Corporate Level- December 2015

KC 4 – Corporate Governance, Ethics & Assurance

(Rehearsal Paper)- 2 hours and 15 minutes

Marking Guide
Section1
Question 1- (This based on KC4- CASL- Pilot Paper)

Basis for allocation of marks

a) 15 marks
i) Proposed audit adjustments (8 marks)
 2 marks for referring to the requirements of SLAuS 450 in evaluating misstatements.
 4 marks on ESOP.
2 marks for explaining the requirement of SLFRS 2 and
the balance 2 marks for its application and explaining the impact on the financial
statements.
 2 marks for explaining that a provision cannot be recognized for the estimated cost of the
new water treatment plant.

(ii) Impact on the audit report (7 marks)

 2 marks for explaining that an adverse opinion may not be suitable.

 2 marks for explaining the meaning and requirement of SLAuS 706 in relation to emphasis
of matter.
 1 mark for clarifying the requirements of LKAS 37 in relation to a contingent liability.
 2 marks for an appropriate conclusion that a qualified opinion is to be revisited in light of
the omission of the disclosure and that the audit report should be structured according
to SLAuS 705.

Section 1
Question 1 (b)

According to SLAuS 450: Evaluation of misstatements identified during the audit, the auditor shall
determine whether uncorrected misstatements are material individually or in aggregate. In

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making this determination, the auditor shall consider the size and nature of misstatements both
in relation to particular account balances, classes of transactions or disclosures and the financial
statements as a whole, and the particular circumstances of their occurrence.

Proposed adjustments
ESOP
The proposed adjustment on account of ESOP represents 10% of profit before tax and is material
to the financial statements. It is assumed that this adjustment had been derived based on the
fair value of the share option at the grant date and the number of eligible options. SLFRS 2: Share-
based payment, requires an expense and a corresponding entry to equity to be recognised over
the vesting period of a share-based payment scheme. (2 marks)
In determining the value of a share option many variables are taken into account. Share price
and its expected volatility are considered as variables in valuation models used to determine
option prices. In this context, the finance director’s argument is not valid as the basis for non-
recognition of share-based payment. Further, a letter of representation cannot substitute for the
failure to comply with SLFRS 2. Therefore, management should be requested to make the
necessary adjustment to recognise the expense and entry to equity. (2 marks)
Provision - water treatment plant
The estimated cost of the new water treatment plant does not meet the definition of a provision
in terms of LKAS 37. The entity does not have an obligating event, i.e. an event that creates a
legal or constructive obligation that results in an enterprise having no realistic alternative to
settling that obligation. Because the Company can avoid the future expenditure by its future
actions, for example by upgrading the water purifying system, relocating the factory, etc, no
provision is recognized. This adjustment is not individually material but should be accumulated
with other misstatements. (2 marks)
(ii) Impact on auditor’s report

In aggregate, the misstatements have a net effect of LKR 10 million which represents 7% of profit
before tax. This is however less than 1% of the total assets. If these adjustments are not made,
the financial statements could be materially misstated. However, these adjustments are unlikely
to be considered as having a pervasive impact on the financial statements so as to require an
adverse audit opinion in terms of the amounts and number of elements involved. Therefore, a
qualified opinion may be expressed, with the auditor stating in the opinion that except for the
effects of the matters described in the “basis for qualified opinion” paragraph, the financial
statements show a true and fair view. (2 marks)

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(iii) The effect of the litigation

The impact of the litigation has been included after the audit opinion as an emphasis of matter.
According to SLAuS 706: Emphasis of Matter Paragraphs and Other Matter Paragraphs in the
Independent Auditor’s Report, emphasis of matter refers to a matter appropriately presented or
disclosed in the financial statements that, in the auditor’s judgment, is of such importance that
it is fundamental to users’ understanding of the financial statements. (2 marks)

If it has been established that the litigation is a contingent liability because of the uncertainty of
the future outcome which is not wholly within the control of the enterprise (possible obligation),
or because of the inability to reliably assess the outcome, the entity should provide appropriate
disclosures on the contingent liability.

The inclusion of an emphasis of matter paragraph in the auditor’s report does not affect the
auditor’s opinion. An emphasis of matter paragraph is not a substitute for disclosures in the
financial statements that the applicable financial reporting framework requires management to
make. The auditor should re-evaluate the appropriateness of the qualified opinion in light of the
significance of this issue along with other issues noted in (ii) above. If the auditor concludes that
omission of the disclosure is fundamental to the user’s understanding and is pervasive, an
adverse opinion may be expressed.

The audit opinion should be supported by a basis for an adverse/qualified opinion paragraph.
The basis for such adverse/ qualified opinion paragraph should be placed immediately before the
opinion paragraph and should contain a description of the matters giving rise to the modification.
This should include a description and a quantifying of the financial effects of the misstatement /
details of the omission.

Section 2
1. Explain how the risk appetite of the business has changed with the transition of business
from Sarath to Sureka
5 Marks
Basis for allocation of marks

 1 mark for explaining the meaning of risk appetite

 2 mark for explaining risk appetite when Sarath was running the business
 2 marks for explaining that the risk appetite has changed with risk-taking behavior of
Sureka.

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Risk Appetite- Refers to the amount of the risk an entity is willing to take at the board level and
depends on risk capacity, risk tolerance and risk attitude.
Sarath believed in organic growth and promoted the home-made- authentic value of his products.
This strategy was partly complemented through traditional labor intensive products. He has
nevertheless made some major strategic moves as a reaction to change in the competitive land scape.
These include closing down unprofitable locations and opening up new outlets, sell unproductive
lands and building network with farmers etc. In this sense, Sarath is inclined to demonstrate a more
risk averse behavior.
In contrast Sureka’s management style reflects risk taking behavior and many such dramatic strategic
moves are reflected in the case.

Examples
 Moving into export market
 Change board compositions
 Acquisitions/ business partnership with outside partners

2. Evaluate three main internal and external threats to Lanka Food in light of recent
change in strategic direction of the company.
12 Marks
Basis for allocation of marks

 2 marks for explaining the risk

 2 marks for evaluating the risk in terms of impact and likelihood

1. Partnership with Indian Company be detrimental to the Company

The funding from PSP has resulted in offering a board position of a family owned company. PSP may
probably have a significant influence over company’s financial and operational decisions. Sureka has
no previous business relationship with this partner and there may be potential conflicts over strategic
issues and reaching consensus may be difficult. This risk could have a significant impact on the
business operations and assessing the likelihood may be difficult at the early stage.

2. Acquisition of Northern Food – Not realizing the anticipated synergies

There may be financial and operational issues with the acquisition of Northern Food, example the
food quality control systems of Northern Food may not be as robust as the company and this may
affect the reputation of Lanka food. Further, there could be other misalignment with Northern Food
and anticipated synergies may not be realized. . Given the significance of the investments and that
this directly affects the business operations of the company, potential impact of related risk may be

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high. Result of the due diligence study may enable management to assess the likelihood of potential
risk arising from the acquisition.

3. Noncompliance with laws and regulations

Two assessment had been issued by the Inland Revenue department challenging the company’s
compliance with income tax and VAT law. Depending on the amount of this assessment the impact
of this risk could be high. Further, this has an impact of the company’s reputation and their by hinder
its ability to attract more investments. The likelihood of the risk seems to be high as the assessment
could be evidence of non-compliance with tax law.

Other risk
Reconstituted board
Lanka food is a family owned business that has grown by entrepreneurs (Sarath and his father),
inviting new members to the board should be done with care as this will affect company’s future
direction.
Listing in the stock exchange
With the listing there may be a threat to family ownership by possible takeover bid
Export market
The company has no previous experience in export market and assess its vulnerabilities in terms of
competitiveness. There may be specific laws and regulations that govern the food security which
the company should comply with.
Financial Risk
Working Capital and Credit Risk
Working capital being tied up in debtors and stocks as the customer base has increased to super
markets and larger retailers. This may also increase the credit risk. This risk is evident from the audit
qualification in relation to the impairment of receivable.
Gearing

With 1 billion new funding, company’s gearing will go up and this may exert pressure on net profit
and affect company’s ability to raise funds. The level of risk also depends on covenants relating to
the borrowings.
Currency Risk
With the export sales, the company is exposed to currency risk and company should attempt to
mitigate such risk. E.g. currency forward contacts

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3. Evaluate the reformulated board in terms of board balance and independence based on the
corporate governance best practices applicable to a listed entity
6 Marks

Basis for allocation of marks

 2 marks for explaining the board composition and requirements on independent non-
executive directors applicable for the company
 2 Marks explaining the CEO/Chairman dominance
 2 Marks explaining the issues affecting independence of directors

1. Board Balance and Independence non- executive Directors

The board of directors of a Listed Entity shall include at least,

- two non-executive directors; or
- such number of non-executive directors equivalent to one third of the total number of
directors whichever is higher.
Where the constitution of the board of directors includes only two non-executive directors in
both such non-executive directors shall be ‘independent’. In all other instances two or 1/3 of non-
executive directors appointed to the board of directors, whichever is higher shall be
‘independent’.

Sureka plays a dominant role at the top of the company affecting balance of power and
authority. With her power she could influence and dominate board decision making and lessens
the governance role of non-executive and independent directors.
When CEO and chairman position is combined, majority of the board should be non-executive.

Lanka Food Board Structure (Only for working)

EDs NEDs
1. Chairman- Sureka 1. Upul- NED
2. Kapila- Director 2. NED- MD of Partha
Marketing & 3. SID- Sarath
operation
3. Deshani- FD

Although there are 3 non-executive directors, only one out of the three appears to be
independent.

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Sarath cannot be considered as an Independent Director, as he has his daughter as the main
individual running the business. SID is appointed to balance power and authority when the CEO
and Chairman position is combined to listen to the concerns of other directors which were not
considered by the board.

4. Advice Sureka on developing an Audit Committee Charter stating the areas to be covered and
explaining key role of the audit committee
8 Marks

Basis for allocation of marks

 2 marks listing the elements of Audit Committee Charter

 1 ½ marks for explaining four key roles of Audit Committee

Audit Committee Charter should include

1. Purpose
2. Power and authority
3. Chairman and members
4. Roles and Responsibilities
5. Meeting Frequency

Audit Committee key roles

(The below areas can be briefly explained, prior can be given to areas which are much relevant to
Lanka food)
1. Financial Reporting.
Review of financial statements including interim financial results/ press release. The audit
committee should review significant judgements in relation to accounting estimates, fair value
measurement and changes to accounting policies

2. Risk Management and internal controls

3. Independence of Auditors

4. Compliance with laws and regulations

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Non- Compliance with Laws

5. Main role of the internal auditor is to “create business value and protect the
Business”
In light of the above comment by Sureka, outline the key roles of internal auditor in terms
of Definition of internal audit
4 Marks

 2 marks identifying key aspects of the definition of internal audit

 2 marks for relating the definition to Sureka’s comment

Internal auditing is an independent, objective assurance and consulting activity designed to add value and
improve an organization's operations. It helps an organization accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control,
and governance processes.

As Lanka food is growing rapidly with complexity and exposed to many business risk, it should have a
robust governance, risk and control system to create sustainable growth while minimizing the exposure
to risk. Internal auditor could provide an independent assurance to the board about the effectiveness of
risk management, control, and governance processes.

6. Evaluate five significant risk of material misstatements which audit team should focus on the
audit of consolidated financial statements of Lanka Food.
15 Marks
Acquisition of Subsidiary

(i) Measurement of goodwill on acquisition

The goodwill should be recognised as an intangible asset and measured according to LKAS 38
Intangible Assets and SLFRS 3
Business Combinations. The purchase consideration should reflect the fair value of total
consideration paid and payable, and there is a risk that the amount shown in the calculation is
not complete, for example, if any deferred or contingent consideration has not been included.
Completeness of identifiable assets and assumed liabilities
The net assets acquired should be all identifiable assets and liabilities at the date of acquisition.
There is a risk that not all acquired assets and liabilities have been identified, or that they have
not been appropriately measured at fair value, which would lead to over or understatement of
goodwill and incomplete recording of assets and liabilities in the consolidated financial
statements.

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Impairment
LKAS 38 requires that goodwill is tested annually for impairment regardless of whether indicators
of potential impairment exist.

(ii) The non-controlling interest has been measured at fair value.

This is permitted by SLFRS 3, and the decision to measure at fair value can be made on an
investment by investment basis. The important issue is the basis for measurement of fair value.
Nothern Food is a not listed, then management should have used estimation techniques
according to the fair value hierarchy of inputs contained in SLFRS 13 Fair Value Measurement.
This would introduce subjectivity into the measurement of non-controlling interest and goodwill
and the method of determining fair value must be clearly understood by the auditor.

(iii) The fair value adjustment of made in relation to Co’s property

The auditor should also consider if any further adjustments need to be made to Co’s net assets
to ensure that Group accounting policies have been applied. SLFRS 3 requires consistency in
accounting policies across Group members, so if the necessary adjustments have not been made,
the assets and liabilities will be over or understated on consolidation.

(iv) Fraud Risk

- Incentive to mislead financial information in the backdrop of IPOs
- Sureka’s dominant role
iv) Impact of tax assessments, the need to recognize provisions/ disclosure as a contingent
liability
(v) Impact of the previous year qualification on the current year audit.
(vi) Valuation of biological assets and AFS.

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