Q56 Plumb Ltd

You are in charge of the audit of Plumb Ltd for the year ended 30 September 20X5. The principal
activity is the provision of plumbing and central heating services under fixed-price short-term
contracts. The majority of the companys business is conducted on a sub-contract basis for
construction companies many of which used Plumb Ltd on a regular basis. It is common practice in
the industry sector for construction companies to pay 95% of the contractvalue on completion with the
5% balance being retained by the customer for six months as security against problems witht the work
undertaken.

Plumb Ltd also has retain outlets through which it sells consumables used in the plumbing trade.
However, management is currently negotiating the sale of the retail operation and plans to use the
proceeds to repay a loan falling due in Feb-06. Following the disposal of the retail operation, Plumn
Ltd will continue to buy consumables used in its contract work from the existing suppliers but in
smaller quanities.

Plumb Ltd made an operating loss for the year ended 30 Sep-05. This is mainly due to a substantial
provision for rectification work relating to a contract for Builda plc, one of Plumb Ltds major
customers. The contract was completed in early Sept-X5 but failed to meet the customers
specification. Furthermore, in Oct-X5, Plumb Ltd received notification that Builda plc had lodged a
claim against the company for substantial compensation for alleged damage to the customers
business. No provision has been made to this compensation as the directors of Plumb Ltd have
instructed the companys legal advisors to fight the claim.

The company is currently trading as its overdraft limit and the directors have been negotitating with
the compays bankers in order to increase its borrowings. The directors have prepared profit and cash
flow forecasts for three years ending 30-Sep-X8 in support of this request for funding. The companys
bankers require this information to be reviewed by indepdent accountants and the board of directors
has requested that your firm undertakes this review.

(a) In relation to the audit of the financial statmenets, identify from the information provided
above, the matters which give cause for concern and explain why they give cause for concern
(6 marks).

Matters Explanation
Fixed price contracts Cost overruns may result in losses
Retentions May not be paid if work is faulty/adverse impact
on cash flows
Sale of retail operations Unable to generate funds from operations to
repay loan;
Proceeds may not be sufficient to cover loan;
Operating loss Adverse impact on cash flow
Legal claim/dispute Substantial damanges may have to be paid;
Loss of business as unlikely to retain major
customer.
Trading at overdraft limit May not obtain the increased facility
Going concern status in doubt If not a going concern the basis of the preperation
of the accounts will be affected;
May require disclosure in the auditors report as
an emphasis of matter.

(b) Identify the different types of modification to the auditors report which may arise from a
going concern problem and state the circumstances in which they are appropriate (6 marks).

Auditors report
 Modified report but unmodified opinion, with emphasis of matter paragrah;
o Material uncertainty about the going concern stattus and
o Adequate disclosure in the financial statements of the uncertainty;
Qualfiied except for diagreement:
o Diagreement over disclosure details;
o But satisfied with basis of preperation;
Adverse do not give a true and fair view
o Diagreement over basis of preperation;
Qualified except for/disclaimer of opinion/limitation on scope
o Evidence reasonably expected to be avaliable is not avaliable;
o Management unwilling to make or extend assessment of going concern.

(c) Identify the infromation provided above, the specific matters you would consider when
reviewing the assumptions underlying the income and expenditure included in the profit
forecast and the receipts and payments included in the cash flow forecast (8 marks)

Matters to consider
Income
o Includes income from retail operations to date of disposal/excludes income
from retail operatings following disposal
o Allows for loss of income from major customer.
Expenditure
o Allowance made for any loss of bulk discounts due to reductiion of purchase
consumables;
o Includes legal costs of fighting legal actions;
o Wages to reflect reduction in operations due to loss of major customer;
o Additional overdraft interest but no loan interest following reapyment of
loan;
o Costs of rectification work;
o Profit or loss on disposal of retail operations included;
o Accounting policies are consistent with histroical financial statemnets.
Cash flows - Receipts
o Timing allows for retentions;
o Reflects disposal proceeds
Cash flow payments
o Loan repayment made in Feburary
o Includes cost of disposal;
o Suppliers paid in accordance with their terms of trading;
General
o Items in cash flow are consistnt with profit forecast.

Q57 Ash and Medlar (20 marks)

Described below are situations which have arisen in two unrelated audit clients of your firm. The year
end in each case is 30-Sep-07.

Ash Ltd (Ash)

On 22-Nov-07, Ash was notifified that an adminstrator had been appointed at Elm Ltd (Elm). Elm is a
regular customer of Ash with annual sales to Elm amounting to 0.2% of revenue. The balance due
from Elm at 30-Sep-07 was 25,000. The managing director of Ash has had a majority shareholding
in Elm.

The pre-tax profit for Ash for the year ended 30-Sep-X7 is 4.2m and total assets at 30-Sep-07 are
12.1m.

Medlar Ltd (Medlar)

On 13-Oct-07, Medlar was notified that an adminstrator had been appointed at Robina Ltd (Robina),
a major customer of Medlar. Sales to Robina in the year ended 30-Sep-07 amounted to 35% of
revenue and the balance due from Robina at 30-Sep-07 was 65,000. The directors are condifnet that
Medlar will be able to continue to trade, despite forecasting a trading loss for the year ending 30-Sep-
08, as the forecast for the years ending 30-Sep-09 and 30-Sep-10 indicate a return to profitability.
This is because the directors of Medlar are pursing a policy of widening the companys customer base.

The pre-tax profits of Medlar for the year ended 30-Sep-07 is 520,000 and total assets at 30-Sep-07
are 3.2m.

(a) Explain the possible effects of the situations described above on the financial statements of
Ash and Medlar for the year ended 30-Sep-07; and

Ash Ltd

Effects on financial statements

The appointment of an adminstrator represents an ajdusting event after the reproting period as it
provides evidence of conditions that excisted at the year end date and the trade receivable should be
written down to the extent that it is not recoverable. The amount is not mateiral by size as it is only
0.6% of profit before tax, 0.2% of total assets and less than 0.5% of revene. However, it is material by
nature as it is a related part transaction and as such should be disclosed in the notes to the financial
statements even if paid after the year end date.

Effect on auditors report.

If details of the realted party transaction are not disclosed in the financial statements the audit
opinion would be modified on the grounds of diagreement over disclosure. It will be an except for
qualification as it is not pervasive. The auditors report should provide details of the transaction.

Medlar Ltd

Effect on the financial statements

The amount due from Robinia represents 12.5% of profit before tax, 2% of total assts and is greater
than 1% of revenue and is therefore material by size. Consequently, provision should be made for the
outstanding amount to the extent that it is not recoverable.

As Robina is a major customer, the appointment of an adminstrator could have goinc concern
implications. The effect on the financial statements is determined by
(b) Discuss the implications for the auditors reports on the financial statements of Ash and
Medlar.