Section A – This ONE question is compulsory and MUST be attempted

Hesket Nuclear (HN) is a nuclear power station in Ayland, a large European country. The HN plant is operated by Hesket Power Company (HPC), which in turn is wholly owned by the government of Ayland. Initially opened in the late 1950s, the power station grew in subsequent decades by the addition of several other facilities on the same site. HN now has the ability to generate 5% of Ayland’s entire electricity demand and is one of the largest nuclear stations in Europe. At each stage of its development from the 1950s to the present day, development on the site was welcomed by the relevant local government authorities, by the businesses that have supported it, by the trade union that represents the majority of employees (called Forward Together or FT for short) and also by the national Ayland government. A nuclear reprocessing facility was added in the 1980s. This is a valuable source of overseas income as nuclear power producers in many other parts of the world send material by sea to HN to be reprocessed. This includes nuclear producers in several developing countries that rely on the cheaper reprocessed fuel (compared to ‘virgin’ fuel) that HN produces.

HPC is loss-making and receives a substantial subsidy each year from the government of Ayland. HPC has proven itself uneconomic but is deemed politically and environmentally necessary as far as the government is concerned. The government of Ayland has reluctantly accepted that large subsidies to HPC will be necessary for many years but considers nuclear power to be a vital component of its energy portfolio (along with other energy sources such as oil, gas, coal, renewables and hydroelectric) and also as a key part of its ‘clean’ energy strategy. Unlike energy from fossil fuels (such as coal, gas and oil), nuclear power generates a negligible amount of polluting greenhouse gas. HN also provides much needed employment in an otherwise deprived part of the country. The HN power station underpins and dominates the economy of its local area and local government authorities say that the HN plant is vital to the regional economy.

Since it opened, however, the HN power station has been controversial. Whilst being welcomed by those who benefi t from it in terms of jobs, trade, reprocessing capacity and energy, a coalition has gradually built up against it comprising those sceptical about the safety and environmental impact of nuclear power. Some neighbouring countries believe themselves to be vulnerable to radioactive contamination from the HN plant. In particular, two countries, both of whom say their concerns about HN arise because of their geographical positions, are vocal opponents. They say that their geographical proximity forced them to be concerned as they are affected by the location of the HN plant which was not of their choosing.

The government of Beeland, whose capital city is 70 km across the sea from HN (which is situated on the coast), has consistently opposed HN and has frequently asked the government of Ayland to close HN down. The Beeland government claims that not only does ‘low-level’ emission from the site already contaminate the waters separating the two countries but it also claims that any future major nuclear ‘incident’ would have serious implications for the citizens of Beeland. There is some scientifi c support for this view although opinion is divided over whether Beeland is being irrational in its general opposition to HN.

The government of Ceeland is also a vocal opponent of HN. Ceeland is located to the north of Beeland and approximately 500 km away from Ayland. Some nuclear scientists have said that with such a large stretch of water between the HN plant and Ceeland, even a much-feared incident would be unlikely to seriously impact on Ceeland. Some commentators have gone further and said that Ceeland’s concerns are unfounded and ‘borne of ignorance’. FT, the trade union for HN employees, issued a statement saying that Ceeland had no reason to fear HN and that its fears were ‘entirely groundless’.

HN’s other vocal and persistent opponent is No Nuclear Now (NNN), a well-organised and well-funded campaigning group. Describing itself on its website as ‘passionate about the environment’, it describes HN’s social and environmental footprint as ‘very negative’. NNN has often pointed to an environmentally important colony of rare seals living near the HN plant. It says that the seals are dependent on a local natural ecosystem around the plant and are unable to move, arguing that the animals are at signifi cant risk from low-level contamination and would have ‘no chance’ of survival if a more serious radioactive leak ever occurred. NNN points to such a leak that occurred in the 1970s, saying that such a leak proves that HN has a poor safety record and that a leak could easily recur.

Each time an objection to the HN power station is raised, FT, the trade union, robustly defends the HN site in the media, and argues for further investment, based on the need to protect the jobs at the site. Furthermore, the radiation leak in the 1970s led to FT uniting with the HPC board to argue against those stakeholders that wanted to use the leak as a reason to close the HN site. The combination of union and HPC management was able to counter the arguments of those asking for closure.

HN places a great deal of emphasis on its risk management and often publicises the fact that it conducts continual risk assessments and is in full compliance with all relevant regulatory frameworks. Similarly, FT recently pointed out that HN has had an ‘impeccable’ safety record since the incident in the 1970s and says on its website that it is ‘proud’ that its members are involved in ensuring that the company is continually in full compliance with all of the regulatory requirements placed upon it.

The board of HPC, led by chairman Paul Gog, is under continual pressure from the government of Ayland to minimise the amount of government subsidy. Each year, the government places challenging targets on the HPC board requiring stringent cost controls at the HN power station. In seeking to reduce maintenance costs on the expiry of a prior maintenance contract last year, the board awarded the new contract to an overseas company that brought its own workers in from abroad rather than employing local people. The previous contract company was outraged to have lost the contract and the move also triggered an angry response from the local workforce and from FT, the representative trade union.

FT said that it was deplorable that HPC had awarded the contract to an overseas company when a domestic company in Ayland could have been awarded the work. The union convenor, Kate Allujah, said that especially in the nuclear industry where safety was so important, domestic workers were ‘more reliable’ than foreign workers who were brought in purely on the basis of cost and in whose countries safety standards in similar industries might not be so stringent. HPC said that it had done nothing illegal as the foreign workers were allowed to work in Ayland under international legal treaties. Furthermore, it argued that pressure by FT to raise wages over recent years had created, with the government’s subsidy targets, the cost pressure to re-tender the maintenance contract.

On HN’s 50th anniversary last year, NNN published what it called a ‘risk assessment’ for the HN power station. It said it had calculated the probabilities (P) and impacts (I) of three prominent risks.

Risk of major radioactive leak over the next 10 years: P = 10%, I = 20

Risk of nuclear explosion over the next 50 years: P = 20%, I = 100

Risk of major terrorist attack over next 10 years: P = 10%, I = 80

Impacts were on an arbitrary scale of 1–100 where 100 was defi ned by NNN as ‘total nuclear annihilation of the area and thousands of deaths’.

The governments of Beeland and Ceeland seized upon the report, saying that it proved that HN is a genuine threat to their security and should be immediately closed and decommissioned. HN’s risk manager, Keith Wan, vigorously disagreed with this assessment saying that the probabilities and the impacts were ‘ridiculous’, massively overstated and intended to unnecessarily alarm people. HN’s public relations offi ce was also angry about it and said it would issue a rebuttal statement.

Required:

(a) Distinguish between voluntary and involuntary stakeholders, identifying both types of stakeholders in Hesket Nuclear. Assess the claims of THREE of the involuntary ‘affected’ stakeholders identifi ed. (12 marks)

(b) The trade union, Forward Together, has had a long relationship with HN and represents not only the main workforce but also the employees of the maintenance company replaced by the foreign workers.

Required:

Explain the roles of employee representatives such as trade unions in corporate governance and critically evaluate, from the perspective of HPC’s board, the contribution of Forward Together in the governance of HPC. (10 marks)

(c) Explain what an agency relationship is and examine the board of HPC’s current agency relationship and objectives. Briefl y explain how these would differ if HPC was a company with private shareholders. (10 marks)

(d) As a part of HPC’s public relations effort, it has been proposed that a response statement should be prepared for the company’s website to help address two major challenges to their reputation.

Required:

Draft this statement to include the following:

(i) Referring to the NNN report, explain why accurate risk assessment is necessary at Hesket Nuclear. (8 marks)

(ii) Explain what a social and environmental ‘footprint’ is and construct the argument that HN’s overall social and environmental footprint is positive. (6 marks)

Professional marks will additionally be awarded in part (d) for drafting a statement that is clear, has a logical fl ow, is persuasive and is appropriately structured. (4 marks)

Section B – TWO questions ONLY to be attempted

(a) Cate is an entity in the software industry. Cate had incurred substantial losses in the fi nancial years 31 May 2004 to 31 May 2009. In the fi nancial year to 31 May 2010 Cate made a small profi t before tax. This included signifi cant non-operating gains. In 2009, Cate recognised a material deferred tax asset in respect of carried forward losses, which will expire during 2012. Cate again recognised the deferred tax asset in 2010 on the basis of anticipated performance in the years from 2010 to 2012, based on budgets prepared in 2010. The budgets included high growth rates in profi tability. Cate argued that the budgets were realistic as there were positive indications from customers about future orders. Cate also had plans to expand sales to new markets and to sell new products whose development would be completed soon. Cate was taking measures to increase sales, implementing new programs to improve both productivity and profi tability. Deferred tax assets less deferred tax liabilities represent 25% of shareholders’ equity at 31 May 2010. There are no tax planning opportunities available to Cate that would create taxable profi t in the near future. (5 marks)

(b) At 31 May 2010 Cate held an investment in and had a signifi cant infl uence over Bates, a public limited company. Cate had carried out an impairment test in respect of its investment in accordance with the procedures prescribed in IAS 36, Impairment of assets. Cate argued that fair value was the only measure applicable in this case as value-in-use was not determinable as cash fl ow estimates had not been produced. Cate stated that there were no plans to dispose of the shareholding and hence there was no binding sale agreement. Cate also stated that the quoted share price was not an appropriate measure when considering the fair value of Cate’s signifi cant infl uence on Bates. Therefore, Cate estimated the fair value of its interest in Bates through application of two measurement techniques; one based on earnings multiples and the other based on an option–pricing model. Neither of these methods supported the existence of an impairment loss as of 31 May 2010. (5 marks)

(c) At 1 April 2009 Cate had a direct holding of shares giving 70% of the voting rights in Date. In May 2010, Date issued new shares, which were wholly subscribed for by a new investor. After the increase in capital, Cate retained an interest of 35% of the voting rights in its former subsidiary Date. At the same time, the shareholders of Date signed an agreement providing new governance rules for Date. Based on this new agreement, Cate was no longer to be represented on Date’s board or participate in its management. As a consequence Cate considered that its decision not to subscribe to the issue of new shares was equivalent to a decision to disinvest in Date. Cate argued that the decision not to invest clearly showed its new intention not to recover the investment in Date principally through continuing use of the asset and was considering selling the investment. Due to the fact that Date is a separate line of business (with separate cash fl ows, management and customers), Cate considered that the results of Date for the period to 31 May 2010 should be presented based on principles provided by IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. (8 marks)

(d) In its 2010 fi nancial statements, Cate disclosed the existence of a voluntary fund established in order to provide a post-retirement benefi t plan (Plan) to employees. Cate considers its contributions to the Plan to be voluntary, and has not recorded any related liability in its consolidated fi nancial statements. Cate has a history of paying benefi ts to its former employees, even increasing them to keep pace with infl ation since the commencement of the Plan. The main characteristics of the Plan are as follows:

(i) the Plan is totally funded by Cate;

(ii) the contributions for the Plan are made periodically;

(iii) the post retirement benefi t is calculated based on a percentage of the fi nal salaries of Plan participants dependent on the years of service;

(iv) the annual contributions to the Plan are determined as a function of the fair value of the assets less the liability arising from past services.

Cate argues that it should not have to recognise the Plan because, according to the underlying contract, it can terminate its contributions to the Plan, if and when it wishes. The termination clauses of the contract establish that Cate must immediately purchase lifetime annuities from an insurance company for all the retired employees who are already receiving benefi t when the termination of the contribution is communicated. (5 marks)

Required:

Discuss whether the accounting treatments proposed by the company are acceptable under International Financial Reporting Standards.

Professional marks will be awarded in this question for clarity and quality of discussion. (2 marks)

The mark allocation is shown against each of the four parts above.

(a) Kayte operates in the shipping industry and owns vessels for transportation. In June 2014, Kayte acquired Ceemone whose assets were entirely investments in small companies. The small companies each owned and operated one or two shipping vessels. There were no employees in Ceemone or the small companies. At the acquisition date, there were only limited activities related to managing the small companies as most activities were outsourced. All the personnel in Ceemone were employed by a separate management company. The companies owning the vessels had an agreement with the management company concerning assistance with chartering, purchase and sale of vessels and any technical management. The management company used a shipbroker to assist with some of these tasks.

Kayte accounted for the investment in Ceemone as an asset acquisition. The consideration paid and related transaction costs were recognised as the acquisition price of the vessels. Kayte argued that the vessels were only passive investments and that Ceemone did not own a business consisting of processes, since all activities regarding commercial and technical management were outsourced to the management company. As a result, the acquisition was accounted for as if the vessels were acquired on a stand-alone basis.

Additionally, Kayte had borrowed heavily to purchase some vessels and was struggling to meet its debt obligations. Kayte had sold some of these vessels but in some cases, the bank did not wish Kayte to sell the vessel. In these cases, the vessel was transferred to a new entity, in which the bank retained a variable interest based upon the level of the indebtedness. Kayte’s directors felt that the entity was a subsidiary of the bank and are uncertain as to whether they have complied with the requirements of IFRS 3 Business Combinations and IFRS 10 Consolidated Financial Statements as regards the above transactions. (12 marks)

(b) Kayte’s vessels constitute a material part of its total assets. The economic life of the vessels is estimated to be 30 years, but the useful life of some of the vessels is only 10 years because Kayte’s policy is to sell these vessels when they are 10 years old. Kayte estimated the residual value of these vessels at sale to be half of acquisition cost and this value was assumed to be constant during their useful life. Kayte argued that the estimates of residual value used were conservative in view of an immature market with a high degree of uncertainty and presented documentation which indicated some vessels were being sold for a price considerably above carrying value. Broker valuations of the residual value were considerably higher than those used by Kayte. Kayte argued against broker valuations on the grounds that it would result in greater volatility in reporting.

Kayte keeps some of the vessels for the whole 30 years and these vessels are required to undergo an engine overhaul in dry dock every 10 years to restore their service potential, hence the reason why some of the vessels are sold. The residual value of the vessels kept for 30 years is based upon the steel value of the vessel at the end of its economic life. At the time of purchase, the service potential which will be required to be restored by the engine overhaul is measured based on the cost as if it had been performed at the time of the purchase of the vessel. In the current period, one of the vessels had to have its engine totally replaced after only eight years. Normally, engines last for the 30-year economic life if overhauled every 10 years. Additionally, one type of vessel was having its funnels replaced after 15 years but the funnels had not been depreciated separately. (11 marks)

Required:

Discuss the accounting treatment of the above transactions in the financial statements of Kayte.

Note: The mark allocation is shown against each of the elements above.

Professional marks will be awarded in question 3 for clarity and quality of presentation. (2 marks)

This information was taken from an internal newsletter of The Knowledge Partnership LLP (TKP), a company which offers project and software consultancy work for clients based in Zeeland. The newsletter was dated 2 November 2014 and describes two projects currently being undertaken by the partnership.

Project One

In this project, one of our clients was just about to place a contract for a time recording system to help them monitor and estimate construction contracts when we were called in by the Finance Director. He was concerned about the company supplying the software package. ‘They only have an annual revenue of $5m’, he said, ‘and that worries me.’ TKP analysed software companies operating in Zeeland. It found that 200 software companies were registered in Zeeland with annual revenues of between $3m and $10m. Of these, 20 went out of business last year. This compared to a 1% failure rate for software companies with revenues of more than $100m per year. We presented this information to the client and suggested that this could cause a short-term support problem. The client immediately re-opened the procurement process. Eventually they bought a solution from a much larger well-known software supplier. It is a popular software solution, used in many larger companies.

The client has now asked us to help with the implementation of the package. A budget for the project has been agreed and has been documented in an agreed, signed-off, business case. The client has a policy of never re-visiting its business cases once they have been accepted; they see this as essential for effective cost control. We are currently working with the primary users of the software – account managers (using time and cost data to monitor contracts) and the project support office (using time and cost data to improve contract estimating) – to ensure that they can use the software effectively when it is implemented. We have also given ‘drop in’ briefing sessions for the client’s employees who are entering the time and cost data analysed by the software. They already record this information on a legacy system and so all they will see is a bright new user interface, but we need to keep them informed about our implementation. We are also looking at data migration from the current legacy system. We think some of the current data might be of poor quality, so we have established a strategy for data cleansing (through offshore data input) if this problem materialises. We currently estimate that the project will go live in May 2015.

Project Two

In this project, the client is the developer of the iProjector, a tiny phone-size projector which is portable, easy to use and offers high definition projection. The client was concerned that their product is completely dependent on a specialist image-enhancing chip designed and produced by a small start-up technology company. They asked TKP to investigate this company. We confirmed their fears. The company has been trading for less than three years and it has a very inexperienced management team. We suggested that the client should establish an escrow agreement for design details of the chip and suggested a suitable third party to hold this agreement. We also suggested that significant stocks of the chip should be maintained. The client also asked TKP to look at establishing patents for the iProjector throughout the world. Again, using our customer contacts, we put them in touch with a company which specialises in this. We are currently engaged with the client in examining the risk that a major telephone producer will launch a competitive product with functionality and features similar to the iProjector.

The iProjector is due to be launched on 1 May 2015 and we have been engaged to give advice on the launch of the product. The launch has been heavily publicised, a prestigious venue booked and over 400 attendees are expected. TKP have arranged for many newspaper journalists to attend. The product is not quite finished, so although orders will be taken at the launch, the product is not expected to ship until June 2015.

Further information:

TKP only undertakes projects in the business culture which it understands and where it feels comfortable. Consequently, it does not undertake assignments outside Zeeland.

TKP has $10,000,000 of consultant’s liability insurance underwritten by Zeeland Insurance Group (ZIG).

Required:

(a) Analyse how TKP itself and the two projects described in the scenario demonstrate the principles of effective risk management. (15 marks)

(b) Describe the principle of the triple constraint (scope, time and cost) on projects and discuss its implications in the two projects described in the scenario. (10 marks)

Ms Huang, a shareholder of the Daqing Limited Liability Company (Daqing), found that the general manager, Mr Ding, had accepted bribes from several suppliers, which materially caused losses to Daqing, and adversely affected the interests of all shareholders.

Further examination, through a Certified Public Accountant firm, disclosed that there were a lot of affiliated transactions between Daqing and Everbright Co, which was the majority shareholder of Daqing. Mr Ding was recommended by Everbright Co and appointed by Daqing’s board of directors, which was substantially influenced by Everbright Co. With a series of such transactions Daqing transferred huge profits to Everbright Co and adversely affected Daqing.

Required:

(a) State whether Ms Huang was entitled to take legal action against Mr Ding for his illegal behaviour of accepting bribes which adversely affected all the shareholders. (2 marks)

(b) State TWO different legal actions Ms Huang was entitled to take to protect the rights of Daqing and its shareholders due to the affiliated transactions with Everbright Co. (4 marks)

Is the following statement true or false?

A significant change in the ownership of an existing audit client is a factor which makes it appropriate for the auditor to review the terms of engagement.

A.True

B.False

You are the audit supervisor of Maple & Co and are currently planning the audit of an existing client, Sycamore Science Co (Sycamore), whose year end was 30 April 2015. Sycamore is a pharmaceutical company, which manufactures and supplies a wide range of medical supplies. The draft financial statements show revenue of $35·6 million and profit before tax of $5·9 million.

Sycamore’s previous finance director left the company in December 2014 after it was discovered that he had been claiming fraudulent expenses from the company for a significant period of time. A new finance director was appointed in January 2015 who was previously a financial controller of a bank, and she has expressed surprise that Maple & Co had not uncovered the fraud during last year’s audit.

During the year Sycamore has spent $1·8 million on developing several new products. These projects are at different stages of development and the draft financial statements show the full amount of $1·8 million within intangible assets. In order to fund this development, $2·0 million was borrowed from the bank and is due for repayment over a ten-year period. The bank has attached minimum profit targets as part of the loan covenants.

The new finance director has informed the audit partner that since the year end there has been an increased number of sales returns and that in the month of May over $0·5 million of goods sold in April were returned.

Maple & Co attended the year-end inventory count at Sycamore’s warehouse. The auditor present raised concerns that during the count there were movements of goods in and out the warehouse and this process did not seem well controlled.

During the year, a review of plant and equipment in the factory was undertaken and surplus plant was sold, resulting in a profit on disposal of $210,000.

Required:

(a) State Maples & Co’s responsibilities in relation to the prevention and detection of fraud and error. (4 marks)

(b) Describe SIX audit risks, and explain the auditor’s response to each risk, in planning the audit of Sycamore Science Co. (12 marks)

(c) Sycamore’s new finance director has read about review engagements and is interested in the possibility of Maple & Co undertaking these in the future. However, she is unsure how these engagements differ from an external audit and how much assurance would be gained from this type of engagement.

Required:

(i) Explain the purpose of review engagements and how these differ from external audits; and (2 marks)

(ii) Describe the level of assurance provided by external audits and review engagements. (2 marks)

There has been significant divergence in practice over recognition of revenue mainly because International Financial Reporting Standards (IFRS) have contained limited guidance in certain areas. The International Accounting Standards Board (IASB) as a result of the joint project with the US Financial Accounting Standards Board (FASB) has issued IFRS 15 Revenue from Contracts with Customers. IFRS 15 sets out a five-step model, which applies to revenue earned from a contract with a customer with limited exceptions, regardless of the type of revenue transaction or the industry. Step one in the five-step model requires the identification of the contract with the customer and is critical for the purpose of applying the standard. The remaining four steps in the standard’s revenue recognition model are irrelevant if the contract does not fall within the scope of IFRS 15.

Required:

(a) (i) Discuss the criteria which must be met for a contract with a customer to fall within the scope of IFRS 15. (5 marks)

(ii) Discuss the four remaining steps which lead to revenue recognition after a contract has been identified as falling within the scope of IFRS 15. (8 marks)

(b) (i) Tang enters into a contract with a customer to sell an existing printing machine such that control of the printing machine vests with the customer in two years’ time. The contract has two payment options. The customer can pay $240,000 when the contract is signed or $300,000 in two years’ time when the customer gains control of the printing machine. The interest rate implicit in the contract is 11·8% in order to adjust for the risk involved in the delay in payment. However, Tang’s incremental borrowing rate is 5%. The customer paid $240,000 on 1 December 2014 when the contract was signed. (4 marks)

(ii) Tang enters into a contract on 1 December 2014 to construct a printing machine on a customer’s premises for a promised consideration of $1,500,000 with a bonus of $100,000 if the machine is completed within 24 months. At the inception of the contract, Tang correctly accounts for the promised bundle of goods and services as a single performance obligation in accordance with IFRS 15. At the inception of the contract, Tang expects the costs to be $800,000 and concludes that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will occur. Completion of the printing machine is highly susceptible to factors outside of Tang’s influence, mainly issues with the supply of components.

At 30 November 2015, Tang has satisfied 65% of its performance obligation on the basis of costs incurred to date and concludes that the variable consideration is still constrained in accordance with IFRS 15. However, on 4 December 2015, the contract is modified with the result that the fixed consideration and expected costs increase by $110,000 and $60,000 respectively. The time allowable for achieving the bonus is extended by six months with the result that Tang concludes that it is highly probable that the bonus will be achieved and that the contract still remains a single performance obligation. Tang has an accounting year end of 30 November. (6 marks)

Required:

Discuss how the above two contracts should be accounted for under IFRS 15. (In the case of (b)(i), the discussion should include the accounting treatment up to 30 November 2016 and in the case of (b)(ii), the accounting treatment up to 4 December 2015.)

Note: The mark allocation is shown against each of the items above.

Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)

Moonstar Co is a property development company which is planning to undertake a $200 million commercial property development. Moonstar Co has had some difficulties over the last few years, with some developments not generating the expected returns and the company has at times struggled to pay its finance costs. As a result Moonstar Co’s credit rating has been lowered, affecting the terms it can obtain for bank finance. Although Moonstar Co is listed on its local stock exchange, 75% of the share capital is held by members of the family who founded the company. The family members who are shareholders do not wish to subscribe for a rights issue and are unwilling to dilute their control over the company by authorising a new issue of equity shares. Moonstar Co’s board is therefore considering other methods of financing the development, which the directors believe will generate higher returns than other recent investments, as the country where Moonstar Co is based appears to be emerging from recession.

Securitisation proposals

One of the non-executive directors of Moonstar Co has proposed that it should raise funds by means of a securitisation process, transferring the rights to the rental income from the commercial property development to a special purpose vehicle. Her proposals assume that the leases will generate an income of 11% per annum to Moonstar Co over a ten-year period. She proposes that Moonstar Co should use 90% of the value of the investment for a collateralised loan obligation which should be structured as follows:

– 60% of the collateral value to support a tranche of A-rated floating rate loan notes offering investors LIBOR plus 150 basis points

– 15% of the collateral value to support a tranche of B-rated fixed rate loan notes offering investors 12%

– 15% of the collateral value to support a tranche of C-rated fixed rate loan notes offering investors 13%

– 10% of the collateral value to support a tranche as subordinated certificates, with the return being the excess of receipts over payments from the securitisation process

The non-executive director believes that there will be sufficient demand for all tranches of the loan notes from investors. Investors will expect that the income stream from the development to be low risk, as they will expect the property market to improve with the recession coming to an end and enough potential lessees to be attracted by the new development.

The non-executive director predicts that there would be annual costs of $200,000 in administering the loan. She acknowledges that there would be interest rate risks associated with the proposal, and proposes a fixed for variable interest rate swap on the A-rated floating rate notes, exchanging LIBOR for 9·5%.

However the finance director believes that the prediction of the income from the development that the non-executive director has made is over-optimistic. He believes that it is most likely that the total value of the rental income will be 5% lower than the non-executive director has forecast. He believes that there is some risk that the returns could be so low as to jeopardise the income for the C-rated fixed rate loan note holders.

Islamic finance

Moonstar Co’s chief executive has wondered whether Sukuk finance would be a better way of funding the development than the securitisation.

Moonstar Co’s chairman has pointed out that a major bank in the country where Moonstar Co is located has begun to offer a range of Islamic financial products. The chairman has suggested that a Mudaraba contract would be the most appropriate method of providing the funds required for the investment.

Required:

(a) Calculate the amounts in $ which each of the tranches can expect to receive from the securitisation arrangement proposed by the non-executive director and discuss how the variability in rental income affects the returns from the securitisation. (11 marks)

(b) Discuss the benefits and risks for Moonstar Co associated with the securitisation arrangement that the non-executive director has proposed. (6 marks)

(c) (i) Discuss the suitability of Sukuk finance to fund the investment, including an assessment of its appeal to potential investors. (4 marks)

(ii) Discuss whether a Mudaraba contract would be an appropriate method of financing the investment and discuss why the bank may have concerns about providing finance by this method. (4 marks)

You are an audit manager at Rockwell & Co, a firm of Chartered Certified Accountants. You are responsible for the audit of the Hopper Group, a listed audit client which supplies ingredients to the food and beverage industry worldwide.

The audit work for the year ended 30 June 2015 is nearly complete, and you are reviewing the draft audit report which has been prepared by the audit senior. During the year the Hopper Group purchased a new subsidiary company, Seurat Sweeteners Co, which has expertise in the research and design of sugar alternatives. The draft financial statements of the Hopper Group for the year ended 30 June 2015 recognise profit before tax of $495 million (2014 – $462 million) and total assets of $4,617 million (2014: $4,751 million). An extract from the draft audit report is shown below:

Basis of modified opinion (extract)

In their calculation of goodwill on the acquisition of the new subsidiary, the directors have failed to recognise consideration which is contingent upon meeting certain development targets. The directors believe that it is unlikely that these targets will be met by the subsidiary company and, therefore, have not recorded the contingent consideration in the cost of the acquisition. They have disclosed this contingent liability fully in the notes to the financial statements. We do not feel that the directors’ treatment of the contingent consideration is correct and, therefore, do not believe that the criteria of the relevant standard have been met. If this is the case, it would be appropriate to adjust the goodwill balance in the statement of financial position.

We believe that any required adjustment may materially affect the goodwill balance in the statement of financial position. Therefore, in our opinion, the financial statements do not give a true and fair view of the financial position of the Hopper Group and of the Hopper Group’s financial performance and cash flows for the year then ended in accordance with International Financial Reporting Standards.

Emphasis of Matter Paragraph

We draw attention to the note to the financial statements which describes the uncertainty relating to the contingent consideration described above. The note provides further information necessary to understand the potential implications of the contingency.

Required:

(a) Critically appraise the draft audit report of the Hopper Group for the year ended 30 June 2015, prepared by the audit senior.

Note: You are NOT required to re-draft the extracts from the audit report. (10 marks)

(b) The audit of the new subsidiary, Seurat Sweeteners Co, was performed by a different firm of auditors, Fish Associates. During your review of the communication from Fish Associates, you note that they were unable to obtain sufficient appropriate evidence with regard to the breakdown of research expenses. The total of research costs expensed by Seurat Sweeteners Co during the year was $1·2 million. Fish Associates has issued a qualified audit opinion on the financial statements of Seurat Sweeteners Co due to this inability to obtain sufficient appropriate evidence.

Required:

Comment on the actions which Rockwell & Co should take as the auditor of the Hopper Group, and the implications for the auditor’s report on the Hopper Group financial statements. (6 marks)

(c) Discuss the quality control procedures which should be carried out by Rockwell & Co prior to the audit report on the Hopper Group being issued. (4 marks)