Make your own free website on Tripod.com
Paper 10 Examination Technique - Part 2

by Paul Robins

This is the second in a series of two articles that considers good examination technique in Paper 10 Questions. You will recall from the article in the March issue that Paper 10 is divided into three sections:

  • Section A – containing three accounting questions, with a choice of two from three.
  • Section B – containing an integrated accounting and auditing question.
  • Section C – containing an auditing question.

The previous article looked at a Section A question. This month we will attempt to unpack a Section B question. Remember that such questions are 30 mark questions and the split of marks between accounting and auditing is usually exactly 50:50. The auditing issues are usually exactly related to the accounting issues and generally it is best to attempt the accounting parts first.

The last article contained a summary of procedures that should be adopted in answering any examination question (read the question, ensure you are clear on the requirements etc.). This summary will not be repeated in this article but if in doubt you should refer to March’s article before reading on.

This month we will consider Question 4 from the December 2000 paper – the most recent AAP paper available at the time of writing.

Question 4 December 2000
During the preparation of the draft financial statements of Simpkins plc for the year to 30 September 2000 the following problem areas have arisen:

(i) On 1 July 2000 Simpkins plc entered into an agreement with Merchant Financial Services to factor its debtors. A representative of Merchant Financial Services analysed Simpkins plc’s debtors into three groups:

Group 1 – these debtors would not be factored or administered by Merchant Financial Services. They will be collected in the normal way by Simpkins plc.

Group 2 – these debtors would be factored and collected by Merchant Financial Services on a ‘with recourse’ basis. A finance charge of 1% per month on the outstanding balance at the beginning of the month will be made. The terms of the recourse are that any individual balance outstanding after three months would be reimbursed by Simpkins plc in full.

Group 3 – these debtors would be factored and collected ‘without recourse’. Merchant Financial Services would pay Simpkins plc 95% of the book value of the debtors.

The following analysis of the debtor groups and related information has been made:

  Group 1
£000
Group 2
£000
Group 3
£000
Balance 1 July 2000 500 600 800
% of 1 July balance
collected in July
30% 40% 50%
% of 1 July balance
collected in August
30% 30% 25%
% of 1 July balance
collected in September
20% 20% 22%

Simpkins plc’s policy is to make a provision for doubtful debts of 25% of a debtor balance when it becomes three months old.

(ii) On 1 October 1999 Simpkins plc issued £10 million 8% Debentures on the following terms:

The issue price was at 95p in the £1 (i.e. a discount of 5%).

Direct costs relating to the issue were £200,000.

On 30 September 2003 the Debentures will be redeemed at a premium of 15%.

After the issue Merchant Financial Services suggested that had they been consulted they would have recommended that Simpkins plc had issued convertible loan stock instead of the debentures. The terms of the issue could have been structured such that favourable terms of conversion to equity shares would be offered and therefore, a lower interest rate (coupon rate) could be specified on the loan stock. This would have the advantage of a lower finance charge to the profit and loss account and the loan stock could be classed as equity in the balance sheet as this is the substance of what it would be on conversion. This would improve the company’s profit and reduce its gearing.

(iii) Simpkins plc has three freehold properties in different regional areas of the UK. The original costs, accumulated depreciation and book (carrying) values of them at 1 October 1999 are shown below. The accompanying ‘change column is the estimated percentage change from their book value, at 1 October 1999, as provided by an independent surveyor on that date:

  Cost
£000
Depreciation
£000
Book value (1 October 1999)
£000
Change on book value
%
Property
in the South
4,000 800 3,200 +40
Property
in Midlands
2,500 1,000 1,500 nil
Property
in the North
2,000 1,200 800 -20

All properties had an expected life of 50 years from their date of acquisition and this has not changed. The company policy is to depreciate properties over their life on a straight-line basis. None of the properties are investment properties.

As can be seen from the ‘change’ column the value of the property in the South has increased significantly. In its financial statements for the year to 30 September 2000, the directors of Simpkins plc are proposing to adopt the current value (as from 1 October 1999) of the property in the South, but to leave the remaining properties at their original depreciated cost. In the case of the property in the North, the directors feel this would be justified on the basis that a recovery in the market value of the property was expected within the next few years.

Required:
(a) (i) Calculate the charge for doubtful debts and finance costs relating to each group of debtors in item (i) above for the period 1 July 2000 to 30 September 2000; and show the value at which these debtors would appear on the balance sheet of Simpkins plc at 30 September 2000. (5 marks)

(ii) Calculate the profit and loss account finance charge and show the balance sheet extracts for the year to 30 September 2000 for the 8% Debentures in item (ii) above; and comment on the suggestion of Merchant Financial Services. (5 marks)

Note: for the purposes of your answer finance charges may be calculated on a straight-line basis.

(iii) Assuming the directors are committed to using current value for the property in the South, advise the directors as to the acceptability of their proposal; and calculate the profit and loss account charges and the fixed asset balance sheet extracts relating to all the properties for the year to 30 September 2000 in accordance with the requirements of FRS 15, Tangible Fixed Assets. (5 marks)

(b) You are the training partner of Shortland and Company the auditors of Simpkins plc. Ms Duckworth is the manager in charge of the audit of Simpkins plc She has recently joined Shortland and Company after working for another firm of auditors. Ms Duckworth has written to the engagement partner to express her concerns. When she was with her previous firm she was involved in the audit of a client with a similar profile to that of Simpkins plc. It too had factored its debtors, issued debentures at a discount and selectively revalued some properties. Although it may be no more than coincidence, what is worrying Ms Duckworth is that shortly after these transactions the previous audit client went into receivership. Ms Duckworth has done some research into the problem of going concern and she observed that SAS 130, The Going Concern Basis in Financial Statements, which was issued in 1994 (after many recent business failures) requires auditors to take more positive steps to investigate the appropriateness of the going concern basis of a client company, rather than the previous more passive approach. She has also read research findings published by the ACCA in 1995 that showed that less than one in seven company failures in the UK between 1987 and 1994 had any form of going concern qualification in their financial statements prior to their failure. This was a lower qualification rate shown by similar research covering the previous ten-year period in which qualified audit reports had been issued for 26% of companies that had failed. In response to these concerns, the engagement partner has asked for your assistance.

Required:
(i) Draft a memorandum, to be circulated to audit managers, explaining the going concern concept and the implications it has on a company’s financial statements if it is not appropriate. (7 marks)

The memorandum should include a check-list of factors that may indicate going concern problems.

(ii) In respect of the three types of transactions in part (a) that were specifically referred to by Ms Duckworth, describe how they may disguise going concern problems. (3 marks)

(iii) Describe the further audit procedures to be undertaken where a client’s going concern status may be in doubt. (5 marks)
(30 marks)


Analysis of the question

Remember that we start off by looking at the requirements. In advance of looking at the detailed scenario it appears we have three separate small accounting issues to deal with in part (a). Part (b) – the auditing part – asks us to reflect on going concern issues generally and the implications of the three specific issues to the going concern status of the company in particular. The company name is Simpkins plc
The first accounting issue concerns an arrangement made by Simpkins to factor its debts. Group 1 debts are not factored at all, Group 2 debts are factored with recourse, and Group 3 debts are factored without recourse. We are given the factoring charges for both of Groups 2 and 3. The requirement is to show, for each group, the doubtful debts and finance charges in the P&L account and the debtor balances in the balance sheet. There are some easy marks here – where the debts aren’t factored at all (Group 1) then this is a fairly basic foundation level issue. Where the debts are factored without recourse (Group 3) then they won’t appear in the balance sheet at all.

The second accounting issue concerns an issue of debentures at a discount. You are asked to compute the finance charge in the P&L account and the closing loan balance in the balance sheet. The Examiner (as he often seems to at Paper 10) allows you to account for the finance costs on a straight-line basis. You are also asked to comment on the difference, if any, to your answer if the loan stock were to be convertible into equity shares. If you know the relevant provisions of FRS 4, you will realise that the balance sheet classification of convertible loan stock is the same as non-convertible loan stock. Any capital instrument other than shares that carries an obligation to transfer economic benefits must be classified as debt.

The third accounting issue concerns the company’s properties. There is a proposal to revalue one of these but leave the others at depreciated historical cost. If you have studied FRS 15, you will be aware that such a practice is totally contrary to its requirements – all assets in a particular class must be revalued if the revaluation route is chosen. The requirement asks you for the extracts from the P&L account and balance sheet assuming a revaluation takes place. One of the properties (in the North) has a revalued amount that is less than current carrying value. This means that there is a revaluation deficit that must be recognised in the P&L account.

The audit requirements are partly general, in that they ask you to discuss the ‘danger signals’ that may indicate a company has going concern problems and to outline the additional audit tests you might perform in these circumstances. However, you are also asked to indicate how the three transactions we have already discussed might disguise going concern problems. As far as this issue is concerned, it is worth remembering that:

  • Debt factoring may indicate cash-flow problems.
  • Trying to show loan stock as shareholders funds and wishing to revalue fixed assets might indicate a concern about the level of gearing.

Having completed our analysis of the question it is now appropriate to produce an answer. Remember that in the examination you don’t start to do this until you have thoroughly analysed the question, as we have just done.

A suggested answer
Part a (i)

  Group 1
£000
Group 2
£000
Group 3
£000
Profit and loss account      
Bad debts (W1) 25 15 nil
Finance charge (W2) nil 11 40
Balance sheet      
Gross debtors 100 60 nil
Provision for bad debts (25) (15) nil
Net debtors 75 45 nil

Working 1
The bad debt provision is 25% of the debtors existing at 1 July 2000 that were still uncollected at 30 September 2000. No provision is needed regarding Group 3 since the factoring is with recourse, so the risk is completely removed.

Working 2

  • There is no finance charge relating to Group 1 debtors since they aren’t factored.
  • The charge relating to Group 2 debtors is derived from the fact that 40% (£240,000) pay in July, 30% (£180,000) in August and 20% (£120,000) in September. Therefore the total charge for the three month period will be [1% x £600,000 + 1% x £360,000 + 1% x £180,000 = £11,400.
  • Since the group 3 debts are factored without recourse, the finance charge is 5% (100 – 95) of the factored debts of £800,000.

Part a (ii)
The total finance cost associated with the debentures is:

  £000 £000
Total amount payable:    
Interest [8% x £10 million x 4] 3,200  
Repayment [£10 million x 1.15] 11,500  
    14,700
Net amount receivable:    
Issue proceeds [95% x £10 million] 9,500  
Direct costs of issue (200)  
    (9,300)
So finance cost is   5,400

Since the finance cost is recognised on a straight-line basis the annual charge in the profit and loss account is £1,350,000 [£5.4 million x ¼]. Since the interest paid on the debentures is £800,000 each year, then each year the carrying value of the debentures in the balance sheet will increase by £550,000. Therefore, at 30.9.00 the carrying value of the debentures will be £9,850,000 [£9.3 million (the initial carrying value) + £550,000].

As we stated earlier, FRS 4 does not allow companies to anticipate the likely future conversion of convertible loan stock when recognising the finance cost and reporting the capital instrument in the balance sheet. This might result in capital instruments that are in substance equity instruments being reported as debt instruments. The FRS 4 requirement is most likely driven by the wish to prevent companies manipulating gearing ratios to show a more favourable picture.

Part a (iii)
As we stated earlier FRS 15 does not allow companies to take a selective approach to the valuation of fixed assets within a particular class. This means that all three properties need to be revalued. Following revaluation depreciation needs to be based on their remaining useful economic life. We can summarise the effect on the financial statements in the following table:

Property NBV
1.10.99

£000
Revaluation

£000
NBV after
revaluation

£000
Depreciation
for the year

£000
NBV
30.9.00

£000
South 3,200 1,280 4,480 (112) 4,368
Midlands 1,500 Nil 1,500 (50) 1,450
North 800 (160) 640 (32) 608
Total 5,500 1,120 6,620 (194) 6,426

Working – depreciation:

  • One years’ depreciation on the cost of the property in the South is £80,000 (£4m/50). Therefore, 10 years’ depreciation has been charged to 30.9.99 and the remaining useful economic life is 40 years (50 – 10).
  • The depreciation on the property in the Midlands doesn’t change with the revaluation.
  • One years’ depreciation on the cost of the property in the North is £40,000 (£2m/50). Therefore, 30 years’ depreciation has been charged to 30.9.99 and the remaining useful economic life is 20 years (50 – 30).

The revaluation deficit on the property in the North is taken to the profit and loss account, making the total charge for the year £354,000 (£160,000 + £194,000). The surplus on the property in the South is credited to a revaluation reserve and reported in the Statement of Total Recognised Gains and Losses.

Part b (i)
This part requires a memorandum that explains the going concern concept and outlines factors that may indicate a company is not a going concern. The key to gaining marks in a question like this is to identify specific points you want to make rather than just writing aimlessly. Relevant points here might include:

  • The going concern concept is that a company will continue in existence for the foreseeable future.
  • The concept means that fixed assets can be carried at an amount that is often in excess of their net realisable values.
  • If the concept is not applicable then assets need to be restated at forced sale values.
  • Danger signals would include:
    – Problems with collection of debtors.
    – Loan repayments becoming due.
    – Adverse accounting ratios.
    – Companies deferring investments.
    – Companies leasing assets rather than purchasing them.

The above is not an exhaustive list but remember the question only carries 7 marks. You need to ensure that whatever you write is relevant and will gain credit.

Part b (ii)

  • Factoring of debts for the first time will result in an immediate inflow of cash that, in the short term, could hide a basic problem with the ongoing cash-flow of the company.
  • Issuing debentures will also result in an immediate cash inflow. Where the issue is at a discount this could well make the issue more attractive but the user would need to be aware that the overall amount to be repaid is considerably greater than the initial carrying value.
  • Revaluation of fixed assets increases the net asset base and therefore, reduces gearing, assuming the revaluation is positive. High levels of gearing are one of the signals that a company might be suffering from going concern problems.

Part b (iii)
The message here for examination technique is very similar to that in part b (i). Procedures that might be relevant would include:

  • Examination of any cash-flow forecasts.
  • Review relevant post-balance sheet events (cash receipts from debtors, capital expenditure etc.).
  • Seek assurances from providers of finance regarding their willingness to refinance the business.
  • Discuss future plans for the business with the directors.
  • If necessary qualify the audit report.

We have now completed an outline answer to this question and with it a review of examination technique for Paper 10. We will resume this series later in the year with a consideration of examination technique in financial accounting papers for the New Syllabus.

Paul Robins BSc MBA ARCS FCA, is a freelance lecturer and consultant