ADVANCED LEVEL EXAMINATION

MONDAY 5 NOVEMBER 2018

(3½ HOURS)

CORPORATE REPORTING
This exam consists of three questions (100 marks).

Marks breakdown

Question 1 40 marks
Question 2 30 marks
Question 3 30 marks

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The questions in this paper have been prepared on the assumption that candidates do
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© ICAEW 2018.
QUESTION 1
You are Trina Briggs, an ICAEW Chartered Accountant, working for Dealy and Brant (DB), a
firm of ICAEW Chartered Accountants. DB has audited Zmant plc and its subsidiaries for
some years and you are the audit manager for the Zmant group audit.

Zmant plc supplies specialist audio equipment and has several 100%-owned subsidiaries.
Zmant and its subsidiaries have a 30 September year end. During the year ended
30 September 2018, Zmant made the following acquisition:

Investment in KJL

Zmant made an investment in KJL, a company that produces and sells audio equipment to
Zmant. KJL is based in Otherland where the currency is the Otherland $ (O$).

On 1 January 2018, Zmant bought 60% of the issued ordinary share capital of KJL for
O$52,800,000. On acquisition, there were no fair value adjustments needed to the carrying
amounts of the assets and liabilities of KJL.

On 1 January 2018, Zmant made a loan of O$21,000,000 to KJL, at an annual interest rate of
6%, repayable at par on 30 September 2020.

KJL prepares its financial statements under IFRS and has a 30 September year end. DB is
not the auditor for KJL.

DB’s individual audits of Zmant and its subsidiaries are almost finished and the audit of the
consolidation is now in progress. The DB audit partner responsible for the Zmant group audit
has given you the following briefing:

Briefing from audit partner

“KJL was identified as a significant component in the group audit plan. KJL is audited by
Welzun, an audit firm based in Otherland. The audit plan included an assessment of
Welzun’s professional qualifications and independence and no issues were noted. We
performed a review of KJL’s financial statements for the year ended 30 September 2018 and
identified two matters of potential significance to the group audit:

 Research and development (R&D) expenditure of O$10,700,000

 Income tax receivable balance of O$8,025,000
“We asked Welzun to prepare a report explaining these two matters and the audit procedures
that it performed. I have provided you with Welzun’s report (Exhibit 1).

“Zmant has a new finance director, Janet Gray, who is an ICAEW Chartered Accountant. She
has asked for help in finalising Zmant’s consolidated financial statements and has sent some
extracts and queries to me (Exhibit 2). She has also sent me a newspaper article published
in the Otherland News (Exhibit 3) which I find very concerning.

“I need you to prepare a working paper in which you:

ICAEW/CR/N18 Page 2 of 18
(1) For each matter in Exhibit 1:

 set out and explain the appropriate financial reporting treatment for KJL’s financial
statements for the year ended 30 September 2018;

 identify and explain any weaknesses in the audit procedures completed by Welzun;
and

 set out any additional audit procedures that should be performed by DB and by
Welzun to provide assurance for the group audit opinion.

(2) Set out and explain the appropriate adjustments for the financial reporting queries
raised by Janet (Exhibit 2) for the year ended 30 September 2018 for:

 the individual financial statements of Zmant

 the consolidated financial statements of Zmant.

(3) Calculate goodwill to be recognised for KJL in Zmant’s consolidated financial

statements for the year ended 30 September 2018. Assume Zmant uses the
proportion of net assets method to value the non-controlling interest in KJL.

(4) Explain the ethical issues for DB arising from the newspaper article (Exhibit 3) and any
related matters. Set out and explain how DB should respond. Advise Janet on any
actions she should take.”

Requirement
Prepare the working paper requested by the audit partner.
Total: 42 marks

ICAEW/CR/N18 Page 3 of 18
Exhibit 1: Report on matters of significance to the group audit - prepared by Welzun,
KJL’s auditor
We set out below our report on the matters of significance identified by DB in its review of
KJL’s financial statements for the year ended 30 September 2018.

Audit procedures have been performed in accordance with component materiality determined
by DB at O$1,800,000.

Research and development (R&D) expenditure of O$10,700,000

The government in Otherland gives generous tax relief for R&D costs provided that the costs
are expensed in the statement of profit or loss. O$10,700,000 has been expensed in the year
ended 30 September 2018, comprising the costs of the following two R&D projects:

Project Sound: O$7,900,000

Project Sound commenced on 1 January 2018. The project’s objective was to adapt an
existing speaker produced by KJL for the car industry. The project started after L-Motors, a
customer of KJL, requested a customised speaker for its cars. On 1 April 2018, L-Motors
placed a large order for the speaker. Costs of this project, which have been expensed to the
statement of profit or loss, are:

O$’000
Materials for prototype model 1,725
New computer equipment - bought on 1 January 2018 1,700
Salary costs of development staff
 incurred after 1 April 2018 1,270
 incurred before 1 April 2018 790
Registration fees for design 910
Car used for speaker testing - bought on 1 January 2018 555
Allocated general overheads 950
7,900

As each cost was less than component materiality, no detailed audit procedures were
performed.

We asked KJL whether the computer equipment and the car should have been included in
PPE rather than expensed.

 KJL informed us that the cost of the computer equipment was expensed because it was
being used for this project. If capitalised, this computer equipment would have been
written off over two years under KJL’s depreciation policy.

 KJL informed us that, since completion of the project, the CEO of KJL has driven the car.
Including the cost of the car in PPE would result in a personal tax liability for the CEO
under Otherland tax rules.

Project Entertain: O$2,800,000

The project’s objective is to determine the success of product events. KJL obtains new
business by arranging product events for existing and potential customers. A product event
involves sales staff and other KJL personnel entertaining customers with food and drink and

ICAEW/CR/N18 Page 4 of 18
at the same time demonstrating and selling KJL’s products. KJL paid O$2,800,000 to a public
relations company, GetGo, which made all the arrangements for the product events and
carried out analysis of the new business generated.

We agreed the cost of O$2,800,000 to invoices from GetGo, authorised by KJL’s CEO, and
to the bank statements. We requested a copy of GetGo’s report showing the analysis of the
new business generated and we were told by KJL that GetGo will provide the report in 2019.

Income tax receivable balance of O$8,025,000

The income tax receivable balance is in respect of a tax refund for R&D expenditure.
Welzun’s tax department confirmed that a tax refund will be received based on the following
formula:

250% x R&D expenditure included in the statement of profit or loss x 30% tax rate.

Welzun’s tax department confirmed that KJL pays tax at 30% and that the receivable balance
of O$8,025,000 has been correctly calculated. As the R&D tax claim was prepared by
Welzun’s own tax department, no audit procedures were performed.

ICAEW/CR/N18 Page 5 of 18
Exhibit 2: Financial statement extracts and queries from Janet Gray

Extracts from financial statements for the year ended 30 September 2018
Zmant KJL
group
£’000 O$’000
Equity
Share capital 10,000 25,000
Retained earnings at 1 October 2017 9,200 45,000
Profit for the year 2,200 15,000
21,400 85,000

Janet Gray’s queries

Before I complete the consolidation of KJL with Zmant, I would like your advice on the correct
financial reporting treatment of the following:

Loan to KJL £3,500,000

In Zmant’s statement of financial position, there is a receivable balance of £3,500,000 which
represents the O$21,000,000 loan made to KJL on 1 January 2018.
My predecessor translated the O$21,000,000 loan using the exchange rate at 1 January
2018, which was £1 = O$6.0. The exchange rate at 30 September 2018 was £1 = O$4.8.

I do not know whether I need to include any adjustments for exchange differences because,
under Zmant’s and KJL’s tax jurisdictions, there is no tax payable on exchange differences
recognised in the statement of profit or loss. Instead, gains and losses are taxed at 20%
when the loan is repaid. In any case, I understand that the balances will cancel on
consolidation.

Inventory

In the year ended 30 September 2018, Zmant bought goods from KJL for £5,500,000. KJL
charges Zmant a mark-up of 35% on cost. There are no intra-group trading balances
outstanding at the year end between KJL and Zmant.
Zmant’s inventory at 30 September 2018 includes £2,500,000 of goods which were bought
from KJL. I believe I need to adjust for the intra-group profit. I have calculated the adjustment
as follows, but I am not sure that it is correct:
Profit on goods bought by Zmant from KJL = £5,500,000 x 35% £1,925,000

Profit on goods bought by Zmant from KJL for 9 months from

1 January 2018 to 30 September 2018 = £1,925,000 x 9/12 £1,443,750

£1,443,750 translated at the average rate for the period from

1 January 2018 to 30 September 2018 of £1 = O$5.7 O$8,229,375

The journal is:

DR KJL Retained earnings O$8,229,375
CR KJL Inventory O$8,229,375

ICAEW/CR/N18 Page 6 of 18
Exhibit 3 Article from the Otherland News - sent by Janet Gray

Otherland News: 31 October 2018

An Otherland government official has resigned after accusations of corruption were

made following his attendance at a ‘product event’ paid for by KJL. The official, who is
the husband of a KJL board member, attended the 5-day event at a luxury spa hotel. An
undercover journalist reported that the guest list for the event comprised KJL’s directors
and their families and a representative from L-Motors, a long-standing customer of KJL.

A former KJL finance assistant told the Otherland News that KJL is manipulating its
financial statements to claim large refunds of tax. The Otherland tax authority stated that
it investigates any incidence of tax fraud.

ICAEW/CR/N18 Page 7 of 18
QUESTION 2

You are Aiden Clark, an ICAEW Chartered Accountant. You have recently been appointed as
financial controller at Chelle plc, a company listed on the London Stock Exchange. Chelle
was incorporated 15 years ago to import delicatessen products, such as olive oil and luxury
tinned goods, to the UK. Suppliers deliver goods to Chelle’s distribution centre near London
and Chelle’s own vans transport goods to the company’s customers (supermarket chains and
smaller retailers). The company’s year end is 31 October.

Between the years ended 31 October 2010 and 31 October 2016, Chelle experienced steady
growth in revenue and profits. However, the company has become less profitable in the years
ended 31 October 2017 and 31 October 2018 and its share price has fallen.

Chelle’s directors own 20% of the company’s ordinary shares. The remaining shares are
owned 40% by several institutional investors and 40% by individual investors. Each investor
owns no more than 5% of the company’s ordinary shares. A significant source of finance for
Chelle is long-term convertible bonds. The bonds will mature at the end of October 2020.

Chelle’s finance director is on long-term sick leave. The financial controller, Joe Bold, left
Chelle in early November 2018. Before he left, he prepared draft financial statements for the
year ended 31 October 2018 (Exhibit 1) and notes on outstanding matters (Exhibit 2).

Jen West, Chelle’s managing director, emails you:

Chelle has not been doing well. The depreciation of £ sterling since June 2016 has
increased costs. Profits have suffered as a result. Revenues have been adversely
affected by increased competition. The board is concerned about the company’s cash
flows over the next year or two. As you are new to the company, you can help us by
providing a fresh interpretation of the draft financial information (Exhibit 1).

The company’s shareholders are not happy because of the falling share price. Chelle
did not declare a dividend for the year ended 31 October 2018. This was the first time in
many years that a dividend was not declared and some of the directors think we should
recommence paying dividends as soon as possible. The board wants to know when
Chelle can start paying dividends again.

Please:

(1) Set out and explain any adjustments required to the draft financial statements for
the year ended 31 October 2018, in respect of the outstanding matters
(Exhibit 2). Provide supporting journal entries.

(2) Prepare a revised statement of profit or loss for the year ended 31 October 2018
and a revised statement of financial position at that date. Include calculations of
earnings per share and diluted earnings per share.

(3) Prepare a report to the board, analysing the key elements of the financial
position, performance and cash flow for the year ended 31 October 2018, in
comparison with the two previous financial years. Use your revised financial
statements and other information provided.

ICAEW/CR/N18 Page 8 of 18
 (4) Calculate the amount of Chelle’s legally distributable reserves at 31 October
2018, providing explanations to support your calculations.

Requirement
Respond to Jen West’s email.
Total: 30 marks
Ignore deferred tax

ICAEW/CR/N18 Page 9 of 18
Exhibit 1: Chelle plc draft financial information for the year to 31 October 2018
prepared by Joe Bold

Draft statement of profit or loss and other comprehensive income

2018 2017 2016

£’000 £’000 £’000
Draft Final Final
Revenue 30,600 31,800 35,700
Cost of sales (22,803) (23,044) (25,444)
Gross profit 7,797 8,756 10,256
Operating costs (8,235) (7,904) (6,996)
Finance costs (500) (617) (609)
(Loss)/profit before tax (938) 235 2,651
Tax 178 (47) (530)
(Loss)/profit for the year (760) 188 2,121

Other comprehensive income ─ (273) 46

Additional information
2018 2017 2016
Earnings per share To be 1.9p 21.2p
calculated

Dividend per ordinary share Nil 1p 2p

Chelle share price at 31 October 980p 1139p 1711p

£1 = 100 pence (p)

ICAEW/CR/N18 Page 10 of 18
Draft statement of financial position
2018 2017 2016
£’000 £’000 £’000
Draft Final Final
Non-current assets
Property, plant and equipment 53,675 51,497 48,574
Financial asset 1,503 1,503 1,776
55,178 53,000 50,350
Current assets
Inventories 2,770 2,910 3,307
Trade receivables 7,710 7,503 7,997
Tax asset 178 ─ ─
Cash ─ 525 2,273
10,658 10,938 13,577
TOTAL ASSETS 65,836 63,938 63,927

Equity
Share capital (£1 shares) 10,000 10,000 10,000
Other components of equity 913 913 913
Available-for-sale reserve 503 503 776
Retained earnings 37,294 38,054 37,966
48,710 49,470 49,655

Long-term liabilities (5% 9,603 9,603 9,486

convertible bonds)
Current liabilities
Trade payables 6,304 4,818 4,256
Tax payable ─ 47 530
Bank overdraft (limit £5 million) 1,219 ─ ─
7,523 4,865 4,786

TOTAL EQUITY AND LIABILITIES 65,836 63,938 63,927

Extracts from draft statement of cash flows

2018 2017 2016
£’000 £’000 £’000
Draft Final Final
Net cash inflows from operating 11,316 11,173 10,516
activities
Net cash (outflows) from investing (13,060) (12,821) (8,462)
activities
Net cash (outflows) from financing ─ (100) (200)
activities
Change in cash (1,744) (1,748) 1,854
Cash brought forward 525 2,273 419
Cash carried forward (1,219) 525 2,273

ICAEW/CR/N18 Page 11 of 18
Exhibit 2: Notes on outstanding matters in respect of the financial statements for the
year to 31 October 2018 - prepared by Joe Bold

1. Convertible bond instrument

On 31 October 2012, Chelle issued a £10 million 5% convertible bond for proceeds of £10
million. The bond is repayable at par on 31 October 2020, but can instead be converted at
that date, at the choice of the bondholders, into one new ordinary share for every £10 unit
held. At the date of issue, the market interest rate for similar debt without conversion rights
was 6.5%. Interest was paid on 31 October 2018 and recorded in finance costs, but I have
not made any other accounting entries in respect of the convertible bond in the year ended
31 October 2018.

2. Available-for-sale financial asset

Several years ago, Chelle paid £1 million for 100,000 of the 1,500,000 £1 ordinary shares of
Spence plc, its main supplier of refrigeration equipment. The available-for-sale reserve
relates entirely to these shares. I have not recorded any entry in respect of the financial asset
since the 31 October 2017 year end. The price of one ordinary share in Spence plc at
31 October 2018 was £18.50.

3. Tax

The applicable corporation tax rate during the financial year ended 31 October 2018 can be
assumed to be 19%, chargeable on accounting profits before tax. A current tax credit,
calculated at 19%, can be recognised in respect of accounting losses.

ICAEW/CR/N18 Page 12 of 18
QUESTION 3

Solvit plc is a listed company supplying accounting software and related services to
education and public-sector customers. Some of Solvit’s customers purchase only software
but others enter into multiple element contracts, purchasing software together with
customisation, integration and maintenance services.

Kanes LLP, a firm of ICAEW Chartered Accountants, recently won the audit of Solvit from
Fenn Yo LLP, following a competitive tender. You are a senior working for Kanes LLP and
have been assigned to the audit of Solvit for its financial year ending 31 March 2019.

The audit manager calls you into her office:

“I need you to help plan the audit of Solvit for the year ending 31 March 2019. The Audit
Committee Chair has requested that we present our audit plan at next week’s Audit
Committee meeting and has asked that this plan sets out our initial assessment of the key
audit matters we expect to include in our audit report.

“I have provided you with extracts from last year’s audit report (Exhibit 1) so that you can
see the key audit matters that Solvit’s previous auditor, Fenn Yo LLP, identified. This is a
good starting point for us, but we will need to update last year’s key audit matters and identify
additional key audit matters. It’s important that where we identify a key audit matter, we are
precise about the audit objectives and where the greatest audit risk arises.

“I have also provided notes from my meeting with the Fenn Yo LLP audit partner and
manager (Exhibit 2) and a summary of points from my initial audit planning meeting with the
Solvit Finance Director, Sam Browne (Exhibit 3).

“I need you to do the following:

(1) In respect of the key audit matters to be included in our plan for the Solvit audit for the
year ending 31 March 2019:

a) Explain why the key audit matters identified by Fenn Yo LLP (Exhibit 1) continue
to be relevant and explain how each of these has changed this year.

b) Identify additional key audit matters for this year’s audit and explain the factors
which have led you to select each of them as a key audit matter.

(2) For each of the key audit matters identified in (1) above:

a) Identify the relevant financial reporting standard and explain how it should be
applied to the key audit matter in Solvit’s financial statements for the year ending
31 March 2019.

b) Explain the specific audit objectives and set out the audit procedures to provide
assurance in respect of the key audit matter.

(3) Draft a brief response to the Finance Director’s question (Exhibit 3) about the likely
impact of IFRS16, Leases, on Solvit’s financial statements for the year ending
31 March 2020.”

ICAEW/CR/N18 Page 13 of 18
Requirement

Respond to the audit manager’s instructions.

Total: 28 marks

ICAEW/CR/N18 Page 14 of 18
Exhibit 1 – Extract from last year’s audit report on the financial statements of Solvit plc
for the year ended 31 March 2018 - prepared by Fenn Yo LLP

Key audit matters

Revenue recognition

We identified revenue recognition as a key audit matter because the allocation of revenue to
each component of a sale (software, services and maintenance), when sold together in a
bundle, requires the application of judgment. We assessed this risk to be greatest in larger,
more complex transactions, where there is increased likelihood of multiple components or the
delivery of customised software.

Our audit procedures focused on the larger, more complex revenue transactions with the
objective of checking that the allocation of revenue between components was consistent with
the terms of the sale contracts and in line with Solvit plc’s accounting policy. In particular, we
audited the basis upon which management had calculated the fair value attributable to the
components of revenue. Our audit procedures identified one contract where, because of a
calculation error, too much revenue was allocated to the initial software supplied rather than
deferred to cover future maintenance. An adjustment of £1.3 million was recorded to correct
this error.

Provision for onerous lease

We identified as a key audit matter the provision of £1.4 million made by management to
reflect the anticipated net future cost of leased office premises no longer required by Solvit.
Offices in London were vacated during March 2018 with 15 years of the lease term
remaining. Judgement was required to assess both the period for which the premises would
remain empty and the level of rental income the premises would generate once sublet to a
new tenant.

We reviewed the lease, together with professional advice received by Solvit about the rental
market in London. Our objective was to challenge the judgements made by management in
determining the assumptions to be used in the calculation of the provision. We then
recalculated the provision based on the assumptions selected. We concluded that the
provision made was reasonable.

ICAEW/CR/N18 Page 15 of 18
Exhibit 2: Kanes LLP audit manager’s notes from handover meeting with Fenn Yo LLP
audit partner and manager
These notes summarise key points from my meeting with the Fenn Yo LLP audit partner and
manager responsible for the Solvit audit for the financial years ended 31 March 2016, 2017
and 2018. They clearly knew the client well and could provide helpful insights into the work
they performed and their audit report.

In addition to meeting with the engagement partner and manager, we performed a detailed
review of the Fenn Yo LLP audit working papers. This review identified no issues with the
audit procedures performed or the conclusions reached.

Key points from meeting with the Fenn Yo audit team

 Materiality for the year ended 31 March 2018 was set at 5% of profit before taxation, giving
a materiality figure of £1 million.

 The error noted in revenue recognition was a calculation error and arose in March 2018
when a new revenue accountant was appointed. He lacked the experience of his
predecessor and made an error in determining the separate prices of the component parts.

 The provision for the onerous lease was calculated on the assumption that the property
would remain empty for two years. The property would then be sublet for the rest of the
lease term, at a rent sufficient to cover all Solvit’s rental cost. No discounting was applied,
as the effect of the time value of money was considered immaterial.

 In addition to the revenue error identified, there was one other item on the schedule of
misstatements. This was in relation to the allowance for aged receivables where a
judgemental excess allowance of £700,000 was identified. This was not adjusted in the
financial statements.

 In addition to the key audit matters included in the audit report for the year ended
31 March 2018, Fenn Yo also considered the presumed risk of material misstatement
arising from management override of controls. Management was judged to have a
relatively low incentive to overstate results for the year, as Solvit had far exceeded the
target performance required for the maximum management bonus to be paid. Therefore,
Fenn Yo did not identify this as a key audit matter.

ICAEW/CR/N18 Page 16 of 18
Exhibit 3: Summary of meeting with Solvit Finance Director, Sam Browne – prepared
by Kanes LLP audit manager

Revenue

A typical customer relationship for Solvit starts with a contract for the supply of software. In
most cases this is standard software for which the customer pays a one-off, up-front licence
fee.

However, there are also complex contracts under which Solvit supplies standard software
together with other elements such as customisation, integration and maintenance services.
At the end of the contract period, customers can renew the maintenance agreement at the
standard price quoted in Solvit’s price list.

Customisation and integration services are also sold separately at standard day rates.

Sam commented that applying IFRS15 for the first time from 1 April 2018 was challenging
and he has relied heavily on Solvit’s revenue accountant.

Revenue for the six months ended 30 September 2018 is at the same level as the same
period last year but is £5 million lower than forecast. This is largely because sales of new
software for the education market have grown more slowly than expected because of issues
with the software. The education market has proved to be very price-competitive and Solvit
has incentivised customers to purchase its software by giving large discounts on
maintenance agreements for up to three years.

Management bonus

Lower than budgeted revenues for the six months ended 30 September 2018 have resulted
in lower than expected profit and Solvit will need to perform exceptionally well in the second
half of the year to meet its profit target. Sam is confident that it will do so and has therefore
accrued half of the maximum management bonus for the year in the results for the six
months ended 30 September 2018.

Receivables

The new education clients have been slow to settle their debts and receivables days have
increased from 45 days at 31 March 2018 to 75 days at 30 September 2018. The allowance
for receivables remains at the same level as at 31 March 2018, as Sam is confident that most
receivables will be paid once the issues with the software are sorted out.

Onerous leases

The London offices vacated in March 2018 were sublet with effect from 1 August 2018 and
so the entire provision of £1.4 million has been released. The sub-tenant has a break clause
and can choose to terminate the arrangement after five years, but Sam is hopeful that the
sub-tenant will remain longer than this. A rent-free period of six months was given but, after
that initial period, the rent received will be equal to the rent which Solvit pays under the lease.

ICAEW/CR/N18 Page 17 of 18
Sale and leaseback

On 1 October 2018, Solvit sold its northern office property to a property company for £18
million and leased it back. The lease has a term of 10 years and rentals of £600,000 per
annum paid quarterly in advance. Immediately prior to the transaction with the property
company, the office property had a carrying amount of £11 million and a fair value of £15
million. It has an estimated remaining useful life of 20 years.

Sam informed me that Solvit does not intend to adopt IFRS16 Leases early. However, he
would like to understand its impact when it is adopted in the financial statements for the year
ending 31 March 2020. In addition to the lease transactions discussed above, Solvit has
operating leases for cars and equipment with terms of 3 to 10 years and combined annual
rentals of £1.3 million.

ICAEW/CR/N18 Page 18 of 18