28 DIRECTORY

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TECHNICAL
ALL YOU NEED TO KNOW
Articles on key examinable
topics to support your studies

30 CLARITY AUDITING
STANDARDS
Relevant to ACCA Qualification
Papers F8 and P7

PROJECT MANAGEMENT:
BUSINESS CASES
AND GATEWAYS
Relevant to ACCA Qualification
Paper P3

GROUP AUDITING
Relevant to ACCA Qualification INTERPRETING
Paper P7 BREAKEVEN AND
PROFIT–VOLUME
AUDIT CHARTS
AND INSOLVENCY Relevant to CAT
Relevant to ACCA Qualification Qualification
Papers P7 (UK) and (IRL) Paper 10

ONLINE RESOURCES
CAT Qualification: www.accaglobal.com/students/cat
ACCA Qualification: www.accaglobal.com/students/acca
30 TECHNICAL
TECHNICAL ARTICLES
6 APRIL 2011 RELEVANT TO ACCA AND CAT QUALIFICATION STUDENTS
CLARITY AUDITING STANDARDS
RELEVANT TO ACCA
QUALIFICATION PAPERS F8 AND P7
An overview of clarity auditing
standards, with a focus on the
new ISA/HKSA 265 (Clarified),
Communicating Deficiencies in
Internal Control to those Charged with
Governance and Management.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER F8
www.accaglobal.com/students/acca/
exams/f8/
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P7
www.accaglobal.com/students/acca/
exams/p7/
PROJECT MANAGEMENT:
BUSINESS CASES AND GATEWAYS
RELEVANT TO ACCA
QUALIFICATION PAPER P3
Ken Garrett looks at the need to
carefully evaluate a project’s benefits
and disbenefits from the outset, and
the importance of regularly monitoring
and re-evaluating its progress.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P3
www.accaglobal.com/students/acca/
exams/p3/
GROUP AUDITING
RELEVANT TO ACCA
QUALIFICATION PAPER P7
This article reviews the most
significant elements of group audits
and changes to ISA 600 that were
introduced as a result of the recent
‘clarity’ project. Future exams may
focus on the audit of group financial
statements, or on the requirements
of the group auditor to report to
management on matters all around
the group.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P7
www.accaglobal.com/students/acca/
exams/p7/
AUDIT AND INSOLVENCY
RELEVANT TO ACCA
QUALIFICATION PAPERS F7 (UK)
AND (IRL)
Lisa Weaver, examiner for Paper P7,
highlights some of the issues that
auditors may have to deal with in
respect of insolvency.
ACCESS RESOURCES RELEVANT
TO ACCA QUALIFICATION PAPER P7
www.accaglobal.com/students/acca/
exams/p7/
INTERPRETING BREAKEVEN AND
PROFIT–VOLUME CHARTS
RELEVANT TO CAT
QUALIFICATION PAPER 10
Charlotte Bower, examiner for CAT
Paper 10, outlines the difference
between breakeven and
profit–volume charts, and discusses
how to interpret the charts and what
effects changes to a variable can have
on the breakeven point.
ACCESS RESOURCES RELEVANT TO CAT
QUALIFICATION PAPER 10
www.accaglobal.com/students/cat/
exams/t10/
ACCA QUALIFICATION
TECHNICAL ARTICLES
PAPER F1
www.accaglobal.com/students/acca/
exams/f1/technical_articles/
PAPER F2
www.accaglobal.com/students/acca/
exams/f2/technical_articles/
PAPER F3
www.accaglobal.com/students/acca/
exams/f3/technical_articles/
PAPER F4
www.accaglobal.com/students/acca/
exams/f4/technical_articles/
PAPER F5
www.accaglobal.com/students/acca/
exams/f5/technical_articles/
PAPER F6
www.accaglobal.com/students/acca/
exams/f6/technical_articles/

PAPER F7
www.accaglobal.com/students/acca/
exams/f7/technical_articles/
PAPER F8
www.accaglobal.com/students/acca/
exams/f8/technical_articles/
PAPER F9
www.accaglobal.com/students/acca/
exams/f9/technical_articles/
PAPER P1
www.accaglobal.com/students/acca/
exams/p1/technical_articles/
PAPER P2
www.accaglobal.com/students/acca/
exams/p2/technical_articles/
PAPER P3
www.accaglobal.com/students/acca/
exams/p3/technical_articles/
PAPER P4
www.accaglobal.com/students/acca/
exams/p4/technical_articles/
PAPER P5
www.accaglobal.com/students/acca/
exams/p5/technical_articles/
PAPER P6
www.accaglobal.com/students/acca/
exams/p6/technical_articles/
PAPER P7
www.accaglobal.com/students/acca/
exams/p7/technical_articles/
STUDENT ACCOUNTANT ISSUE 07/2011
31
CAT QUALIFICATION
TECHNICAL ARTICLES
PAPER 1
CHANGES TO THE ACCA
www.accaglobal.com/students/cat/ QUALIFICATION FROM
exams/t1/tech_articles/
JUNE 2011
PAPER 2 Read more at www.
www.accaglobal.com/students/cat/
exams/t2/tech_articles/ accaglobal.com/students/
PAPER 3
student_accountant/
www.accaglobal.com/students/cat/ archive/2010/108/3333957
exams/t3/tech_articles/
PAPER 4 FOUNDATIONS
www.accaglobal.com/students/cat/
exams/t4/tech_articles/ IN ACCOUNTANCY
PAPER 5 Learn more about ACCA’s
www.accaglobal.com/students/cat/ suite of entry-level
exams/t5/tech_articles/
qualifications – Foundations
PAPER 6
www.accaglobal.com/students/cat/
in Accountancy at
exams/t6/tech_articles/ www.accaglobal.
PAPER 7
com/fia
www.accaglobal.com/students/cat/
exams/t7/tech_articles/
RESOURCES
PAPER 8 www.acca
www.accaglobal.com/students/cat/
exams/t8/tech_articles/ global.com/
PAPER 9
students/acca
www.accaglobal.com/students/cat/
exams/t9/tech_articles/
www.acca
PAPER 10 global.com/
www.accaglobal.com/students/cat/
exams/t10/tech_articles/ students/
cat
ACCA ONLINE STUDY RESOURCES
www.accaglobal.com/students/
32 TECHNICAL
EXAM SUPPORT
EXAMINERS’ APPROACH AND EXAMINERS’ ANALYSIS INTERVIEWS
ACCA is committed to providing
support to all its students. As part of
this support, a range of materials –
in a variety of media to reach as many
students as possible – is available
specifically to address the ACCA
Qualification exams. Information from
ACCA’s examiners including examiner
reports, examiner interviews and a
wide variety of technical articles are
available in a range of different media
on the ACCA website.
The two sets of examiner interviews are
available on www.accaglobal.com
and are extremely valuable resources.
Each set of interviews can help
you prepare for your exams in
different ways and, when used in
conjunction with the paper resources
available, they can make a big
difference to your studies.
EXAMINERS’ APPROACH INTERVIEWS
The examiners’ approach interviews
are very useful when you are
undertaking a particular paper for
the first time, giving you a real insight
into what examiners are looking
for in terms of exam performance.
They cover the main themes of each
paper and give information on the
style of the exams and how they
are structured. They also advise on
exam technique, with tips on how to
succeed and potential pitfalls to avoid.
The examiners’ approach interviews
complement the examiners’ approach
articles, which were written to
give guidance on how to tackle each
exam paper. These resources contain
similar information but the difference
in delivery method can be a useful
advantage when studying and may
give you a better chance of absorbing
the examiners’ advice. The examiners’
ACCA IS COMMITTED TO PROVIDING SUPPORT TO
ALL ITS STUDENTS. EXAMINER REPORTS, EXAMINER
INTERVIEWS, EXAM NOTES (WHICH PROVIDE
GUIDANCE ON EXAMINABLE MATERIAL INCLUDING
RELEVANT ACCOUNTING AND AUDITING DOCUMENTS
FOR PAPERS F3, F7 AND P2) AND A WIDE VARIETY
OF TECHNICAL ARTICLES ARE AVAILABLE IN A RANGE
OF DIFFERENT MEDIA ON THE ACCA WEBSITE AT
WWW.ACCAGLOBAL.COM/STUDENTS/ACCA/EXAMS
approach interviews also contain
useful links to other relevant resources
for your exam.
EXAMINERS’ ANALYSIS INTERVIEWS
The examiners’ analysis interviews build
on the examiners’ approach interviews.
They highlight where students
are performing well, where students are
performing less well, and give advice on
how students can improve performance
in problem areas.
It’s never too soon to start listening
to the examiners’ analysis interviews,
but they would probably be most useful
once you have covered the syllabus and
are starting to think about the detail of
a paper and how to apply what you have
learned in the exam.
They are designed to give guidance
around which areas of the syllabus
students have been struggling with
in recent exam sittings and how
students can tackle the difficulties
others have been having. The analysis
interviews are closely related to
the examiners’ reports, which are
published after each exam session.
They bring together the examiners’
reports from the first three sessions
of the ACCA Qualification, illustrating
that some mistakes are being repeated
consistently and highlighting critical
areas of the syllabus to focus on.
Remember, this does not mean one
of those areas will necessarily be
examinable in the next session. The
ACCA website will soon feature new
examiner interviews recently recorded
at this year’s Learning Providers’
Conference – look out for details in
upcoming issues of Student Accountant.
It is still very important to make use
of the individual examiners’ reports
available in Student Accountant and on
the ACCA website, as well as listening to
the analysis interviews. After you have
worked through a practice question,
refer to the relevant examiner’s report
and you will find an analysis of that
question, what the examiner is looking
for in a good answer, typical answers
given by students, why they might not
be relevant and so on.
All of these resources and others
such as the Syllabus and Study
Guide, past papers, examinable
documents and technical articles can
be accessed at www.accaglobal.com/
students/acca/exams/
Your Success is
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34 TECHNICAL
EXAMINABLE
DOCUMENTS
RELEVANT TO THE JUNE 2011 SESSION
CAT QUALIFICATION
Paper 3
www.accaglobal.com/students/cat/
exams/t3/examinable_documents
Paper 6
www.accaglobal.com/students/cat/
exams/t6/examinable_documents
Paper 8
www.accaglobal.com/students/cat/
exams/t8/examinable_documents
Paper 9
www.accaglobal.com/students/cat/
exams/t9/exam_docs
ACCA QUALIFICATION
Corporate and Business Law
Paper F4
www.accaglobal.com/students/acca/
exams/f4/docs
Financial reporting
Paper F3 (International)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3int_
examdoc2011.pdf
Paper F3 (UK)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3uk_
examdoc2011.pdf
Paper F7 and P2 (INT and UK)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f7p2int_
examdocs2011.pdf
Paper F7 and P2 (Hong Kong)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3f7p2hkg_
examdoc2011.pdf
Paper F7 and P2 (Malaysia)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/mys2011_
examdoc.pdf
Paper F7 and P2 (Singapore)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/sgp2011_
examdoc.pdf
CBE (International)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/cbe_
J08examdocs.pdf
CBE (UK)
www.accaglobal.com/pubs/students/
acca/exams/f3/examinable/f3uk_
J08examdocs.pdf
Tax
Papers F6
www.accaglobal.com/students/acca/
exams/f6/exam_docs/
Paper P6
www.accaglobal.com/students/acca/
exams/p6/exam_docs
Audit
Papers F8 and P7 (Hong Kong)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/
examnotesHKG2011.pdf
Papers F8 and P7 (INT and UK)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/
IntUK2011examnotes.pdf
Papers F8 and P7 (Malaysia)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/f8p7mys_
examnotes.pdf
Papers F8 and P7 (Singapore)
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/f8p7_
sgpexamdocs.pdf
Guidance Notes for Irish
Stream students
www.accaglobal.com/pubs/students/
acca/exams/f4/docs/irish_notes.pdf
Examinability of the Clarity
Auditing Standards
www.accaglobal.com/pubs/students/
acca/exams/f8/examinable/clarity_
audit_standards.pdf
RELEVANT TO ACCA QUALIFICATION PAPERS F8 AND P7

Clarity auditing standards

To enhance the application of auditing standards in exam questions,
candidates must familiarise themselves with the clarity auditing standards.
The International Auditing and Assurance Standards Board (IAASB) has
completed its comprehensive project to enhance the clarity of all of its
International Standards on Auditing (ISAs) in 2009 for improving
understandability of auditing standards, and all the new clarity auditing
standards are now examinable. This also affects the Hong Kong Standards on
Auditing (HKSAs).

The full set of clarity auditing standards features 39 documents, which include:
• a new International/Hong Kong Standard on Auditing on communicating
deficiencies in internal control – ISA/HKSA 265 (Clarified), Communicating
Deficiencies in Internal Control to those Charged with Governance and
Management
• 35 clarity ISAs/HKSAs
• a clarified international/Hong Kong standard on quality control – ISQC 1/
HKSQC 1, Quality Controls for Firms that Perform Audits and Reviews of
Financial Statements, and Other Assurance and Related Services Engagements
• a revised glossary of terms
• a revised preface to the International/Hong Kong Standards on Quality
Control, Auditing, Review, Other Assurance and Related Services.

ISA/HKSA 265 (Clarified), Communicating Deficiencies in Internal

Control to those Charged with Governance and Management
Among the clarified auditing standards, ISA/HKSA 265 (Clarified) is a
completely new standard.

It deals with the auditor’s responsibility to communicate appropriately to those

charged with governance and management deficiencies in internal control that
the auditor has identified in an audit of financial statements.

When auditors plan for an audit, they are required to perform risk assessment
through understanding internal controls, and also test for the appropriateness
of design of internal controls and whether they are implemented. When control
reliance strategy is adopted, auditors are required to perform tests of controls
to gather audit evidence on the operating effectiveness of controls.

During both processes, auditors might identify deficiencies in internal controls.

In accordance with ISA/HKSA 265 (Clarified), ‘deficiency’ exists when ‘a
control is designed, implemented or operated in such a way that it is unable to
prevent, or detect and correct, misstatements in financial statements on a
timely basis; or a control necessary to prevent, or detect and correct
misstatements in the financial statements on a timely basis is missing’. It is
equivalent to a deviation from an internal control.

© 2011 ACCA
2

CLARIFIED AUDITING STANDARDS

APRIL 2011

It is common in practice and in exam questions to identify and explain

deficiencies in internal control systems. An example is Question 3(b) of Paper
F8 in the June 2010 exam session. Candidates were required to identify and
explain deficiencies in the cash cycle of a window cleaning company, suggest
controls to address each of these deficiencies, and list tests of controls the
auditor would perform to assess if the controls were operating effectively.

If the deficiency is significant, it is known as ‘significant deficiency’. It is ‘a

deficiency or combination of deficiencies in internal control that, in the
auditor’s professional judgment, is of sufficient importance to merit the
attention of those charged with governance’. It depends not only on whether a
misstatement has actually occurred, but also on the likelihood that a
misstatement could occur and the potential magnitude of the misstatement.
Significant deficiencies may therefore exist even though the auditor has not
identified misstatements during the audit.

Consideration points should include:

• the likelihood of the deficiencies leading to material misstatements in the
financial statements in the future
• the susceptibility to loss or fraud of the related asset or liability
• the subjectivity and complexity of determining estimated amounts, such as
fair value accounting estimates
• the financial statement amounts exposed to the deficiencies
• the volume of activity that has occurred or could occur in the account
balance or class of transactions exposed to the deficiency or deficiencies
• the importance of the controls to the financial reporting process
• the cause and frequency of the exceptions detected as a result of the
deficiencies in the controls
• the interaction of the deficiency with other deficiencies in internal control.

When you found the following indicators in real practice or exam questions,
this would indicate significant deficiencies. These include:
• evidence of ineffective aspects of the control environment, such as
management fraud not mitigated by internal controls, not sufficient
oversight of significant management interests by those charged with
governance, and no implementation of remedial actions against significant
deficiencies communicated
• absence or inefficiency of a risk assessment process
• evidence of ineffective responses to identified significant risks
• misstatements detected by the auditor’s procedures, which were not
prevented, detected and corrected by the internal controls
• restatement of previously issued financial statements to reflect the
correction of a material misstatement due to error or fraud
• evidence of management’s inability to oversee the preparation of the
financial statements.

© 2011 ACCA
3

CLARIFIED AUDITING STANDARDS

APRIL 2011

In response to significant deficiencies in internal control identified during the

audit, the auditor will communicate in writing the significant deficiencies to
those charged with governance on a timely basis. For the communication, this
would include a description of the deficiencies, an explanation of their potential
effects, and sufficient information to enable those charged with governance
and management to understand the context of the communication.
In terms of the sufficiency of the details of communication, the consideration
factors include:
• the nature of the entity – more details for public interest entities than
non-public interest entities
• the size and complexity of the entity – more details for larger and more
complex entities
• the nature of significant deficiencies that the auditor has identified – more
details for those involving integrity of management and fraud
• the entity’s governance composition – more details for inexperienced
governance members
• legal or regulatory requirements regarding the communication of specific
types of deficiency in internal control

Evaluation of misstatements
As well as deficiencies in internal controls, misstatements may also be
detected during an audit. ISA/HKSA 450 (Clarified), Evaluation of Misstatements
Identified During the Audit is actually a new separate standard as well. This
highlights the importance of focusing on the deficiencies/misstatements
during the audit, which is a common consideration for a risk-based approach.

ISA/HKSA 450 (Clarified) deals with the auditor’s responsibility to evaluate the
effect of identified misstatements on the audit and of uncorrected
misstatements, if any, on the financial statements. ‘Misstatement’ is defined
as ‘a difference between the amount, classification, presentation, or disclosure
of a reported financial statement item and the amount, classification,
presentation, or disclosure that is required for the item to be in accordance
with the applicable financial reporting framework. Misstatement can arise from
error or fraud.’ This also relates to those that require adjustments for issuing a
true and fair view on the financial statements.

For these kind of identified misstatements, the auditor should determine

whether the nature and the circumstances of their occurrence indicate the
existence of other misstatements, which could be material individually or in
aggregate. These misstatements should be communicated to the appropriate
level of management on a timely basis.

The auditor should also consider whether there is a need to revise the audit
strategy and audit plan – especially when those areas are confirmed to have
appropriate design, implementation and effective operation of controls, now
there are identified misstatements. Does the initial conclusion need to be

© 2011 ACCA
4

CLARIFIED AUDITING STANDARDS

APRIL 2011

reconsidered? This would definitely affect the risk assessment, audit strategy
and audit plan.

‘Uncorrected misstatements’ are the ‘misstatements that the auditor has

accumulated during the audit that have not been corrected’. Before evaluating
the effect of the uncorrected misstatements, the auditor should confirm
whether the materiality still remains appropriate. Afterwards, the auditor will
determine the uncorrected misstatements are material individually or in
aggregate. The auditor will consider:
• the size and nature of the misstatements, and the particular circumstances
of the occurrence
• the effect of uncorrected misstatements related to the prior periods.

The auditor will communicate the uncorrected misstatements and their

implication on the auditor’s report to those charged with governance. The
auditor will also request a written representation (including a summary of
uncorrected misstatements) from management and – where appropriate –
those charged with governance as to whether they believe the effects of
uncorrected misstatements are immaterial, individually and in aggregate to the
financial statements as a whole.

Conclusion
To summarise, candidates need to update their auditing knowledge,
understand them and apply them in the exam questions.

As stated by the Paper P7 examiner: ‘A significant proportion of candidates

continue to produce answers that are simply too vague or too brief, do not
actually answer the question requirements, and display inadequate technical
knowledge of the clarified ISAs (HKSAs). These candidates are encouraged to
improve their exam technique, as well as knowledge of the syllabus, by
practising as many past exam questions as possible, using up-to-date study
materials, and by taking on board the comments made in examiner’s articles
and reports.’

Allan Lee FCCA is director of Allan Lee Professional Solutions Ltd and co-
chairman of ACCA Hong Kong’s Student Affairs Subcommittee
This article was originally written for ACCA Hong Kong Student News Update
magazine, Winter 2010 issue but is still relevant for all auditing students.

© 2011 ACCA
RELEVANT TO ACCA QUALIFICATION PAPER P3

Project management: business cases and gateways

It can be assumed that whenever an organisation embarks on a project to improve
its performance and results, the project is expected to bring benefits to that
organisation.

This statement might seem self-evident, but it requires care to ensure that all the
effects of a project (both benefits and disbenefits) are evaluated in advance as
carefully as possible, and that the project is closely monitored and re-evaluated
throughout its progress. Furthermore, it is vital to ensure that benefits are realised.
For example, a new IT system could be implemented on time and within cost
budget, but if staff, customers or suppliers resist making use of new facilities
offered, then no benefits will be realised from the project.

The challenges will be dealt with under the following headings:

1. Constructing a business case
2. Carrying out the project, keeping it under constant review
3. Reviewing the results

CONSTRUCTING A BUSINESS CASE

At its simplest, this could simply mean showing that a proposed project has a
positive net present value (‘NPV’). Indeed, when you are carrying out an NPV
calculation you are often presented with the cash flows expected to arise from a
‘project’. However, applying discount factors to a set of cash flows is by far the
easiest part of any NPV calculation. The real skill is to be found in assessing what
the cash flows are likely to be. It is here, for example, that predictions need to be
made about changes in market share, revenue, and competitor reactions.

Constructing a business case, therefore, needs to be broken down into a series of

steps:
• Identification of the organisation’s drivers and where improvement is
required.
• Identification of the organisation’s stakeholders and how they are affected.
• Identification and classification of benefits and disbenefits.
• Planning of benefits realisation.

Identification of the organisation’s drivers and where improvement is required

An organisation’s drivers should relate back to its mission and its stakeholders’
perception of the organisation’s purpose. A profit-seeking organisation will
ultimately be interested in increasing shareholder wealth and any project
undertaken should, at least in the long term, lead towards that. Not-for-profit
organisations are more complex, but in a school, for example, you would expect
children’s educational standards to be important, and in a hospital you would
expect patient care and effective treatment to be part of its purpose.

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Complacent management might never see any need for improvement in

organisations, but that approach is usually the road to ruin. Both internal and
external changes will mean that management must continually respond to events so
that improvement and benefits are constantly sought. This is simply the process of
strategic appraisal and the tools and frameworks should be familiar. They include:
• PESTEL – looking at changes in the macro-environment. For example, a new
government might establish strict requirements for hospitals to measure their
success in diagnosing and curing certain diseases. This political driver could
mean that the hospital has to respond with a project that involves buying new
equipment and setting up new clinics.
• Porter’s five forces – looking at the activities of competitors, customers, new
entrants, suppliers and the emergence of substitutes. For example, a new,
powerful, low-cost competitor could be eyeing up the market. In response, the
company might consider embarking on a project to allow it to personalise its
production so that it can offer differentiation as a way of combating the
increased competition.
• Resources and competences. For example, if the company’s research and
development efforts have been disappointing then if might consider taking
over a successful smaller competitor in order to buy in know-how and patent
rights. Taking over that competitor might be defined as a project.
• The value chain. For example, if customers’ tastes change and what was
previously valued is no longer appreciated, then the company will have to
establish a project to find and implement new ways of adding value.

Of course, all of the results from these frameworks can be summarised in a SWOT
analysis.

It can also be useful to classify potential improvements as arising from:

• doing new things – for example, expanding into new overseas markets
• doing existing things better – for example, generating market growth
• stop doing things – for example, closing down part of the company’s
operations.
Identification of the organisation’s stakeholders and how they are affected
It is important that this step is carried out early in a project’s life. It was stated
above that projects should be undertaken if they are expected to bring benefits to
the organisation. However, that is a considerable simplification because it regards
the organisation and its purposes as consisting of a set of homogeneous interests.
In reality, many stakeholders are involved and their requirements and preferences
are likely to be diverse.

Any given project is likely to have implications that benefit some stakeholders, do
not affect others, and which bring disbenefits to the remainder. For example, if a
bank is considering closing its branch network and operating only over the internet,
then its premises costs will decrease (a benefit), but customers might be alienated
(a disbenefit). The hospital example mentioned above could mean that resources
are switched from one group of patients to another as a result of political pressure.

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Organisations cannot always choose simply to enjoy the benefits of any change
while disregarding disbenefits; benefits and disbenefits usually come as a package.
So, when it comes to identifying and classifying benefits and disbenefits (see
below), it is important that organisations carefully identify all affected stakeholders
so that they will have a greater chance of evaluating all the potential effects of a
project. They must also assess the power and influence of the stakeholders because
powerful, motivated, disgruntled stakeholders can cause projects to fail.

Identification and classification of benefits and disbenefits

Ward and Daniel1 classify benefits as observable, measurable, quantifiable and
financial. Rather than regarding these as discrete differences, they might be better
presented as a continuum as the distinctions between them are not always definite:

• Observable • Measurable • Quantifiable • Financial

 
 
Observable benefits
Observable benefits are those that cannot be objectively measured and their
assessment depends on the views of appropriately experienced observers. These
benefits relate mainly to matters such as customer satisfaction, staff morale, ethical
standing and empathy with patients. They are of relatively little use in initial project
justification because they are so difficult to communicate with any accuracy, but
undoubtedly they can be recognised after projects have been completed. Almost
inevitably, efforts are made to try to measure these ‘soft’ benefits because then they
become easier to deal with and less reliance needs to be invested in the opinions of
the observing experts.
It is important to realise that many observable effects are also likely to be
unexpected effects. The very fact that they are unexpected means that no attempt
will have been made to measure them; only after the project has been completed do
they become obvious. This does not mean that effects that are merely observable or
unexpected are unimportant. Some of the most significant benefits and disbenefits
are those that surprise everyone dealing with the project. An example can be seen
in a new intranet and group working software being implemented in a firm of
accountants. The expected benefit might be faster communication, but an
unexpected benefit might be the ability to shift routine work to less expensive staff
situated in cheaper areas of the country.

Measurable benefits
This term has a very precise meaning: the benefit can be measured objectively, but
it is not possible to predict how a project will change it in advance. By definition,
these benefits are not going to be very useful when constructing a business case for
a project. However, retrospectively, it will be extremely interesting to see how
various measures have moved and these effects will be important in post-
implementation reviews.

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Quantifiable benefits
Here, the extent of the benefits or improvements can be forecast. It is only once
benefits have become quantifiable that there is any hope of progressing to financial
measurement and the construction of a sound economic business case for the
project. There are several challenges:
• Ensuring that all quantifiable benefits and costs are captured. If an important
factor is omitted, then the analysis will be distorted.
• Establishing a starting point – a baseline against which changes can be
compared. This requires measurement techniques to be established.
• Predicting the changes that the project will cause – turning measurable changes
into quantifiable changes.

Ward and Daniel offer suggestions for transforming measurable to quantifiable:

• Pilot operations. For example, implement a new inventory system in one branch
and carefully monitor results. Extrapolate changes company-wide.
• External benchmarking. Monitor what other industry members are achieving
using their approaches. If possible, monitor the best-in-class performance. If a
rival performs better and uses a particular approach to business, then there
might be evidence there about how our performance would change.
• Reference sites. External benchmarking is not available for changes that are
relatively new to an entire industry because there are few comparisons available.
However, unless a company is absolutely the first, often reference sites will exist
where suppliers have persuaded another organisation to be an early adopter of
new technology or methods. Some care is needed here as, obviously, suppliers
will not readily provide information about their failures.
• Modelling and simulation. For example, if an organisation has a sophisticated
financial model on a spreadsheet, then different assumptions can be introduced
and the results quickly seen. Call centres keep very careful records of queuing
times and the number of callers who hang-up before being attended to. They
can extrapolate with some confidence the effect of reducing waiting times.
• Historical internal data. This is particularly relevant to organisations thinking
about stopping an activity. It is important that their cost data is accurate so that
the true implications of ceasing an activity are properly quantified. Activity-
based costing is almost certainly more relevant than the conventional treatment
of fixed overheads.

Financial benefits
Once changes have been quantified, it should be a reasonably easy step to convert
those to financial effects. It is important that this is done – at least for profit-seeking
organisations – and that the calculations are not distorted to ensure that a project is
improperly justified. Typically, net present value or return on capital calculations
will be used to evaluate the financial effects. Sensitivity analysis will be an essential
part of the exercise to identify risk areas and plan for more investigative work to be
done there.

Planning of benefits realisation

Planning of benefits realisation means:

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• assigning dates by which defined benefits should be enjoyed

• detailing the implementation and change management procedures needed to
ensure that the expected benefits are actually achieved as fully as possible
• establishing dates and methodologies for measurement of the benefits for
subsequent comparison to plans.

Note that the opportunities for benefit creation will start with completing the various
parts of a project (its activities) on time, within budget, to the correct quality
standards, and focused accurately on previously agreed outcomes. However,
although each part of a project can be properly delivered, the project as a whole can
fail to produce benefits unless it is whole-heartedly embraced by key stakeholders.
For example, a technically excellent new website could be implemented, but if
customers choose not to use it then few benefits will arise.

CARRYING OUT THE PROJECT, KEEPING IT UNDER CONSTANT REVIEW

The Office of Government Commerce (OGC) is an independent office of the UK
Treasury, established to help government deliver best value from its spending. The
OGC has developed the OGC GatewayTM Process in which projects are examined at
various key decision points before they are allowed to progress to the next stage.
This UK-based example is indicative of a formal system of project implementation
and review where evaluation takes place at several gateway points to ensure that the
original business case, the project objectives and expected benefits continue to be
achieved.
The OGC GatewayTM Process can be represented as follows: 
Stages of the project   OGC GatewayTM reviews
  Review 0: continuous,
Develop business case throughout project
  Review 1: examine the
business justification Ensure the project is still
Develop delivery   relevant to the overall strategy
strategy of the organisation
    Review 2: examine the
suggested delivery Ensure that the programme is
strategy supported by key stakeholders
Carry out competitive  
procurement Review the arrangements for
    Review 3: investment managing and monitoring the
decision project
Design, build, test    
  Review 4: verify readiness Review the arrangements for
for implementation identifying and managing the
Implement     main risks, including risks such
as changing business priorities
  Review 5: operational
review and benefits
Check that provision for
realisation
sufficient financial and other
Ongoing management    
resources has been made for
of delivered solution
the project
 

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After the project business case is established, Gateway’s review 1 would be carried
out to examine the justifications and arguments presented. The reviewing board will
be looking for benefits and disbenefits that might have been overlooked or
assumptions that appear to be unrealistic.

If all is well, the project will go forward to the next stage in which a detailed delivery
strategy is worked out. The ‘Who? How? When? What?’ questions are addressed
here. For example:
• Who will be on the project team?
• How much will be subcontracted?
• What exactly will be delivered and by when?

Review 2 will look critically at these decisions and objectives. Only when the
reviewing board is satisfied that the project is sufficiently well-defined and specified
will it give the go-ahead to receive tenders from outside suppliers.

After the competitive tenders have been received, the next stage will be signing a
supply contract and committing the organisation to substantial expenditure. Before
that is done, Review 3 will look at the tenders received, their costs, the standing and
competence of the suppliers and whether – now that costs are known more
accurately – the project still offers value for money (net benefits).

Assuming the supply contract is signed, then investment in the project will start. It
could be an IT project requiring software design, writing and testing; it could be a
project to reorganise the structure and reporting lines of the company; it could be a
project to merge with a rival organisation. However, before action is taken and the
software or plans are implemented, it is important to review what is proposed.
There is no point in trying to implement proposals that are not-tested, incomplete
or poorly designed. So Review 4 will look at the project plans and see if they are
sufficiently robust and comprehensive to attempt to implement. It will also be
necessary to ensure that the organisation is ready for implementation of the plans.

Review 5 then looks at the results that the project is delivering. Have the expected
benefits materialised? If not, then why not? Can shortfalls in benefits or unexpected
disbenefits be corrected? Review 5 could be carried out several times as the new
solution gradually settles down and management problems are ironed out.

Note carefully the purpose of Review 0. This should be carried on continuously

throughout the project and is there to keep questioning whether the original
business case on which the project was predicated remains valid. No matter how
meticulously a project is managed, changing events can suddenly undermine a
business case. For example, a project to build a new factory can suddenly look
uneconomic if the economy suffers a sharp fall. Or, further investment in a project
might be pointless if its completion seems to be in jeopardy because funds have
become very tight.

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REVIEWING THE RESULTS

After a project has been implemented, there are three types of review that should be
performed, reflecting different perspectives.
• A post-project review. This examines how the project went in terms of how the
project team and how the project manager performed and identifying what
aspects of planning and review went well and what didn’t go so well. Was the
project completed within time and budget? The focus here is on the project.
Lessons learnt are fed back into the project management system. For
example, if the project estimation was poor, then better methods of
estimation might be integrated into the project management process to help
ensure that future estimates are more accurate.
• A post-implementation review. This is essentially the Gateway review 5 and it
examines what the project achieved (its product or outcome) and should
compare the post-implementation observations and measurements with the
hoped-for benefits that were the basis of the original business case. As part of
this review, it will be important to gather information from key stakeholders.
The initial focus here is on the product or outcome produced by the project.
Does it meet its objectives? Lessons learnt are fed back into the product
production process – for example, in the development of a website, technical
mistakes might be fed back into the software development process to help
ensure that they do not happen again in the future.
• Benefits realisation is a type of post-implementation review. It focuses on the
realisation of the anticipated business benefits. As mentioned before, it could
be performed several times, reflecting the expected benefits timing defined in
the formal investment appraisal. A product might be successfully delivered
(for example, a new website or the merger of two organisations); however, the
anticipated business benefits may not be delivered. Lessons learnt in benefits
realisation are fed back into the benefits management process. For example,
this could lead to better ways of classifying benefits. It is important to
recognise that an appropriate product might be delivered (a website), but the
anticipated business benefits may never accrue. The reasons for this have to
be investigated and understood. Perhaps the initial business case was
over-optimistic or perhaps external business factors have changed that
prevent the business benefits from being delivered.

Without these reviews, an organisation will be condemned to repeating any mistakes

it may have made and will be unable to make use of any lessons learned.

Ken Garrett is a freelance author and lecturer

Reference
1 Benefits Management: Delivering Value from IS and IT Investments, John Ward and Elizabeth
Daniel, Wiley, 2006.

© 2011 ACCA
RELEVANT TO ACCA QUALIFICATION PAPER P7

Group auditing
In March 2008, Lisa Weaver, examiner for Paper P7, wrote an article about
auditing groups and joint audits.

This article is a reminder of some of the most significant elements of group

audits, which feature frequently in the Paper P7 exam. The significant changes
to ISA 600, Special Considerations – Audits of Group Financial Statements
(Including the Work of Component Auditors) that were introduced as a result of
the recent Clarity project are likely to make group auditing even more
examinable. Exam questions may focus on the audit of group financial
statements, or on the requirements of the group auditor to report to
management on matters all around the group.

Similarities within the ISA 600 series of auditing standards

Group auditing often necessitates that the group auditor places considerable
reliance on other audit firms. However, ISA 600 doesn’t allow the group auditor
to wholly outsource responsibility for parts of the audit to another auditor.

To begin at the beginning: acceptance of the assignment

ISA 600 requires the group engagement partner each year formally to assess
whether it is appropriate to act as group auditor. If at any point the group
engagement partner concludes that they lack the professional skills necessary
to form a group audit opinion, they should resign. ISA 600 requires that the
group engagement partner resign immediately if there is any significant
restriction placed by the parent company management on information made
available from within the group (or disclaim opinion if resignation is not legally
possible).

ISA 600 (revised and redrafted) extends this responsibility to require that the
auditor relying on the third party’s work has obtained their own understanding
of the specialist area in question, or business of each subsidiary or associate
(referred to as ‘components’ in ISA 600, with that company’s auditor referred
to as the ‘component auditor’). The group auditor must form their own
concurring opinion on any judgmental areas. This does not require having the
same depth of knowledge as the expert/other auditor, but they would need to
be able to review the third party’s files and have sufficient independent
knowledge to understand the work done, the reason for the work and the
conclusions from that evidence.

Group audit opinion

The parent company of a group will normally publish its financial statements
as an individual company and the group financial statements in the same
document, so, the audit opinion will normally be expressed on ‘the financial
statements of the company and of the group as at...’ Although presented as
one opinion, it logically contains two separate opinions; one on the entity

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financial statements of the parent itself and another on the financial

statements of the group. ISA prohibits the group auditor from making any
reference to the work of any other experts or auditors, as doing so would
diminish the credibility of the audit opinion and allow the group auditor to
‘pass the buck’ for responsibility for part of the audit. You should be prepared
to explain this point in the exam. This is an example of where ISA differs from
US audit standards, where reference to other auditors conducting some of the
work on components is permissible.

Planning work required

Groups often have a number of subsidiaries that are either dormant or
immaterial. At a minimum, the group engagement team must develop an
understanding of each component of the group and review the financial
statements of each subsidiary.

Where a component is judged to be material or a significant contributor of

inherent risk at the group level, further work will be required to be satisfied
that the financial statements of each component, in order to be satisfied that
the component is unlikely to introduce errors that could be material at the
group level. This work might include:
• discussing with the component auditor, and/or the management of the
component, the business activities that are significant to the group
• reviewing the more significant parts of the component auditor’s working
papers
• discussing with the component auditor the susceptibility of the
company’s financial statements to material error or deliberate
misstatement
• reviewing the component auditor’s documentation of identified
significant risks, and the conclusions reached on these risks
• observing final clearance meetings between the component auditor and
the management of the company.

The group auditor as the repository of information

The group engagement team’s role brings information flowing to them that is
useful to disseminate around the group. This includes materiality (see below)
and matters such as related party relationships, which may be unknown at the
component level, because two subsidiaries may be unaware of each other’s
existence. The group auditor asks each component auditor for known related
party relationships and then communicates a collated list of all related party
relationships to each component auditor.

Materiality
At the planning stage, the group engagement partner must determine several
figures for materiality for each component part of the group (ISA 600:21).

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Each
Group Parent
component
Financial statements Component
Group auditor Group auditor
materiality auditor
Materiality for the
consolidation package as Group auditor Group auditor Group auditor
a whole
Level of reduced materiality
Group auditor Group auditor Group auditor
for sensitive figures
Performance materiality Group auditor Group auditor Group auditor

Performance materiality is the figure below that any errors in the financial
statements may be considered trivial. The component auditor will be required
to communicate to the group auditor a summary of all unadjusted errors in the
consolidation package.

It is common in larger group audits for the financial statements to be prepared

using a consolidation package of information that is sent to the parent
company by each component company. This will omit many of the disclosures
that will be in the eventual entity financial statements. The component auditor
may, therefore, be required to issue a special audit opinion on the truth and
fairness of the consolidation package. This opinion is likely to be addressed to
the directors of the component company, or may be addressed to the group
auditor directly.

In order to minimise the risk of several accidental or deliberate errors in the

financial statements together exceeding group materiality, component
materiality figures will normally be significantly lower than the group
materiality figure, even for the largest component companies.

Example 1
Imagine that financial statements materiality is taken to be 10% of profit or
loss for each entity within a group and performance materiality is set at 0.5%
of profit. Imagine that a group has a parent company and two components,
one of which is profit making and one of which is loss making:
$’000s Parent Subsidiary 1 Subsidiary 2 Group
Profit 2,000 12,000 (8,000) 6,000
Component
200 1,200 800 600
materiality @ 10%
Performance
materiality @ 10 60 40 30
0.5%

If subsidiary 1 were audited by another firm using the same materiality

calculation method as the parent, an unadjusted error of $10m would correctly
result in issuance of an unmodified audit opinion on the financial statements of

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that individual company. However, the effect of losses elsewhere in the group
would mean that although this error would not be material at the component
level, it would be material at the group level. Since it is only likely to be the
parent auditor who has this overview of the group, the group engagement team
must communicate materiality figures to component auditors in advance of
audit work commencing. In this example, the maximum component materiality
figure that the group auditor could communicate to the component auditors
would be 600, but it would be wise to select a lower figure than this, in order to
reduce to a tolerable level the risk of errors in both component companies
together exceeding 600.

In the exam, if you are given extracts from draft financial statements, it’s often
a good start to recommend and briefly explain a figure for materiality.

Communication between auditors

ISA 600 in its revised form contains extensive new requirements on the
communication between parent and component auditor. In addition to
practical matters such as materiality, the required format of the consolidation
package, deadlines and contact details, the group auditor must communicate a
number of matters at the planning to the component auditor, including:
• related party relationships known anywhere around the group
• identified significant risks, whether due to error or fraud
• methodology to be used for impairment testing of goodwill. Audit of
estimates is subjective and so it’s essential that the group auditor’s
preferred method is used throughout the group. Be prepared to explain
this in Paper P7.

Matters that the component auditor must communicate to the group auditor
will include:
• any known related party relationships and related party transactions
• any indications of management bias
• any significant risks to the truth and fairness of the component financial
statements, work done on these risks and the conclusions reached
• all intra-group transactions, period end balances and allowances for
unrealised profit
• any observed non-trivial failure to observe relevant laws and regulations
• all observed control weaknesses, flagging significant weaknesses
separately
• any known events after the reporting date.

Audit of the consolidation process

Once the group engagement partner is satisfied that the individual financial
statements within the group are free from material misstatement, attention
can now shift to audit of the consolidation process.

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The good news for exam purposes is that this stage of the audit is very similar
regardless of the specific company, so good marks can be obtained largely by
memorising the risks and responses below.

Principal risks arising in the consolidation process include errors or omissions

arising during:
• transcription of figures from individual financial statements to
consolidation workings
• classification of components (eg associate, subsidiary)
• cancellation of intra-group trading, cancellation of intra-group balances
and allowance for unrealised profit on intra-group transfers
• recognition of impairment of purchased positive goodwill
• determination of fair values being used on acquisition
• arithmetical inaccuracy in the consolidation process
• identification and disclosure of related party relationships and
transactions
• foreign currency translation from functional currency of components to
reporting currency of the group.

The most reliable evidence on completeness and accuracy of consolidation

adjustments in a large group is likely to be determining whether the client’s
accounting systems adequately flags transactions with fellow group
companies. The process is still likely to be highly substantive in nature and will
probably include these tests of detail:
• line-by-line agreement of all items from audited component financial
statements (or consolidation packages submitted to head office) to the
consolidation schedules
• detailed discussion with management on the reason for classification of
each component
• sample testing of known intra-group transactions to ensure that they
have been eliminated in the client’s consolidation
• recalculation of all significant workings, such as goodwill, non-controlling
interests and foreign currency translation.

Final review of financial statements

The group audit opinion may be signed on some date on or after the audit
opinions on material components are signed. Once the component auditor has
issued their opinion, their responsibility for reporting on the impact on events
after the reporting date is greatly diminished, yet there may be material events
that could be material in the group financial statements. The group
engagement team will normally agree in advance with the auditor of significant
components that an update on events is given by the component auditor to the
group engagement partner immediately before the group audit opinion is
signed. It is the responsibility of the group engagement team to ensure that
material events are reported.

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Reporting to management and the board

In addition to the usual requirements for reporting to those charged with
governance (the ‘management letter’), ISA 600:49 requires the group
engagement partner also to report to management on any concerns that they
had about possible fraud anywhere in the group, any restrictions on
information made available by component management and any concerns that
they had about the quality of work performed by any component auditor.

In addition to the audit report to shareholders, the group auditor is required by

ISA 600 to report on a group-wide basis to group management and separately
to those charged with governance at a group level, such as the audit committee
of the board. This split communication echoes the requirements of ISA 260
Communication with Those Charged with Governance to produce different
letters to different levels of management.

The report to management will include details of all observed instances of

non-trivial fraud and all non-trivial deficiencies in internal controls around the
group.

The report to those charged with governance, most probably the audit
committee, will include:
• an overview of the audit approach insofar as it affects component
auditors
• any doubts that the group auditor may have about the quality of work
performed by the component auditor, giving the group auditor a
potentially awkward need to publicly question the skills of a fellow
professional.
• any limitations on audit scope anywhere within the group
• any suspected fraud where management is suspected of involvement.

Summary
ISA 600 represents a significant extension of the responsibilities of both group
auditor and component auditor compared with the previous ISA. It is likely to
be a controversial standard in practice, and it is therefore likely to be in many
Paper P7 exams.

Understanding and memorising the key points of the standard is a very good
use of study time when preparing for the Paper P7 exam.

Graham Fairclough is group technical director at the ExP Group

© 2011 ACCA
RELEVANT TO ACCA QUALIFICATION PAPER P7 (UK) AND (IRL)

Audit and insolvency

From June 2011, the syllabus for Paper P7 (UK) and (IRL) includes specific
learning outcomes relevant to auditing aspects of insolvency (syllabus
reference E7). This topic has been added to the syllabus on the
recommendation of the Financial Reporting Council’s Professional Oversight
Board in order to comply with the requirements of the Statutory Audit
Directive, as the topic is considered required knowledge for those wishing to
obtain the audit qualification and practice as an auditor.

Why should auditors need to understand aspects of insolvency? The simple

answer is that, unfortunately, many auditors’ clients will face financial distress
at some point in their business lifecycle. The global economic recession of the
past few years has caused many companies to face insolvency, and in times of
crisis the directors of such companies may turn to their auditor for information
and advice. Therefore, auditors must be in a position to determine the level of
financial difficulty being faced by a client, explain and recommend the various
options available to management, and explain the consequences of liquidation
or administration.

This article highlights some of the issues that auditors may have to deal with in
respect of insolvency. Of course, it is important to study this topic in its
entirety using an up-to-date study text to gain full knowledge and
understanding of this new syllabus area.

The meaning of insolvency

It is important to understand what is actually meant by a company being
‘insolvent’, and to distinguish insolvency from general, less severe financial
difficulties. A company is insolvent if the value of its assets is less than its
liabilities – in other words, the statement of financial position shows a position
of net liabilities. If all of the company’s assets were sold at book value, the
existing liabilities could not be paid. This is a more fundamental problem than
simply being short of cash.

Company directors are charged with monitoring financial position and

performance. This is especially important when the company is experiencing
financial difficulties, as a company experiencing cash flow problems can
quickly turn insolvent. When a company is facing insolvency, the directors
must consider the interests of creditors (payables), shareholders and other
stakeholders, which is impossible to do without up-to-date financial
information. Directors must, therefore, prepare and monitor financial
statements and cash flow and profit forecasts on a regular basis in order to
determine the financial position of the company. Auditors may be asked to
advise on whether a company is insolvent, or to review historic or projected
financial information. Having up-to-date financial information and taking

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professional advice may also help to protect directors from legal claims such
as wrongful trading or misfeasance.

Options available
The directors of an insolvent company face a difficult decision. Should they
continue to trade, in the hope that the company’s performance and position
will improve, or should they cut their losses and wind up the company? This is
a dilemma that the auditor may be asked to help resolve by evaluating the
advantages and disadvantages of the options available, and considering the
impact of each on the relevant parties, including creditors, shareholders,
management and employees. The auditor may also be asked to explain the
procedures involved in placing a company into administration or liquidation, as
directors will usually have limited knowledge in this area.

Administration
If the directors decide to try to save the company, it can be placed into
administration, which offers some breathing space and legal protections while
a rescue plan is formulated to try to preserve the company’s going concern
status. The main advantage of administration is that once an administrator is
appointed, a moratorium over the company’s debts commences meaning that
it is not possible for a winding up petition to be presented at court by the
company’s creditors (payables) – thus allowing time for the rescue plan to be
designed and initiated.

A company in administration is under the control of the appointed

administrator who is given a short period of time (usually eight weeks) to set
out a proposal for achieving the aim of the administration, or to decide that it
is not reasonable that the company can be rescued. A creditors’ meeting is
called, at which the proposals are accepted or rejected. The administrator
takes over management of the company and has the power to appoint and
remove directors.

The process for appointment of an administrator varies, and may or may not
involve a court order. A company, its directors or one or more creditors
(payables) can apply to the court for the appointment of an administrator. The
court will grant an administration order only if it is satisfied that the company
is – or is likely to become insolvent, and that the administration process is
likely to achieve its purpose of rescuing the company as a going concern. It is
also possible for an administrator to be appointed without a court order, either
by a floating chargeholder, or by the company or its directors. Administration
usually lasts for 12 months, after which time the administrator automatically
vacates office, though the period of administration can – in some cases – be
extended subject to approval from creditors (payables). On the other hand,
administration may not last for the full 12-month period, and may end early if
the administration has been successful.

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Liquidation
If the company cannot be saved, then liquidation or ‘winding up’ is likely to be
initiated. The company will cease to trade, assets are sold, liabilities are paid
(to the extent allowed by the proceeds from the sale of assets and by applying
the rules for allocation of assets described below), and eventually the company
will be dissolved. Once liquidation proceedings are under way share dealings
must stop, and the directors lose their power to manage the company.

The procedures involved in placing a company into liquidation are complicated

by the fact that there are different ways that the process is initiated –
compulsory liquidation, members’ voluntary liquidation, and creditors’
voluntary liquidation.

Compulsory liquidation is usually initiated by one or more creditors, who apply

to the court and must demonstrate that the company is unable to pay its
debts. A creditor who is owed more than £750, and who has served the
company with a written demand for payment that has not been settled, has
grounds to apply to the court for compulsory liquidation. In less common
circumstances, a member (shareholder) who is dissatisfied with the directors’
management of the company may petition the court for the company to be
wound up on the just and equitable ground. For this to be successful, the
member had to demonstrate to the court that winding up is the only remedy
available.

Voluntary liquidation can occur through two different routes – a member’s

voluntary liquidation, or a creditors’ voluntary liquidation. The former is used
where the company is solvent, and can only take place when the directors have
made a declaration of solvency. Creditors have no involvement with this type of
liquidation, as the declaration of solvency means that they will be paid in full
and therefore have no risk exposure. Shareholders pass a resolution to wind up
the company and appoint a liquidator, who is responsible for closing down the
company.

In contrast, in a creditors’ voluntary liquidation the creditors are heavily

involved with proceedings, as in this case the company is not solvent, and
therefore creditors face the risk that they will not be paid the full amount owing
to them. The process is started by a shareholders’ meeting where a resolution
is passed to agree that the company should be wound up, but subsequently,
the creditors’ wishes over the appointment of the liquidator and the process of
winding up will override the wishes of the shareholders.

Allocating company assets

An important issue arising on liquidation is the order of priority for allocating
company assets. This is especially important for creditors and shareholders
because, by definition, an insolvent company cannot pay everything that is
owed. The amounts that will be paid on liquidation depend on matters such as
whether debts are secured or unsecured, whether charges over assets are fixed

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or floating in nature, whether shareholders own preference or equity shares,

the costs suffered by the liquidator (which are generally paid first) and the
amount of preferential creditors (including employees’ salaries and other
benefits in arrears). In most liquidations equity shareholders receive very little,
and usually nothing, as they rank last in the order of priority in allocating
company assets. The auditor of an insolvent or potentially insolvent company
may be asked to advise on the allocation of company assets.

Advantages of administration
In many cases, it may be preferable to place a company into administration,
rather than go through the process of liquidation. The obvious advantage is
that if the administration is successful, the company will continue as a going
concern, allowing shareholders to continue to hold their shares and, hopefully,
eventually receive a return on that investment. In contrast, as mentioned
above, shareholders usually receive nothing when a company is wound up. For
creditors, the continued existence of the company may also prove beneficial,
as its improved cash flows should allow debts to be repaid, and trading
relationships can be maintained. Administration may also be beneficial to
employees, as there will continue to be employment of some staff in the
continued business (though, of course, the administrator may make some
redundancies as part of the company’s rescue plan). In contrast, in a
compulsory liquidation the employees are automatically dismissed.

Conclusion
Auditors have a part to play in advising directors of companies that are in
financial distress or, indeed, are insolvent. Candidates attempting Paper P7
(UK) or (IRL) must be prepared to identify the issues relating to insolvency in a
given scenario and to provide appropriate explanations and recommendations.
Auditing aspects of insolvency will not be examined at each sitting, but will
feature fairly regularly in case study type questions. Studying from an
up-to-date study text is essential.

Lisa Weaver is examiner for Paper P7

© 2011 ACCA
RELEVANT TO CAT QUALIFICATION PAPER 10

Interpreting breakeven and profit–volume charts

I commented in my examiner’s report on the December 2010 exam that in Question
4, Part (b), the vast majority of students drew a breakeven chart rather than a
profit–volume chart. This is either because candidates misread the requirement, or
because there is a lack of understanding of the difference between the two types of
chart. In addition, candidates showed a lack of understanding in Question 4, Part (c),
as to what the profit–volume line actually showed, and therefore how a change in one
variable – in this case, the fixed costs – would affect the profit–volume line.

The study sessions 19 (b) and (c) of the syllabus state respectively that candidates
must be able to:
• analyse the effect on the breakeven point of changes in sales price and costs
• prepare and explain the breakeven charts and profit–volume charts.

It is not enough just to be able to ‘mechanically’ draw a breakeven or profit–volume

chart; candidates must fully understand what the lines represent, how a change in a
variable will affect the lines and the breakeven point, and how to interpret the charts.
This article aims to aid candidates’ understanding of these areas.

BREAKEVEN CHART
Let’s use the information from the December 2010 exam that was either given in the
question, or required to be calculated in Part (a):

Fee per tourist $4.0

Variable cost per tourist $1.5
Contribution per tourist $2.5
Fixed costs $30,000
Breakeven point 12,000 tourists

It is perfectly possible to draw a breakeven chart with this information. The sales
revenue, variable costs and fixed costs can all be plotted and the breakeven point of
12,000 tourists shown.

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Note how the axes are labelled – the vertical axis shows dollars ($) and the horizontal
axis shows output/sales, which in this case is the number of tourists. It is important
that candidates label the axes if they are drawing a chart in an exam question.
Candidates need to be able to explain what will happen to the lines on the chart, and
the breakeven point, if costs or revenue change.

What if fixed costs increase?

If fixed costs increase by $7,000 as happened in Part (c) of this question in the
December 2010 exam, the horizontal fixed cost line will move up to $37,000. This will
have a knock-on effect to the total cost line – its intersection with the vertical axis will
now start at $37,000, rather than $30,000. Note that there has been no change in the
variable cost per unit, so the slope or gradient of the variable cost line will not change
and, therefore, the slope or gradient of the total cost line will not alter, only the point
of intersection on the vertical axis. Revenue has not been affected, and so this line will
not change.

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It is now possible to identify the new breakeven point of 14,800 units.

It is worth checking whether this new breakeven point makes sense intuitively. The
breakeven point has increased – ie we need to take more tourists in order to be in a
position of nil loss/nil gain. Does this seem reasonable? The answer is yes. The fixed
costs have risen, and Joe will need to take more tourists out on his boat to earn the
extra contribution required to cover the increased fixed costs.

It is always worth taking a minute in questions to see if the new breakeven point
makes sense intuitively. By doing this, you should be able to spot if you have made a
silly error either in your calculations or in drawing your graph.

Let us look at what happens to the breakeven chart and point if other variables
change. (Note that I will always start with the data as per the original question as my
base position.)

What if the sales price per unit had changed?

In this case, all the cost lines would remain the same – only the total revenue line
would be affected, which would in turn affect the breakeven point.

Before looking at the effect on the graph, let us think intuitively about what an
increase in sales price or, in this case, fee per tourist would mean to Joe. What if the
fee per tourist went up to $5? Joe would earn more contribution per tourist ($3.5) and
would therefore need to take fewer tourists out in order to cover his fixed costs of
$30,000.

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Again the new breakeven point of 8,571 can be read from the chart.

It follows that if the sales price per unit had fallen, Joe would earn less contribution
per tourist taken, and therefore have to take more tourists out on his boat in order to
cover his fixed costs – ie the breakeven point would have risen.

What if the variable cost per unit had changed?

In this scenario, the gradient of the variable cost line would alter, which would then
affect the total cost line and the breakeven point.

Again, thinking intuitively, what would happen if Joe’s variable costs increased to $2.5
per tourist? In this case, Joe would earn less contribution per tourist – only $1.5 ($4 –
$2.5) – and so he would have to take more tourists out in his boat in order to earn the
contribution to cover fixed costs of $30,000.

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In the graph above, the new breakeven point is 20,000 units.

PROFIT–VOLUME CHART
Now we will use the same information to consider profit–volume charts:

Fee per tourist $4.0

Variable cost per tourist $1.5
Contribution per tourist $2.5
Fixed costs $30,000
Breakeven point 12,000 tourists

It can be argued that a profit–volume chart is easier to draw, as you only need to be
able to plot two points in order to draw the profit–volume line. The two points can be
any two of the fixed costs, the breakeven point, or a profit figure at a certain level of
output.

Using the information above and plotting the fixed costs and breakeven point, the
profit–volume chart appears as follows:

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Note how the axes are labelled for a profit–volume chart. The horizontal axis is still the
number of tourists, but the vertical axis is now profit/loss in dollars ($).

The intercept on the vertical axis shows the level of fixed costs, and where the line
crosses the horizontal axis represents the breakeven point – ie where profit is zero.
The gradient of the line represents the contribution per unit.

Let us look at what happens to the profit–volume chart and if variables change. (Note
that I will again always start with the data as per the original question as my base
position.)

What if fixed costs increase?

If the fixed costs increase to $37,000, the intercept on the vertical axis will change to
reflect the increased costs (it will move to the new fixed costs of $37,000). However,
neither sales revenue per unit (fee per tourist) or variable cost per unit have altered.
The contribution per unit has not altered and, therefore, the gradient of the profit–
volume line will not alter. It is therefore possible to draw on the new profit–volume line
by keeping the same gradient but changing the point of intersection on the vertical
axis.

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The new breakeven point can be read from the chart as 14,800 units.

What if the sales price per unit had changed?

In this case the total fixed costs do not change, and therefore the intercept on the
vertical axis will not change. However, the contribution per unit will change and,
therefore, the gradient of the profit–volume line.

We know intuitively that if the sales price goes up to say $5 per tourist, then the
breakeven point will decrease (see earlier), so this means that the intercept on the
horizontal axis will be nearer the origin. By how much though? Where is the new
breakeven point?

You can either calculate the new breakeven as being $30,000/$3.5=8,571 units, or
you can calculate the profit that will be earned at an output level. For example, the
profit earned if 10,000 tourists are taken out will be 10,000 x ($5 – $1.5) –$30,000 =
$5,000. Plot the $5,000 profit on your graph and then read off the new breakeven
point.

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What can be seen from the graph is that a change in sales price affects the gradient of
the profit–volume line only – not the intercept on the vertical axis – because fixed
costs have not altered.

What if the variable cost per unit had changed?

The same is true if the variable cost per unit is altered. The intercept on the vertical
axis will not change because fixed costs have not altered, only the gradient of the
profit–volume line, as the contribution per unit has again altered.

Using the figures we had earlier when we considered a change in variable cost per unit
under the breakeven section, the new contribution per unit was $1.5, so the
profit/(loss) at 10,000 units would be 10,000 x $1.5 – $30,000 = ($15,000). Knowing
the fixed costs and profit at 10,000 units allows the profit volume line to be plotted
and the new breakeven point read off the graph. Again, it would have been possible to
calculate the new breakeven point as 20,000 units and plot this, along with the fixed
costs of $30,000, in order to draw the new profit–volume line.

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CONCLUSION
It is important that candidates understand how a chart – whether breakeven or
profit–volume – is constructed, what the lines represent, how a change in a variable
will affect the chart and the breakeven point, and therefore be able to interpret the
charts.

Candidates must not draw the charts ‘mechanically’ but also think intuitively about
whether the graphs and the answers that they have given are reasonable.

It is hoped that this article will help with some of these elements.

Charlotte Bower is examiner for CAT Paper 10

© 2011 ACCA