SOLUTIONS - BUSINESS REPORTING N14

BR Solutions November 2014

Question 1 Robicorp
Scenario
The candidate is required to reply to a request by a newly appointed finance director to provide appropriate
accounting treatment for a number of transactions. In addition the candidate has to adjust profits and
calculate earnings per share. The transactions relate to convertible bonds, development costs, revenue
recognition, convertible bonds and acquisition/disposal of equity investments
The candidate was required to test whether a dilution occurs in respect of the convertible bond and the share
options. The bond is anti-dilutive and therefore requires no adjustment to the EPS. The candidate had to
calculate the number of free shares arising as a consequence of the share options and hence a diluted EPS
calculation.
Requirements
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.
Maximum marks

Technical
marks
4

Skills

Skills assessed

13

Apply technical knowledge of IAS

38 to the scenario to determine
appropriate accounting treatment
of the application.
Identify need for amortisation of
development costs
Analyse and interpret journal to
determine reversal of accrued
production costs required.
Link information to determine the
correct accounting treatment for
the revenue from the XL5 order.
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

Assimilate adjustments and

prepare revised profit after tax
Calculate basic EPS and revised
EPS

23

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SOLUTIONS - BUSINESS REPORTING N14

To:
From:
Subject:

Marina Nelitova
Alex Murphy
Review of financial statements for year ended 30 September 2014

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 able 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 2014 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 x 2.5 million) should therefore
have been created.
The following journal is therefore required:
Dr Profit or loss
Cr Intangible asset

6 million
6 million

Once sales of the XL5 commenced on 1 August 2014 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 2014, and this gives an amortisation charge of 500,000 (15
million x 1,200/36,000).
Dr Profit or loss
Cr Intangible asset

500,000
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 and 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.
Dr Revenue (1,800 x 25,000)
Cr Deferred income

45 million

Cr Cost of sales (1,800 x 11,000)

Dr Accrued expenses

19.8 million
19.8 million

45 million

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 nonconvertible instrument.
This gives an initial bond element of 33.037 million (working 1) and the balance of the bond is taken directly
to equity, giving a figure of 6.963 million.
Dr Share Capital
Dr Share Premium
Cr Bond liability
Cr Equity

4 million
36 million
33.037 million
6.963 million
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SOLUTIONS - BUSINESS REPORTING N14

An interest charge of 2.478 million (33.037 million x 10% x 9/12) should therefore have been charged in
the statement of profit or loss and added to the liability and the interest accrual reversed
Dr Profit or Loss
Cr Bond liability

2.478 million
2.478 million

Dr Accruals
Cr Retained earnings

0.9 million
0.9 million

Share option scheme

Robicorps 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 2016. 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 2013 should be expensed over the vesting period of the
scheme.
This gives a total cost at 30 September 2014 of 1.4 million (25 execs x 48,000 shares x 350 pence x 1/3).
An expense is shown for this amount and an equal sum credited to equity at 30 September 2014.
Dr Profit or loss
Cr Equity

1.4 million
1.4 million

Investment in Lopex/Saltor
Robicorps 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 2013, they would have been
measured at fair value of 3.68 million (400,000 x 9.20 pence) 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 x 3.20
pence).
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 x 2.5 x 5.50). The balance in
the available for sale reserve should be transferred to the income statement at the derecognition date.
Robicorp should also have recognised a new financial asset in the form of the shares in Saltor at 1 August
2014 at the fair value of 5.5 million.
Dr Financial Asset (shares in Saltor)
Cr Financial Asset (shares in Lopex)
Dr Available for sale reserve
Cr Profit or loss account, gain on disposal

5.5 million
3.68 million
1.28 million
3.10 million.

At 30 September 2014 the shares in Saltor should be remeasured at fair value, which per IAS 39 is the bid
price of 4.80 pence. This gives a value of 4.8 million (1 million x 480 pence) and the movement in fair
value of 700,000 (5.5 million less 4.8 million) is taken to profit or loss.
Dr Profit or Loss
Cr Financial Asset

700,000
700,000

The sales commission of 4 pence per share is ignored.

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SOLUTIONS - BUSINESS REPORTING N14

Earnings Per Share

After taking into consideration the above changes basic earnings per share decreases to 81.61 pence.
(Working 2).
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:

The convertible bond could potentially increase Robicorps 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.

The share option scheme could increase Robicorps 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 79.1 pence (Working 3).

Working 1
Robicorp convertible bond
PV Interest 1/1/15 @10%
PV Interest 1/1/16 @10%
PV Interest and capital 1/1/17 @ 10%
Total

'000
1,091
992
30,954
33,037

Working 2
Basic Earnings Per Share
Draft
Development costs expensed
Development costs amortised
Revenue/costs not recognised
Bonds instead of shares
Interest expense
Share option expense
Gain on sale of Lopex
Fair value loss on Saltor
Revised totals
Basic EPS

Earnings
'000
65,820
(6,000)
(500)
(25,200)

Shares
44,000,000

(4,000,000)
(2,478)
(1,400)
3,100
(700)
32,642

40,000,000

81.61 pence

Working 3
Diluted EPS
Basic totals
Convertibles (see below)
Share options (free shares)
Total
Diluted EPS

000
32,642

40,000,000

32,642

200,526
40,200,526

81.2 pence
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Options calculation
Earnings figure = 32,642,000
Fair value of services yet to be rendered
(1.2m x 3.50 x 2/3)
Per option (2.8m/1.2m)
Adjusted exercise price (4.00 + 2.33)

2,800,000
2.33
6.33

Number of shares under option

No. that would have been issued at average market price
[(1.2m 6.33/7.60]

1,200,000
(999,474)

No. shares treated as issued for nil consideration (free shares)

200,526

Convertibles calculation dilution test

Earnings/shares

2,478,000/3,000,000

82.6p

As 82.6p is greater than the basic EPS of the 81.61p then the convertibles are antidilutive and therefore
excluded from the diluted EPS calculation.
Examiners comments
General comment on candidates performance
The answers were generally structured, very clear and with good explanation of most parts of the question.
Detailed comments
XL5 intangible and revenue recognition
In general, this element was completed well by most candidates, with the majority correctly identifying that
the intangible had been incorrectly recognised, needed to be amortised and then the revenue and cost of
sales adjusted to reflect the proportion of items delivered. The issue that was missed most frequently was
the cost of sales adjustment and the correcting journal.
Bond

Most also dealt with the bond reasonably well identifying that split accounting was required and
making a good attempt at calculating the debt and equity elements.
The majority of candidates knew therefore that this was a hybrid instrument and that the equity
option and the liability needed to be dealt with separately. Although the equity was correctly treated
as a balancing figure the liability was often not calculated correctly.
The most frequently error was the lack time apportioning the interest.

Share option

Most scored full marks on this although a good number thought the vesting period was 4 years not 3.

Lopex share for share exchange

The answers to Lopex were of a very mixed quality. This section was not attempted very well by
weaker candidates.
Many candidates did not seem to make it clear that the previous AFS asset would be derecognised
and replaced by new shares in Saltor. Gains calculations were made but there was a tendency to
revalue before derecognition. Many stated the journal entry to work out the gain on disposal but did
not make it clear that the disposal proceeds would become the new value of Saltor shares.
In addition although the bid price was often used correctly to revalue to FV at the end of the year
many tried to deduct/add the transaction costs and this is incorrect.
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SOLUTIONS - BUSINESS REPORTING N14

EPS

Weak answers tended to be muddled and unstructured in their approach

Basic computation was fine
However the diluted computation when attempted was often confusing.
Although a number of candidates realised that a calculation of free shares was needed very few
calculated the number correctly. The dilution for the bond was either ignored (with no explanation
why) or included fully without any thought as to whether it was dilutive or not.

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SOLUTIONS - BUSINESS REPORTING N14

Question 2
Scenario
The candidate is required to draft an email to the clients responding to their enquiries concerning the taxation
issues arising from the incorporation of their partnership and property issues. Therefore to answer this
question well the candidate must extend professional knowledge of the tax implications of incorporation to
determine that incorporation relief should be disapplied dependent upon the personal circumstances of the
partners and also to include the interaction of a TOGC with the capital goods scheme and SDLT issues. The
candidate is also required to determine the range of tax implications of either a lease or sale of a property to
the newly incorporated company. The candidate is required to demonstrate communication skills for their
given audience by preparing an email response to the clients and workings for the manager.
Requirements

Technical
marks

Skills

Draft an email to Tara, Fran and

Nancy in non-technical language
responding to Taras queries which
includes

an explanation of the tax

implications for Tara, Fran and
Nancy and MakOver of the
incorporation of the TFN Apps
partnership on 1 July 2014; and

Skills assessed

Apply technical knowledge to

determine use of overlap profits to
final year of assessment
Link information on incorporation
valuations to determine tax
liabilities
Consider a range of taxes in the
advice given to the client
Identify opportunity to minimise
Nancys tax liability by disapplying
incorporation relief
Provide an alternative tax
treatment
Discriminate information to
determine relevance of information
provided Tara to computation of
tax liabilities
Appreciate the different
perspectives of the partners given
personal circumstances

an explanation of the tax

implications for Tara and for
MakOver of the lease or sale of
the new office property at Yale
Street (Exhibit 2)

Prepare a separate document for me

showing the detailed workings which
support your response to Taras
queries.

Available marks
Maximum marks

Formulate advice considering both

the perspective of Tara and the
company

Present information in technical

format for the manager.
Communicate in appropriate
manner to a given audience

19
25

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SOLUTIONS - BUSINESS REPORTING N14

Draft Email
To:
From:
Date:
Subject:

Tara, Fran and Nancy

Mia
November 2014
Tax queries and information

Taxation implications of incorporation

On incorporation the trade of the partnership was taken over by MakOver. The assets and liabilities of the
partnership have been transferred to MakOver in return for share capital in that company.

Trading income profits

As you ceased to trade, final tax year rules will determine your share of the 2014/15 taxable profit. This will
be your share of the partnership taxable trading profits for the year ended 30 June 2014 less your overlap
profits.
Overlap profits are the profits made in the first 12 months of trading as a partnership which were effectively
taxed twice due to the application of opening year rules.
This happened because the partnership started up on 1 January 2012, so the assessment for the tax year
2011/12 was based on the 3 months to the end of the tax year. In the next tax year, 2012/13, the accounting
period was less than 12 months long so the profits of the first 12 months of trading were used. As a result
some of the partnerships profits were in effect taxed twice. You are allowed to deduct your share of these 9
months of overlap profits in calculating your 2014/15 taxable profits. Therefore your taxable partnership
profits for 2014/15 will be as follows

2014/15 (12 m/e 30 June 2014)

Less : Overlap relief
(3 m/e 5 April 2012)
(6 m/e 31 Dec 2012)
Taxable profits

Total

Tara

Fran

Nancy

000
600

000
300

000
150

000
150

(60)

(30)

(15)

(15)

(90)

(45)

(22.5)

(22.5)

450

225

112.5

112.5

Chargeable gains
Not all assets which are transferred result in chargeable gains for you as individuals. Chargeable gains will
arise on the transfer of the following assets:
000
Gan Road property
Open market value (1 July 2014)
Cost (1 January 2012)
Gain taxable on Tara

260
(200)
60

Goodwill
Open market value (30 June 2014)
Cost
Gain taxable on all partners

2,000
Nil
2,000

Plant and machinery is normally exempt from capital gains tax.

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SOLUTIONS - BUSINESS REPORTING N14

Summary

Gains

Allocation 50/25/25
Tara
000
60

Fran
000

Property

000
660

Goodwill

2,000

1,000

5505005
00

2060

1,060

500

Nancy
000

500
500

The gains are automatically deferred (unless an election is made to prevent this) against the base cost of the
shares as all the assets have been transferred to the company in return for shares.
The base cost of the new shares is reduced, leading to a larger capital gain on a future sale. For Tara and
Fran the gain on the shares may qualify for entrepreneurs' relief (ER), and so future gains should be taxable
at 10%. However Nancy needs to consider whether to disapply incorporation relief as she will not qualify for
ER if she sells the shares in May 2015. This is because she will not have worked for the company. She will
qualify for ER on the chargeable gain on the incorporation and would pay tax at the ER rate of 10% instead
of at 28% on a future sale.
VAT and SDLT
The business appears to have been transferred as a going concern, and therefore no VAT is chargeable on
the assets when they are taken over by MakOver. You should have notified HMRC within 30 days of the
transfer.
No VAT payable applies to the property at Gan Street since no option to tax was made on the building and it
has been transferred as part of a TOGC. Further information should be obtained about this property since
the scenario states that Tara purchased the property in January 2012. We would need to know whether the
property was a new commercial property to explain fully the tax implications of the transfer. Making the
assumption that this was not a new commercial property there would be no VAT payable provided that the
conditions for the TOGC were not breached and there is no evidence in the scenario to suggest this is at
point.
SDLT will however be payable on the cost of the property by MakOver (260,000 x 3%) = 7,800.
The computer hardware and fixture and fittings can be transferred at tax written down value and an election
is required for this. Otherwise as the partnership and the company are regarded as connected the transfer
would be deemed to have been made at market value and balancing allowances and charges would arise on
the partnership profits.
Capital goods scheme
The input VAT on the computer hardware would have been recovered in full under the capital goods scheme
as it had 100% business use.
Where an item is transferred as part of a TOGC then its disposal represents neither a taxable supply nor an
exempt supply so no adjustment on sale is required on incorporation. Instead the MakOver assumes
responsibility for any adjustments of input tax required under the scheme for the remainder of the adjustment
period.
Tax implications for Tara of grant of a lease to MakOver
Tara will be granting a short lease from a freehold interest. Tara will have a property income assessment of
74,800 in the tax year 2014/15 and a chargeable gain of 1,931 (Mia - please see working 2)
VAT
As Tara has opted to tax the property therefore VAT of 16,000 will be payable on the lease premium
(80,000 x 20% = 16,000)

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Tax implications for MakOver

Corporation tax
MakOver can claim a deduction against its trading profits for the premium assessed on Tara divided by the
number of years of the lease 68,800/8 = 8,600 pa and also for the rent it pays to her.
Stamp Duty Land Tax (SDLT)
SDLT is chargeable on land transactions including the grant of a lease.
Where a land transaction is made for chargeable consideration (payment in money or money's worth), there
is a charge to SDLT based on the amount of that consideration. It is based on the VAT inclusive amount.
For leases, the lease premium is charged under the normal rules as if the lease premium were the
chargeable consideration. However, if the rent is 1,000 pa or more and the land is non-residential property,
the 0% rate is not available and the whole of the premium will be chargeable at 1% or higher.
Therefore MakOver will pay SDLT of 80,000 + 16,000 = 96,000 x 1% = 960
On the grant of a lease, in addition to any SDLT payable on the premium, SDLT is payable on the rental. The
rental charge is based on the net present value of the rent payable to the landlord over the term of the lease
(inclusive of VAT)

Rental payable over the term of the lease

8 x (24,000 x 1.2)
Less non-residential threshold

230,400
150,000
80,400

SDLT @ 1% = 804
VAT
The VAT of 16,000 should be recoverable by MakOver together with the VAT on the rent, as it is unlikely
that MakOver is making exempt supplies - however this point needs to be confirmed.
Tax implications of selling Yale street property to MakOver
Tax implications for Tara
The gain on the disposal will be taxed as a capital gain. Tara will be able to deduct her annual exemption
unless this has been utilised elsewhere. As a higher rate tax payer she will pay capital gains tax at 28% on
the gain. The property was not previously used by the partnership and therefore Taras assertion that she
should qualify for ER at a 10% tax rate is incorrect. This is not an associated disposal but merely the sale of
an investment property which does not qualify for ER relief.

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Disposal proceeds
Cost
Annual exemption (assuming not used
elsewhere)

000
580
480
100
(10.9)
89.1

CGT @ 28%

24,948

VAT
VAT will be chargeable on 580,000 x 20% = 116,000 and recoverable by MakOver subject to the above
concern over exempt supplies.
Income tax - Interest on directors loan
Interest of 25,000 pa will be paid to Tara in respect of her loan to MakOver. She will pay income tax at her
marginal rate of tax on this amount. MakOver will deduct this amount in computing its trading income.
MakOvr will be required to deduct the basic rate of income tax before paying the interest to Tara.
Tara would also pay income tax on the rental income less rental expenses.
SDLT
The rate for SDLT on the sale of the freehold would be 4% and again this is payable by MakOver on the VAT
inclusive amount 580,000 + 116,000 = 696,000 x 4% = 27,840.

Workings for the attention of the manager

Working 1
Calculation of overlap profits
Total
000

Tara
000

Fran
000

Nancy
000

60

30

15

15

120
90
210

105

52.5

52.5

2013/14 (12 m/e 30 June 2013)

180

90

45

45

2014/15 (12 m/e 30 June 2014)

Less : Overlap relief
(3 m/e 5 April 2012)
(6 m/e 31 Dec 2012)

600

225

112.5

112.5

2011/12 (3 months to 5 April 2012)

3
/6 120,000
2012/13 no 12 month accounting period
therefore use first 12 months trading results
ie 12 m/e 31 December 2012
6
/6 120,000
6
/12 180,000

Total taxable profits

Total accounting profits

(60)
(90)
450

900
900

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SOLUTIONS - BUSINESS REPORTING N14

Working 2 Taras property income assessment and chargeable gain.

Tara has granted a short lease from a freehold interest. This means that the lessor (Tara) has retained a
reversionary interest in the property and it is therefore a part disposal for capital gains tax. However, as this
is only a short lease some of the lease premium is treated as property income of Tara and taxed as income.
Only the capital element of the premium is used to calculate a capital gain at the date of grant.
A normal part disposal computation is required with the cost adjusted using the formula:
A
C+B

Cost

Where
A = capital proceeds ie the capital element of the lease premium ie the total less the amount assessed as
property income
B = market value of the reversionary interest
C = the total lease premium received
Property income assessment

Premium (80,000 x

50 - 7
50

*Rent 24,000 /4

68,800
6,000
74,800

Chargeable gain

Consideration (80,000 68,800)

Less Deemed cost
11,200
x 480,000
80,000 + 500,000
Chargeable gain

11,200
(9,269)

1,931

Examiners comments
General comment on candidates performance
There was a very broad variation in the quality of answers to this question. It was very clear when a
candidate was well prepared for the tax question as all parts of the question were answered. However, a
number of candidates missed out complete sections of this question demonstrating lack of knowledge in
areas of the syllabus. It was apparent that candidates had not focussed their pre-exam time to the tax
question. Overall this question was not answered as well as previous tax questions.
Detailed comments
Trading profits, MakOver and Gains

The majority of candidates were able to describe the impact and action of incorporation relief and its
interaction with entrepreneurs relief (ER), with the result that they were able to recommend that
Nancy disapply incorporation relief now. Few made a decent attempt at calculating the overlap
profits and then deducting them from the final year profits.

If a candidate mentioned plant and machinery and the balancing adjustment necessary, it was only a
minority of those candidates that suggested an election to transfer at TWDV may be appropriate
given the scenario.

Candidates sometimes presented very long generic answers about the taxation position of the
company and partners post incorporation including knowledge dumping of NIC differences. Given

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SOLUTIONS - BUSINESS REPORTING N14

that the scenario stated that the partners were not drawing salaries or dividends and indeed that
Nancy would now be working for the company, few marks were available for such discussions.

Likewise extensive discussions about loss relief were also largely irrelevant

VAT/SDLT
Candidates were confused by when stamp duty should be charged on the VAT exclusive price vs the
VAT inclusive price and when the capital goods scheme was relevant.
Yale Street - Lease to MakOver

The computation of the gain and income split was done well with many scoring full marks.
The annual rental charge was also usually identified but not always apportioned correctly.
Only a minority of candidates demonstrated the skill of looking at the transaction from both Tara and
the companys perspective and included a corporation tax deduction for the lease premium with a
correct calculation.

Yale Street - sale to MakOver

Although many calculated the gain for Tara correctly a minority did not understand that ER would not
be available and taxed the gain at 10%.
It was worrying how a minority of candidates calculated an indexation allowance to the cost of the
asset.
There was a good deal of discussion about the fact that the company was a close company and
therefore s455 would apply to loans. This missed the point that the loan was to Tara not a loan being
taken out by Tara. This lead to discussion about notional tax being paid and reclaimed by the
company unfortunately it was often described well but gained no marks as it did not apply here.
Many candidates did not therefore appreciate that Tara would be receiving interest which would be
liable to tax.

Separate documents

Although the majority of candidates correctly set out their response as two separate documents and
adapted the style of writing to the recipient of each, a significant minority ignored this requirement
despite this being explicit in the question.

When separate documents were provided, it was not always very clear that the documents were
actually separate. The structure and layout and labelling of the answers could be improved.

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Question 3
Maxvol scenario
The candidate is the senior planning the audit of a listed company with a recently acquired subsidiary.
The candidates firm has been asked to accept appointment as auditor of the subsidiary and he / she is
presented with background information, a letter from the predecessor auditor and some notes from an
initial fact finding meeting. These raise some ethical issues in respect of accepting the appointment.
They also raise concerns about the quality of work done and independence of the previous auditor.
As well as identifying and assessing the ethical issues, the candidate is also required to identify
financial reporting and audit issues both for the group and for the acquired company.
The successful candidate will have a good understanding of the requirements of IFRS13 in determining
fair values and of a number of other areas of financial reporting. They will need to go beyond identifying
the issue to assessing its impact on the audit both of the subsidiary and of the parent. Analytical skills
and application of general principles to a particular situation are required throughout the question.

Requirement

Technical
marks

Set out the ethical issues that arise

for L&K and explain the
implications for L&K noting any
actions that it should take. Identify
any additional information you
believe L&K should seek

Skills
marks
7

Skills

Determine that tax fraud may be a

reason for not accepting the
appointment as auditor

Use technical knowledge to explain

that SBA cannot deny access to
working papers according to CA
2006 once formal appointment has
been made
Appreciate the implication of lack of
independence of SBA on the
reliability of the brought forward
balances.
Link information to identify potential
for creative accounting deriving from
the deferred consideration for
Remixit shares.
Use financial statement analysis to
determine that profit target under
achieving; increase in current assets
out of line with increase in revenue.
Assimilate information from various
parts of the scenario to determine
potential misstatement of tax
balances
Identify the need for specialist tax
advice

Explain the audit risks you have

identified for the audit of Remixit
for the year ending 31 December
2014 assuming that we accept the
Remixit audit engagement,. For
each risk, set out the key audit
procedures you believe we should
perform;

10

Page 14 of 29

Apply scepticism to the employee

fraud and the extent of Kierans
awareness
Identify that there is insufficient
information concerning the fraud
Explain that fee dispute would not
present an ethical issue but a
commercial impact on the decision to
accept the appointment
Identify the perspectives of both
parties in the fee dispute

SOLUTIONS - BUSINESS REPORTING N14

Explain for the Maxvol group for

the year ending 31 December
2014:

the financial reporting issues

which arise as a consequence
of the Remixit acquisition; and

the group audit issues arising

from the acquisition. Exclude
any issues already raised for
the Remixit audit, unless
there are different implications
for the group. Audit
procedures are not required
at the moment
Total marks
Maximum marks

25
29

Page 15 of 29

Apply technical knowledge to explain

incorrect financial reporting
treatment of;
o valuation of property not in
accordance with IFRS 13
o Restructuring provision
Apply scepticism to the level of
current liabilities to identify the
potential for understatement.
Identify the risks arising from the
claim for faulty goods on inventory
and other balances.
Determine relevant audit procedures
for risk identified.
Apply scepticism to the quality of
work to be performed by the Remixit
finance department.
Identify the audit risk from dominant
personality of Barry and the risks
arising from the contingent
consideration.
Distinguish between financial
reporting issues at company and
group level
Apply technical knowledge to
determine incorrect treatment of
contingent consideration and impact
on group financial statements.
Distinguish between the treatment of
contingent liabilities and the
restructuring provision at group and
company level
Appreciate the timing and materiality
of the subsidiary on the group audit
work
Demonstrate appropriate oversight
and challenge of the work performed
by the subsidiary auditors.
Explain the need for separate audit
teams and the overall responsibility
of group auditors.

SOLUTIONS - BUSINESS REPORTING N14

(i)

Implications of ethical issues and actions L&K should take

There are a number of ethical issues raised by and in respect of the previous auditor. However as L&K are
already group auditors they will be keen to accept appointment if possible and will, in any event, need to gain
assurance on Remixits results from the perspective of group auditor.
Taking first the matters raised by SBA:
Expenses fraud

Fraud is a matter which may affect the decision to act as auditor, although further consideration needs
to be given to the nature of the fraud, who it was committed by and the action which was taken by
Remixit in response to the fraud. At present we do not have enough information to assess fully the
implications of this disclosure.
In addition, while we have assurance that the fraud is not material, we will need to satisfy ourselves on
this as materiality considerations may well be different when it comes to fraud and considerations of
legality come into play.
It is odd that Kieran did not mention the fraud or the additional work done on expenses when asked
about issues arising in the prior year audit. However it is possible that all discussion on this matter
took place with Barry and the other directors.
It would be particularly concerning if the fraud allegations were in respect of a senior member of staff
or a member of the finance staff or if Remixit had not taken appropriate action to investigate fully the
allegations and take appropriate action. This matter needs to be discussed with Barry and also those
charged with governance at Maxvol to determine what happened and who is aware of the allegations.
Gaining an understanding of the tone at the top will also be important.

Fee dispute
The fee dispute is not in itself a matter which should affect the decision to act but it is useful information and
underlines the fact that Remixit (and Barry in particular) may be difficult to deal with. However, Kieran
implies that there is another side to the dispute and that SBA may not have provided timely service.
Tax matters
The information provided by SBA suggests that Remixit management may have been economical with the
truth in the past regarding tax matters. This is information which might affect L&Ks decision to act but again
further information is required. In particular it is important to understand whether the individuals concerned
are still working for the company and whether the chief executive, Barry Gibbons is implicated. There may
also be implications for the accuracy of tax provisions in the prior year accounts (see below)

Access to working papers and explanations

SBAs letter says that it will not grant access to its working papers or provide any further explanations.
However the Companies Act 2006 says that it must provide the successor auditor with access to all relevant
information, including access to relevant working papers. L&K should respond to the letter, setting out this
requirement and stating that it will provide details of the information it requires in due course. It should also
point out that this will not be a breach of confidence as it is done in accordance with a mandatory
requirement. Remixit should however be informed.
The guidance says that the request should be made after the successor has been formally appointed so it
cannot be made until the appointment decision has been made. L&K can however start to think about what
information it requires as the guidance also requires the request to be as specific as possible.
Independence of SBA
A number of factors raise questions about the independence of SBA as auditor of Remixit and therefore the
extent to which L&K can rely on the prior year audit work. These include the nature of the other services
provided by SBA tax advisory work; accounting advice; and preparation of accounts. None of these is
banned by the ethical standards but all raise a potential self review threat in connection with the audit and, in
addition, there may be a self interest threat if the fees for this work are greater than the audit fee and
significant to SBA. Additional information is required to assess this. Previous auditors potential lack of
Page 16 of 29

SOLUTIONS - BUSINESS REPORTING N14

independence is not a matter which would preclude acceptance but caution and full understanding are
required.
In addition, SBA may have placed itself in a position of conflict by acting both for Barry in a personal capacity
and for Remixit. This is not uncommon but should be part of the consideration.
The risk is further enhanced by the personal association between Barry and the SBA audit partner, although
again this would not appear to be a banned relationship under the ethical standards but may raise a
familiarity threat.
L&K should gain a full understanding of the non audit work done and the relationships before determining
how much reliance to place on SBAs work on the opening balance and how much work it should do itself to
gain assurance over those balances. This might influence the extent to which a detailed working paper
review is required and may also lead to specific questions about safeguards in the discussion with SBA.
If investigations show that SBA have acted inappropriately then L&K would have an obligation to report the
firm to the ICAEW.
(ii)

Explanation of Audit risks for Remixit audit and related audit procedures

Management incentive / enhanced fraud risk

There is a significant amount of contingent consideration payable to Barry which is dependent on the
results of Remixit for the year ending 31 December 2014. This gives Barry an incentive to manipulate
the results of the company for his own personal benefit.
Based on the results for the 9 months to 30 September and assuming that profits accrue evenly
throughout the year, Remixit is on track to make a profit of 2.8 million which is 200,000 short of the
3.0 million required for the additional consideration to be paid.
Faulty product claim for a major customer may put more pressure on results if it has a significant effect
on the companys reputation.
Barry continues to work in the business in the role of chief executive and his response to the previous
auditor and level of involvement in financial matters suggest that he might be a dominant personality
used to getting his own way.
Fraud has been discovered in the past and there is also an allegation from the previous auditors that
Remixit management may have been economical with the truth in the past. This would be of particular
concern if it involved Barry.

Audit procedures in response to this risk should include:

Further enquiries about past fraud

Detailed consideration of all judgmental provisions, including assessment of whether there is any
evidence of bias
Consideration of all late / unusual accounting adjustments or journal entries
Enhanced procedures on cut-off and completeness of liabilities
Enhanced procedures on revenue recognition as this may be an area which is open to manipulation
according to the date on which systems or elements are accepted and revenue recognised.
Detailed analytical review procedures to identify any unexplained or unusual trends which require
further analysis
Consideration of items over which Barry has particular control such as the manipulation of his salary /
bonus to ensure that the profit target is met.

Increase in current assets giving rise to potential risk of overstatement

Summary financial statements for Remixit at 30 September 2014 show a 37% increase in current assets
compared to only an 8% increase in revenue (assuming revenue accrues evenly throughout the year). This
suggests that either inventory levels have risen considerably or that customers are slower to pay.
Further investigation is needed to understand what balance has risen and the reasons for it. If either
inventory or receivables ageing has deteriorated then particular audit focus should be given to the adequacy
of any provisions.

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SOLUTIONS - BUSINESS REPORTING N14

Taxation
The acquisition into the Maxvol group could affect Remixits tax status and here may also be past issues as
indicated by the letter from SBA. As a result there is an enhanced risk that the tax balances may be misstated:

Specialist tax advice is likely to be required as part of our audit and a tax specialist should be identified
and fully briefed.
Details of prior year tax computations and of any issues raised by HMRC should be obtained.
The discussion with the previous auditors should include gaining a fuller understanding of the nature
and implications of the situation where Remixit management were economical with the truth as this
may mean that there is a liability to future tax.
Discussions should be held with Maxvols tax department to understand any issues or concerns they
have identified from their involvement in Remixits tax affairs to date.
Detailed work will be required on current and deferred tax balances.

Tangible non-current assets valuation risk and disclosures

In its own financial statements, Remixit has a choice as to whether to continue to record its land and
buildings at cost less depreciation or include them at valuation. As the revaluation has been recorded
in Remixits financial statements, it seems likely that the revalued amount is to be used.
Under IFRS13 the asset should be valued at the price at which it could be sold in an orderly
transaction in either the principal or most advantageous market. It should be at its highest and best
value. This implies that the opportunity to sell the piece of land to a developer should potentially be
taken into account, resulting in a higher value of 3.5 million and an additional 500,000 revaluation
gain. Possible that selling costs should also be taken into account.

Audit procedures on this balance should include:

Review of the detailed external valuation to ensure that the basis used is in accordance with IFRS13

Consideration of the market evidence for the higher valuation of surplus land, including the likelihood
of planning permission being granted for the change of use.

Consideration of the qualifications of the valuer.

Depreciation rate for equipment risk that the rate may not be appropriate
Equipment is being depreciated over a useful life of 5 years but discussion with Kieran suggests that its
actual life may be much longer.
Need to look at evidence of actual lives and assess what would be the most appropriate useful life for each
category of equipment as may not be appropriate either to use the same rate for all.
Financial expertise of Remixit team
While additional expertise will now be provided by the Maxvol team there may have been transactions in the
first 9 months of the year, particularly in the months after SBA had resigned where the Remixit team did not
have enough expertise to determine the correct accounting treatment.
We should enquire as to whether were any such one off transactions and look carefully at the financial
reporting treatment adopted.
Restructuring provision risk of misstatement
Under IAS37, provision for restructuring costs should only be made once a constructive obligation exists
and a reliable estimate can be made. This is only the case if a detailed plan has been made and an
announcement made to those affected.
Will need to ensure that the appropriate level of commitment and communication existed at 30 September
2014, given that the restructuring appears to relate to an acquisition which only took place on that date. Will
also need support for the amounts included as may be a judgmental area capable of manipulation.

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SOLUTIONS - BUSINESS REPORTING N14

Completeness of liabilities
Excluding the provision, current liabilities have actually decreased despite an increase in activity. This
means that there is a risk of unrecorded liabilities.
Audit procedures should include

analytical procedures on expenses and accruals;

review of post year end invoices and payments to ensure appropriate accruals made where these
relate to pre year end items;

Review of supplier statement reconciliations

Examination of minutes and other documents for evidence of any unrecorded liabilities such as
approved bonuses, claims etc

Consideration of whether there is / should be a warranty provision given that the lawyers response
mentions a warranty period
Contingent liability risk associated with judgement and required disclosures
Assuming that the lawyers assessment of the position remains unchanged, the claim should be disclosed as
a contingent liability in Remixits financial statements.
The key audit procedure here will be obtaining an updated view from Remixits lawyers. We will also need to
consider the broader implications of the faulty product such as whether an increased provision for product
under warranty is required, whether sales will be affected by the loss of reputation, whether any amounts due
from the major customer are collectible etc
(iii)

Financial reporting issues and group audit issues arising from the acquisition of Maxvol

Date of acquisition
Need to ensure that the date from which Maxvol has included the results of Remixit is the date on which
control passed this will require scrutiny of the sale and purchase agreement.
Control
Maxvol owns 75% of Remixit and therefore would normally be presumed to have control. Should however
check that there is nothing in S&P agreement which would change this.
Calculation of fair values and goodwill
Maxvol will need to reflect the acquisition of Remixit in its financial statements for the year ending 31
December 2014 and record at fair value the separable net assets acquired.
There are a number of issues with the current calculation of goodwill set out by Gil:

The contingent consideration has not been included in the calculation. IFRS3 requires that contingent
consideration be included and a liability recognised for the cash amount payable even if it is not
deemed probable that it will be paid. This liability will need to be reassessed once Remixits results for
the year ending 31 December 2014 have been determined. If it is not payable then the liability will be
released and a gain recognized in Maxvols profit or loss account.

Treatment of the non-controlling interest at present this has been determined using the proportion of
net assets method which is acceptable. However Maxvol could choose to use the fair value method
and further discussion is required as to which is to be adopted.

No taxation charge has been provided by Remixit for the period ending 30 September 2014 but the tax
liability at that date should form part of the calculation of fair values and so current and deferred tax
balances should be determined.

No valuation of equipment appears to have been performed at the acquisition date but equipment too
should be valued at fair value in the calculation of goodwill and be brought into Maxvols financial
statements at that value.

There may be other separable intangibles such as customer lists which should be identified separately
from goodwill and a valuer will be required to assess this and determine the amounts of any such
intangible assets.

A liability should not be recognised by Maxvol on acquisition for costs such as reorganisation costs
expected to be incurred as a result of the business combination. It would only do so were Remixit to
be committed to the plan pre acquisition which seems unlikely here as it only arises due to savings

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SOLUTIONS - BUSINESS REPORTING N14

which may be possible post acquisition. Hence the 400k provision should not be part of the fair value
calculation.
The contingent liability should however be included at fair value if the fair value can be measured
reliably. This is the case even if an outflow is not probable.
The matters identified as risks for the Remixit audit may all have implications for the assets and
liabilities of Remixit at the acquisition date and these need to be taken into account. Also need to
consider work done at the time of the acquisition and extent to which reliance can be placed on this.

Group audit issues

Timing of audit work the Remixit financial statements were only completed in July in the prior year which is
well after the Maxvol deadline for group reporting of 15 February. Need to ensure that the Remixit finance
team have the support and resources required to meet this deadline.
Audit scoping generally the acquisition of a material subsidiary will affect the determination of group audit
materiality and also potentially the scope of work required at each significant component. This will need to
be taken into account in planning the group audit.
A separate team from L&K will perform the work at Remixit - the group audit team will need to assess the
extent of the work performed and the implications of any issues arising from the audit for the group audit
report
Specific audit procedures in respect of the consolidation of Remixit results will need to be planned for the
component auditors to perform to be reviewed by the group audit team.
Examiners comments
General comment on candidates performance
The answers were generally well presented with headings to show the various issues covered, and laid out
in an organised manner that would be expected in practice.

Detailed comments
Ethical issues

Whilst many candidates were able to identify the events that might lead to ethical issues for L&K,
they were not able to clearly articulate the issue/threat that L&K might face in the course of their
work; for example the non-payment of fees would be discussed at length with the decision being
made that the appointment should not be accepted because the previous auditors had not been
paid. Although important, many candidates discussed this as an ethical issue without identifying any
threats.
Weak candidates could not distinguish between ethical issues and audit issues/risks and so
discussed the same points in this answer and the next section.
The question asked for further information and actions which was not always presented in the
answer.
Few candidates appreciated the Companies Act requirement for the previous auditors to provide the
relevant papers and thus focused on the impact of not having access to these papers.

Audit risks and procedures

This section was answered well with the financial reporting points and general control issues
discussed with a good range of procedures. Many scored full marks
Marks were lost when the audit tests were not appropriately linked to the scenario.
The best answers noted that the issues identified in the earlier section meant that L&K could not rely
on a controls approach to the audit and more substantive testing would be needed.
However a significant number thought that an acceptable approach for many issues in the
circumstances would be to obtain management representations.
A few very good candidates produced some financial analysis. However the majority failed to take
notice of the financial statements and the implications arising from interpreting the numbers
presented to them

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SOLUTIONS - BUSINESS REPORTING N14

Financial reporting issues

Most candidates identified that Remixit was now a subsidiary and that the contingent consideration
needed to be factored into the goodwill calculation. Therefore the points about consolidation and
goodwill impairment were made well.
Some candidates excluded the contingent consideration stating incorrectly that if it was unlikely then
it should be ignored.
Very few noted that there might be other intangibles to be recognised on consolidation.
The fair value of the contingent liability should have been deducted from the net assets at
acquisition. Many said that it should just be disclosed hence forgetting the basics of consolidations.

Group audit issues

Weak candidates simply went through the audit issues previously noted. As a result a significant
minority were awarded zero marks for this section.
Candidates struggled to distinguish between the financial reporting and group auditing
considerations. Few identified that as L&K were auditors of both Remixit and Maxvol; separate
teams would be needed; materiality would need to be considered on a different basis; and that the
team structure might need to be changed to deal with the challenges of the tight timescale.

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SOLUTIONS - BUSINESS REPORTING N14

Question 4 Hoop plc

Scenario
The company in this scenario, Hoop, operates in the food packaging industry. The candidate works for RN,
the auditors of Hoop. In this role the candidate has replaced the previous audit senior who had left several
unresolved financial reporting and audit issues
These issues relate to: recognition of pension costs in profit or loss; a change in accounting policy for
inventory from FIFO to weighted average cost; and cut off issues relating to revenue and cost of sales for a
partially completed contract with a payment in advance.
There is an additional issue that the previous audit senior believes that Hoop might be trying to understate
profit in a good year.
Candidates are required to:

Set out and explain the appropriate financial reporting treatment.

Outline the key audit risks and the detailed audit procedures.

Determine whether there is any evidence of profit manipulation

Requirements
Set out and explain the appropriate
financial reporting treatment.

Technical
marks
3

Skills
10

Skills assessed
Pension
Apply technical knowledge of IAS
19 to the data provided to
determine the appropriate
accounting treatment.
Explain the accounting treatment
selected
Compare correct treatment to
original treatment and reverse
previous entries
Change of accounting policy inventories
Apply technical knowledge of IAS 2
and IAS 8 to the data provided to
determine the appropriate
accounting treatment.
Explain the accounting treatment
selected
Compare correct treatment to
original treatment and reverse
previous entries
Revenue recognition
Apply technical knowledge of IAS
18 and cut-off procedures to the
data provided to determine the
appropriate accounting treatment.
Explain the accounting treatment
selected
Compare correct treatment to
original treatment and reverse
previous entries

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SOLUTIONS - BUSINESS REPORTING N14

Outline the key audit risks and the

detailed audit procedures.

Determine whether there is any

evidence of profit manipulation

Available marks
Maximum marks

20
23

Page 23 of 29

Assimilate information to identify

key audit risks
Use judgement to select audit
procedures which most
appropriately respond to each of
the key risks identified.
Clearly explain the nature and
purpose of each audit procedure
selected
Clearly identity the individual and
cumulative impact of each of the
adjustments to the draft profit
Draw clear conclusions whether
the adjustments provide evidence
of manipulation by the Hoop board
to understate profit.

SOLUTIONS - BUSINESS REPORTING N14

Hoop
Issue (1) Pension obligation
Financial reporting
Present value of defined benefit obligation:

1 July 2013
Past service cost
Current service cost
Benefits
Interest cost (20,500 + 800 + (2,100 x 6/12) (1,500 x 6/12)) x 4%)
Remeasurement gain (balancing figure)
30 June 2014

000
20,500
800
2,100
(1,500)
864
22,764
(64)
22,700

The remeasurement gain (net of any remeasurement gain/loss on assets) is recognised through other
comprehensive income.
Audit risks and procedures
Present value of defined benefit obligation
It is necessary to assess whether we can rely on the work of the actuaries. In this case as the actuary is an
auditors expert, rather than a management expert, a high degree of reliance can be placed on the
independence and competence of the actuarial assumptions based on RNs quality control procedures in
appointing the actuary.
Nevertheless, in respect of the actuarys work in assessing the present value of the defined benefit
obligation, the auditor should have a clear understanding of:
o
The source data used
o
The assumptions and methods used
o
The results of actuaries work in the light of RNs knowledge of the business and results of other audit
procedures
Current service costs

Discuss with directors and actuaries the factors affecting current service cost and review service costs
against salaries (for example, as the scheme is closed to new employees, for employees in the
scheme the current service costs may see an increase year on year as a percentage of pay with the
average age of the workforce increasing).
Agree terms of service costs to the pension agreement between employees and the pension fund
Verify an appropriate method has been used (e.g. projected unit credit method)
Review discount rate used by comparison to market yield on high quality fixed-rate corporate bonds.

Past service costs

A plan amendment arises when an entity either introduces a defined benefits plan or changes the benefits
payable under an existing plan. As a result, Hoop has taken on additional obligations that it has not hitherto
provided for. This will create a new defined benefit obligation.

Discuss with directors the reasons for the change

Agree the amendments to the terms of the scheme to the revised pension plan agreement
documentation
Ensure that all costs to Hoop arising from past service costs are recognised immediately in profit or
loss.
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SOLUTIONS - BUSINESS REPORTING N14

Discuss with directors and actuaries the factors affecting past service costs (future benefits, timing of
benefits, discount rate used)

Interest cost

Confirm that net interest cost has been based on the discount rate determined by reference to market
yields on high quality fixed-rate corporate bonds.

Benefits paid
Gary said he has verified the cash contributions and benefits paid to supporting documentation. As a
minimum this should have included:

Agree cash payments to cashbook and bank statements

Agree appropriate amounts have been paid using a sample of employees
Carry out analytical procedures to evidence the total benefits paid (number of retired employees,
increase in pensions per scheme agreement, number of deaths in year)
Ensure payments paid promptly

Note
Pension contributions are not relevant to obligations and the entries made by Hoop should be reversed.
Issue (2) - Change in accounting policy - inventories
Financial reporting
Profit
000
Inventory valuation (change in policy)
Adjustment to opening inventories (782 785)
Adjustment to closing inventories (786 795)

3
(9)

Therefore the net effect is to reduce profit by 6,000.

Audit risks and procedures
The difference in measurement is small and well below the materiality level. Nevertheless, enquiries should
be made of Hoop management as to why they have changed the inventory identification basis for such a
small financial difference. In particular because the implementation of weighted average cost is more difficult
to administrate than FIFO.
However IAS 8 only permits a change in accounting policy (other than due to an IFRS change) if it results in
the financial statements providing more reliable and more relevant information. In the case of packaged
foods that are perishable this seems unlikely, with physical movement more properly reflecting a FIFO basis.
Audit procedures:

(3)

Review recent purchases and changes in invoice prices (Attest to original invoices)
Examine procedures for maintaining a moving average of costs as inventory levels change
(continuous inventory records may be in place)
Review inventory count records and attest the means of identifying the age and movement of
inventories.
Revenue recognition

Financial reporting
The Illustrative Guidance to IAS 18 states that revenue from sales is normally recognised when the goods
are delivered, even where cash is paid in advance.

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SOLUTIONS - BUSINESS REPORTING N14

An exception to this general rule is buy and hold where goods are accepted by the buyer are on hand,
identified and ready for delivery to the buyer. This does not appear to be the case for Hoop as only a deposit
has been received in respect of the goods retained in inventory.
Consequently revenue and profit can only be recognised on goods that have been delivered. Therefore:

Total value of order (90,000/0.2)

450,000

Revenue to be recognised: (450,000 x 70%)

315,000

The 90,000 should initially have been recognised as a payment on account liability rather than
revenue.

The remaining payment on account at the year-end is: 90,000 x 30% = 27,000

Inventories are: (200,000 x 30%) =

60,000

The correcting journal is

Dr Sales
Cr Cash

90,000
90,000

Reversing original entry

The remaining journals are therefore.
Dr Inventories
Cr Cost of sales

60,000
60,000

Cost of production included in inventory

Dr Cash
Cr Payment of Account

90,000
90,000

Receipt of deposit from DistribFoods

Dr Receivables
Cr Sales

315,000
315,000

Goods delivered pre year end

Dr Payments on account
Cr Receivables

63,000
63,000

Transfer from payment on account to receivables for goods delivered.

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SOLUTIONS - BUSINESS REPORTING N14

Audit risks and procedures

Hoop has taken credit for only 90,000 of revenue which is on a cash received basis and is incorrect.
Audit procedures

From the year-end inventory count, trace the goods in respect of this order to ascertain whether the
correct figure of 60,000 has been included at the year end
Trace the delivery on 14 June 2014 to supporting documentation (delivery note, invoice and
subsequent cash received) checking dates and physical movements
Attest receipt of cash on 19 May 2014 to cash book and bank statement
Verify details against initial contract
Circularise receivable for balance outstanding
Post year end check to see if remaining element of contract delivered and balance settled before audit
clearance.

Assessment of profit understatement risk

Pension obligation
Hoop has recognised the contributions it has paid of 1 million as its pension expense.
The correct expense would include:
000
Past service cost

800

Current service cost

2,100

Interest cost

864

Expected return on plan assets*

(776)
2,988

* 19.4m x 4% (this uses opening/closing assets as an approximation for average assets)

Overall therefore there is no evidence of Hoop seeking understate profits based on the pension obligations
as the charge to profit or loss made of 1m was significantly lower than the correct charge of 2.988m.
Inventory change of accounting policy
As noted above, the change in policy decreases profit by 6,000 but this figure is immaterial (e.g. by
comparison to the pensions adjustment or the materiality level) and therefore reducing profit seems a poor
motivation for the change in policy.
Revenue recognition
Revenue of 90,000 has been recognised rather than the correct revenue of 315,000. There is some
evidence of Hoop seeking understate profits based on the revenue recognition as revenue is understated by
225,000 (315,000 - 90,000).
In addition, inventories have been incorrectly accounted for as all contract costs have been recognised in the
year ended 30 June 2014, rather than apportioned between cost of sales and inventories. There should be
recognised in inventories an additional 60,000 (30% x 200,000) and cost of sales reduced by the same
amount. This has the effect of increasing profit for the year ended 30 June 2014 by a further 60,000.
The total adjustment for profit should therefore be an increase of:
Additional revenue
Reduced cost of sales
Increased profit

225,000
60,000
285,000

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SOLUTIONS - BUSINESS REPORTING N14

Conclusion
There is mixed support for the notion that Hoop is seeking to understate profit based on the three
transactions highlighted by Gary. Two of the three adjustment decrease profit and the dominant effect is the
pension adjustment so, in value terms, there is a net decrease in profit from the adjustments. There is
therefore little conclusive evidence based on these three adjustments, to support the notion that the client is
trying to understate profit.
Overall effect on profit:

Profit before tax

Adjustments:
Pension
Inventory
DistribFoods

000
8,000
(1,988)
(6)
285
6,291

Note:
As a consequence of the adjustments the level of planning materiality should be reviewed.
Examiners comments
General comment on candidates performance
This question was well answered but many candidates ignored the final requirement to identify manipulation
of profit In this scenario it is the potential for understating not overstating profits that is at point and many
candidates found the concept that management may be motivated to understate profits difficult to
understand.
Pension obligation
The numerical elements of this question were attempted well, although many spent pages setting out
the pension accounting treatment when it could have been summarised more succinctly and saved
them time.
Time was also wasted presenting the scheme assets when the question stated that the procedures
had already been reviewed.
The audit risks and tests were also generally well completed. However many candidates failed to
appreciate that the actuary had been appointed by RN and presented therefore a number of
irrelevant procedures.
The main errors were on the calculation of the interest charge as many did not include the past
service and the average of the half year service and benefit adjustment.
Many correctly identified that there was little chance of manipulation but did not quantify the overall
effect on the profits
Inventory
Very few candidates correctly calculated the potential impact of the change in policy in the opening and
closing balances, with the result that many did not appreciate the immaterial nature of the adjustment. This
lead to time spent setting out audit procedures and tests which were not directed at the risks and which
therefore didnt earn as many marks as might be expected. Although the auditors should be sceptical there
was too much discussion about manipulation for such an immaterial amount.

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SOLUTIONS - BUSINESS REPORTING N14

Revenue Recognition
Almost all candidates correctly identified that revenue should only be recognise when the goods are
delivered, but few were able to correctly calculate the impact on more than one of the affected balances of
Hoop plc. Audit risks and procedures were generally well answered with many candidates scoring close to
full marks for these elements.
Most candidates included some commentary about the potential manipulation of profits, with the better
answers linking this to each adjustment.

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