ACCA AA Syllabus E. Review And Reporting - Going Concern Review & Indicators - Past Papers ^{3 / 4}

Elounda Co manufactures chemical compounds using a continuous production process. Its year end was 31 July 20X6 and the draft profit before tax is $13·6 million. You are the audit supervisor and the year-end audit is due to commence shortly. The following matters have been brought to your attention.

(i) Revaluation of property, plant and equipment (PPE)
At the beginning of the year, management undertook an extensive review of Elounda Co’s non-current asset valuations and as a result decided to update the carrying value of all PPE. The finance director, Peter Dullman, contacted his brother, Martin, who is a valuer and requested that Martin’s firm undertake the valuation, which took place in August 20X5. (5 marks)

(ii) Inventory valuation
Your firm attended the year-end inventory count for Elounda Co and ascertained that the process for recording work in progress (WIP) and finished goods was acceptable. Both WIP and finished goods are material to the financial statements and the quantity and stage of completion of all ongoing production was recorded accurately during the count.

During the inventory count, the count supervisor noted that a consignment of finished goods, compound E243, with a value of $720,000, was defective in that the chemical mix was incorrect. The finance director believes that compound E243 can still be sold at a discounted sum of $400,000. (6 marks)

(iii) Bank loan
Elounda Co secured a bank loan of $2·6 million on 1 October 20X4. Repayments of $200,000 are due quarterly, with a lump sum of $800,000 due for repayment in January 20X7. The company met all loan payments in 20X5 on time, but was late in paying the April and July 20X6 repayments. (4 marks)

Required:
(b) Describe the procedures which the auditor of Elounda Co should perform in assessing whether or not the company is a going concern. (5 marks)

Mercury Motoring Co (Mercury) specialises in manufacturing engine parts for motor cars and the company has a diverse customer base but seven significant customers. The company’s year end was 30 September 2015.

During the year, a number of the company’s significant customers have experienced a fall in sales, and consequently they have purchased fewer items from Mercury. As a result, Mercury has paid a number of its suppliers later than usual and some of them have withdrawn credit terms meaning the company must pay cash on delivery. One of Mercury’s main suppliers is threatening legal action to recover the sums owing. As a result of the increased level of payables, the company’s current ratio has fallen below 1 to 0·9 for the first time.

Mercury has produced a cash flow forecast to 30 June 2016 and this shows net cash outflows until May 2016.

Mercury has a loan of $2·3 million which is due for repayment in full by 30 September 2016.

The finance director has just informed the audit manager that there is a possible change in legislation which will result in one of Mercury’s top product lines becoming obsolete as it will not comply with the proposed law. The prepared cash flow forecasts do not reflect this possible event.

Required:
(a) Explain FIVE potential indicators that Mercury Motoring Co is NOT a going concern. (5 marks)

Mercury Motoring Co (Mercury) specialises in manufacturing engine parts for motor cars and the company has a diverse customer base but seven significant customers. The company’s year end was 30 September 2015.

During the year, a number of the company’s significant customers have experienced a fall in sales, and consequently they have purchased fewer items from Mercury. As a result, Mercury has paid a number of its suppliers later than usual and some of them have withdrawn credit terms meaning the company must pay cash on delivery. One of Mercury’s main suppliers is threatening legal action to recover the sums owing. As a result of the increased level of payables, the company’s current ratio has fallen below 1 to 0·9 for the first time.

Mercury has produced a cash flow forecast to 30 June 2016 and this shows net cash outflows until May 2016.

Mercury has a loan of $2·3 million which is due for repayment in full by 30 September 2016.

The finance director has just informed the audit manager that there is a possible change in legislation which will result in one of Mercury’s top product lines becoming obsolete as it will not comply with the proposed law. The prepared cash flow forecasts do not reflect this possible event.

Required:
(b) Describe the audit procedures which you should perform in assessing whether or not Mercury Motoring Co is a going concern. (5 marks)

You are the audit senior of Holtby & Co and are planning the audit of Walters Co (Walters) for the year ended 31 December 2014. The company produces printers and has been a client of your firm for two years; your audit manager has already had a planning meeting with the finance director. He has provided you with the following notes of his meeting and financial statement extracts.

Walters’s management were disappointed with the 2013 results and so in 2014 undertook a number of strategies to improve the trading results. This included the introduction of a generous sales-related bonus scheme for their salesmen and a high profile advertising campaign. In addition, as market conditions are difficult for their customers, they have extended the credit period given to them.

The finance director of Walters has reviewed the inventory valuation policy and has included additional overheads incurred this year as he considers them to be production related.

The finance director has calculated a few key ratios for Walters; the gross profit margin has increased from 44·4% to 52·2% and receivables days have increased from 61 days to 71 days. He is happy with the 2014 results and feels that they are a good reflection of the improved trading levels.

Financial statement extracts for year ended 31 December

Required:
(b) Describe the procedures that the auditor of Walters Co should perform in assessing whether or not the company is a going concern. (5 marks)

Clarinet Co (Clarinet) is a computer hardware specialist and has been trading for over five years. The company is funded partly through overdrafts and loans and also by several large shareholders; the year end is 30 April 2014.

Clarinet has experienced significant growth in previous years; however, in the current year a new competitor, Drums Design Co (Drums), has entered the market and through competitive pricing has gained considerable market share from Clarinet. One of Clarinet’s larger customers has stopped trading with them and has moved its business to Drums. In addition, a number of Clarinet’s specialist developers have left the company and joined Drums. Clarinet has found it difficult to replace these employees due to the level of their skills and knowledge. Clarinet has just received notification that its main supplier who provides the company with specialist electrical equipment has ceased to trade.

Clarinet is looking to develop new products to differentiate itself from the rest of its competitors. It has approached its shareholders to finance this development; however, they declined to invest further in Clarinet. Clarinet’s loan is long term and it has met all repayments on time. The overdraft has increased significantly over the year and the directors have informed you that the overdraft facility is due for renewal next month, and they are confident it will be renewed.

The directors have produced a cash flow forecast which shows a significantly worsening position over the coming  12 months. They are confident with the new products being developed, and in light of their trading history of significant growth, believe it is unnecessary to make any disclosures in the financial statements regarding going concern.

At the year end, Clarinet received notification from one of its customers that the hardware installed by Clarinet for the customers’ online ordering system has not been operating correctly. As a result, the customer has lost significant revenue and has informed Clarinet that they intend to take legal action against them for loss of earnings. Clarinet has investigated the problem post year end and discovered that other work-in-progress is similarly affected and inventory should be written down. The finance director believes that as this misstatement was identified after the year end, it can be amended in the 2015 financial statements.

Required:
(b) Explain SIX potential indicators that Clarinet Co is not a going concern. (6 marks)

Clarinet Co (Clarinet) is a computer hardware specialist and has been trading for over five years. The company is funded partly through overdrafts and loans and also by several large shareholders; the year end is 30 April 2014.

Clarinet has experienced significant growth in previous years; however, in the current year a new competitor, Drums Design Co (Drums), has entered the market and through competitive pricing has gained considerable market share from Clarinet. One of Clarinet’s larger customers has stopped trading with them and has moved its business to Drums. In addition, a number of Clarinet’s specialist developers have left the company and joined Drums. Clarinet has found it difficult to replace these employees due to the level of their skills and knowledge. Clarinet has just received notification that its main supplier who provides the company with specialist electrical equipment has ceased to trade.

Clarinet is looking to develop new products to differentiate itself from the rest of its competitors. It has approached its shareholders to finance this development; however, they declined to invest further in Clarinet. Clarinet’s loan is long term and it has met all repayments on time. The overdraft has increased significantly over the year and the directors have informed you that the overdraft facility is due for renewal next month, and they are confident it will be renewed.

The directors have produced a cash flow forecast which shows a significantly worsening position over the coming  12 months. They are confident with the new products being developed, and in light of their trading history of significant growth, believe it is unnecessary to make any disclosures in the financial statements regarding going concern.

At the year end, Clarinet received notification from one of its customers that the hardware installed by Clarinet for the customers’ online ordering system has not been operating correctly. As a result, the customer has lost significant revenue and has informed Clarinet that they intend to take legal action against them for loss of earnings. Clarinet has investigated the problem post year end and discovered that other work-in-progress is similarly affected and inventory should be written down. The finance director believes that as this misstatement was identified after the year end, it can be amended in the 2015 financial statements.

Required:

(c) Describe the audit procedures which you should perform in assessing whether or not Clarinet Co is a going concern. (6 marks)

You are the audit manager of Kiwi & Co and you have been provided with financial statements extracts and the following information about your client, Strawberry Kitchen Designs Co (Strawberry), who is a kitchen manufacturer. The company’s year end is 30 April 2012.

Strawberry has recently been experiencing trading difficulties, as its major customer who owes $0•6m to Strawberry has ceased trading, and it is unlikely any of this will be received. However the balance is included within the financial statements extracts below. The sales director has recently left Strawberry and has yet to be replaced.

The monthly cash flow has shown a net cash outflow for the last two months of the financial year and is forecast as negative for the forthcoming financial year. As a result of this, the company has been slow in paying its suppliers and some are threatening legal action to recover the sums owing.

Due to its financial difficulties, Strawberry missed a loan repayment and, as a result of this breach in the loan covenants, the bank has asked that the loan of $4•8m be repaid in full within six months. The directors have decided that in order to conserve cash, no final dividend will be paid in 2012.

Financial statements extracts for year ended 30 April:

Required:

Explain the potential indicators that Strawberry Kitchen Designs Co is not a going concern. (6 marks)

Medimade Co is an established pharmaceutical company that has for many years generated 90% of its revenue through the sale of two specific cold and fl u remedies. Medimade has lately seen a real growth in the level of competition that it faces in its market and demand for its products has significantly declined.

To make matters worse, in the past the company has not invested sufficiently in new product development and so has been trying to remedy this by recruiting suitably trained scientific staff, but this has proved more difficult than anticipated.

In addition to recruiting staff the company also needed to invest $2m in plant and machinery. The company wanted to borrow this sum but was unable to agree suitable terms with the bank; therefore it used its overdraft facility, which carried a higher interest rate.

Consequently, some of Medimade’s suppliers have been paid much later than usual and hence some of them have withdrawn credit terms meaning the company must pay cash on delivery. As a result of the above the company’s overdraft balance has grown substantially.

The directors have produced a cash flow forecast and this shows a significantly worsening position over the coming 12 months.

The directors have informed you that the bank overdraft facility is due for renewal next month, but they are confident that it will be renewed.

They also strongly believe that the new products which are being developed will be ready to market soon and hence trading levels will improve and therefore that the company is a going concern. Therefore they do not intend to make any disclosures in the accounts regarding going concern.

Required:

Identify any potential indicators that the company is not a going concern and describe why these could impact upon the ability of the company to continue trading on a going concern basis. (8 marks)

Smithson Co provides scientific services to a wide range of clients. Typical assignments range from testing food for illegal additives to providing forensic analysis on items used to commit crimes to assist law enforcement officers.

The annual audit is nearly complete. As audit senior you have reported to the engagement partner that Smithson is having some financial difficulties. Income has fallen due to the adverse effect of two high-profile court cases, where Smithson’s services to assist the prosecution were found to be in error.

Not only did this provide adverse publicity for Smithson, but a number of clients withdrew their contracts. A senior employee then left Smithson, stating lack of investment in new analysis machines was increasing the risk of incorrect information being provided by the company.

A cash flow forecast prepared internally shows Smithson requiring significant additional cash within the next 12 months to maintain even the current level of services. Smithson’s auditors have been asked to provide a negative assurance report on this forecast.

Required:

State the audit procedures that may be carried out to try to determine whether or not Smithson Co is a going concern. (8 marks)

ISA 570 Going Concern provides guidance to auditors in respect of ensuring that an entity can continue as a going concern.

Required:

Explain the actions that an auditor should carry out to try and ascertain whether an entity is a going concern. (5 marks)