Going Concern Review & Indicators

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Question 2a

Daley Co is a family owned, unlisted company which imports motor cars. The company buys cars from a variety of car manufacturers for sale to car dealerships and vehicle leasing companies within its own domestic market. Daley Co has been a client of your firm for the last three years and you are the newly appointed audit manager on the audit for the year ended 31 August 20X8. The audit for the current reporting period is nearing completion and you are reviewing the working papers of the going concern section of the audit file.

Extracts from the draft financial statements and other relevant information are given below.

Statement of financial position

31 August 20X8 31 August 20X7
Draft Actual
$ million $ million
Assets
Non-current assets
Property, plant and equipment 13·5 14·6

13·5

14·6
Current assets
Inventory 5·8 3·7
Trade receivables 3·7 2·6
Cash at bank and in hand
0·6
9·5
6·9
Total assets 23·0
21·5
Equity and liabilities
Equity
Share capital 1·0 1·0
Retained earnings 1·3 4·7

2·3

5·7
Non-current liabilities
Long-term borrowings 11·2 12·4
Provisions 3·5 0·5

14·7

12·9
Current liabilities
Trade payables 4·2 2·9
Bank overdraft 1·8

6·0
2·9
Total equity and liabilities 23·0
21·5
Statement of profit or loss for the year
31 August 20X8 31 August 20X7
Draft Actual
$ million $ million
Revenue 11·3 8·8
Cost of sales (4·4 )
(2·9 )
Gross profit 6·9 5·9
Other operating expenses (9·1 )
(1·3 )
Operating profit (2·2 ) 4·6
Finance costs (1·5 )
(0·7 )
Profit before taxation (3·7 ) 3·9
Taxation 0·3
(1·3 )
Net (loss)/profit for year (3·4 )
2·6

You have also ascertained the following information during your review:

1. Daley Co has undergone a period of rapid expansion in recent years and is intending to buy new warehousing facilities in January 20X9 at a cost of $4·3 million.

2. In order to finance the new warehousing facilities, the company is in the process of negotiating new finance from its bankers. The loan application is for an amount of $5 million and is to be repaid over a period of four years.

3. The provision of $3·5 million in this year’s statement of financial position relates to legal actions from five of Daley Co’s largest customers. The actions relate to the claim that the company has sold cars which did not comply with domestic regulations.

4. A major new competitor has moved in to Daley Co’s market in October 20X8.

5. The going concern working papers include a cash flow forecast for the 12 months ending 31 August 20X9.

The cash flow forecast assumes that Daley Co’s revenue will increase by 25% next year and that following the reorganisation of its credit control facility, its customers will pay on average after 60 days. The forecast also assumes that the bank will provide the new finance in January 20X9 and that the company will have a positive cash balance of $1·7 million by 31 August 20X9.

6. The financial statements have been prepared on a going concern basis and make no reference to any significant uncertainties in relation to going concern.

Required:
(a) Using analytical review where appropriate, evaluate the matters which may cast doubt on Daley Co’s ability to continue as a going concern. (10 marks)

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Question 2a

Malevich & Co is a firm of Chartered Certified Accountants offering audit and assurance services to a large portfolio of clients. You are a manager in the audit department responsible for the audit of two clients, Kandinsky Co and the Rothko University, both of which have a financial year ended 31 July 2015. The audits of both clients are being completed and you are reviewing issues which have been raised by the audit seniors.

(a) Kandinsky Co is a manufacturer of luxury food items including chocolate and other confectionery which are often sold as gift items individually or in hampers containing a selection of expensive items from the range of products.

Due to an economic recession sales of products have fallen sharply this year, and measures have been
implemented to support the company’s cash flow. You are aware that the company only has $150,000 in cash at the year end.

Extracts from the draft financial statements and other relevant information are given below

Note July 2015 July 2014
(Draft) (Actual)
$’000 $’000
Revenue 2,440 3,950
Operating expenses (2,100) (2,800)
Finance charge (520) (500)
(Loss)/profit before tax
(180)

650
Total assets 10,400 13,500
Long-term liabilities – bank loan 1 3,500 3,000
Short-term liabilities – trade payables 2 900 650
Disclosed in notes to financial statements:
Undrawn borrowing facilities 3 500 1,000
Contingent liability 4 120 -

Notes:
1. The bank loan was extended in March 2015 by drawing on the borrowing facilities offered by the bank. The loan carries a fixed interest rate and is secured on the company’s property including the head office and manufacturing site. The first repayment of loan capital is due on 30 June 2016 when $350,000 is due to be paid.

2. Kandinsky Co renegotiated its terms of trade with its main supplier of cocoa beans, and extended payment terms from 50 days to 80 days in order to improve working capital.

3. The borrowing facilities are due to be reviewed by the bank in April 2016 and contain covenants including that interest cover is maintained at 2, and the ratio of bank loan to operating profit does not exceed 4:1.

4. The contingent liability relates to a letter of support which Kandinsky Co has provided to its main supplier of cane sugar which is facing difficult trading conditions.

Required:
In respect of the audit of Kandinsky Co:

(i) Identify and explain the matters which may cast significant doubt on the company’s ability to continue as a going concern; and (9 marks)

(ii) Recommend the audit procedures to be performed in relation to the going concern matters identified. (6 marks)

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Question 3a i ii (part 3)

Dasset Co operates in the coal mining industry. The company owns ten mines across the country from which coal is extracted before being sold onto customers who are energy providers. Coal mining companies operate under licence from the National Coal Mining Authority, an organisation which monitors the environmental impact of coal mining operations, and requires coal mines to be operated in compliance with strict health and safety regulations.

You are an audit manager in Burton & Co, responsible for the audit of Dasset Co and you are reviewing the audit working papers for the year ended 31 August 2013. The draft financial statements recognise profit before tax of  $18 million and total assets of $175 million. The audit senior has left a note for your attention:

Accident at the Ledge Hill Mine

On 15 August 2013, there was an accident at the Ledge Hill Mine, where several of the tunnels in the mine collapsed, causing other tunnels to become flooded. This has resulted in one-third of the mine becoming inaccessible and for safety reasons, the tunnels will be permanently closed. However, Dasset Co’s management thinks that the rest of the mine can remain operational, as long as improvements are made to ensure that the mine meets health and safety regulations.

Luckily no one was injured in the accident. However, the collapse caused subsidence which has damaged several residential properties in a village located above the mine. A surveyor has been commissioned to report on whether the properties need to be demolished or whether they can be safely repaired. A group of 20 residents has been relocated to rental properties in the local area and Dasset Co is meeting all expenses in relation to this.

The Ledge Hill Mine was acquired several years ago and is recognised in the draft statement of financial position at $10 million. As no employees were injured in the accident, Dasset Co’s management has decided not to report the accident to the National Coal Mining Authority.

Required:

In respect of the accident at the Ledge Hill Mine:
(i) Comment on the matters which you should consider; and

(ii) Describe the audit evidence which you should expect to find, in undertaking your review of the audit working papers and financial statements of Dasset Co.

Note: The total marks will be split equally between each part. (14 marks)

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Question 5a

You are the manager responsible for the audit of Burford Co, a company which designs and manufactures engine parts. The audit of the financial statements for the year ended 31 July 2013 is nearing completion and you are reviewing the working papers of the going concern section of the audit file. The draft financial statements recognise a loss of $500,000 (2012 – profit of $760,000), and total assets of $13•8 million (2012 – $14•4 million).

The audit senior has left the following note for your attention:

‘I have performed analytical review on Burford Co’s year-end financial statements. The current ratio is 0•8 (2012 – 1•2), the quick ratio is 0•5 (2012 – 1•6). The latest management accounts show that ratios have deteriorated further since the year end, and the company now has a cash balance of only $25,000.

Burford Co has a long-term loan outstanding of $80,000 with a covenant attached, which states that if the current ratio falls below 0•75, the loan can be immediately recalled by the lender.’
You are also aware that one of Burford Co’s best-selling products, the QuickFire, has become technically obsolete during 2013 as customers now prefer more environmentally friendly engine parts.

Historically, the QuickFire has generated 45% of the company’s revenue. In response to customers’ preference, $1•3 million has been spent on designing a new product, the GreenFire, due for launch in February 2014, which will be marketed as an environmentally friendly product.

A cash flow forecast has been prepared for the year to 31 July 2014, indicating that based on certain assumptions, the company’s cash balance is predicted to increase to $220,000 by the end of the forecast period.

Assumptions include:

1. The successful launch of the GreenFire product,
2. The sale of plant and machinery which was used to manufacture the QuickFire, generating cash proceeds of $50,000, forecast to take place in January 2014,
3. A reduction in payroll costs of 15%, caused by redundancies in the QuickFire manufacturing plant, and
4. The receipt of a grant of $30,000 from a government department which encourages innovation in environmentally friendly products, scheduled to be received in February 2014.

Required:

(i) Identify and explain the matters which cast doubt on the going concern status of Burford Co.
(6 marks)

(ii) Explain the audit evidence you should expect to find in your file review in respect of the cash flow forecast. (8 marks)

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Question 2a b

Butler Co is a new audit client of your firm. You are the manager responsible for the audit of the financial statements for the year ended 31 May 2011. Butler Co designs and manufactures aircraft engines and spare parts, and is a subsidiary of a multi-national group. Extracts from the draft financial statements are shown below:

Statement of financial position

31 may 2011 31 may 2010
draft actual
$ million $ million
assets
non-current assets
intangible assets (note 1) 200 180
property, plant and equipment (note 2) 1300 1200
deferred tax asset (note 3) 235 20
financial assets 25 35
--------- ---------
1760 1435
--------- ---------
current assets
inventory 1300 800
trade receivables 2100 1860
--------- ---------
3400 2660
--------- ---------
total assets 5160 4095
====== ======
equity and liabilities
equity
share capital 300 300
retained earnings -525 95
--------- ---------
-225 395
--------- ---------
non-current liabilities
long-term borrowings (note 4) 1900 1350
provisions (note 5) 185 150
--------- ---------
2085 1500
--------- ---------
current liabilities
short-term borrowings (note 6) 800 400
trade payables 2500 1800
--------- ---------
3300 2200
--------- ---------
total equity and liabilities 5160 4095
====== ======

Notes to the statement of financial position:

Note 1 Intangible assets comprise goodwill on the acquisition of subsidiaries ($80 million), and development costs capitalised on engine development projects ($120 million).

Note 2 Property, plant and equipment includes land and buildings valued at $25 million, over which a fixed charge exists.

Note 3 The deferred tax asset has arisen following several loss-making years suffered by the company. The asset represents the tax benefit of unutilised tax losses carried forward.

Note 4 Long-term borrowings include a debenture due for repayment in July 2012, and a loan from Butler Co’s parent company due for repayment in December 2012.

Note 5 Provisions relate to warranties provided to customers.

Note 6 Short-term borrowings comprise an overdraft ($25 million), a short term loan ($60 million) due for repayment in August 2011, and a bank loan ($715 million) repayable in September 2011.

You have received an email from the audit partner responsible for the audit of Butler Co:

To: Audit manager
From: Audit partner
Regarding: Butler Co – going concern issues

Hello

I understand that the audit work on Butler Co commences this week. I am concerned about the future of the company, as against a background of economic recession, sales have been declining, several significant customer contracts have been cancelled unexpectedly, and competition from overseas has damaged the market share previously enjoyed by Butler Co.

(i) Please prepare briefing notes, for my use, in which you identify and explain any matters arising from your review of the draft statement of financial position, and the cash flow forecast, which may cast significant doubt on the company’s ability to continue as a going concern. The cash flow forecast has just been sent to me from the client, and is attached. It covers only the first three months of the next financial year, the client is currently preparing the forecasts for the whole 12 month period. Please be sceptical when reviewing the forecast, as the assumptions may be optimistic. (10 marks)

(ii) In addition, please recommend the principal audit procedures to be carried out on the cash flow forecast. Your recommendations can be included in a separate section of the briefing notes. (8 marks)

Thanks

Attachment: Cash flow forecast for the three months to 31 August 2011

jun 2011 jul 2011 aug 2011
$ million $ million $ million
cash inflows
cash receipts from customers (note 1)
175 195 220
loan receipt (note 2)
150
government subsidy (note 3)
50
sales of financial assets
50
-------- -------- --------
total cash inflows
225 345 270
-------- -------- --------
cash outflows
operating cash outflows
200 200 290
interest payments 40 40 40
loan repayment
60
-------- -------- --------
total cash outflows
240 240 390
-------- -------- --------
net cash flow for the month
-15 105 -120
opening cash
-25 -40 65
-------- -------- --------
closing cash -40 65 -55
-------- -------- --------

Notes to the cash flow forecast:

This cash flow forecast has been prepared by the management of Butler Co, and is based on the following assumptions:

1. Cash receipts from customers should accelerate given the anticipated improvement in economic conditions. In addition, the company has committed extra resources to the credit control function, in order to speed up collection of overdue debts.

2. The loan expected to be received in July 2011 is currently being negotiated with our parent company, Rubery Co.

3. The government subsidy will be received once our application has been approved. The subsidy is awarded to companies which operate in areas of high unemployment and it subsidises the wages and salaries paid to staff.

Required:

Respond to the email from the audit partner. (18 marks)

Note: The split of the mark allocation is shown within the partner’s email.

Professional marks will be awarded for presentation, and for the clarity of explanations provided. (2 marks)

(b) Given the information provided relating to Butler Co, it is likely that the auditor may conclude on completion of all necessary audit procedures, that the use of the going concern assumption in the financial statements is appropriate, but that a material uncertainty, or several uncertainties, exist regarding the company’s ability to continue as a going concern.

Required:

If audit procedures indicate that one or more material uncertainties exist regarding Butler Co’s ability to continue as a going concern:

Explain the matters that should be considered in forming the audit opinion and the potential impacts on the auditor’s report. (7 marks)

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