Corporate Reporting – Advanced level – July 16

MARK PLAN AND EXAMINER’S COMMENTARY – Corporate Reporting July 2016

This report includes:

 a summary of the scenario and requirements for each question

 the technical and skills marks available for each part of the requirement
 a description of how skills should be demonstrated
 detailed points for a full answer
 examiner’s commentary on candidates’ performance

The information set out below was that used to mark the questions. Markers were encouraged to use discretion
and to award partial marks where a point was either not explained fully or made by implication.

Question 1

Scenario

The candidate is asked to review the work of an audit senior who has summarised the minutes of board
meetings during the audit of Earthstor an AIM-Listed company. The audit senior identified the company’s
financial reporting treatment of the transactions in the minutes in a separate exhibit. The CEO of Earthstor
dominates the board which presents both ethical and governance issues. The finance director has resigned
after raising concerns over transactions with a supplier TraynorCo and has not been replaced. Potentially
Earthstor is assisting TraynerCo to evade tax in a non UK tax jurisdiction. The candidate is required to review
the work of the audit senior and identify appropriate financial reporting treatments for the transactions noted in
the minutes which include an interest free loan in a foreign currency to a supplier; an equity investment in a
foreign company; IAS 40 issues in respect of a foreign investment property; and website development costs.

Requirements Marks Skills assessed

(1) Explain the financial reporting
implications of each of the
transactions noted from the board
minutes by Greg (Exhibit 2 and 3).
Recommend appropriate accounting
adjustments. Please ignore any tax
implications of these adjustments.
18  Assimilate and demonstrate understanding of
a large amount of complex information.
 Identify appropriate accounting treatments for
complex transactions including an interest
free loan in a foreign currency to a supplier;
equity investment in a foreign company; IAS
40 issues in respect of a foreign investment
property; and website development costs.
 Apply technical knowledge to identify
inappropriate accounting adjustments.
 Recommend appropriate accounting
adjustments

(2) Identify the key audit risks arising from
each of the transactions (Exhibits 2
and 3) and recommend the audit
procedures we will need to complete
to address each risk.
(3) Prepare a revised draft statement of
financial position at 30 June 2016
(Exhibit 1). This should include any
adjustments identified in (1) above.
(4) Explain any corporate governance
issues for Earthstor that you identify
from Greg’s file note (Exhibit 2). Also
explain any ethical issues for our audit
firm and set out any actions that our
firm should take.
10  Assimilate knowledge, drawing upon question
content to identify key audit risks
 Describe relevant audit procedures required
to provide verification evidence for each risk.
5  Assimilate adjustments to prepare draft
statement of financial position.
7  Assimilate information to identify potential
problems with the governance of Earthstor.
 Identify potential ethical and money-
laundering issues.
 Discuss appropriate responses and actions
for the firm in respect of the potential ethical
issues.

Total 40

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 Corporate Reporting – Advanced level – July 16

Working paper for the attention of Tom Chang

Financial reporting treatment and key disclosure requirements of each of the transactions noted by Greg

Loan to TraynerCo

The loan to TraynerCo represents a financial asset for Earthstor. IAS39 para 43 requires a financial asset to be
measured initially at fair value. A zero interest rate loan issued at par would not result in an arm’s length
transaction and IAS 39 AG 64 requires the fair value in such a case to be determined as the present value of
the cash receipts under the effective interest rate method. The discount rate should be that on similar loans.
The loan will fall within IAS 39’s definition of loans and receivables and should be subsequently measured at
amortised cost.

The initial fair value of the loan when issued on 1 July 2015 is therefore:

MYR20 million / (1.06)2 = MYR17.800 million

In terms of £ sterling this would be translated at this date as:

MYR17.800 million /5 = £3.560million

The difference of £0.44 million between the £4 million recognised by the company in trade and other receivables
and £3.56 million is recognised as an expense in profit or loss.

Each year the unwinding will be treated as finance income. It would be appropriate to use the amortised cost
method as the loan is a non-derivative financial asset; there is a determinable repayment date and the intention
appears to hold the investment to maturity. The loan at the financial year end of 30 June 2016 is:

MYR17.8 million x 1.06 = MYR18.87 million

This is a monetary asset and would be translated at the year-end rate of £1 = MYR6. In the financial statements
of Earthstor it would therefore be translated as:

MYR18.87 million /6 = £3.15 million

There are two elements to this transaction for financial reporting purposes:

(i) interest income on the loan; and

(ii) exchange loss.

Interest income

The interest income is recognised at the effective rate, even though there is no cash interest received. As the
interest accrues over the year, it is translated at the average exchange rate.

The interest cost in MYR is therefore:

MYR17.8 million x 6% = MYR1.07 million

Translated using the average rate into £ this is:

MYR1.07 million / 5.5 = £0.20 million

Exchange loss

The exchange loss has two elements:

 On the interest
 On the loan

The exchange loss on the interest is:

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 Corporate Reporting – Advanced level – July 16

MYR1.07 million/5.5 – MYR1.07 million/6 = £0.02 million

The exchange loss on the loan is:

MYR17.8 million/5 – MYR17.8 million/6 = £0.59 million

£’000
Interest income 200
Exchange loss:
On interest (20)
On loan (590)
410

This reconciles with the opening balance divided by the opening exchange rate less the closing balance divided
by the closing exchange rate as above (£3.56m - £3.15m) = £0.41 million.

The loan is currently recognised at MYR20 million / 5 = £4 million and should be recognised at £3.15 million.

Exchange differences and interest should be reported as part of profit or loss. An adjustment is required as
follows:

£000
Dr Loans and receivables 3,150
Cr Trade receivables 4,000
Dr Exchange differences – retained earnings (0.02 + 0.59) 610
Cr Interest income – retained earnings 200
Dr Interest cost – (£4m – £3.56m) 440

TraynerCo Loan - Audit risks and procedures

Audit risk Audit procedures

The supplier may not be able to repay the loan
and it would then be impaired. This is a key risk
as there are no cash interest payments to
observe that these can at least be serviced.
Check procedures used to verify the
creditworthiness of the supplier when the loan
was originally extended.
Verify the terms of the loan and whether any
security has been pledged if the loan is not
repaid – e.g. enquire whether there is a charge
over assets as security for the loan.

Examine correspondence (legal

correspondence, board minutes, as well as
letters/emails/memos with TraynerCo) for any
possibility of early repayment.

The market rate of interest of 6% may not be a Compare rates to corporate loans to similar
risk equivalent in which case the measurement companies where interest is paid in full.
of the loan and the interest payments would be
incorrect.

Classification of the loan as loans and Confirm terms by examining the loan
receivables may be inappropriate. agreement.
Examine correspondence for any possibility of
early repayment.

There is a control risk in authorising a large Review level of authorisation of loan (main
loan on favourable terms. board).

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 Corporate Reporting – Advanced level – July 16

Review treasury procedures to attest

information on creditworthiness, legal advice
and means of drawing up loan agreements.

Consider whether there is a risk of a link
between the provision of the loan and the cost
of goods from TraynerCo - the CEO has
referred to a deal on the rent and this may also
apply to the loan.
Examine the contractual supply agreement with
TraynerCo for example deep discounting of
purchase cost of goods as part of loan
agreement.
Prepare analytical procedures on history of
cost of goods from TraynerCo.

Risk of incorrect exchange rates. Verify exchange rates and estimate average
exchange rates.

Confirm the date on which loan was extended.

TraynerCo - equity investment

The investment in TraynerCo is an equity investment and should be categorised as available for sale because it
is for the long term and not intended for immediate sale. The movement in the fair value of an AFS asset is
taken to other comprehensive income including foreign currency exchange gains and losses (except in the case
of an impairment).

IAS39 para 43 states that (unless the financial asset is measured FVTPL) the transaction costs are added to
value of the asset, not written off to profit or loss. Therefore, Earthstor’s treatment of the legal costs is correct.

IFRS 13 defines fair value as 'the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date'. Fair value is a market-based
measurement, not an entity-specific measurement. It focuses on assets and liabilities and on exit (selling)
prices. It also takes into account market conditions at the measurement date. In other words, it looks at the
amount for which the holder of an asset could sell it and the amount which the holder of a liability would have to
pay to transfer it. IFRS 13 states that valuation techniques must be those which are appropriate and for which
sufficient data are available. Entities should maximise the use of relevant observable inputs and minimise the
use of unobservable inputs.

With regards to the investment in TraynerCo, there is no observable quoted price for the shares. There is
evidence that the price has fallen because Henry Min has sold a further 10% of the shares for MYR 36 million
and therefore the fair value recognised at 1 October 2015 may have changed at 30 June 2016. Where no active
market exists and no reliable fair value is available, equity investments, such as the unquoted equity investment
in TraynerCo can be measured at cost less impairment.

The exclusion is only appropriate for financial instruments linked to unquoted equity investments such as
TraynerCo.

The question is whether the subsequent sale of a further 10% of the shares in TraynerCo by Henry Min
represents a fall in the fair value of the shares at the year-end due to: 1) market conditions or 2) because the
company is performing poorly or 3) because the initial valuation was incorrect either deliberately or
unintentionally as suggested by the comments made by the finance director.

There is also a question of whether the valuation is reliable - If the valuation is not reliable the investment should
be continued to be recognised at cost.

If the fall is due to market conditions, then the loss including the exchange difference is taken to OCI. If the
asset is subsequently determined to be impaired, the loss previously recognised in other comprehensive income
should be reclassified to profit or loss, even though the asset has not been derecognised. The impairment loss
to be reclassified is the difference between the acquisition cost and current fair value.

There is insufficient information to determine whether the fair value of TraynerCo has been impaired or whether
the movement represents a change in the fair value. Or whether the transaction was not at fair value originally.

Until further information is obtained I have assumed that the value has fallen due to market conditions and
therefore the following adjustments are required:

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 Corporate Reporting – Advanced level – July 16

(Alternative assumptions are also acceptable).

Recognition and subsequent recognition

£’000
Initial recognition of shares is MYR45m / 5 including transaction costs 9,500
At year end MYR36m /6 6,000
Loss to be recognised in OCI 3,500

Assuming that the loss should be recognised in other comprehensive income therefore an adjustment is
required as follows:

£’000

Dr AFS - TraynerCo 1,500

Cr Translation reserve 1,500

Cr AFS - TraynerCo 3,500

Dr OCI/AFS reserve 3,500

Being reversal of translation of AFS asset and movement in fair value

IFRS 7 requires disclosure of risks relating to financial instruments which include credit, currency, interest rate,
liquidity, loans payable and market risk. For each type of risk, disclosure is required of the exposures to each
risk and how they arise, the entities policies and processes for managing risk and any changes from previous
period.

TraynerCo Equity investment - Audit risks and procedures

Audit risk Audit procedures

There is a risk that management have not
understood the significance of fall in price for
the shares in relation to this equity instrument
and the additional disclosure required under
IFRS 7 resulting in incorrect measurement and
recognition
Consider the guidance provided in the design
of audit procedures set out in IAPN 1000.
Review and assess the valuations made by the
directors.
Ensure disclosure of risks is appropriate and in
compliance with IFRS 7.
Agree the cost of acquisition of the shares to
legal documents, share certificates and
payment.

A key risk is that supporting evidence may not
be available in respect of the valuation as the
shares are unquoted.
Obtain third party evidence of the valuation at
30 June 2016.
Consider the nature of the fall in fair value in
the light of other information about TraynerCo –
by reference to financial statements, cash flow
projections.

(Consider whether there is a risk of a link
between the provision of the equity finance and
the cost of goods from TraynerCo -the CEO
has referred to a deal on the rent and this may
also apply to the equity finance.
Examine the contract for the acquisition of the
shares and ensure that this is not related to the
supply agreement for goods.
Prepare analytical procedures on history of
cost of goods from TraynerCo.

Risk of inaccurate exchange rates. Verify exchange rates)

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 Corporate Reporting – Advanced level – July 16

Singapore investment property

The property should be recognised as an investment property. The company has adopted the fair value method
to account for investment properties and therefore the property should be revalued at the year end to its fair
value. Movement on the change in fair value of investment properties is recognised in profit or loss.

The Singapore investment property should be recognised at cost on 1 February 2016 and the change in fair
value measured as follows:

£’000
At 1 February 2016 SG$10,000,000 /2.1 4,762
At 30 June 2016 SG$11,000,000 /2.7 4,074
Change in fair value 688

The property should be separately recognised as investment property.

£’000
Dr Operating costs (retained earnings) 688
Cr PPE 4,762
Dr Investment property 4,074

Investment property

Audit risk Audit procedures

The valuation presents a significant risk as this
may not be a market price in an active market
Check that fair value has been measured in
accordance
with IFRS 13
 Obtain more recent evidence of the
market value and confirm the
reasonableness of the valuation
 Agree valuation to evidence of other
sale
 Recalculate gain or loss on change in
fair value and agree
to amount in statement of profit or loss
and other comprehensive income
 Consider the use of an auditor’s expert
to perform valuation

There is a risk that management lack of Confirm compliance with IAS 40/IFRS 13, for
expertise will result in inadequate disclose example:

 Disclosure of policy adopted

 If fair value model adopted disclosure
of a reconciliation of
carrying amounts of investment
property at the beginning and end of
the period

Website development costs

The costs of acquiring and developing software that is not integral to the related hardware should be capitalised
separately as an intangible asset. This does not include internal website development and maintenance costs
which are expensed as incurred unless representing a technological advance leading to future economic
benefit.

Capitalised software costs include external direct costs of material and services and the payroll and payroll
related costs for employees who are directly associated with the project.

Capitalised software development costs provided they meet the criteria under SIC 32 and IAS 38 - the fact that
the costs integrate the website with other process systems of the business and are not merely providing content
and advertising would suggest that they do - should be stated at historic cost less accumulated amortisation.

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 Corporate Reporting – Advanced level – July 16

Amortisation is calculated on a straight-line basis over the assets’ expected economic lives. Amortisation is
included within administrative expenses in the statement of profit or loss.

Therefore, Earthstor has probably incorrectly capitalised the planning costs, and also possibly the fees paid to
Tanay and the photography and graphic design costs (further information is required on the nature of these
expense). These costs should be expensed during the year. An amortisation charge of £22 million / 7 years’ x
2/12 = £524,000 is required to be charged from 1 May 2016. Although this is below the materiality level on its
own but taken together with the incorrect capitalisation of costs, this should be adjusted:

£’000
Dr Operating expenses (£3,000,000 +£1,300,000 + £5,000,000 + 9,824
£524,000
Cr Intangible assets 9,824

Reporting to Audit committee

The adjustments will be required to be reported to the Audit committee as they are all above the agreed
£120,000 reportable limit.

Audit risk Audit procedures

Given the increased capital expenditure during
the year there is a risk that both external and
internally generated expenditure relating to the
website have been incorrectly capitalised
instead of being written off through the income
statement.
Obtain details of internal software development
costs and agree to:
 Invoices from third parties
 Where the costs relate to staff costs,
agree to time records.

There is a risk that the useful life of seven Ensure that costs capitalised are incremental
years may be excessive given the nature of the costs relating to the project and not time spent
expenditure on management

Consider the appropriateness of the useful life,

enquire of appropriate management and past
history of similar projects.

Related party transactions

 TraynerCo

TraynerCo is a supplier and although there is significant interdependence between Earthstor and TraynerCo,
TraynerCo is not a related party of Earthstor.

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 Corporate Reporting – Advanced level – July 16

Revised statement of financial position as at 30 June 2016

£'000 £’000
Non-current assets Revised

Intangible assets - website 31,300 - 9,824 21,476

Financial asset - TraynerCo 8,000 - 2,000 6,000
PPE 56,309 - 4,762 51,547
Investment property 4,074
Loan to TraynerCo 3,150

Current assets
Inventories 144,380 144,380
Trade and other receivables 22,420 – 4,000 18,420
Cash and cash equivalents 71,139 71,139
Total assets 333,548 320,186

EQUITY AND LIABILITIES

Equity
Ordinary share capital (£1/€1 10,000 10,000
shares)
AFS reserve (1,500) + (2,000) (3,500)
Retained earnings 163,362 – 850 – 688 - 9824 152,000
Non-current liabilities 12,175 12,175
Current liabilities 149,511 149,511
Total liabilities and equity 333,548 320,186

Ethical and corporate governance implications

Dominic appears to dominate the board which represents a governance issue – but not necessarily an ethical
issue. There seems to be no separation between the chair of the board’s role and the CEO. The company is
also operating without a finance director which would again present a governance issue as the board would not
be operating with the appropriate skills to manage the company effectively. The board is therefore not acting
effectively and there is a lack of transparency in the Dominic’s behaviour.

A deal appears to have been made to charge no rent to TraynerCo in exchange for lower cost of goods sold.
There may potentially be an ethical issue as the company may be entering into a transaction which could be
assisting a supplier company to evade tax in a non-UK tax jurisdiction. However, more detail of the tax
treatment of the rental deduction and the taxation of profits would need to be obtained and consulting a tax
expert in Singapore and Malaysia. Also need to ensure that Earthstor’s tax position is correct and that the
company is paying the correct UK taxes.

There may be an intimidation threat if Dominic attempts to intimidate the audit staff – the firm should ensure that
appropriately briefed and experienced staff are assigned to the audit.

As there is no finance director, the firm may face a management threat if it acts in the finance director role.

Actions the firm should take:

The increase in audit risk should be addressed with additional audit procedures in respect of the above
transactions.

AIM listed companies are not required to make disclosures of compliance with the provisions of the UK
Corporate Governance Code. However, ISA 260 requires matters of concern to be raised with those charged
with governance; the audit committee would be a point of contact to raise concerns. In addition, information
published in the financial statements should be reviewed for consistency and appropriate professional

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 Corporate Reporting – Advanced level – July 16

scepticism. In respect of the potential tax evasion, further information should be obtained and the matter
reported with the firm’s money laundering officer. The firm will need to engage expert tax advice in Malaysia and
Singapore.

Examiners’ comments

General comments

This was the best answered question on the paper, especially with regards to the financial reporting treatment
and identification of risks and procedures. Very few candidates commented on the need to report to the audit
committee.

Detailed comments

(1) Financial reporting treatment

Many candidates identified (erroneously) a related party issue with this question and those who did often produced
lengthy explanations of the disclosures that would be required. Some better answers identified that there was an
issue with transactions not conducted at arm’s length, but that this did not create a related party.

The financial asset aspects of the question were often not handled well. In relation to the interest-free loan, weaker
candidates simply accounted for the foreign currency movement and disregarded discounting and interest
altogether. Only a small number of candidates who managed to discount the opening receivable could explain
that discounting resulted in an initial expense in the profit or loss. Some recognised that the transaction resulted
in the recognition of a receivable but then accounted for the unwinding of the receivable (interest income) as a
cost to profit or loss. Some even considered the asset was a liability. However, this was a relatively difficult topic
and it was pleasing that so many candidates did manage to make the necessary adjustments correctly.

In relation to the investment in 10% of Trayner’s shares, it was quite common to find candidates accounting for
this as an associate and therefore recommending the equity method. Sometimes this was as a result of arguments
that Earthstor and Trayner are very closely linked, and that the apparent overpayment for the 10% investment
could have involved a premium related to significant influence. However, in many cases it appeared that
candidates think that an investment of 10% automatically results in significant influence. Most candidates,
however, did manage to correctly classify this as an AFS investment and most (but not all) of them realised that
the treatment of transaction costs was correct. However, many thought that the creation of a translation reserve
was also correct. Occasionally there were some reasoned debates demonstrating higher skills about the nature
of and reason for the movement in the fair value and these were credited in the marking.

Most candidates gained marks on the website asset. Weaker candidates took the opportunity to write out sections
of the standards for the markers to read – unfortunately the marks at this level are for the application of knowledge
to the scenario – to gain marks the candidate has to explain why a particular standard applies to the scenario.

However, in general candidates were able to articulate that costs for the website should only be capitalised when
future economic benefit had been demonstrated. Almost all then went on to undertake a reasonable calculation
of the amortisation for the period.

There were some surprising errors in relation to the mainstream topic of investment property. A substantial
minority of candidates put time and effort into isolating the foreign currency effect of the investment property fair
value movement and reporting it separately, which is not required. More surprising at this level was the readiness
to post the fair value movement to a revaluation reserve rather than to profit or loss. Many candidates got tangled
up in lengthy explanations about the granting of rent-free accommodation to TraynerCo.

(2) Audit risks and procedures

In general, the audit risks and procedures were sufficiently well identified and discussed for candidates to score
highly with many scoring close to maximum marks for this section. Marks were lost when the audit tests were not
appropriately linked to the scenario or were repetitious. The best answers highlighted the recoverability issues
with the TraynerCo loan and suggested appropriate procedures to address this risk. However, a significant
number thought that an acceptable approach to many risks would be to obtain management representations,
despite the governance and ethical issues discussed in relation to Dominic Roberts in the last section of the
question.

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 Corporate Reporting – Advanced level – July 16

Candidates should identify the main risk with each issue. Weaker candidates start by discussing the exchange
rates and the correct discount factors and then do not comment on the more obvious issues like the recoverability
of the loan. Candidates score better if they produce quality rather than quantity.

For the investment many discussed disclosure as an AFS investment and the exchange rate issues again but did
not think that the fall in value would be significant (some had called it a non- adjusting post period end event).
This meant that the procedures were weak too.
The risks surrounding the website and the investment property were identified more clearly.

Procedures were not thought through well. Many mentioned looking at board minutes although it was clear from
the question that Dominic may not have discussed/minuted these and had cancelled meetings.

There was a lot of discussion about related parties which was not relevant. Many thought the incorrect/insufficient
disclosures of related parties was the main risk for some issues.

There was also a lot of discussion about the reliance of Earthstor on Trayner for supplies and that there was a
going concern risk for Earthstor. The question said that if they could not buy supplies from Trayner they may not
be able to trade successfully in the footwear market but this was sometimes interpreted as imminent corporate
failure for Earthstor.

(3) Statement of financial position

Most candidates were able to use their own figures from section 1 to complete enough of the key elements of this
section. However, few presented the loan to Trayner separately from trade receivables and many candidates
failed to demonstrate that the balance sheet should balance.

(4) Corporate governance and ethics

The corporate governance element of this section was generally well completed with most candidates identifying
the dominance of Dominic Roberts, lack of segregation of CEO/chairman and the cancelling of board meetings
as indicative of poor corporate governance. Some very weak candidates speculated on the nature of the ‘close
friendship’ with Henry and said this was unethical.

However, many incorrectly noted that, as the company was AIM listed, it was required to comply with the
Corporate Governance Code, rather than it being best practice.

The ethics section was poorly completed by most. A large proportion of candidates interpreted the requirement
as relating to Dominic Roberts ethics rather than the audit firm’s and commented on potential unethical business
practices. Where candidates did interpret the question correctly, few raised anything other than the intimidation
threat as an ethical issue. Very few recognised the potential for tax evasion. Consequently, the ‘actions’ were very
limited.

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 Corporate Reporting – Advanced level – July 16

Question 2 - EyeOP

The candidate is working in the finance department of a listed company, HiDef plc, and is required to respond to
the instructions of the CEO. HiDef has an investment in EyeOP Ltd and is planning to acquire a controlling
interest. The candidate is required to explain the impact of financial reporting issues including: the calculation of
consolidated goodwill; the correction for the accounting treatment of the company’s pension scheme obligations;
the treatment of development costs and revenue recognition. Having made appropriate adjustments, the
candidate is required to prepare a draft forecast statement of comprehensive income assuming HiDef makes
the acquisition of EyeOP’s shares. Finally, the candidate is required to analyse the impact of the acquisition on
key performance targets.

Requirements Marks Skills assessed

1) Calculate the goodwill relating to 4
the proposed purchase of  Use technical knowledge to calculate the
650,000 ordinary shares in goodwill on consolidation.
EyeOP on 1 August 2016, which
would be included in HiDef’s
consolidated statement of
financial position for the year
ending 30 November 2016. For
this purpose, use the expected
fair value of EyeOP’s net assets
at 1 August 2016 of £63 million.

2) Explain the impact of each of the 12  Assimilate complex information in order to

outstanding financial reporting
issues (Exhibit 1) on EyeOP’s
forecast financial statements for
the year ending 31 December
2016. Recommend appropriate
adjustments using journal entries.
3) Prepare a revised forecast
consolidated statement of
comprehensive income for HiDef
for the year ending 30 November
2016. Assume that HiDef
acquires 650,000 shares in
EyeOP on 1 August 2016 and
incorporate any adjustments you
recommend in respect of the
outstanding financial reporting
issues (Exhibit 1).
recommend appropriate accounting
adjustments
 Apply technical knowledge to the
information in the scenario to determine the
appropriate accounting for pension
accounting, development costs and revenue
recognition
 Clearly set out and explain appropriate
accounting journals
6  Assimilate and use adjustments identified in
(2) in drafting the statements requested.
 Use knowledge of financial statement
presentation to present the financial
statements in appropriate format
 Appreciate that control threshold passed
and therefore a gain on re-measurement to
fair value arises which is recognised in profit
or loss
 Appreciate that previous gains are also
reclassified to profit or loss.

4) Analyse the impact of the 8  Analyse information to determine EyeOP’s

acquisition of 650,000 shares in
EyeOP on HiDef’s key
performance targets (Exhibit 2)
for the year ending 30 November
2016 and, where possible, for the
year ending 30 November 2017.
impact on the performance ratios
 Determine the predicted impact for 2017
 Conclude on the extent to which
performance targets are met subsequent to
the acquisition.

Total 30

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 Corporate Reporting – Advanced level – July 16

1. Calculate the goodwill relating to the proposed purchase of 650,000 ordinary shares in EyeOP on 1 August
2016, which would be included in HiDef’s consolidated statement of financial position for the year ending
30 November 2016. For this purpose, use the expected fair value of EyeOP’s net assets at 1 August 2016
of £63 million.

Goodwill is calculated as:

£m
Fair value of consideration paid to acquire control 85.0
Non-controlling interest (valued using the proportion of net assets method) 18.9
30% x £63 million
Fair value of previously held equity interest at acquisition date 6.2
110.1
Fair value of net assets of EyeOP 63.0
Goodwill 47.1

This calculation assumes that there is no impact on the net assets figure at 1 August 2016 arising from the
correction of the errors identified below in EyeOP’s financial statements for the year ending 31 December 2016.

2. Explain the impact of each of the outstanding financial reporting issues (Exhibit 1) on EyeOP’s forecast
financial statements for the year ending 31 December 2016. Recommend appropriate adjustments
using journal entries.

Pension schemes (Working 1)

Scheme B appears to be a defined contribution plan therefore the accounting treatment adopted by the finance
assistant is correct. This is a defined contribution plan because there is no obligation on the part of EyeOP other
than to pay its contribution of 7% to the pension fund.

Scheme A is a defined benefit plan because EyeOP has provided a guarantee over and above its obligations to
make contributions. Therefore, the contribution of £6.4 million in respect of scheme A should be credited from
the statement of profit or loss and debited to the net benefit obligation. The service cost of £5.9 million and
finance cost of £1.9 million (see calculation below) should be charged to the profit or loss.

In addition, a gain on re-measurement must be calculated and taken to OCI as follows:

Plan assets Plan

£m obligations
£m
At 1 December 2015 22.0 (60.0)
Interest cost on obligation (5% x £60m) (3)
Interest on plan assets (5% x £22m 1.1
Current service cost (5.9)
Payments to pensioners (2.1) 2.1
Contribution paid 6.4
Curtailment (4.2)
Sub total 27.4 71.0
Gain/(Loss) on re-measurement recognised in 5.2 (3.5)
OCI
At 30 November 2016 32.6 (74.5)

Tutorial note: Above table shown for marking purposes – a merged presentation also acceptable.

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 Corporate Reporting – Advanced level – July 16

Recommended adjustments:

£m
Dr Finance costs (£3 million - £1.1 million = £1.9 million) 1.9
Cr Net benefit obligation 1.9

Dr Operating expenses (£5.9 million + £4.2 million) 10.1

Cr Net benefit obligation 10.1

Dr Net benefit obligation 6.4

Cr Operating expenses 6.4

Cr OCI 1.7
Dr Net benefit obligation 1.7

IAS 19 requires that the interest should be calculated on the net benefit obligation. This means that the amount
recognised in the profit or loss is the net of interest charge on the obligation and the interest income on the
assets. Therefore, the actual return on the plan assets is not relevant here.

EyeOP has taken on an additional liability in respect of the senior employees made redundant – this cost is a
curtailment cost which is charged to the statement of profit or loss.

Medsee camera – revenue recognition (working 2)

This item does not represent a non- recurring item and it is incorrect to expense all the development costs as it
is possible that some of the costs should be capitalised.

In the period to 1 January 2016 not all the criteria in IAS 38 appear to have been satisfied as the technical
breakthrough in relation to the project happened on 1 January 2016, and so the costs of £4 million a month
should be expensed in the statement of profit or loss. Therefore, the treatment was correct for the financial
statements for the year ended 31 December 2015 as the probable future economic benefits were uncertain
before that date.

Once the technical breakthrough was made on 1 January 2016, the development costs should have been
capitalised until the project was completed on 30 April 2016. An intangible asset of £14 million (4 x £3.5 million)
should therefore have been created.

The following adjustment is therefore required:

£m
Dr Intangible asset 14
Cr Profit or loss 14

Once sales of the Medsee commenced in May 2016, the development costs should be amortised. This could be
done either on a time or sales basis. I recommend that £14 million is amortised over the number of Medsee
cameras delivered to customers at 30 November 2016. This gives an amortisation charge of £200,000 (£14
million x 50/3500).

£m
Dr Operating expenses 0.2
Cr Intangible asset 0.2

Revenue should only be recognised once the risks in relation to the orders for the cameras have been
transferred to the buyer. This normally is upon delivery, and so revenue in respect of only 50 cameras should be
included in the statement of profit or loss 50 x £60,000 = £3 million. The cash received in relation to orders not
yet fulfilled should be treated as deferred income.

The adjusting journal is therefore:

£m
Dr Revenue 33.00
Cr Receivables 24.75
Cr Deferred income 8.25

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 Corporate Reporting – Advanced level – July 16

The accrual for cost of sales should therefore be removed in relation to the original journal for revenue.

£m
Dr Payables 12.1
Cr Cost of sales (550 x £22,000) 12.1

EyeOP draft statement of profit or loss

First draft Adjustment Ref to Revised draft

£m £m working £m

Revenue 178.9 (33) 2 145.9

Cost of sales (92.6) 12.1 2 (80.5)
Operating expenses (36.3) (10.1) 6.4 1 (40.2)
(0.2) 2

Non recurring item (14.0) 14.0 2 0

Finance cost (12.2) (1.9) 1 (14.1)
Profit before tax 23.8 11.1
Income tax expense (4.8) (4.8)
Profit for the year 19.0 6.3

OCI (Gain) 1.7 1 1.7

3. Prepare a revised forecast consolidated statement of comprehensive income for HiDef for the year
ending 30 November 2016. Assume that HiDef acquires 650,000 shares in EyeOP on 1 August 2016
and incorporate any adjustments you recommend in respect of the outstanding financial reporting
issues (Exhibit 1).

Consolidation adjustments

 Disposal of previously held shareholding in EyeOP

When control is achieved:

o Any previously held equity shareholding should be treated as if it had been disposed of and the
reacquired at fair value at the acquisition date.

o Any gain or loss on re-measurement to fair value should be recognised in profit or loss in the period.

One of the consequences of the previously held equity being treated as disposed of is that any unrealised gains
in respect of it become realised at the acquisition date.

As the shares in EyeOP were previously classified as an available-for-sale financial asset, any gains in respect
of it which were previously recognised in other comprehensive income should now be reclassified from other
comprehensive income to profit or loss.

Therefore, the following journal is required in HiDef’ statement of comprehensive income to dispose of the
shareholding in EyeOP before consolidation:

£m
Dr Investment in EyeOP £2.5m + £1.8m = £3.7m to increase to 3.7
£6.2m
Dr Other comprehensive income and AFS reserve - recycle to PorL 1.8
Cr Profit or loss 5.5
To recognise the gain on the deemed disposal existing prior to
control being obtained.

IFRS 10 states that where a subsidiary prepares accounts to a different reporting date from the parent, that
subsidiary may prepare additional statements to the reporting date of the rest of the group, or if this is not
possible, the subsidiary’s financial statements may be used for consolidation provided that the gap is three
months or less and that adjustments are made for the effects of significant transactions.

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 Corporate Reporting – Advanced level – July 16

EyeOP
2016
Adjusted Consolidated
£m £m £m £m

Revenue 383.0 145.9 x 4/12 48.6 431.6

Cost of sales 264.2 80.5 x 4/12 26.8 291.0
Gross profit 118.8 65.4 21.8 140.6
Administrative expenses (102.0) (40.2) x 4/12 (13.4) (115.4)
Profit on disposal of EyeOP
investment 5.5 5.5

Profit from operations 22.3 25.2 8.4 30.7

Finance costs (5.5) (14.1) x4/12 (4.7) (10.2)
Profit before tax 16.8 11.1 3.7 20.5
Income tax (2.3) (4.8) x 4/12 (1.6) (3.9)
Profit for the year 14.5 6.3 2.1 16.6
Other comprehensive income
(1.8) 1.7
for the year 1.7 (0.1)
Total comprehensive income
12.7 8.0
for the year 3.8 16.5

Profit attributable to:

Owners of HiDef 16.0
Non-controlling interest 0.6

Consolidated statement of other comprehensive income

Profit for the year 16.6

Reclassification of gain on available for sale investment (1.8)
Re-measurement gains on defined benefit pension plan 1.7

Total comprehensive income for the year 16.5

Total comprehensive income attributable to:

Owners of HiDef 15.4
Non-controlling interest (3.8 x 30%) 1.1

4. Analyse the impact of the acquisition of 650,000 shares in EyeOP on HiDef’s key performance targets
(Exhibit 2) for the year ending 30 November 2016 and, where possible, for the year ending 30
November 2017.

1. Revenue increase by 7%

Consolidating the adjusted revenue of EyeOP results in the revenue target being met in the year ending 30
November 2016.

£400 million x 107% = £428 million compared to projected revenue including EyeOP for 4 months, of £431.6
million.

Next year the target will also be met as predicted revenue will be £578.4m (see below) which represents a 34%
increase on the revenue for 2016. However, in subsequent years without further initiatives or acquisitions,
revenue will remain constant and therefore the growth will need to be either organic or from other acquisitions.

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 Corporate Reporting – Advanced level – July 16

2. Gross profit of 35%

This target is currently not predicted to be achieved either with (32.5%) or without (31%) the acquisition of the
650,000 EyeOP shares. EyeOP achieves a gross profit percentage of 45% compared to HiDef 31%. The
acquisition will not have a significant impact in achieving this target in the current financial year because only 4
months of EyeOP’s results will be consolidated with HiDef’s. In addition, the impact of the Medsee contract on
the consolidated gross profit for the current financial year is relatively small because only the sale of 50 cameras
should be recognised in revenue.

The margin predicted on the Medsee contract in 2017 and subsequently is 63%:

£m
Revenue (3500/4 = 875 cameras x £60,000) 52.50
Cost of sales (875 x £22,000) 19.25
Gross profit 33.25

EyeOP’s gross margin in 2016 excluding the revenue from the 50 new imaging cameras contract is as follows:

£m £m £m

Revenue 145.9 -3.0 142.9

Cost of sales 80.5 -1.1 79.4
Gross profit 65.4 63.5
44.8% 44.4%

The directors should be sceptical about EyeOP’s assertions regarding the margin achievable on the Medsee
contract as currently it is significantly greater than the margin achieved on its other contracts. There may also be
additional fixed costs.

In 2017, 100% of EyeOP’s results for the entire year will be included in the consolidated statement of profit or
loss which will increase the overall gross profit percentage. Given the assumption that other revenues and costs
will remain constant, the contract for the sale of imaging cameras therefore represents further additional
revenue for the group.

EyeOP’s gross profit for the year ended 30 November 2017 would include an additional £33.25 million from the
Medsee contract which would be consolidated together with its results for the entire year (assuming these
remain constant) in the group financial statements for the year ending 30 November 2017 (see working below).

Predicted group revenue and gross profit for the year ending 30 November 2017.

Revenue Cost of
sales
EyeOP £m £m
2016 excluding Medsee 142.9 79.4

Add: new contract additional revenue 875 52.5 19.3

cameras
Projected for year ending 31.12.2017 195.4 98.7

Add HiDef 383.0 264.2

Group revenue 578.4 362.9
Group cost of sales (362.9)
Gross profit 215.4

GP % 37.3%
The group gross profit percentage for the year ending 30 November 2017 is likely to be 37% which would mean
that the target of 35% would be met next year.

Tutorial note: the amortisation of the development costs could also be included in cost of sales.

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 Corporate Reporting – Advanced level – July 16

3. EBITDAR/Interest more than 10 times

The finance cost is a significant figure on EyeOP’s profit or loss indicating that EyeOP is highly geared. In
addition, EyeOP has a significant pension obligation which affects this cost.

EBITDAR before consolidation of EyeOP £m

Profit from operations 16.8
Add:
Depreciation 28.1
Lease rentals 35.5
80.4
Interest 5.5
EBITDAR/Interest 14.6 times

Before consolidation, this key ratio target has been met comfortably. On consolidation of EyeOP, the ratio
decreases to 9.6 times and therefore the target of 12 times will not be met.

EBITDAR after consolidation of EyeOP £m

Group profit from operations 30.7
Add:
Depreciation (£4.1m x 4/12) + £28.1m 29.5
Lease rentals (£5.5m x 4/12) + 35.5m 37.3
Amortisation of
development
costs £0.2m x 4/12 = £0.06m 0.1
97.6
Interest 10.2
EBITDAR/Interest 9.6 times

Examiner’s comments

General comments
This question was generally well answered by most candidates although some found the sections relating to
the production of a PorL and subsequent analysis quite challenging.

Detailed comments

(1) Goodwill calculation

This was extremely well completed by candidates with many scoring full marks.

(2) FR issues
Candidates attempted this element well. Most identified the difference between the two pension schemes
and were able to calculate correctly and account for the movements in the defined benefit scheme. In
addition, the issues in relation to the capitalisation of the Medsee expenses were well discussed. Many
then went on to correctly identify that there should also be an adjustment to revenue and cost of sales,
although often missing the deferred income element.

Some candidates became confused between the two pension schemes, but follow through marks were
given where information was correctly applied. Marks were lost however when candidates were not explicit
regarding which statement the various movements should be posted to.

A worrying aspect of some candidates’ answers was the lack of understanding regarding the recognition
of revenue with many failing to apply the recognition criteria as the point of delivery.

(3) Financial Statements

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 Corporate Reporting – Advanced level – July 16

Whilst most candidates were able to complete the basic requirements of this question, many did not
correctly identify the time period over which the results of EyeOP should be apportioned and/or did not
time apportion the profit adjustments in addition to the original PorL amounts.

Some of the more common errors were:

 Adjusting EyeOP but then failing to add it to Hi-Def;

 Inability to work out the number of months between 1 August 2016 to 30 November 2016 (it is 4 months
not 5 or 11);
 Adjusting HiDef rather than EyeOP;
 Not recycling gain on AFS £1.8m to PorL;
 Taking 70% of EyeOP’s revenue and expenses;

(4) KPI’s
There were few candidates who made a satisfactory attempt at this question – calculating the ratios and
then linking the data back to the scenario for both the current and future periods. Of the remaining
candidates, the majority just calculated some ratios and then concluded whether or not the KPI was met;
a significant minority did not attempt this element of the question.

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Question 3
Outline of question
This question requires the candidate to provide accounting advice on an arrangement which may include a
lease and then to identify the risks associated with the audit of PPE, together with an outline audit approach.
The question required the application of knowledge of IFRIC4 and lease accounting and the ability to
differentiate between inherent, control and detection risks. The candidate was also required to prepare an
outline audit plan using appropriate approaches and timing for the given situation.
Requirements
(1) Draft a response to Karel’s request for
advice on the financial reporting
implications of the proposed agreement
with Beddezy on the TT financial
statements for the year ending 31 August
2016 (Exhibit 3). You can ignore any tax
or deferred tax consequences.
(2) Identify and explain the inherent, control
and detection audit risks associated with
our audit of the PPE balance in TT’s
financial statements for the year ending
31 August 2016.
(3) Prepare an outline audit approach for
TT’s PPE balance at 31 August 2016
which explains those aspects of our audit
of PPE where:
a) we are able to test and place reliance on
the operating effectiveness of controls;
b) we will need expert input;
c) audit software can be used to achieve a
more efficient audit;
d) substantive analytical procedures will
provide us with adequate audit
assurance; and
e) tests of details can be performed during
our interim audit visit.
Total marks
Copyright © ICAEW 2016. All rights reserved.
Corporate Reporting – Advanced level – July 16
Marks Skills assessed
6  Assimilate complex information in order to
produce appropriate accounting
adjustments
 Apply knowledge of relevant accounting
standards to the information in the scenario
to appreciate that the rights of use of the
two assets result in different accounting
response.
 Determine that the management training
centre arrangement results in a lease
under IAS 17.
 Identify the need for further information
needed to conclude on whether the training
centre arrangement results in an operating
or finance lease.
 Provide reasoned calculations regarding
the NPV of the MLP to determine the
arrangement is not a finance lease.
 Clearly set out and explain appropriate
accounting adjustments.
12  Apply technical knowledge to explain risks
relevant to the scenario.
 Assimilate information to identify control
activities relevant to audit assertions.
 Identify weaknesses in control and impact
on audit procedures.
 Determine the additional information
needed to ensure audit assertion is met.
12  Appreciate that evidence of good controls
over additions last year should again be
tested for effectiveness and informal nature
of recording system indicate controls would
not be effective.
 Identify the need for an auditor’s expert in
terms of valuations
 Identify specific areas for audit software for
depreciation arithmetic, samples for control
testing, to identify unusual journal entries
 Appreciate that substantive analytical
procedures over depreciation calculations
will be effective.
 Determine areas where tests of control
would be required – e.g. additions,
classification and existence
30
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 Corporate Reporting – Advanced level – July 16

(1) Draft response to Karel’s request for advice

Draft financial reporting advice

The proposed arrangement with Beddezy involves both the sale of a piece of land and ongoing
arrangements in respect of 2 buildings which will be built on it.

To determine how both the initial land sale and the ongoing arrangements should be accounted for, it is
necessary to consider whether the arrangements in respect of the buildings constitute lease
arrangements. This is addressed by IFRIC4.

Key considerations are whether:

(i) the arrangement is fulfilled by the use of a specific asset – that is clearly the case in both
elements of the arrangement here as both have a specified asset which it is intended that TT
will use in some way – in one case the hotel and in the other the management training centre;
and
(ii) the arrangement conveys the right to use the asset. In both cases TT will obtain more than an
insignificant amount of the asset’s output which is the first requirement. However, for the
arrangement to qualify as a lease:

a. TT will need to have the ability to operate the asset or to direct others to do so or the
ability to control physical access to it while obtaining or controlling more than an
insignificant amount of the output or other utility of the asset; or
b. There must be only a remote possibility that parties other than TT will take more than an
insignificant proportion of the asset’s output and the price is not fixed per unit or linked to
the market price at the time of delivery.

In the case of the hotel, this condition is not met as TT will not have the ability to operate the
hotel and there is more than a remote possibility that more than an insignificant amount of its
capacity will be taken by parties other than TT. Indeed, TT has no commitment to take any
rooms.

In the case of the management training centre, the condition is met as the centre will be
operated by TT and its manager will supervise those controlling access to the building. It will
also have exclusive use of the centre. The arrangement does therefore include a lease for
the management centre and this should be accounted for under IAS17.

Having established that the arrangement contains a lease, it is necessary to return to the sale of the land
and consider how that should be accounted for. Half of the land which has been sold will be used for the
hotel and TT has no right to re-acquire that land and no lease over it during the term of that arrangement.
That element of the sale should therefore be accounted for as a disposal, resulting in the disposal of an
asset with a carrying amount of £1.5 million (assuming the entire plot is priced at the same price per acre)
and the recognition of a profit of £1 million in the period in which the arrangement is signed. Further
information is needed to assess whether the price for the land is a fair market price given that the sale is
part of a much more complex arrangement.

This entry will give rise to an increase in net assets as the profit is recognised.

The financial accounting treatment of the sale and lease back of the land provided for the management
training centre and for the centre itself will depend on whether the lease is considered a finance lease or
an operating lease. That will depend on whether the risks and rewards of ownership remain with TT or
have been transferred to Beddezy.

For the land element, it is likely to be an operating lease as the land will have a useful life considerably in
excess of 15 years and the option to re-acquire the land and building is at market value and it is by no
means certain to be exercised.

For the building lease, we need to consider in turn the factors which would normally lead to a lease being
considered a finance lease:

- The lease contains no automatic transfer of ownership to TT at the end of the term;

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 Corporate Reporting – Advanced level – July 16

- TT’s option to purchase back the land along with the building on it is at market value and so there is
no real certainty as to whether that option will be exercised;
- The asset’s economic life is not known at present. The lease term is for 15 years which seems less
than the “normal” expected life of a building but that will depend on the construction and further
information is required to conclude on this point.
- The present value of the lease payments cannot be calculated without first determining what element
of the payments relates to the cleaning, maintenance, security and reception services to be provided
as this would need to be excluded from the calculation. The cost of the building to Beddezy will be £4
million. Excluding the element (of £100,000 per annum) which relates to staff costs and services, the
minimum lease payments (undiscounted) will be £3 million (15 times £200,000).

However, this covers the lease of the land as well as the building. Apportioning between them in the
ratio of the cost to Beddezy would mean that (£3 million x 4.0/6.5) = 1.84 million would relate to the
building even before discounting. This is only 46% of the cost. Even if none of the lease payment is
allocated to the service element, total lease payments will be £4.5 million which is 69% of the total
cost to Beddezy of both land and buildings without any discounting. We can therefore conclude that
the net present value of the minimum lease payments will not amount to substantially all of the fair
value of the asset.

This criterion for a finance lease is not met.

- If the training centre were a specialised building, then it would be classified as a finance lease.
However, as the building has a wide variety of uses, this would not appear to be the case. Hence
this criterion for a finance lease is not met.

We can therefore conclude that the lease is an operating lease.

Financial reporting adjustments

The element of the lease payments which relates to the services to be provided should be taken to profit
or loss as a charge in the period in which those services are provided.

The land sale for the management training centre will be recognised immediately as for the hotel.
Assuming that the sale of land is determined to be at fair value, £1 million profit will be recognised
immediately and the lease and service payments recognised over the course of the lease in the period to
which they relate. If the land sale is determined to be at above fair value, then an element of the profit
(equal to the difference between the proceeds and the fair value) will be deferred and recognised over
the period of the lease. As above the profit recognition will increase net assets.

(Should the planned changes to IAS 17 lease accounting take place, the accounting will change and the
lease liability and asset will be recognised in the statement of financial position.)

(2) Identification and explanation of audit risks associated with PPE

Inherent risks

Management incentive to mis-state the balance

We need further information to assess the extent to which management may be under pressure to
overstate assets and it is possible that there is an incentive to do so. This risk is considered further below
in connection with the judgements involved in the proposed revaluation.

Overall business environment

Training needs and revenues will fluctuate with changing regulations and so facilities and courses offered
may need to change over time as the engineering courses have in the current period. This means that
asset lives could be shorter than anticipated. The fact that the disposals recorded in the 9 months to 31
May 2016 had a carrying value which represented 40% of their cost is also indicative that the useful lives
used for depreciation may be too long and need to be reassessed in the light of actual experience and the
changing business environment.

Carrying value and level of transactions in the period

The PPE balance is very significant and is many multiples of materiality in size. This increases the risk of
material misstatement as individual transactions may well be material if accounted for incorrectly.

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 Corporate Reporting – Advanced level – July 16

There are a number of ongoing capital projects with a high value and this increases the risk of mis-
statement due to the large number of transactions which need to be processed.

Complexity of transactions
The proposed transaction with Beddezy is complex and the client is seeking assistance in determining the
financial reporting treatment. Complex transactions increase the risk that inappropriate accounting policies
may be adopted or the nature of a transaction misunderstood by the accounts department.

In addition to the Beddezy transaction, major renovation projects such as those on the science
laboratories are likely to have elements which are capital and other elements which are revenue in nature
as they represent more routine repairs. Separating the different elements can be difficult in practice
especially if projects evolve or change as they progress. In addition, the capital elements of the projects
will result in the construction of components which have differing lives – some relating potentially to the
fabric of the building and others to shorter lived assets such as air conditioning or lift systems or moveable
partitions. In addition, there may be elements which should be classified as furniture, fittings and
equipment rather than freehold land and buildings and it is surprising that, on the transfer of the new
business school into depreciable assets, the whole of the £13.5million was categorised as freehold land
and buildings. This suggests that appropriate componentisation and classification may not have taken
place.

Work on the renovation of Laboratory 2 includes some rework costs which should not be capitalised as
they will not contribute any value to the finished building. We will need to ensure that, to the extent that
the costs incurred by year end have not added value, they are charged to the profit or loss account rather
than being capitalised and should also consider whether there are other similar costs included in the total
cost of other projects.

The IT project is likely to include elements which are PPE – i.e. physical equipment – but also elements
which should be classified as intangible assets such as software. There may also be other elements such
as training which should not be capitalised at all.

Expert input
TT is proposing to revalue its assets in the current year and has included in its plan an upward revaluation
of £40million, representing nearly 30% of the carrying value of land and buildings prior to that revaluation.
This is not totally unreasonable when compared to the observed movement in market prices since the
estate was last revalued (25%) or the anticipated profit on the sale of the land to Beddezy (67%) although
that may or may not be at fair value and may not reflect existing use. However, the uplift of the valuation is
very significant in the context of an organisation which may be trying to maximise its net asset value (see
above).

The revaluation of an extensive campus is a complex and judgemental exercise especially when the
campus includes specialised assets such as the laboratories. It is unlikely that such properties will have
moved with market indices and, indeed, an alternative valuation model such as depreciated replacement
cost may in fact be appropriate. In addition, there is evidence as summarised above that land values may
have moved more than building values so separate consideration of each element needs to be made.

TT had a professional valuation 3 years ago and is not required to have another one for 3-5 years. It may
therefore be entitled to use its internal experts for the valuation at 31 August 2016 providing that they
have the requisite skills and experience. However, use of internal experts increases the risk of
management manipulation of results and the influence of senior management such as the finance
director. It is also questionable when the expected revaluation change is so significant.

Judgements
Assessment of useful lives for depreciation purposes is inherently judgemental and, as outlined above,
there are some indications that past judgements may have been incorrect. This increases the risk of mis-
statement. The average useful life for fixtures, fittings and equipment appears to be around 8 years
(Depreciation charge for the year = £3.8 million; average cost = (£32.1m +£0.5m – £29.5m)/2 = £31.05m;
£31.05m/£3.8m = 8.17 years) which is quite long for some types of equipment. However, this may well be
offset by assets which do have a longer useful life.

Another factor which will make a difference to the depreciation charge is the timing of the transfer of
completed assets from assets in the course of construction which are not depreciated into categories of
asset which are depreciated. If this entry is not made on a timely basis, then depreciation will be
understated. Karel’s email says that Laboratory 1 has been completed but the forecast figures for the

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 Corporate Reporting – Advanced level – July 16

final quarter in the management accounts do not show any transfer to Freehold land and buildings (other
than the Business School which has already been transferred).

Susceptibility to theft
Certain of the PPE assets are susceptible to theft – in particular IT equipment such as laptops and
expensive but portable equipment in other areas.

Unrecorded disposals
Major renovation projects such as those on the science Laboratories potentially result in the replacement
of components created by previous renovation work or indeed the initial construction of the building. The
level of disposals recorded in the management accounts is very low and there is therefore a risk that the
recording of disposals may be incomplete.

Quality of accounting systems

The systems for accounting for tangible fixed assets are not part of the main accounting system and were
developed by the finance department. There is therefore a risk that they have not been maintained
correctly or that mis-programming has occurred. However, the fact that there have been no audit
adjustments in prior years suggests that the systems have in fact worked well.

Control risks

Staff
The long term sickness of Harry George and the fact that another individual has had to take over the
accounting for PPE increases the risk that errors are made. As the individual who has taken over is not
within the accounts department there is also a risk that they might have less knowledge of the financial
reporting treatment of more complex transactions. This means that it will be difficult to place reliance on
their assessment in the more judgemental and complex areas such as major projects.

Segregation of duties
The person who has taken over responsibility for the fixed asset accounting sits within the estates
department rather than the finance department. He / she may have other responsibilities within that
department and will, in any event, report to a manager who does. There is therefore a risk that
segregation between approval, initiating and recording transactions may be compromised although
additional information is required to assess the extent to which this might be the case.

Use of spreadsheets and PC

The use of spreadsheets to calculate key accounting entries and record extensive data increases the risk
that the IT systems are not robust, reliable and subject to appropriate security and integrity checks.
A PC is also likely to have poor built in controls and security.

Detection risk

There are no specific factors (such as first year audit or incomplete records) which affect the detection risk
associated with this balance. Prior year audits have highlighted no major issues or limitations of scope
and the fact that the balance is largely comprised of relatively few high value assets helps to reduce the
detection risk.

(3) Outline audit plan

a) Areas where we may be able to test and rely on the operating effectiveness of controls

- Completeness and accuracy of additions to fixtures, fittings and equipment posted during the year.
Controls in this area were operating effectively last year and, although there have been changes in
staff, the basic processing and classification of invoices may not have been affected adversely.
While further judgement and analysis may well be required for major projects, accounting for
additions to fixtures, fittings and equipment is more straight forward and controls reliance may still be
possible.
- The physical verification exercise proposed is a good control over unrecorded disposals and should
be relied on to the extent that we can.

While there may also be some good controls in other areas, the informal nature of the accounting system
and the change in personnel make it less likely that they are operating effectively.

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 Corporate Reporting – Advanced level – July 16

b) Areas where we will need expert input

- The key area for expert input will be in the revaluation of freehold land and buildings. We will need
our expert to look at the methodology, assumptions and conclusions in the valuation report and to
ensure that they are reasonable and do not show signs of bias.
- Expert input may also be required when considering the componentisation of major projects or
indeed the revalued assets.
-
c) Areas where audit software can be used

- To re-perform depreciation calculations for individual assets looking both at the charge for the year
and the remaining carrying amount.
- To check the arithmetic accuracy of the fixed asset register and also the integrity of formulae used to
create reports etc.
- To select samples for controls testing or tests of detail.
- To identify any journal entries or other unusual transactions which require further investigation.

d) Areas where substantive analytical procedures will give adequate assurance

- If the depreciation charge is not tested in its entirety using audit software, then it can be tested using
substantive analytical procedures to establish an expectation of the depreciation charge for the year
by category based on the cost / valuation of assets; additions and disposals in the year; assets
already fully depreciated; the average useful life of assets in that category. This can then be
compared to the actual charge for the year.

e) Tests of detail which can be completed during the interim audit visit

- Review of major projects completed in the year (Business School and Laboratory 1 of the Science
refurbishment) to test the appropriateness of the amounts capitalised, the timing of the transfer from
assets in the course of construction, the classification and componentisation of assets, the complete
recording of any associated disposals.
- Testing of additions to fixtures, fittings and equipment for the first 9 or10 months of the year.
- Testing of disposals recorded in the first 9 or 10 months of the year.
- Review of the agreements with Beddezy and further consideration of the financial reporting
treatment.
- Testing of the data provided to be used by the estates department as part of the revaluation of
freehold land and buildings.
- Consideration of the useful lives used in the depreciation calculation, taking into account the risk
factors identified above.
- Our own testing on the existence of assets on the register, including sample testing of freehold land
and buildings to evidence of ownership such as the land registry.

Examiner’s comments

General comments

It was evident that quite a number of candidates did not allow sufficient time for this question as their answers
were clearly rushed and disorganised. The question was capable of being done well, as some very good
candidates demonstrated.

Detailed comments

(1) Financial reporting - Sale of land

In general, this element was reasonably well completed by most candidates. Whilst, only around half the
candidates identified that the two transactions should have been dealt with separately, most then demonstrated
sufficient relevant technical knowledge to obtain follow through marks. Many candidates spotted that there was
a possible sale and leaseback in the scenario, although most concluded that it was a finance, not an operating,
lease. Explanations were quite often lengthy, disorganised and incoherent. But some did this section well and
scored full marks.

Weaker candidates used this section to knowledge dump by copying out sections of IAS 17 – it is the application
to the scenario which gains the marks – even if an inappropriate conclusion were drawn provided that there
was supporting evidence presented, follow through marks were awarded.

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 Corporate Reporting – Advanced level – July 16

(2) Identification of inherent, control and detection audit risks associated with the audit of PPE

Overall strong candidates identified a good selection of inherent and control risks, relating them to the scenario.
In particular, most identified the absence of Harry George, complexity of accounting, materiality of assets,
segregation of duties and the use of spreadsheets as risks. There was some confusion between what was an
inherent risk compared to a control risk, but marks were awarded as long as the risks were linked to the
scenario. Limited marks were given for generic risks not linked to the scenario of Topclass Teach plc.

Hardly any candidate identified that there were no specific factors that impacted detection risk, instead
discussing team structure and lowering materiality as risks/actions. A handful identified that the absence of
Harry George might give rise to difficulty in accessing supporting evidence and potential limitation in scope.

A common error was to set out a generic set of risks, largely or wholly unrelated to the information in the
scenario.

(3) Outline audit approach for TT’s PPE balance at 31 August 2016.

The majority of candidates provided a well-structured answer to this part of the question, dealing with each of
the aspects requested and relating the areas for testing to the facts of Topclass Teach plc. Weaker candidates
lost marks where the answer was not structured as requested or where the audit approach was merely a list of
audit procedures often generic rather than a reasoned approach to each aspect. These candidates were not
demonstrating higher skills required at this level. The question requirement was very helpful in organising the
answer but many weaker candidates simply ignored this.

The main weaknesses were:

 Candidates could not identify the areas where controls could be relied upon.
 ‘Substantive analytical procedures’ was often read as ‘substantive procedures’ and so detailed tests
were listed and not analytical procedures.
 Vague descriptions of tests of detail lost marks e.g. ‘look at additions and disposals’.
 Also some candidates provided tests that would have been more relevant at the year end and not for
an interim audit - for example cut off procedures.

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