cash perspective.

The current ratio has fallen below 1 indicating difficulty in meeting short-term liabilities. This could create issues
of suppliers refusing to supply and may, therefore, result in an inability to trade. It is worth noting that the quick
ratio shows the situation to be even worse at 0.5. Given that a major product has become obsolete, the quick
ratio may be a more indicative measure of risk.

The company is very close to breaking its current ratio banking covenant 0.75. The current ratio is standing at
0.8 having declined from 1.2 last year and this is, therefore, likely to result in a breach of the covenant at some
point over the coming months. This could result in an immediate recall of finance resulting in an inability to trade.

The company’s best selling product which accounts for 45% of its revenue has become technically obsolete.
This is of fundamental risk if the company does not replace it with another product. Although a new product is to
be launched, it would need to replace this 45% of revenue before the breach of banking covenants and before
cash runs out.

The cash flow forecast includes many events that may not happen. For example, the sale of plant and
machinery, a reduction in payroll costs and the receipt of a government grant. The cash flow may, therefore, be
over optimistic.

Audit evidence

1) The launch of the GreenFire product:

 ➢ Review of the project plan to ensure that the launch could be achieved by February 2014.
➢ Obtain evidence to support calculations of revenue and expected market share – perhaps in the
form of independent reports.

2) Sale of the plant and machinery:

➢ Verification of the market value of £50,000. Ideally, this would be in the form of observable
market data for identical assets. If the valuation is based on similar assets, then obtaining
evidence of adjustments to the observable market data will be necessary.
➢ Obtain evidence of negotiation with a buyer, proving that the sale will be taking place in January
2014.

3) Reduction in payroll costs of 15%:

➢ Recalculation to prove the 15% based upon a plan involving specific job roles.
➢ Review the correspondence with the HR department proving that the reduction is possible and is
not outweighed by redundancy costs associated with the reduction.

4) Government grant encouraging environmentally friendly products:

➢ Obtain evidence that the new product has complied with the environmental criteria of the grant.
➢ Review correspondence from the government confirming that the criteria have been satisfied and
that £30,000 is due for receipt in February 2014.

(b)

The audit committee is only prepared to include a brief note with regard to the uncertainty over the going
concern status of the business. Where there is a fundamental uncertainty with regard to the going concern
status of the business it is a requirement for this concern to be adequately disclosed in the financial statements.
Where this happens, there cannot be a disagreement of accounting treatment as we agree with the going
concern status and the disclosure has been made adequately. However, whilst we would not qualify our report,
we would draw the reader’s attention to the uncertainty by modifying the report with a material uncertainty
regarding going concern paragraph.

If the disclosure in the financial statements is not adequate, then there is a disagreement of accounting
treatment resulting in either a material or pervasive disagreement and therefore a qualified audit report.
Professional judgement will be required to determine whether the disclosure is sufficient enough. It should be
detailed enough to explain the key risks such as the potential breach of banking covenant and the risks
associated with the recovery plan – for example, a delay in the new product launch.

The auditor should discuss this potential impact on the audit report with the audit committee. This would enable
them to change their approach to the situation by for example including more disclosure around the going
concern status.

Although they were initially reluctant to do this, they may think differently once they are aware of the impact on
the audit report and the perception that a qualified report may create amongst the users of the financial
statements.