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DIRECTORY
Contact the Lead Tutors: Isaac Phiri (FCCA,ACMA,MBA,AZICA) Gilbert Muyalwa (FCCA,MBA,FZICA) Handson Goma ( FCCA,MBA,FZICA)
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TECHNICAL ALL YOU NEED TO KNOW
Articles on key examinable topics to support your studies 30 CLARITY AUDITING STANDARDS
Relevant to ACCA Qualifcation Papers F8 and P7 PROJECT MANAGEMENT: BUSINESS CASES AND GATEWAYS
Relevant to ACCA Qualifcation Paper P3 GROUP AUDITING
Relevant to ACCA Qualifcation Paper P7
INTERPRETING BREAKEVEN AND PROFIT–VOLUME
AUDIT
CHARTS
AND INSOLVENCY
Relevant to CA CAT T Qualifcation Paper 10
Relevant to ACCA A CCA Qual Qualifca ifcatio tion n Papers P7 (UK) and (IRL) ONLINE RESOURCES
CAT Qualifcation: www CAT www.accaglobal.com/students/cat .accaglobal.com/students/cat ACCA Qualifcation: www www.accaglobal.com/students/acca .accaglobal.com/students/acca
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TECHNICAL
TECHNICAL ARTICLES 6 APRIL 2011 RELEV RELEVANT ANT TO ACCA A CCA AND CA CAT T QUALIFICA QUALIFI CATION TION STUDENTS CLARITY AUDITING ST STANDARDS ANDARDS RELEVANT TO ACCA QUALIFICATION PAPERS F8 AND P7 An overview of clarity auditing auditing standards, with a focus on the new ISA/HKSA 265 (Clarified), Communicating Deficiencies in Internal Control to those Charged with Governance and Management .
ACCESS RESOURCES RELEVANT TO ACCA QUALIFICATION Q UALIFICATION PAPER PAPER F8 www.accaglobal.com/students/acca/ exams/f8/ ACCESS RESOURCES RELEVANT TO ACCA QUALIFICATION Q UALIFICATION PAPER PAPER P7 www.accaglobal.com/students/acca/ exams/p7/
PROJECT MANAGEMENT MANAGEMENT:: BUSINESS CASES AND GATEWAYS RELEVANT TO ACCA QUALIFICATION PAPER P3 Ken Garrett looks at the need to carefully evaluate a project’s benefits and disbenefits from the outset, and the importance of regularl regularly y monitoring and re-evaluating its progress.
ACCESS RESOURCES RELEVANT TO ACCA QUALIFICATION QU ALIFICATION PAPER PAPER P3 www.accaglobal.com/students/acca/ exams/p3/
INTERPRETING BREAKEVEN AND AND PROFIT–VOLUME PROFIT–VO LUME CHARTS RELEVANT TO CAT QUALIFICATION PAPER 10
GROUP AUDITING RELEVANT TO ACCA QUALIFICATION PAPER P7
Charlotte Bower, examiner for CAT Paper 10, outlines the difference between breakeven and profit–volume charts, and discusses how to interpret the charts and what effects changes to a variable can have on the breakeven point.
This article reviews the most significant signific ant elements of group audits and changes to ISA 600 that were introduced as a result of the recent ‘clarity’ project. Future exams may focus on the audit of group financial financial statements, or on the requirements of the group auditor auditor to report to management on matters all around the group.
ACCESS RESOURCES RELEVANT TO ACCA QUALIFICATION QU ALIFICATION PAPER PAPER P7 www.accaglobal.com/students/acca/ exams/p7/
AUDIT AND INSOLVENCY RELEVANT TO ACCA QUALIFICATION PAPERS F7 (UK) AND (IRL) Lisa Weaver, examiner for Paper P7, highlights some of the issues that auditors may have to deal with in respect of insolvency insolvency..
ACCESS RESOURCES RELEVANT TO ACCA QUALIFICATION QU ALIFICATION PAPER PAPER P7 www.accaglobal.com/students/acca/ exams/p7/
ACCESS RESOURCES RE LEVANT TO CAT QUALIFICATION PAPER 10 www.accaglobal.com/students/cat/ exams/t10/
ACCA QUALIFICATION TECHNICAL ARTICLES PAPER F1 www.accaglobal.com/students/acca/ exams/f1/technical_articles/
PAPER F2 www.accaglobal.com/students/acca/ exams/f2/technical_articles/ PAPER F3 www.accaglobal.com/students/acca/ exams/f3/technical_articles/ PAPER F4 www.accaglobal.com/students/acca/ exams/f4/technical_articles/ PAPER F5 www.accaglobal.com/students/acca/ exams/f5/technical_articles/ PAPER F6 www.accaglobal.com/students/acca/ exams/f6/technical_articles/
STUDENT ACCOUNTANT ISSUE 07/2011
PAPER F7 www.accaglobal.com/students/acca/ exams/f7/technical_articles/ PAPER F8 www.accaglobal.com/students/acca/ exams/f8/technical_articles/ PAPER F9 www.accaglobal.com/students/acca/ exams/f9/technical_articles/ PAPER P1 www.accaglobal.com/students/acca/ exams/p1/technical_articles/ PAPER P2 www.accaglobal.com/students/acca/ exams/p2/technical_articles/ PAPER P3 www.accaglobal.com/students/acca/ exams/p3/technical_articles/ PAPER P4 www.accaglobal.com/students/acca/ exams/p4/technical_articles/ PAPER P5 www.accaglobal.com/students/acca/ exams/p5/technical_articles/ PAPER P6 www.accaglobal.com/students/acca/ exams/p6/technical_articles/ PAPER P7 www.accaglobal.com/students/acca/ exams/p7/technical_articles/
CAT QUALIFICATION TECHNICAL ARTICLES PAPER 1 www.accaglobal.com/students/cat/ exams/t1/tech_articles/
PAPER 2 www.accaglobal.com/students/cat/ exams/t2/tech_articles/ PAPER 3 www.accaglobal.com/students/cat/ exams/t3/tech_articles/ PAPER 4 www.accaglobal.com/students/cat/ exams/t4/tech_articles/ PAPER 5 www.accaglobal.com/students/cat/ exams/t5/tech_articles/ PAPER 6 www.accaglobal.com/students/cat/ exams/t6/tech_articles/ PAPER 7 www.accaglobal.com/students/cat/ exams/t7/tech_articles/ PAPER 8 www.accaglobal.com/students/cat/ exams/t8/tech_articles/ PAPER 9 www.accaglobal.com/students/cat/ exams/t9/tech_articles/ PAPER 10 www.accaglobal.com/students/cat/ exams/t10/tech_articles/
ACCA ONLINE STUDY RESOURCES www.accaglobal.com/students/
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CHANGES TO THE ACCA QUALIFICATION QUALIFICA TION FROM JUNE 2011
Read more at www. accaglobal.com/students/ student_accountant/ archive/2010/108/3333957 FOUNDATIONS IN ACCOUNTANCY
Learn more about ACCA’s suite of entry-level qualications – Foundations in Accountancy at www.accaglobal. com/a RESOURCES www.acca global.com/ students/acca
www.acca global.com/ students/ cat
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TECHNICAL
EXAM SUPPORT EXAMINERS’ APPROACH AND EXAMINERS’ ANALYSIS INTERVIEWS ACCA is committed to providing support to all its students. As part of this support, a range of materials – in a variety of media to reach as many students as possible – is available specifically to address the ACCA Qualification exams. Information from ACCA’s ACCA ’s examiners including examiner reports, examiner interviews and a wide variety of technical articles are available in a range of different media on the ACCA website. The two sets of examiner interviews interviews are available on www.accaglobal.com and are extremely valuable resources. Each set of inter views can help you prepare for your exams in different ways and, when used in conjunction with the paper resources available,, they can make a big available difference to your studies. EXAMINERS’ APPROACH INTERVIEWS
The examiners’ approach interviews are very useful when you are undertaking a particular paper for the first time, giving you a real insight into what examiners are looking for in terms of exam performance performance.. They cover the main themes themes of each paper and give information on the style of the exams and how how they are structured. They also advise on exam technique, with tips on how to succeed and potential pitfalls to avoid. The examiners’ approach interviews complement the examiners’ approach articles, which were written to give guidance on how to tackle each exam paper. These resources contain similar information but the difference in delivery method can be a useful advantage when studying and may give you a better chance chance of absorbing the examiners’ advice. The examiners’
ACCA IS COMMITTED TO PROVIDING SUPPORT TO ALL ITS ITS STUDENTS. EXA MINER REPOR TS, EXAMINER INTERVIEWS, EXAM NOTES (WHICH PROVIDE GUIDANCE ON EXAMINABLE MA MATERIAL TERIAL INCLUDING RELEVANT ACCOUNTING AND AUDITING DOCUMENTS FOR PAPERS F3, F7 AND P2) AND A WIDE VARIETY OF TECHNICAL ARTICLES ARE AVAILABLE IN A RANGE OF DIFFERENT MEDIA ON THE ACCA WEBSITE AT WWW.ACCAGLOBAL.COM/STUDENTS/ACCA/EXAMS approach interviews also contain useful links to other relevant resources for your exam. EXAMINERS’ ANALYSIS INTERVIEWS
The examiners’ analysis interviews build on the examiners’ approach interviews. They highlight where students are performing well, where students are performing less well, and give advice on how students can improve performance in problem areas. It’s never never too soon to start listening to the examiners’ analysis interviews, but they would probably be most useful once you have covered the syllabus and are starting to think about the detail of a paper and how to apply what you have learned in the exam. They are designed to give guidance around which areas areas of the syllabus students have been struggling with in recent exam sittings and how students can tackle the difficulties others have been having. The analysis interviews are closely related to the examiners’ reports, which are published after each exam session. They bring together the examiners’ reports from the first three sessions
of the ACCA Qualification, Qualification, illustrating that some mistakes are being repeated consistently and highlighting critical areas of the syllabus to focus focus on. Remember, this does not mean one of those areas will necessarily necessarily be examinable in the next session. The ACCA website will soon feature new examiner interviews recently recorded at this year’s Learning Providers’ Conference – look out for details in upcoming issues of Student Accountant . It is still very important to make use of the individual examiners’ examiners’ reports available in Student Accountant and Accountant and on the ACCA website, as well as listening to the analysis interviews. After you have worked through a practice question, refer to the relevant examiner’s report and you will find an analysis analysis of that question, what the examiner is looking for in a good answer, typical answers given by students, why they might not be relevant and so on. All of these resources resources and others such as the Syllabus and Study Guide,, past papers, examinable Guide documents and technical articles can be accessed at www.accaglobal.com/ students/acca/exams/
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TECHNICAL
EXAMINABLE DOCUMENTS RELEVANT TO THE JUNE 2011 SESSION CAT QUALIFICATION Paper 3 www.accaglobal.com/students/cat/ exams/t3/examinable_documents Paper 6 www.accaglobal.com/students/cat/ exams/t6/examinable_documents Paper 8 www.accaglobal.com/students/cat/ exams/t8/examinable_documents Paper 9 www.accaglobal.com/students/cat/ exams/t9/exam_docs
ACCA QUALIFICATION Corporate and Business Law Paper F4 www.accaglobal.com/students/acca/ exams/f4/docs
Financial reporting Paper F3 (International) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/f3int_ examdoc2011.pdf Paper F3 (UK) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/f3uk_ examdoc2011.pdf Paper F7 and P2 (INT and UK) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/f7p2int_ examdocs2011.pdf Paper F7 and P2 (Hong Kong) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/f3f7p2hkg_ examdoc2011.pdf Paper F7 and P2 (Malaysia) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/mys2011_ examdoc.pdf Paper F7 and P2 (Singapore) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/sgp2011_ examdoc.pdf CBE (International) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/cbe_ J08examdocs.pdf CBE (UK) www.accaglobal.com/pubs/students/ acca/exams/f3/examinable/f3uk_ J08examdocs.pdf
Tax Papers F6 www.accaglobal.com/students/acca/ exams/f6/exam_docs/ Paper P6 www.accaglobal.com/students/acca/ exams/p6/exam_docs
Audit Papers F8 and P7 (Hong Kong) www.accaglobal.com/pubs/students/ acca/exams/f8/examinable/ examnotesHKG2011.pdf Papers F8 and P7 (INT and UK) www.accaglobal.com/pubs/students/ acca/exams/f8/examinable/ IntUK2011examnotes.pdf Papers F8 and P7 (Malaysia) www.accaglobal.com/pubs/students/ acca/exams/f8/examinable/f8p7mys_ examnotes.pdf Papers F8 and P7 (Singapore) www.accaglobal.com/pubs/students/ acca/exams/f8/examinable/f8p7_ sgpexamdocs.pdf Guidance Notes for Irish Stream students www.accaglobal.com/pubs/students/ acca/exams/f4/docs/irish_notes.pdf Examinability of the Clarity Auditing Standards www.accaglobal.com/pubs/students/ acca/exams/f8/examinable/clarity_ audit_standards.pdf
RELEVANT TO ACCA QUALIFICATION PAPERS F8 AND P7
Clarity auditing standards To enhance the application of auditing standards in exam questions, candidates must familiarise themselves with the clarity auditing standards. The International Auditing and Assurance Standards Board (IAASB) has completed its comprehensive project to enhance the clarity of all of its International Standards on Auditing (ISAs) in 2009 for improving understandability of auditing standards, and all the new clarity auditing standards are now examinable. This also affects the Hong Kong Standards on Auditing (HKSAs). The full set of clarity auditing standards features 39 documents, which include: a new International/Hong Kong Standard on Auditing on communicating deficiencies in internal control – ISA/HKSA 265 (Clarified), Communicating Deficiencies in Internal Control to those Charged with Governance and Management 35 clarity ISAs/HKSAs a clarified international/Hong Kong standard on quality control – ISQC 1/ HKSQC 1, Quality Controls for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance and Related Services Engagements a revised glossary of terms a revised preface to the International/Hong Kong Standards on Quality Control, Auditing, Review, Other Assurance and Related Services.
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ISA/HKSA 265 (Clarified), Communicating Deficiencies in Internal Control to those Charged with Governance and Management Among the clarified auditing standards, ISA/HKSA 265 (Clarified) is a completely new standard. It deals with the auditor’s responsibility to communicate appropriately to those charged with governance and management deficiencies in internal control that the auditor has identified in an audit of financial statements. When auditors plan for an audit, they are required to perform risk assessment through understanding internal controls, and also test for the appropriateness of design of internal controls and whether they are implemented. When control reliance strategy is adopted, auditors are required to perform tests of controls to gather audit evidence on the operating effectiveness of controls. During both processes, auditors might identify deficiencies in internal controls. In accordance with ISA/HKSA 265 (Clarified), ‘deficiency’ exists when ‘a control is designed, implemented or operated in such a way that it is unable to prevent, or detect and correct, misstatements in financial statements on a timely basis; or a control necessary to prevent, or detect and correct misstatements in the financial statements on a timely basis is missing’. It is equivalent to a deviation from an internal control. © 2011 ACCA
2 CLARIFIED AUDITING STANDARDS APRIL 2011
It is common in practice and in exam questions to identify and explain deficiencies in internal control systems. An example is Question 3(b) of Paper F8 in the June 2010 exam session. Candidates were required to identify and explain deficiencies in the cash cycle of a window cleaning company, suggest controls to address each of these deficiencies, and list tests of controls the auditor would perform to assess if the controls were operating effectively. If the deficiency is significant, it is known as ‘significant deficiency’. It is ‘a deficiency or combination of deficiencies in internal control that, in the auditor’s professional judgment, is of sufficient importance to merit the attention of those charged with governance’. It depends not only on whether a misstatement has actually occurred, but also on the likelihood that a misstatement could occur and the potential magnitude of the misstatement. Significant deficiencies may therefore exist even though the auditor has not identified misstatements during the audit. Consideration points should include: the likelihood of the deficiencies leading to material misstatements in the financial statements in the future the susceptibility to loss or fraud of the related asset or liability the subjectivity and complexity of determining estimated amounts, such as fair value accounting estimates the financial statement amounts exposed to the deficiencies the volume of activity that has occurred or could occur in the account balance or class of transactions exposed to the deficiency or deficiencies the importance of the controls to the financial reporting process the cause and frequency of the exceptions detected as a result of the deficiencies in the controls the interaction of the deficiency with other deficiencies in internal control.
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When you found the following indicators in real practice or exam questions, this would indicate significant deficiencies. These include: evidence of ineffective aspects of the control environment, such as management fraud not mitigated by internal controls, not sufficient oversight of significant management interests by those charged with governance, and no implementation of remedial actions against significant deficiencies communicated absence or inefficiency of a risk assessment process evidence of ineffective responses to identified significant risks misstatements detected by the auditor’s procedures, which were not prevented, detected and corrected by the internal controls restatement of previously issued financial statements to reflect the correction of a material misstatement due to error or fraud evidence of management’s inability to oversee the preparation of the financial statements.
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In response to significant deficiencies in internal control identified during the audit, the auditor will communicate in writing the significant deficiencies to those charged with governance on a timely basis. For the communication, this would include a description of the deficiencies, an explanation of their potential effects, and sufficient information to enable those charged with governance and management to understand the context of the communication. In terms of the sufficiency of the details of communication, the consideration factors include: the nature of the entity – more details for public interest entities than non-public interest entities the size and complexity of the entity – more details for larger and more complex entities the nature of significant deficiencies that the auditor has identified – more details for those involving integrity of management and fraud the entity’s governance composition – more details for inexperienced governance members legal or regulatory requirements regarding the communication of specific types of deficiency in internal control •
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Evaluation of misstatements As well as deficiencies in internal controls, misstatements may also be detected during an audit. ISA/HKSA 450 (Clarified), Evaluation of Misstatements Identified During the Audit is actually a new separate standard as well. This highlights the importance of focusing on the deficiencies/misstatements during the audit, which is a common consideration for a risk-based approach. ISA/HKSA 450 (Clarified) deals with the auditor’s responsibility to evaluate the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements. ‘Misstatement’ is defined as ‘a difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatement can arise from error or fraud.’ This also relates to those that require adjustments for issuing a true and fair view on the financial statements. For these kind of identified misstatements, the auditor should determine whether the nature and the circumstances of their occurrence indicate the existence of other misstatements, which could be material individually or in aggregate. These misstatements should be communicated to the appropriate level of management on a timely basis. The auditor should also consider whether there is a need to revise the audit strategy and audit plan – especially when those areas are confirmed to have appropriate design, implementation and effective operation of controls, now there are identified misstatements. Does the initial conclusion need to be
© 2011 ACCA
4 CLARIFIED AUDITING STANDARDS APRIL 2011
reconsidered? This would definitely affect the risk assessment, audit strategy and audit plan. ‘Uncorrected misstatements’ are the ‘misstatements that the auditor has accumulated during the audit that have not been corrected’. Before evaluating the effect of the uncorrected misstatements, the auditor should confirm whether the materiality still remains appropriate. Afterwards, the auditor will determine the uncorrected misstatements are material individually or in aggregate. The auditor will consider: the size and nature of the misstatements, and the particular circumstances of the occurrence the effect of uncorrected misstatements related to the prior periods. •
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The auditor will communicate the uncorrected misstatements and their implication on the auditor’s report to those charged with governance. The auditor will also request a written representation (including a summary of uncorrected misstatements) from management and – where appropriate – those charged with governance as to whether they believe the effects of uncorrected misstatements are immaterial, individually and in aggregate to the financial statements as a whole. Conclusion To summarise, candidates need to update their auditing knowledge, understand them and apply them in the exam questions. As stated by the Paper P7 examiner: ‘A significant proportion of candidates continue to produce answers that are simply too vague or too brief, do not actually answer the question requirements, and display inadequate technical knowledge of the clarified ISAs (HKSAs). These candidates are encouraged to improve their exam technique, as well as knowledge of the syllabus, by practising as many past exam questions as possible, using up-to-date study materials, and by taking on board the comments made in examiner’s articles and reports.’ Allan Lee FCCA is director of Allan Lee Professional Solutions Ltd and cochairman of ACCA of ACCA Hong Kong ’s ’s Student Affairs Subcommittee This article was originally written for ACCA for ACCA Hong Kong Student News Update magazine, Winter 2010 issue but is still relevant for all auditing students.
© 2011 ACCA
RELEVANT TO ACCA QUALIFICATION PAPER P3
Project management: business cases and gateways It can be assumed that whenever an organisation embarks on a project to improve its performance and results, the project is expected to bring benefits to that organisation. This statement might seem self-evident, but it requires care to ensure that all the effects of a project (both benefits and disbenefits) are evaluated in advance as carefully as possible, and that the project is closely monitored and re-evaluated throughout its progress. Furthermore, it is vital to ensure that benefits are realised. For example, a new IT system could be implemented on time and within cost budget, but if staff, customers or suppliers resist making use of new facilities offered, then no benefits will be realised from the project. The challenges will be dealt with under the following headings: 1. Constructing a business case 2. Carrying out the project, keeping it under constant review 3. Reviewing the results
CONSTRUCTING A BUSINESS CASE At its simplest, this could simply mean showing that a proposed project has a positive net present value (‘NPV’). Indeed, when you are carrying out an NPV calculation you are often presented with the cash flows expected to arise from a ‘project’. However, applying discount factors to a set of cash flows is by far the easiest part of any NPV calculation. The real skill is to be found in assessing what the cash flows are likely to be. It is here, for example, that predictions need to be made about changes in market share, revenue, and competitor reactions. Constructing a business case, therefore, needs to be broken down into a series of steps: Identification of the organisation’s drivers and where improvement is required. Identification of the organisation’s stakeholders and how they are affected. Identification and classification of benefits and disbenefits. Planning of benefits realisation. •
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Identification of the organisation’s drivers and where improvement is required An organisation’s drivers should relate back to its mission and its stakeholders’ perception of the organisation’s purpose. A profit-seeking organisation will ultimately be interested in increasing shareholder wealth and any project undertaken should, at least in the long term, lead towards that. Not-for-profit organisations are more complex, but in a school, for example, you would expect children’s educational standards to be important, and in a hospital you would expect patient care and effective treatment to be part of its purpose.
© 2011 ACCA
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Complacent management might never see any need for improvement in organisations, but that approach is usually the road to ruin. Both internal and external changes will mean that management must continually respond to events so that improvement and benefits are constantly sought. This is simply the process of strategic appraisal and the tools and frameworks should be familiar. They include: PESTEL – looking at changes in the macro-environment. For example, a new government might establish strict requirements for hospitals to measure their success in diagnosing and curing certain diseases. This political driver could mean that the hospital has to respond with a project that involves buying new equipment and setting up new clinics. Porter’s five forces – looking at the activities of competitors, customers, new entrants, suppliers and the emergence of substitutes. For example, a new, powerful, low-cost competitor could be eyeing up the market. In response, the company might consider embarking on a project to allow it to personalise its production so that it can offer differentiation as a way of combating the increased competition. Resources and competences. For example, if the company’s research and development efforts have been disappointing then if might consider taking over a successful smaller competitor in order to buy in know-how and patent rights. Taking over that competitor might be defined as a project. The value chain. For example, if customers’ tastes change and what was previously valued is no longer appreciated, then the company will have to establish a project to find and implement new ways of adding value. •
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Of course, all of the results from these frameworks can be summarised in a SWOT analysis. It can also be useful to classify potential improvements as arising from: doing new things – for example, expanding into new overseas markets doing existing things better – for example, generating market growth stop doing things – for example, closing down part of the company’s operations. • • •
Identification of the organisation’s stakeholders and how they are affected It is important that this step is carried out early in a project’s life. It was stated above that projects should be undertaken if they are expected to bring benefits to the organisation. However, that is a considerable simplification because it regards the organisation and its purposes as consisting of a set of homogeneous interests. In reality, many stakeholders are involved and their requirements and preferences are likely to be diverse. Any given project is likely to have implications that benefit some stakeholders, do not affect others, and which bring disbenefits to the remainder. For example, if a bank is considering closing its branch network and operating only over the internet, then its premises costs will decrease (a benefit), but customers might be alienated (a disbenefit). The hospital example mentioned above could mean that resources are switched from one group of patients to another as a result of political pressure.
© 2011 ACCA
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Organisations cannot always choose simply to enjoy the benefits of any change while disregarding disbenefits; benefits and disbenefits usually come as a package. So, when it comes to identifying and classifying benefits and disbenefits (see below), it is important that organisations carefully identify all affected stakeholders so that they will have a greater chance of evaluating all the potential effects of a project. They must also assess the power and influence of the stakeholders because powerful, motivated, disgruntled stakeholders can cause projects to fail.
Identification and classification of benefits and disbenefits Ward and Daniel1 classify benefits as observable, measurable, quantifiable and financial. Rather than regarding these as discrete differences, they might be better presented as a continuum as the distinctions between them are not always definite: •
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Observable benefits Observable benefits are those that cannot be objectively measured and their assessment depends on the views of appropriately experienced observers. These benefits relate mainly to matters such as customer satisfaction, staff morale, ethical standing and empathy with patients. They are of relatively little use in initial project justification because they are so difficult to communicate with any accuracy, but undoubtedly they can be recognised after projects have been completed. Almost inevitably, efforts are made to try to measure these ‘soft’ benefits because then they become easier to deal with and less reliance needs to be invested in the opinions of the observing experts. It is important to realise that many observable effects are also likely to be unexpected effects. The very fact that they are unexpected means that no attempt will have been made to measure them; only after the project has been completed do they become obvious. This does not mean that effects that are merely observable or unexpected are unimportant. Some of the most significant benefits and disbenefits are those that surprise everyone dealing with the project. An example can be seen in a new intranet and group working software being implemented in a firm of accountants. The expected benefit might be faster communication, but an unexpected benefit might be the ability to shift routine work to less expensive staff situated in cheaper areas of the country.
Measurable benefits This term has a very precise meaning: the benefit can be measured objectively, but it is not possible to predict how a project will change it in advance. By definition, these benefits are not going to be very useful when constructing a business case for a project. However, retrospectively, it will be extremely interesting to see how various measures have moved and these effects will be important in postimplementation reviews.
© 2011 ACCA
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Quantifiable benefits Here, the extent of the benefits or improvements can be forecast. It is only once benefits have become quantifiable that there is any hope of progressing to financial measurement and the construction of a sound economic business case for the project. There are several challenges: Ensuring that all quantifiable benefits and costs are captured. If an important factor is omitted, then the analysis will be distorted. Establishing a starting point – a baseline against which changes can be compared. This requires measurement techniques to be established. Predicting the changes that the project will cause – turning measurable changes into quantifiable changes.
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Ward and Daniel offer suggestions for transforming measurable to quantifiable: Pilot operations. For example, implement a new inventory system in one branch and carefully monitor results. Extrapolate changes company-wide. External benchmarking. Monitor what other industry members are achieving using their approaches. If possible, monitor the best-in-class performance. If a rival performs better and uses a particular approach to business, then there might be evidence there about how our performance would change. Reference sites. External benchmarking is not available for changes that are relatively new to an entire industry because there are few comparisons available. However, unless a company is absolutely the first, often reference sites will exist where suppliers have persuaded another organisation to be an early adopter of new technology or methods. Some care is needed here as, obviously, suppliers will not readily provide information about their failures. Modelling and simulation. For example, if an organisation has a sophisticated financial model on a spreadsheet, then different assumptions can be introduced and the results quickly seen. Call centres keep very careful records of queuing times and the number of callers who hang-up before being attended to. They can extrapolate with some confidence the effect of reducing waiting times. Historical internal data. This is particularly relevant to organisations thinking about stopping an activity. It is important that their cost data is accurate so that the true implications of ceasing an activity are properly quantified. Activitybased costing is almost certainly more relevant than the conventional treatment of fixed overheads.
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Financial benefits Once changes have been quantified, it should be a reasonably easy step to convert those to financial effects. It is important that this is done – at least for profit-seeking organisations – and that the calculations are not distorted to ensure that a project is improperly justified. Typically, net present value or return on capital calculations will be used to evaluate the financial effects. Sensitivity analysis will be an essential part of the exercise to identify risk areas and plan for more investigative work to be done there. Planning of benefits realisation Planning of benefits realisation means: © 2011 ACCA
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assigning dates by which defined benefits should be enjoyed detailing the implementation and change management procedures needed to ensure that the expected benefits are actually achieved as fully as possible establishing dates and methodologies for measurement of the benefits for subsequent comparison to plans.
Note that the opportunities for benefit creation will start with completing the various parts of a project (its activities) on time, within budget, to the correct quality standards, and focused accurately on previously agreed outcomes. However, although each part of a project can be properly delivered, the project as a whole can fail to produce benefits unless it is whole-heartedly embraced by key stakeholders. For example, a technically excellent new website could be implemented, but if customers choose not to use it then few benefits will arise.
CARRYING OUT THE PROJECT, KEEPING IT UNDER CONSTANT REVIEW The Office of Government Commerce (OGC) is an independent office of the UK Treasury, established to help government deliver best value from its spending. The OGC has developed the OGC GatewayTM Process in which projects are examined at various key decision points before they are allowed to progress to the next stage. This UK-based example is indicative of a formal system of project implementation and review where evaluation takes place at several gateway points to ensure that the original business case, the project objectives and expected benefits continue to be achieved. The OGC GatewayTM Process can be represented as follows: Stages of the project Develop business case
Develop delivery strategy
OGC GatewayTM reviews Review 0: 0: continuous, throughout project Review 1: 1: examine the Ensure the project is still business justification relevant to the overall strategy of the organisation Review 2: examine the Ensure that the programme is suggested delivery supported by key stakeholders strategy
Carry out competitive procurement Review 3: 3: investment decision Design, build, test Review 4: 4: verify readiness for implementation Implement Review 5: operational review and benefits realisation Ongoing management of delivered solution
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Review the arrangements for managing and monitoring the project Review the arrangements for identifying and managing the main risks, including risks such as changing business priorities Check that provision for sufficient financial and other resources has been made for the project
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After the project business case is established, Gateway’s review 1 would be carried out to examine the justifications and arguments presented. The reviewing board will be looking for benefits and disbenefits that might have been overlooked or assumptions that appear to be unrealistic. If all is well, the project will go forward to the next stage in which a detailed delivery strategy is worked out. The ‘Who? How? When? What?’ questions are addressed here. For example: Who will be on the project team? How much will be subcontracted? What exactly will be delivered and by when? • • •
Review 2 will look critically at these decisions and objectives. Only when the reviewing board is satisfied that the project is sufficiently well-defined and specified will it give the go-ahead to receive tenders from outside suppliers. After the competitive tenders have been received, the next stage will be signing a supply contract and committing the organisation to substantial expenditure. Before that is done, Review 3 will look at the tenders received, their costs, the standing and competence of the suppliers and whether – now that costs are known more accurately – the project still offers value for money (net benefits). Assuming the supply contract is signed, then investment in the project will start. It could be an IT project requiring software design, writing and testing; it could be a project to reorganise the structure and reporting lines of the company; it could be a project to merge with a rival organisation. However, before action is taken and the software or plans are implemented, it is important to review what is proposed. There is no point in trying to implement proposals that are not-tested, incomplete or poorly designed. So Review 4 will look at the project plans and see if they are sufficiently robust and comprehensive to attempt to implement. It will also be necessary to ensure that the organisation is ready for implementation of the plans. Review 5 then looks at the results that the project is delivering. Have the expected benefits materialised? If not, then why not? Can shortfalls in benefits or unexpected disbenefits be corrected? Review 5 could be carried out several times as the new solution gradually settles down and management problems are ironed out. Note carefully the purpose of Review 0. This should be carried on continuously throughout the project and is there to keep questioning whether the original business case on which the project was predicated remains valid. No matter how meticulously a project is managed, changing events can suddenly undermine a business case. For example, a project to build a new factory can suddenly look uneconomic if the economy suffers a sharp fall. Or, further investment in a project might be pointless if its completion seems to be in jeopardy because funds have become very tight.
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REVIEWING THE RESULTS After a project has been implemented, there are three types of review that should be performed, reflecting different perspectives. A post-project review. This examines how the project went in terms of how the project team and how the project manager performed and identifying what aspects of planning and review went well and what didn’t go so well. Was the project completed within time and budget? The focus here is on the project. Lessons learnt are fed back into the project management system. For example, if the project estimation was poor, then better methods of estimation might be integrated into the project management process to help ensure that future estimates are more accurate. A post-implementation review. This is essentially the Gateway review 5 and it examines what the project achieved (its product or outcome) and should compare the post-implementation observations and measurements with the hoped-for benefits that were the basis of the original business case. As part of this review, it will be important to gather information from key stakeholders. The initial focus here is on the product or outcome produced by the project. Does it meet its objectives? Lessons learnt are fed back into the product production process – for example, in the development of a website, technical mistakes might be fed back into the software development process to help ensure that they do not happen again in the future. Benefits realisation is a type of post-implementation review. It focuses on the realisation of the anticipated business benefits. As mentioned before, it could be performed several times, reflecting the expected benefits timing defined in the formal investment appraisal. A product might be successfully delivered (for example, a new website or the merger of two organisations); however, the anticipated business benefits may not be delivered. Lessons learnt in benefits realisation are fed back into the benefits management process. For example, this could lead to better ways of classifying benefits. It is important to recognise that an appropriate product might be delivered (a website), but the anticipated business benefits may never accrue. The reasons for this have to be investigated and understood. Perhaps the initial business case was over-optimistic or perhaps external business factors have changed that prevent the business benefits from being delivered. •
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Without these reviews, an organisation will be condemned to repeating any mistakes it may have made and will be unable to make use of any lessons learned.
Ken Garrett is a freelance author and lecturer Reference 1 Benefits Management: Delivering Value from IS and IT Investments , John Ward and Elizabeth Daniel, Wiley, 2006.
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RELEVANT TO ACCA QUALIFICATION PAPER P7
Group auditing In March 2008, Lisa Weaver, examiner for Paper P7, wrote an article about auditing groups and joint audits. This article is a reminder of some of the most significant elements of group audits, which feature frequently in the Paper P7 exam. The significant changes to ISA 600, Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) that were introduced as a result of the recent Clarity project are likely to make group auditing even more examinable. Exam questions may focus on the audit of group financial statements, or on the requirements of the group auditor to report to management on matters all around the group. Similarities within the ISA 600 series of auditing standards Group auditing often necessitates that the group auditor places considerable reliance on other audit firms. However, ISA 600 doesn’t allow the group auditor to wholly outsource responsibility for parts of the audit to another auditor. To begin at the beginning: acceptance of the assignment ISA 600 requires the group engagement partner each year formally to assess whether it is appropriate to act as group auditor. If at any point the group engagement partner concludes that they lack the professional skills necessary to form a group audit opinion, they should resign. ISA 600 requires that the group engagement partner resign immediately if there is any significant restriction placed by the parent company management on information made available from within the group (or disclaim opinion if resignation is not legally possible). ISA 600 (revised and redrafted) extends this responsibility to require that the auditor relying on the third party’s work has obtained their own understanding of the specialist area in question, or business of each subsidiary or associate (referred to as ‘components’ in ISA 600, with that company’s auditor referred to as the ‘component auditor’). The group auditor must form their own concurring opinion on any judgmental areas. This does not require having the same depth of knowledge as the expert/other auditor, but they would need to be able to review the third party’s files and have sufficient independent knowledge to understand the work done, the reason for the work and the conclusions from that evidence. Group audit opinion The parent company of a group will normally publish its financial statements as an individual company and the group financial statements in the same document, so, the audit opinion will normally be expressed on ‘the financial statements of the company and of the group as at...’ Although presented as one opinion, it logically contains two separate opinions; one on the entity © 2011 ACCA
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financial statements of the parent itself and another on the financial statements of the group. ISA prohibits the group auditor from making any reference to the work of any other experts or auditors, as doing so would diminish the credibility of the audit opinion and allow the group auditor to ‘pass the buck’ for responsibility for part of the audit. You should be prepared to explain this point in the exam. This is an example of where ISA differs from US audit standards, where reference to other auditors conducting some of the work on components is permissible. Planning work required Groups often have a number of subsidiaries that are either dormant or immaterial. At a minimum, the group engagement team must develop an understanding of each component of the group and review the financial statements of each subsidiary. Where a component is judged to be material or a significant contributor of inherent risk at the group level, further work will be required to be satisfied that the financial statements of each component, in order to be satisfied that the component is unlikely to introduce errors that could be material at the group level. This work might include: discussing with the component auditor, and/or the management of the component, the business activities that are significant to the group reviewing the more significant parts of the component auditor’s working papers discussing with the component auditor the susceptibility of the company’s financial statements to material error or deliberate misstatement reviewing the component auditor’s documentation of identified significant risks, and the conclusions reached on these risks observing final clearance meetings between the component auditor and the management of the company. •
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The group auditor as the repository of information The group engagement team’s role brings information flowing to them that is useful to disseminate around the group. This includes materiality (see below) and matters such as related party relationships, which may be unknown at the component level, because two subsidiaries may be unaware of each other’s existence. The group auditor asks each component auditor for known related party relationships and then communicates a collated list of all related party relationships to each component auditor. Materiality At the planning stage, the group engagement partner must determine several figures for materiality for each component part of the group (ISA 600:21).
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Financial statements materiality Materiality for the consolidation package as a whole Level of reduced materiality for sensitive figures Performance materiality
Each component Component auditor
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Performance materiality is the figure below that any errors in the financial statements may be considered trivial. The component auditor will be required to communicate to the group auditor a summary of all unadjusted errors in the consolidation package. It is common in larger group audits for the financial statements to be prepared using a consolidation package of information that is sent to the parent company by each component company. This will omit many of the disclosures that will be in the eventual entity financial statements. The component auditor may, therefore, be required to issue a special audit opinion on the truth and fairness of the consolidation package. This opinion is likely to be addressed to the directors of the component company, or may be addressed to the group auditor directly. In order to minimise the risk of several accidental or deliberate errors in the financial statements together exceeding group materiality, component materiality figures will normally be significantly lower than the group materiality figure, even for the largest component companies. Example 1 Imagine that financial statements materiality is taken to be 10% of profit or loss for each entity within a group and performance materiality is set at 0.5% of profit. Imagine that a group has a parent company and two components, one of which is profit making and one of which is loss making: $’000s Parent Subsidiary 1 Subsidiary 2 Group Profit 2,000 12,000 (8,000) 6,000 Component 200 1,200 800 600 materiality materiality @ 10% Performance 10 60 40 30 materiality @ 0.5% If subsidiary 1 were audited by another firm using the same materiality calculation method as the parent, an unadjusted error of $10m would correctly result in issuance of an unmodified audit opinion on the financial statements of
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that individual company. However, the effect of losses elsewhere in the group would mean that although this error would not be material at the component level, it would be material at the group level. Since it is only likely to be the parent auditor who has this overview of the group, the group engagement team must communicate materiality figures to component auditors in advance of audit work commencing. In this example, the maximum component materiality figure that the group auditor could communicate to the component auditors would be 600, but it would be wise to select a lower figure than this, in order to reduce to a tolerable level the risk of errors in both component companies together exceeding 600. In the exam, if you are given extracts from draft financial statements, it’s often a good start to recommend and briefly explain a figure for materiality. Communication between auditors ISA 600 in its revised form contains extensive new requirements on the communication between parent and component auditor. In addition to practical matters such as materiality, the required format of the consolidation package, deadlines and contact details, the group auditor must communicate a number of matters at the planning to the component auditor, including: related party relationships known anywhere around the group identified significant risks, whether due to error or fraud methodology to be used for impairment testing of goodwill. Audit of estimates is subjective and so it’s essential that the group auditor’s preferred method is used throughout the group. Be prepared to explain this in Paper P7. • • •
Matters that the component auditor must communicate to the group auditor will include: any known related party relationships and related party transactions any indications of management bias any significant risks to the truth and fairness of the component financial statements, work done on these risks and the conclusions reached all intra-group transactions, period end balances and allowances for unrealised profit any observed non-trivial failure to observe relevant laws and regulations all observed control weaknesses, flagging significant weaknesses separately any known events after the reporting date. • • •
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Audit of the consolidation process Once the group engagement partner is satisfied that the individual financial statements within the group are free from material misstatement, attention can now shift to audit of the consolidation process.
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The good news for exam purposes is that this stage of the audit is very similar regardless of the specific company, so good marks can be obtained largely by memorising the risks and responses below. Principal risks arising in the consolidation process include errors or omissions arising during: transcription of figures from individual financial statements to consolidation workings classification of components (eg associate, subsidiary) cancellation of intra-group trading, cancellation of intra-group balances and allowance for unrealised profit on intra-group transfers recognition of impairment of purchased positive goodwill determination of fair values being used on acquisition arithmetical inaccuracy in the consolidation process identification and disclosure of related party relationships and transactions foreign currency translation from functional currency of components to reporting currency of the group. •
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The most reliable evidence on completeness and accuracy of consolidation adjustments in a large group is likely to be determining whether the client’s accounting systems adequately flags transactions with fellow group companies. The process is still likely to be highly substantive in nature and will probably include these tests of detail: line-by-line agreement of all items from audited component financial statements (or consolidation packages submitted to head office) to the consolidation schedules detailed discussion with management on the reason for classification of each component sample testing of known intra-group transactions to ensure that they have been eliminated in the client’s consolidation recalculation of all significant workings, such as goodwill, non-controlling interests and foreign currency translation. •
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Final review of financial statements The group audit opinion may be signed on some date on or after the audit opinions on material components are signed. Once the component auditor has issued their opinion, their responsibility for reporting on the impact on events after the reporting date is greatly diminished, yet there may be material events that could be material in the group financial statements. The group engagement team will normally agree in advance with the auditor of significant components that an update on events is given by the component auditor to the group engagement partner immediately before the group audit opinion is signed. It is the responsibility of the group engagement team to ensure that material events are reported.
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Reporting to management and the board In addition to the usual requirements for reporting to those charged with governance (the ‘management letter’), ISA 600:49 requires the group engagement partner also to report to management on any concerns that they had about possible fraud anywhere in the group, any restrictions on information made available by component management and any concerns that they had about the quality of work performed by any component auditor. In addition to the audit report to shareholders, the group auditor is required by ISA 600 to report on a group-wide basis to group management and separately to those charged with governance at a group level, such as the audit committee of the board. This split communication echoes the requirements of ISA 260 Communication with Those Charged with Governance to produce different letters to different levels of management. The report to management will include details of all observed instances of non-trivial fraud and all non-trivial deficiencies in internal controls around the group. The report to those charged with governance, most probably the audit committee, will include: an overview of the audit approach insofar as it affects component auditors any doubts that the group auditor may have about the quality of work performed by the component auditor, giving the group auditor a potentially awkward need to publicly question the skills of a fellow professional. any limitations on audit scope anywhere within the group any suspected fraud where management is suspected of involvement. •
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Summary ISA 600 represents a significant extension of the responsibilities of both group auditor and component auditor compared with the previous ISA. It is likely to be a controversial standard in practice, and it is therefore likely to be in many Paper P7 exams. Understanding and memorising the key points of the standard is a very good use of study time when preparing for the Paper P7 exam. Graham Fairclough is group technical director at the ExP Group
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RELEVANT TO ACCA QUALIFICATION PAPER P7 (UK) AND (IRL)
Audit and insolvency From June 2011, the syllabus for Paper P7 (UK) and (IRL) includes specific learning outcomes relevant to auditing aspects of insolvency (syllabus reference E7). This topic has been added to the syllabus on the recommendation of the Financial Reporting Council’s Professional Oversight Board in order to comply with the requirements of the Statutory Audit Directive, as the topic is considered required knowledge for those wishing to obtain the audit qualification and practice as an auditor. Why should auditors need to understand aspects of insolvency? The simple answer is that, unfortunately, many auditors’ clients will face financial distress at some point in their business lifecycle. The global economic recession of the past few years has caused many companies to face insolvency, and in times of crisis the directors of such companies may turn to their auditor for information and advice. Therefore, auditors must be in a position to determine the level of financial difficulty being faced by a client, explain and recommend the various options available to management, and explain the consequences of liquidation or administration. This article highlights some of the issues that auditors may have to deal with in respect of insolvency. Of course, it is important to study this topic in its entirety using an up-to-date study text to gain full knowledge and understanding of this new syllabus area. The meaning of insolvency It is important to understand what is actually meant by a company being ‘insolvent’, and to distinguish insolvency from general, less severe financial difficulties. A company is insolvent if the value of its assets is less than its liabilities – in other words, the statement of financial position shows a position of net liabilities. If all of the company’s assets were sold at book value, the existing liabilities could not be paid. This is a more fundamental problem than simply being short of cash. Company directors are charged with monitoring financial position and performance. This is especially important when the company is experiencing financial difficulties, as a company experiencing cash flow problems can quickly turn insolvent. When a company is facing insolvency, the directors must consider the interests of creditors (payables), shareholders and other stakeholders, which is impossible to do without up-to-date financial information. Directors must, therefore, prepare and monitor financial statements and cash flow and profit forecasts on a regular basis in order to determine the financial position of the company. Auditors may be asked to advise on whether a company is insolvent, or to review historic or projected financial information. Having up-to-date financial information and taking
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professional advice may also help to protect directors from legal claims such as wrongful trading or misfeasance. Options available The directors of an insolvent company face a difficult decision. Should they continue to trade, in the hope that the company’s performance and position will improve, or should they cut their losses and wind up the company? This is a dilemma that the auditor may be asked to help resolve by evaluating the advantages and disadvantages of the options available, and considering the impact of each on the relevant parties, including creditors, shareholders, management and employees. The auditor may also be asked to explain the procedures involved in placing a company into administration or liquidation, as directors will usually have limited knowledge in this area. Administration If the directors decide to try to save the company, it can be placed into administration, which offers some breathing space and legal protections while a rescue plan is formulated to try to preserve the company’s going concern status. The main advantage of administration is that once an administrator is appointed, a moratorium over the company’s debts commences meaning that it is not possible for a winding up petition to be presented at court by the company’s creditors (payables) – thus allowing time for the rescue plan to be designed and initiated. A company in administration is under the control of the appointed administrator who is given a short period of time (usually eight weeks) to set out a proposal for achieving the aim of the administration, or to decide that it is not reasonable that the company can be rescued. A creditors’ meeting is called, at which the proposals are accepted or rejected. The administrator takes over management of the company and has the power to appoint and remove directors. The process for appointment of an administrator varies, and may or may not involve a court order. A company, its directors or one or more creditors (payables) can apply to the court for the appointment of an administrator. The court will grant an administration order only if it is satisfied that the company is – or is likely to become insolvent, and that the administration process is likely to achieve its purpose of rescuing the company as a going concern. It is also possible for an administrator to be appointed without a court order, either by a floating chargeholder, or by the company or its directors. Administration usually lasts for 12 months, after which time the administrator automatically vacates office, though the period of administration can – in some cases – be extended subject to approval from creditors (payables). On the other hand, administration may not last for the full 12-month period, and may end early if the administration has been successful.
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Liquidation If the company cannot be saved, then liquidation or ‘winding up’ is likely to be initiated. The company will cease to trade, assets are sold, liabilities are paid (to the extent allowed by the proceeds from the sale of assets and by applying the rules for allocation of assets described below), and eventually the company will be dissolved. Once liquidation proceedings are under way share dealings must stop, and the directors lose their power to manage the company. The procedures involved in placing a company into liquidation are complicated by the fact that there are different ways that the process is initiated – compulsory liquidation, members’ voluntary liquidation, and creditors’ voluntary liquidation. Compulsory liquidation is usually initiated by one or more creditors, who apply to the court and must demonstrate that the company is unable to pay its debts. A creditor who is owed more than £750, and who has served the company with a written demand for payment that has not been settled, has grounds to apply to the court for compulsory liquidation. In less common circumstances, a member (shareholder) who is dissatisfied with the directors’ management of the company may petition the court for the company to be wound up on the just and equitable ground. For this to be successful, the member had to demonstrate to the court that winding up is the only remedy available. Voluntary liquidation can occur through two different routes – a member’s voluntary liquidation, or a creditors’ voluntary liquidation. The former is used where the company is solvent, and can only take place when the directors have made a declaration of solvency. Creditors have no involvement with this type of liquidation, as the declaration of solvency means that they will be paid in full and therefore have no risk exposure. Shareholders pass a resolution to wind up the company and appoint a liquidator, who is responsible for closing down the company. In contrast, in a creditors’ voluntary liquidation the creditors are heavily involved with proceedings, as in this case the company is not solvent, and therefore creditors face the risk that they will not be paid the full amount owing to them. The process is started by a shareholders’ meeting where a resolution is passed to agree that the company should be wound up, but subsequently, the creditors’ wishes over the appointment of the liquidator and the process of winding up will override the wishes of the shareholders. Allocating company assets An important issue arising on liquidation is the order of priority for allocating company assets. This is especially important for creditors and shareholders because, by definition, an insolvent company cannot pay everything that is owed. The amounts that will be paid on liquidation depend on matters such as whether debts are secured or unsecured, whether charges over assets are fixed © 2011 ACCA
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or floating in nature, whether shareholders own preference or equity shares, the costs suffered by the liquidator (which are generally paid first) and the amount of preferential creditors (including employees’ salaries and other benefits in arrears). In most liquidations equity shareholders receive very little, and usually nothing, as they rank last in the order of priority in allocating company assets. The auditor of an insolvent or potentially insolvent company may be asked to advise on the allocation of company assets. Advantages of administration In many cases, it may be preferable to place a company into administration, rather than go through the process of liquidation. The obvious advantage is that if the administration is successful, the company will continue as a going concern, allowing shareholders to continue to hold their shares and, hopefully, eventually receive a return on that investment. In contrast, as mentioned above, shareholders usually receive nothing when a company is wound up. For creditors, the continued existence of the company may also prove beneficial, as its improved cash flows should allow debts to be repaid, and trading relationships can be maintained. Administration may also be beneficial to employees, as there will continue to be employment of some staff in the continued business (though, of course, the administrator may make some redundancies as part of the company’s rescue plan). In contrast, in a compulsory liquidation the employees are automatically dismissed. Conclusion Auditors have a part to play in advising directors of companies that are in financial distress or, indeed, are insolvent. Candidates attempting Paper P7 (UK) or (IRL) must be prepared to identify the issues relating to insolvency in a given scenario and to provide appropriate explanations and recommendations. Auditing aspects of insolvency will not be examined at each sitting, but will feature fairly regularly in case study type questions. Studying from an up-to-date study text is essential. Lisa Weaver is examiner for Paper P7
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RELEVANT TO CAT QUALIFICATION PAPER 10
Interpreting breakeven and profit – volume volume charts I commented in my examiner’s report on the December 2010 exam that in Question 4, Part (b), the vast majority of students drew a breakeven chart rather than a profit–volume chart. This is either because candidates misread the requirement, or because there is a lack of understanding of the difference between the two types of chart. In addition, candidates showed a lack of understanding in Question 4, Part (c), as to what the profit–volume line actually showed, and therefore how a change in one variable – in this case, the fixed costs – would affect the profit–volume line. The study sessions 19 (b) and (c) of the syllabus state respectively that candidates must be able to: analyse the effect on the breakeven point of changes in sales price and costs prepare and explain the breakeven charts and profit–volume charts. • •
It is not enough just to be able to ‘mechanically’ draw a breakeven or profit–volume chart; candidates must fully understand what the lines represent, how a change in a variable will affect the lines and the breakeven point, and how to interpret the charts. This article aims to aid candidates’ understanding of these areas. BREAKEVEN CHART Let’s use the information from the December 2010 exam that was either given in the question, or required to be calculated in Part (a):
Fee per tourist Variable cost per tourist Contribution per tourist Fixed costs Breakeven point
$4.0 $1.5 $2.5 $30,000 12,000 tourists
It is perfectly possible to draw a breakeven chart with this information. The sales revenue, variable costs and fixed costs can all be plotted and the breakeven point of 12,000 tourists shown.
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Note how the axes are labelled – the vertical axis shows dollars ($) and the horizontal axis shows output/sales, which in this case is the number of tourists. It is important that candidates label the axes if they are drawing a chart in an exam question. Candidates need to be able to explain what will happen to the lines on the chart, and the breakeven point, if costs or revenue change. What if fixed costs increase? If fixed costs increase by $7,000 as happened in Part (c) of this question in the December 2010 exam, the horizontal fixed cost line will move up to $37,000. This will have a knock-on effect to the total cost line – its intersection with the vertical axis will now start at $37,000, rather than $30,000. Note that there has been no change in the variable cost per unit, so the slope or gradient of the variable cost line will not change and, therefore, the slope or gradient of the total cost line will not alter, only the point of intersection on the vertical axis. Revenue has not been affected, and so this line will not change.
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It is now possible to identify the new breakeven point of 14,800 units. It is worth checking whether this new breakeven point makes sense intuitively. The breakeven point has increased – ie we need to take more tourists in order to be in a position of nil loss/nil gain. Does this seem reasonable? The answer is yes. The fixed costs have risen, and Joe will need to take more tourists out on his boat to earn the extra contribution required to cover the increased fixed costs. It is always worth taking a minute in questions to see if the new breakeven point makes sense intuitively. By doing this, you should be able to spot if you have made a silly error either in your calculations or in drawing your graph. Let us look at what happens to the breakeven chart and point if other variables change. (Note that I will always start with the data as per the original question as my base position.) What if the sales price per unit had changed? In this case, all the cost lines would remain the same – only the total revenue line would be affected, which would in turn affect the breakeven point.
Before looking at the effect on the graph, let us think intuitively about what an increase in sales price or, in this case, fee per tourist would mean to Joe. What if the fee per tourist went up to $5? Joe would earn more contribution per tourist ($3.5) and would therefore need to take fewer tourists out in order to cover his fixed costs of $30,000.
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Again the new breakeven point of 8,571 can be read from the chart. It follows that if the sales price per unit had fallen, Joe would earn less contribution per tourist taken, and therefore have to take more tourists out on his boat in order to cover his fixed costs – ie the breakeven point would have risen. What if the variable cost per unit had changed? In this scenario, the gradient of the variable cost line would alter, which would then affect the total cost line and the breakeven point.
Again, thinking intuitively, what would happen if Joe’s variable costs increased to $2.5 per tourist? In this case, Joe would earn less contribution per tourist – only $1.5 ($4 – $2.5) – and so he would have to take more tourists out in his boat in order to earn the contribution to cover fixed costs of $30,000.
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INTERPRETING BREAKEVEN AND PROFIT–VOLUME CHARTS APRIL 2011
In the graph above, the new breakeven point is 20,000 units. PROFIT – VOLUME VOLUME CHART Now we will use the same information to consider profit–volume charts:
Fee per tourist Variable cost per tourist Contribution per tourist Fixed costs Breakeven point
$4.0 $1.5 $2.5 $30,000 12,000 tourists
It can be argued that a profit–volume chart is easier to draw, as you only need to be able to plot two points in order to draw the profit–volume line. The two points can be any two of the fixed costs, the breakeven point, or a profit figure at a certain level of output. Using the information above and plotting the fixed costs and breakeven point, the profit–volume chart appears as follows:
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INTERPRETING BREAKEVEN AND PROFIT–VOLUME CHARTS APRIL 2011
Note how the axes are labelled for a profit–volume chart. The horizontal axis is still the number of tourists, but the vertical axis is now profit/loss in dollars ($). The intercept on the vertical axis shows the level of fixed costs, and where the line crosses the horizontal axis represents the breakeven point – ie where profit is zero. The gradient of the line represents the contribution per unit. Let us look at what happens to the profit–volume chart and if variables change. (Note that I will again always start with the data as per the original question as my base position.) What if fixed costs increase? If the fixed costs increase to $37,000, the intercept on the vertical axis will change to reflect the increased costs (it will move to the new fixed costs of $37,000). However, neither sales revenue per unit (fee per tourist) or variable cost per unit have altered. The contribution per unit has not altered and, therefore, the gradient of the profit– volume line will not alter. It is therefore possible to draw on the new profit–volume line by keeping the same gradient but changing the point of intersection on the vertical axis.
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INTERPRETING BREAKEVEN AND PROFIT–VOLUME CHARTS APRIL 2011
The new breakeven point can be read from the chart as 14,800 units. What if the sales price per unit had changed? In this case the total fixed costs do not change, and therefore the intercept on the vertical axis will not change. However, the contribution per unit will change and, therefore, the gradient of the profit–volume line.
We know intuitively that if the sales price goes up to say $5 per tourist, then the breakeven point will decrease (see earlier), so this means that the intercept on the horizontal axis will be nearer the origin. By how much though? Where is the new breakeven point? You can either calculate the new breakeven as being $30,000/$3.5=8,571 units, or you can calculate the profit that will be earned at an output level. For example, the profit earned if 10,000 tourists are taken out will be 10,000 x ($5 – $1.5) –$30,000 = $5,000. Plot the $5,000 profit on your graph and then read off the new breakeven point.
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INTERPRETING BREAKEVEN AND PROFIT–VOLUME CHARTS APRIL 2011
What can be seen from the graph is that a change in sales price affects the gradient of the profit–volume line only – not the intercept on the vertical axis – because fixed costs have not altered. What if the variable cost per unit had changed? The same is true if the variable cost per unit is altered. The intercept on the vertical axis will not change because fixed costs have not altered, only the gradient of the profit–volume line, as the contribution per unit has again altered.
Using the figures we had earlier when we considered a change in variable cost per unit under the breakeven section, the new contribution per unit was $1.5, so the profit/(loss) at 10,000 units would be 10,000 x $1.5 – $30,000 = ($15,000). Knowing the fixed costs and profit at 10,000 units allows the profit volume line to be plotted and the new breakeven point read off the graph. Again, it would have been possible to calculate the new breakeven point as 20,000 units and plot this, along with the fixed costs of $30,000, in order to draw the new profit–volume line.
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INTERPRETING BREAKEVEN AND PROFIT–VOLUME CHARTS APRIL 2011
CONCLUSION It is important that candidates understand how a chart – whether breakeven or profit–volume – is constructed, what the lines represent, how a change in a variable will affect the chart and the breakeven point, and therefore be able to interpret the charts.
Candidates must not draw the charts ‘mechanically’ but also think intuitively about whether the graphs and the answers that they have given are reasonable. It is hoped that this article will help with some of these elements. Charlotte Bower is examiner for CAT Paper 10
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