Case study november 2011 marks plan ICAEW

They comprised: 1 an analysis of the 12-month financial statements to 30 September 2011 against specifically defined yardsticks overall revenue and gross profit, EBITDA and the trend in

EXAMINERS’ COMMENTS AND MARK PLAN

Contents

Page Part 1: Executive summary

Part 2: The Case Study examination

Part 3: Commentary on candidates’ performance

Part 4: Appendices

Appendix 2: Calculation of audit adjustments and impact on bank covenants 19

Part 5: Marking Key

PART 1: EXECUTIVE SUMMARY

Attached to this report are appendices with examples of the sort of work that candidates did, or might have done, under „financial analysis‟ The two illustrative scripts offer further insights in the area of financial analysis

Overview of performance

73.9% of all candidates sitting the paper passed, compared with 75.2% in July 2011 and 76.0% in November

2010 The pass rate reflects the fact that this case was of a similar standard to all recent case studies The main departure from previous cases was that the examiners had introduced factors in both Requirements 1 and 2 which made those requirements slightly less predictable However, as in other case studies, the majority of candidates demonstrated the required level of competence in performing the financial analysis in Requirement

1, although weaknesses were apparent in considering and analysing EBITDA and the non-current asset

analysis was often simplistic In Requirement 2 candidates performed the necessary calculations to determine the proposed audit adjustments adequately but then faltered in interpreting and presenting the statement of cash flows in a positive way in the context of a breach in one of 4D‟s loan covenants and the imminent meeting with the bank Requirement 3 was a reasonably straightforward consideration of a new proposal, with most strong candidates presenting a clear analysis of the issues involved and demonstrating their competence Weaker candidates failed to provide an appropriately balanced consideration of the issues they were required to address All three requirements had a similar grades profile and there was little evidence of any real time

pressure for candidates, with most reports containing an Executive Summary which covered all aspects of the assessment

The Advance Information (AI) informs candidates that the 4DVD Limited (4D) case concerns a company

operating in the film and DVD industry 4D earns its revenue from the commissioned production of film and animation output for commercial and public sector clients, on a contract basis A major component of 4D‟s success has been the creation of the Spindles safety animation series for the Department for Education (DfE) and sales of associated DVDs and related merchandise

Until September 2009 4D had experienced steady growth but the results for 2010 showed a decline in overall revenue Since October 2003 4D has had a long-term bank loan which is subject to covenant terms which the company has always met although the headroom had declined in 2010 From the management accounting information in the Exam Paper (EP) it could be seen that the decline in overall revenue had continued, but that the loan and interest repayment schedule had been met and that the company had adequate cash resources The 4D case requirements in the EP followed on from the information provided in the AI They comprised: (1) an analysis of the 12-month financial statements to 30 September 2011 against specifically defined yardsticks (overall revenue and gross profit, EBITDA and the trend in 4D‟s revenue streams as well as an analysis of the non-current assets in the light of recent disposals at a significant loss); (2) an analysis of a series of proposed audit adjustments and their impact on the loan covenants, together with an analysis of the statement of cash flows, in a positive way, in preparation for a meeting with the bank and; (3) an evaluation of the risks and

benefits to 4D of a substantial new advertisement proposal from a client, Foment plc As in previous case studies the exam rubric specifically told candidates that an executive summary was to be provided and that the report should be balanced between the three elements

Tutor firms have commented that this was “an innovative Case Study set in the current economic climate” and

that “although this paper was harder to predict than some recent ones” the analysis required was “commercial” and a “good test of [candidates’] professional skills” The Examiners concur with these views

Successful candidates followed the instructions contained in the rubric and produced well-balanced, relevant

answers to the three main requirements, as well as appropriate appendices and concise, relevant executive summaries The majority of scripts were balanced, clear and focused, dealing with the requirements set

including appropriate appendices

Candidates who failed did so for a number of different reasons Most candidates failed because they

answered a requirement as they saw fit and did not address the issue in the manner requested A very small number failed because of poor exam technique by not planning their time appropriately such that they failed to finish a section or the executive summary All failures should be set against what was a universal agreement amongst tutor firms reviewing the 4D case, that the requirements were “clear and unambiguous”

Requirement 1 assessed the ability of the candidates to perform specific financial statement analysis

Successful candidates provided clear analysis in line with the requirements Weaker candidates had difficulty with different aspects of the financial statement analysis The biggest failure was by not providing all analysis against the bigger picture of economic decline and the key fact of the disposal of non-current assets at a

significant loss This was particularly so in considering EBITDA, which many candidates failed to identify

correctly, or at all, opting instead for an analysis of operating profit (clearly pre-prepared) as their substitute Good candidates identified the size of the loss and its potential impact on the financial results and also raised the question of the value of remaining assets, as well as the possible impact of overvalued assets and

overstated profits on the bank covenants Most weak candidates did not mention the very material loss on disposal, but just glided straight past the figure Other problems for weak candidates were in demonstrating the ability to provide an appropriate analysis of the trend in revenue streams with the recurring problem of not looking at absolute figures and only offering percentage changes without providing a yardstick figure for

comparison As always in financial statement analysis, strong candidates demonstrated their professional competence Weaker candidates demonstrated a lack of analytical understanding, combining this with poor judgement and often banal conclusions These are fundamental weaknesses in a vital basic professional skill

Requirement 2 assessed the candidates‟ ability to calculate the impact of proposed audit adjustments on the financial covenants relating to the bank loan as well as presenting 4D‟s current finances in a positive way for the meeting with the bank, by a review of the statement of cash flows Most candidates correctly calculated the audit adjustments in terms of financial impact Problems occurred for weaker candidates in presenting the impact of these adjustments on the loan covenants Some candidates expressed the shortfall against a specific covenant in percentage terms only, thereby never identifying what the actual financial impact was – or what figure might be the subject of discussion with the bank Unfortunately some candidates confused the existing covenant condition relating to non-current assets with the newly suggested covenant relating to net current assets and therefore believed, incorrectly, that this covenant had been breached However, the most significant failures in this requirement related to the analysis of the statement of cash flows Many weaker candidates simply did not provide any specific analysis of the statement of cash flows – let alone in a positive way Many merely restated 4D‟s opening and closing bank balances Strong candidates demonstrated clear judgement, reasoned conclusions and recommendations; weaker candidates did not demonstrate these skills

Requirement 3 assessed the candidates‟ skills in evaluating the creation of a substantial new advertising campaign for a client, Foment plc, addressing the risks and benefits for 4D The majority of candidates made a reasonable attempt at answering this requirement and there was little evidence of time pressure in either the length or quality of answers Successful candidates wrote clear answers which integrated the AI and EP

information Weaker candidates accentuated the commercial problems of the proposal by making erroneous assumptions outside the scope of the proposal Most of the weaknesses evident in answering this requirement suggested poor preparation and an inability to integrate AI and EP information particularly regarding ethical issues such as the regulation of advertising to children

In the 4D case study the majority of scripts had an even spread of grades between the three requirements, indicating a structured, well-balanced and planned approach to answering the case As in all case study exams the top scripts provided really impressive answers All successful candidates demonstrated the ability to

assimilate, analyse and assess the case information and write a relevant appropriate report Only a very small minority of the scripts showed any evidence of actual time pressure

Overall the examiners consider that 4D was a topical case study, set in the current economic climate, with

appropriately relevant elements which allowed good candidates the opportunity to demonstrate their

professional and commercial skills It exposed the weaknesses of the under-prepared candidate and those who could not think „in situ‟ in response to (as one tutor firm described them) the “tutor proof twists” included in the requirements It also exposed those who did not demonstrate adequate professional skills in their answers As

was stated by one of the tutor firms: “Students were not asked to do anything that they should have considered

to be unusual, unfair or outside their capabilities” This assessment should provide assurance to member firms

that students qualifying as ACAs have been properly assessed and possess the range of skills and abilities required in the workplace

PART 2: THE CASE STUDY EXAMINATION

Scenario for the paper (Advance Information)

The case study relates to 4DVD Limited (4D), an owner-managed company which operates in the film making and DVD production industry, specialising in animation output It is located and operates in Gloucester in the

UK

Four weeks prior to the examination, candidates were provided with a 48-page package of information,

containing a series of exhibits relating to 4D These comprised 14 exhibits:

1 About you, your employer and the subject company (4DVD Limited [4D])

2 The film industry

3 Film and DVD making

4 4DVD Limited (4D)

5 Email dated 12 January 2011 from James Magnet to you: Financial information

6 4DVD Limited management accounts: Summary for the years ended 30 September 2006-10

7 Loan Agreement dated 1 October 2003 between 4D and NP Bank plc

8 Email dated 12 April 2011 from James Magnet to Ali Monet: Financial review

9 Revenue: commissioned film projects and income

10 Revenue: sales of DVDs and merchandise

11 Revenue: corporate DVD production

12 Revenue: advertisement production

13 Advertising regulation

14 News and website articles

Analysis of Advance Information (AI)

By studying and analysing this Advance Information an overall picture of 4D could be established (Additional commentary by the examiners is provided in italics and in brackets.)

Exhibit 1 provides a brief background to Penbury Chartered Accountants (Penbury) and one of its clients,

4DVD Limited (4D), in which the candidate (Ali Monet) is working on a one-year secondment 4D is a film, DVD and broadcast production company which specialises in short film and animation work on a commission basis

for both public and private sector clients.(This exhibit places the candidate inside the organisation 4D, the subject of the case, and indicates the candidate’s previous experience.)

Exhibit 2 gives a brief overview of the film industry, the economics of film production and distribution, and the

type of output that the company such as 4D might produce It also provides background information on the specialised and short film market including the production of animation output for different markets including,

amongst others, education and in the creation of advertisements (The information in this exhibit provides broad background of the film industry, sufficient to prevent further research by candidates.)

Exhibit 3 provides information on film and DVD making including the key personnel involved in film production

as well as the various different ways in which films can earn money for their creators This exhibit describes the

„one-off‟ production process and non-recurring nature of film production work (This exhibit provides sufficient information on the process of film production to avoid the need for further research on behalf of candidates.)

Exhibit 4 provides brief information on 4D‟s operations and more detailed information on its background and the directors who formed this business in October 2000 and their respective roles The main activities, or revenue streams, are identified A number of these activities are clearly related in terms of their production process although they are aimed at different clients: commission income from film production and broadcast work; corporate client work; production of advertisements; and animation output This latter activity is one of the key strengths of 4D, especially with the creation of the Spindles characters and the development and delivery, since

2004, of a national schools safety programme funded by the Department for Education (DfE) based on the Spindles family Linked to these DVD production activities are sales of DVDs and sales of merchandise, related mainly to the Spindles animation series The company is located in a modernised warehouse in Gloucester and also rents a second warehouse for post-production editing and inventory storage In terms of competition 4D

operates in a crowded market where the technical barriers to entry can be low.(The details of the key personnel and the history of success of the business and its operations imply that 4D has the management team, the in- house creative skills and the established products to be successful.)

Exhibit 5 is an email from James Magnet (4D‟s FD) to Ali Monet accompanying 4D‟s management accounts for the past five years, to 30 September 2010 This email provides details about timing of the production of 4D financial information each year, including audit work and any adjustments proposed by the auditors Rigour Briggs It also identifies the existence of a loan agreement with the NP bank plc which is subject to a number of covenant conditions – which 4D has always met This email also indicates that one of the tasks “with which you

could be involved may well be to act as a liaison person on behalf of 4D with the auditors”

Exhibit 6 provides 5 pages of management accounts and notes, for the 5 years to 30 September 2010 These

accounts (which are in line with the audited accounts) provide the following key information:

 4D has achieved good revenue growth from 2006 to 2009 of over 20% per year However, in 2010 there

was a 9% decrease in revenue (G iven the general economic recession and the nature of 4D’s business this decline could be expected.)

 4D‟s gross margins on total revenues have changed over time: 45% (2006); 43% (2007); 41% (2008); 39%

(2009); 37% (2010) (This declining GP% indicates weakening control over costs, or general downward pressure on revenues, or alteration in sales mix over time towards less profitable revenue streams.)

 Overheads as a percentage of revenue have remained almost static at around 34-35% each year (This indicates that these costs have been increasing in line with activity between 2006-2009, which may indicate slack control However, the decrease in line with activity in 2010 indicates that 4D may be taking control of these costs in a difficult year)

 Operating profit percentage declined steadily in the 5 years: 11% (2006); 10% (2007); 8% (2008); 5%

(2009); 3% (2010) (This decline may prove to be important given the details of the bank covenant loan conditions relating to interest cover in Exhibit 7.)

 Net finance expense has varied over time but has generally been in steady decline in line with the reducing

amount of the loan outstanding

 The statement of financial position shows that 4D has a significant investment in non-current assets (see Notes to the accounts below) The company also holds inventories consistent with its sales of DVDs and merchandise There is an increasing level of accounts receivable (see below) which may indicate poor credit control, or an alteration in the terms and conditions of activities The level of accounts payable

appears to be significant (see below) (The other noteworthy points are (i) a steady decrease in the current loan in line with the loan agreement; and (ii) a variable cash and cash equivalents balance and intermittent overdraft which indicate possible difficulties in short-term financial planning.)

non- The statement of cash flows shows significant cash being generated from operations in all years up until

2009 with a reduction to £858k in 2010 However, the company uses the cash to invest heavily in the purchase of non-current assets each year and to pay finance expenses as well as the annual repayment of the loan principal (and taxes) As a result the company‟s cash and cash equivalents at the end of the year oscillate between positive and negative balances at the bank There is a relatively small inflow in terms of proceeds from disposal of non-current assets – and there has been a consistent history of losses on these

disposals The company pays no dividends (This statement requires detailed reading and understanding, particularly for 2010 when the company appears to have been affected by the recession.)

 From the Notes to the accounts the following information can be seen:

o Revenue: the detailed trends in revenue streams can be identified From initial analysis it would appear that the commissions of films activity continue to expand right through to 2010, whereas all other revenue streams are in a state of decline, some (advertisement production) from as early as

2008

o Cost of sales does not permit the identification of the comparative margins on each revenue stream Some costs can clearly be linked to some specific activities (DVDs, merchandise and materials together with web promotional and delivery costs can probably be linked to sales of DVDs and merchandise) but other costs cannot be set against specific revenue streams, which emphasises

the interconnected nature of operational activities

o Overheads/administrative costs provide information which shows that the largest single cost within

this heading is salaries and wages (including, probably, those of at least two directors) (The fact that this cost moves in line with revenues may indicate poor control when revenues were increasing but the company has tightened control in the recession.)

o Non-current assets information is provided for all years since the beginning of October 2005 The details of the different depreciation rates provided indicate a significant difference between the write-off of studio equipment (10 – 20%, reducing balance) and computer equipment (50%,

reducing balance) (A review of the history of disposals of different categories of assets from this schedule, plus the statement of cash flows, indicates a history of losses on disposal on the studio equipment, which might raise questions on the depreciation policy, net profits and valuation of non- current assets.)

o Inventories information shows that the majority of inventories relate to DVDs and merchandise goods In earlier years this figure as a percentage of sales of DVDs and merchandise goods rose out of proportion to activity However, in 2009 and 2010 there has been much stricter control over

such inventory levels Work-in-progress is also included in the inventory figure

o Accounts receivable: the majority of this figure relates to trade receivables and these have been rising faster than total revenues and in 2010 were taking twice as long to collect (55 days) as in

2006 (26 days) (This indicates either poor credit control or changing terms and conditions in

generating revenue.)

o Accounts payable: less than half of the total amount in accounts payable comprises trade payables Included in the figure are other payables and accruals, taxation and social security and, importantly,

a significant figure for deferred income (more than 25% of accounts payable each year)

(As in any case study all the financial information should be read and fully analysed by candidates, ahead of

the exam itself, in order to understand the detailed financial story and current financial position of the business.)

Exhibit 7 comprises details of the loan agreement with NP Bank plc dated 1 October 2003 Amongst other

details the terms of the initial total loan (£2m) the period (20 years) and repayment schedule (£100k on

30 September each year) together with the interest rate (8% minimum) are all provided The loan agreement also provides details of the covenant conditions: (1) relating to the book value of tangible non-current assets (must be maintained at 110% of the value of any outstanding loan and accrued interest); (2) the cover for the net finance expense against operating profit (must be kept at 300%) Compliance with these financial covenants shall be calculated by reference to the most recent published audited annual financial statements Any non-compliance with the financial covenants would require 4D either (i) to provide further security, by way of

directors‟ personal guarantees and provide additional analysis or (ii) to repay immediately any facilities

outstanding, being the amount by which the Loan is “exposed” as a result of any shortfall against any conditions

identified above (This is clearly an important exhibit The implications of these covenant conditions mean that a calculation must take place each year to see whether the conditions are being complied with, or by how much 4D fails to meet them – the bank will impose its sanctions based on the degree of non-compliance.)

Exhibit 8 is an email from James Magnet to Ali Monet which provides additional background information about

4D‟s activities and where 4D is currently positioned It explains how the business has been affected by the recession but how some revenue streams are holding up better than others Within this exhibit there are also details of work-in-progress and deferred income, showing both how the transactions are recorded and how the balances are made up as at 30 September 2010 [Exhibits 9 – 12 are attachments to this exhibit.] (This will

prove to be an important exhibit as both of these areas of the accounts are dealt with in the EP As a side note it could be seen from some of the names on the list of organisations shown making up the balance on work-in- progress and deferred income that 4D has some impressive and substantial clients.)

Exhibit 9 explains more about 4D‟s commissioned film projects and income including the success of the

Spindles safety animations, particularly with regard to the UK's national children's safety programme The balanced working relationship with the DfE is explained, together with details of awards gained, and the 2009 BBC Christmas project featuring the Spindles characters in a themed mini-series of four five-minute animations

well-A schedule of attributable costs for a single five-minute production is included This schedule was prepared as part of the negotiation for the fee with the BBC, with the production personnel costs priced as though 4D would have to buy them in for the project The timeframe for this £1m project is also given in that the work did not start until October 2009, at the earliest, and the 20 minutes of animation output had to be completed in order to be available for the BBC to plan and present in its Christmas schedule 4D retained the rights of further distribution

of the Spindles animation films (In this exhibit there is a lot of information concerning 4D’s acute commercial awareness Its successful negotiation on price uses figures which could be justified in the marketplace, but which are certainly higher than in-house costs on a daily basis – implying that 4D’s profit from this series was much higher than appears on first analysis Its retention of the rights over the Spindles animations is an

important safeguard over future revenue In addition the fact that it could deliver this work on time to meet the Christmas deadline emphasises both the artistic ability and the project management skills of the production team.)

Exhibit 10 provides information on the sales of DVDs and merchandise The success of DVD sales is clearly

linked to the success of the Spindles series and the same applies to the sales of merchandise which is mainly a range of goods based on the Spindles The company protects the Spindles brand from inappropriate

associations with other products (This exhibit emphasises the importance and popularity of Spindles and the market which exists for its branded goods.)

Exhibit 11 deals with revenue from corporate DVD production As well as describing the spectrum of work

which 4D produces under this heading the contribution earned from a typical commercial corporate project is

also provided This contribution schedule indicates that this activity can be very profitable (From information provided elsewhere 4D has suffered a decline in activity and revenue in corporate DVD production caused by the general economic downturn – this started in 2008.)

Exhibit 12 provides information concerning advertisement production revenue The fees and costs associated

with the production of an original commercial advertisement (1 minute of film) suggest that this is a very

profitable activity (a contribution of nearly 50%) However the warning is provided that it is difficult to identify the

exact costs from reducing advertisement because so much depends on the inspiration needed to produce the

idea which meets with the client's approval (The main problem for 4D is that its revenue from advertisement production reached its peak in 2007 and has been declining significantly ever since.)

Exhibit 13 concerns the regulation governing advertising and, in particular, advertising to children This

protection is essential in two main categories: (i) “children's products and services” – those of more or less

exclusive interest to children; and (ii) “products and services of interest to children” – those likely to appeal to

children but which are not of exclusive interest to them Advertisements must neither directly exhort them to buy

a product or service nor encourage them to ask their parents, guardians or other persons to buy or enquire about a product or service for them (It is clear that 4D’s Spindles products could fall into both categories and so the company must pay special attention to all relevant advertising regulations.)

Exhibit 14 comprises a series of news reports concerning different topical items:

 The first article (Exhibit 14a) discusses the issues surrounding product placement on UK television together with the fact that television broadcasters will be allowed longer advertising breaks during free-to-air TV drama broadcasting – increasing to 12 minutes per hour from its current limit of 7 minutes (The implication

is that there will be an increase in demand for companies which can either help this product placement or who could produce advertisement films and DVDs.)

 The second article (Exhibit 14b) describes the problems relating to the commercialisation of childhood and the exploitation of children as consumers at key times of the year as well as those forced to work producing toys in harsh conditions It also provides advice to companies caught up in any adverse situations and how

they should deal with the issues arising (This article serves as a possible warning for organisations involved

in the manufacture and sale of children’s products.)

 The third article (Exhibit 14c) gives a guide to the production of cost-effective corporate videos by adapting

an internally produced corporate DVD to create a positive corporate story for external purposes (This article emphasises how easy it is to produce a corporate DVD at a fraction of the price that companies such as 4D might charge.)

 The final article (Exhibit 14c) deals with: (i) the difficulty children have in distinguishing between advertising and reality, and also that in Sweden there is a ban on advertisements aimed at children under 12; (ii) the problems caused by children's identities increasingly being defined by their consumer habits, and that advertisers are targeting younger and younger children; (iii) the fact that children love to collect things which

some marketing strategies seek to exploit (This article emphasise the issues associated with marketing and selling children’s products.)

Information provided in the Exam Paper

The Exam Paper information contained nine pages of additional information by way of six exhibits The new documents provided to candidates were:

 Exhibit 15 – email dated 9 November from James Magnet (Finance Director of 4D) to Ali Monet: Financial review and report for 4D board

 Exhibit 16 – 4D management accounts for the year to 30 September 2011 (4 pages)

 Exhibit 17 – email dated 7 November 2011 from Don Briggs, partner, Rigour Briggs Chartered Accountants

to the 4D Board: Proposed adjustments to 4D‟s management accounts for the year ended 30 September

2011

 Exhibit 18 – (i) email dated 3 November from Colin Boyd, NP Bank plc to James Magnet and Stephanie Shan of 4D: Review of management accounts for all clients with loans exceeding 10 years; together with (ii) Stephanie Shan‟s related email of 8 November 2011 to 4D Board

 Exhibit 19 – email dated 31 October 2011 from John Jones of Foment plc to the 4D Board: New advertising campaign

 Exhibit 20 – recent news articles relating to (i) junk food advertising and (ii) Foment plc interim results

Examination requirements

You are required by James Magnet to prepare a draft report to the Board of 4D dealing with following:

1 A review of the 4D‟s results for the year to 30 September 2011, as presented in Exhibit 16, and of its

investment in non-current assets at that date

Your review of 4Ds 2011 results should cover the overall revenue, gross profit and EBITDA compared with

2010 It should also include an analysis of the trend in each of 4D's revenue streams You should additionally comment on 4D's investment in non-current assets as at 30 September 2011 in the light of the recent studio closure and equipment disposals

2 A calculation and assessment of the financial impact of the points raised in the email from the auditors

(Exhibit 17)

You should calculate the impact of the proposed adjustments on 4D's draft management accounts, and you should also assess the resulting adjusted accounts against both the financial covenant conditions in the Loan

Agreement with NP Bank plc (Exhibit 7) and the newly-imposed condition (Exhibit 18) Please also suggest

how 4D might explain its current finances in a positive way at the proposed meeting with NP bank, by

providing a review of 4D‟s 2011 statement cash flows and its year-end cash position

3 An evaluation of the email from John Jones of Foment plc (Exhibit 19) requesting us to create a substantial

new advertising campaign for Foment plc, using the Spindles characters

You should address all the risks and benefits of this request – including any possible ethical concerns – and the impact for 4D both currently and in the future

On the instruction page you are told the report should be balanced across the three detailed requirements and must also include an executive summary

The time allocation suggested to candidates was:

With a total of nine pages of information to read in the Exam Paper, time should have been spent reading

quickly through all the new material (Exhibits 15 – 20), in order to understand the range of information

contained in those exhibits It would then have been essential to read Exhibit 15 carefully to understand the

requirements before starting a detailed read of the four pages of financial information provided in Exhibit 16

Using the new financial information it would then be essential to assess the 2011 results in the light of previous information and reflect on any preparatory analysis already carried out The exact financial analysis required

focuses on an evaluation of overall revenue, gross profit and EBITDA (which will require calculating/identifying)

as well as revenue streams and 4D‟s investment in non-current assets in the light of the recent studio closure

and equipment disposals Similarly the impact of the auditors‟ proposed adjustments will have to be calculated

and the resulting adjusted accounts assessed (this will require the identification of the impact of the adjustments

in financial/numeric terms) 4D‟s statement cash flows and its year-end cash position will have to be reviewed in

order to be explained in a positive way at the proposed meeting with NP bank (this positive explanation will be

important in any negotiation with the bank) The third requirement requires an evaluation of the proposal from

Foment plc addressing the risks and benefits of this request With good planning well-prepared candidates should have been able to complete these three tasks, and write an executive summary, within the time available

to produce a well-balanced report

Analysis of Exam Paper (EP) information

From reading the new exhibits candidates should have established that:

 Exhibit 15 identifies the fact that 4D is currently passing through “a period of uncertainty and change”, and that ”in July, as a result of under-utilisation and the need to save costs”, 4D closed its second studio and

“disposed of surplus and technologically obsolete studio equipment” (This sets the context for the financial analysis of 4D’s management accounts and the further work which follows.)

 Exhibit 16 comprises four pages showing the management accounts for the year to 30 September 2011: an

income statement; a statement of financial position and a statement of cash flows, together with

accompanying notes These notes include: details of revenues split into main business activities; details of cost of sales; a schedule of overheads/administrative expenses; details of the non-current assets;

inventories; accounts receivable; accounts payable – similar in format to the information presented in the AI

(Exhibit 6) The information should have posed no problem for any candidate to assimilate (This would

have been a highly predictable exhibit although the actual figures would not have been known in advance However the analysis has to be made in the context of a continuing decline in revenue and the large losses which had been incurred on the disposal of studio equipment Analysis of 4D’s results to 30 September

2011 should have been anticipated and detailed analysis on AI figures for 2010 and earlier years would have been essential preparatory work.)

 Exhibit 17 (email from the auditors to the 4D Board) proposes adjustments to the draft management

accounts relating to inventory and deferred income Both of these areas of the accounts had been identified

in the AI (Exhibit 8) and this should have meant that candidates would have been aware of these

accounting topics James Magnet had also suggested that one of Ali Monet‟s tasks would be “to act as liaison person” with the auditors and so the issue of having to consider any auditor proposals may have been anticipated The adjustments appear relatively uncontroversial and although there may be some room for discussion the calculation of the adjustments and the impact on the financial statements should have

been straightforward (This exhibit, which related specifically to Requirement 2, although not predictable, should have been very easy to comprehend and assimilate not just from within the case but also from professional experience.)

 Exhibit 18 comprises an email from Colin Boyd of NP Bank confirming a meeting to introduce a new bank

manager and to discuss 4D‟s draft management accounts, together with a subsequent internal email from Stephanie Shan responding to this email and the audit adjustments Both emails add an important

complicating context to the adjustments proposed by the auditors from Exhibit 17 Stephanie Shan has assessed the situation very succinctly, as she sees it, by her questioning whether to make the audit

adjustments ahead of the meeting with the bank, and her stating the need to present as strong a case as possible Her observation that “this meeting will need to be handled very carefully” is interpreted by James Magnet (Exhibit 15) as the need for 4D to “explain its current finances in a positive way at the meeting with

NP Bank” (This exhibit places a commercial context and a tight timeframe on the consideration of the audit adjustments It is also important to note that in both the email from the bank and in the response from Stephanie Shan it is a new (additional) covenant condition relating to net current assets that is being

imposed not an adjusted previous covenant condition Candidates were being required to consider these practical issues in a context of potential conflict.)

 Exhibit 19: this email from John Jones of Foment plc concerning a new advertising campaign is a short and

easy-to-understand request It suggests a very large sum (£6m) for a series of 10 short scenario

advertisements with “an advance payment of 25% of whatever total fee is finally agreed upon” This is an impressive financial proposal but it will require 4D to use the Spindles characters in an animated

advertisement to deliver this contract (This email poses a number of difficult questions for 4D because the trade-off between the potential revenue and the possible damage to the Spindles brand has to be fully evaluated.)

 Exhibit 20 comprises two newspaper articles: One presents the arguments against junk food adverting and

the negative impact on children; the second is a brief synopsis of Foment‟s recently-published interim results The latter identifies that Foment has been through a turbulent time and that because of the absence

of provision for doubtful debts on its operations in the Middle East it may be overstating its profits Foment is

also involved in a heavy investment programme in southern Italy which is draining cash from the business

(This exhibit identifies different problems and concerns which would affect the Foment proposal and which

would need to be included as factors in the decision to be made.)

The information provided in the EP follows on from the financial and commercial story told in the AI 4D‟s total revenue has continued to decline with the overall trajectory influenced by the recession There have been substantial disposals of studio equipment at a significant loss The auditors are proposing adjustments to the management accounts As a consequence of all these factors the amount of headroom on the bank loan has reduced and may reduce further This development of a number of previously established factors concerning 4D‟s business mean that different analytical techniques must be used in order to provide business advice to the

4D board The financial information provided to 30 September 2011 requires a clear focus on financial

statement analysis – a basic professional skill and one which candidates must demonstrate The calculation and assessment of the impact of the auditors‟ proposed adjustments requires structured financial data analysis

together with a broader, professionally aware perspective, on the appropriate preparation for the meeting with the bank The basis for consideration of the issues affecting the new Foment advertising campaign proposal requires a balanced review of financial and strategic, as well as non-financial and ethical, factors This

commercial review includes a sceptical and ethical review of the issues The individual requirements clearly

describe the route which should be followed in developing the report

For Requirement 1 the financial statement analysis of 4D‟s management accounts for the year to 30 September

2011 had to be focused on specific key features The fact that the requirement is cross-referenced to Exhibit 16

was to emphasise to candidates that their analysis was to be conducted on the unadjusted figures given in that exhibit For the 12 months income statement the analysis should be of revenues, gross profit and, given the significant losses on disposal of non-current assets, EBITDA It should also include the analysis of revenues by stream as well as 4D‟s investment in non-current assets (one of the factors in the loan agreement) The financial statement analysis was intended to make candidates focus on the commercial reality of the business given the continuing recession: this financial analysis should have been a speedy exercise numerically, but it then had to

be developed with a clear commentary based on the focused numerical analysis

Requirement 2 requires some basic financial data analysis to calculate the audit adjustments, as proposed in

Exhibit 17, to the management accounts provided, and then the newly-adjusted financial statements have to be

evaluated against the loan agreement financial covenant to assess whether 4D complies or not In the event of non-compliance, which is broadly hinted at by Stephanie Shan, then the company must explain its current finances in a positive way at the bank meeting This requires the ability to present a clear explanation of each component of the statement of cash flows This whole process of calculation, evaluation, comparison and eventual consideration of the positive elements of 4D‟s results would require a logical and professional as well

as fully integrated analytical approach

Requirement 3 requires a balanced analysis of the Foment advertising campaign proposal The requirement builds on the broad advertising regulatory information presented in the AI, further developed by the newspaper article in the EP and the importance of the clean image associated with the Spindles brand The counterbalance

is the sheer size of the financial proposal from Foment The question is really whether 4D should sell its Spindle soul for this very big bag of income from an animated advertisement The most important element of this

requirement is to maintain a balanced approach in terms of financial benefits (and risks) and the non-financial and (potentially) ethical issues identified Candidates had to identify all issues, integrate AI and EP and evaluate 4D‟s options

Summary of grades available

The Examiners identified 5 headings under which grades would be awarded, corresponding to the requirements:

 Executive summary

 Review of 4D‟s 2011 financial performance

 Impact of audit adjustments and meeting with NP Bank

 Evaluation of proposal from Foment plc

 Overall paper

Candidates were rewarded according to how well they demonstrated, under each of these topics, their

application of four skills:

 A&UI Assimilating and Using Information

 SP&S Structuring Problems and Solutions

 C&R Conclusions & Recommendations

For each topic, there were a number of „boxes‟ under each of the four skills, representing specific areas in which the skill was to be demonstrated Within each box, candidates were awarded one of five available grades:

The total number of boxes for each topic and skill was as follows:

A&UI SP&S AJ C&R Total

This reflects (i) an even balance between the three main requirements and (ii) a greater and equal weighting of SP&S and AJ, both of which were indicated to candidates in the rubric to the Exam Paper

PART 3: COMMENTARY ON CANDIDATES’ PERFORMANCE

Professional skills

Assimilating and using information

In each requirement candidates had to make extensive use of the Advance Information as well as using the information in the Exam Paper to assimilate and organise material in order to build their answers In the majority

of scripts, candidates demonstrated good assimilation and use of information in each requirement The advance case material provided the background information relating to 4D‟s business history and its financial results and revenue streams Information was also provided about details of a bank loan and the covenants relating to the loan There was good evidence that most candidates had fully assimilated the fact that 4Ds operations were intertwined and that the major product in 4D‟s portfolio was the Spindles animation series From the situation presented in the AI it could be seen that 4D‟s revenue streams had been affected in various ways by the

recession, and that its total revenue had peaked in 2009 and was in decline in 2010

Specifically for Requirement 1 candidates should have prepared for the exam by analysing Exhibit 6 – which provided the historical financial trends (2006-2010 inclusive) in revenue, gross profit and operating profit – and should have paid attention to the notes to the accounts which provided information concerning revenue streams and company costs, extensive information on non-current assets, as well as information on inventories,

accounts receivable and accounts payable The preparatory analysis would have identified that the business has shrunk since 2009 by 9% in terms of total revenue It would also have identified that the gross profit

percentage has been declining steadily since 2006 (down from 45% to 37%) – which indicates that 4D is

struggling to control its direct costs Overheads have reduced in absolute terms in 2010 but remain at 34% of revenue Apart from commission income all other revenue streams have reduced in 2010 But it is clear that the revenue streams are inter-twined: sales of DVDs and merchandise have held up remarkably well, particularly given that they would be considered to be discretionary spending – presumably because of the success of the BBC Spindles broadcasts Candidates should also have worked through the other notes to the accounts to understand the non-current asset and depreciation policy and the components of inventories, accounts

receivable, and accounts payable As well as being fully familiar with the key components of the financial

statements and 4D‟s financial story candidates should also have grasped the essential point that 4D is in the grip of a recession From that starting point it should have been easy for candidates to pick up the financial story, and the necessary key facts provided in the EP as this situation continues to develop for 4D Despite continuing decline in overall revenue, some revenue streams have flourished Stronger candidates assimilated and integrated the AI and EP information effectively However weaker candidates failed to assimilate the less predictable elements sufficiently which gave a poor platform for their subsequent analysis The rationalisation of 4D in one location has meant the disposal of significant amounts of studio equipment at a loss and raises questions about the depreciation policy

For Requirement 2 the key information in the AI was the loan agreement (Exhibit 7), which contained the

covenant conditions Candidates should have familiarised themselves with the details of the covenant conditions relating to non-current assets and interest cover They should have considered the “headroom” for the loan conditions and the likelihood of a breach: whether that breach would be material or not, and whether it would pose a major or a minor problem for 4D Although some preparation could have been done on work-in-progress and deferred income it would have been speculative From the EP it would have been necessary to assimilate the details of the auditors‟ proposed adjustments (Exhibit 17) and which accounts they would affect, in order to give an accurate calculation of the impact on the income statement, statement of financial position and

statement of cash flows A review of the adjusted position against the existing covenant conditions and the new covenant condition concerning net current assets would then have been straightforward This work had to be

set in the context of the imminent meeting with the bank, the change in bank contact (possibly to a less benign manager) and the general fact that banks are more risk averse in the current climate Stronger candidates had assimilated the appropriate information from the AI and then integrated the information presented in the EP as the basis for addressing this topic Weaker candidates appeared to have more difficulty in gathering and

integrating the material into a cohesive starting point for their work

For Requirement 3 candidates should have studied and reviewed those exhibits in the AI which dealt with advertising regulations, public perception of advertising to children, and the potential for the market to grow in terms of demand for the creation of advertisements Candidates should also have formed a clear opinion of the type of product that Spindles was and its brand image The majority of candidates appeared well prepared for a broad strategic analysis requirement with the possibility of ethical concerns over advertising to children The EP

provided clear information concerning the proposal from Foment (Exhibit 19) The proposal was easy to

assimilate and the two newspaper articles in Exhibit 20 were both linked to this subject and identified other

issues and concerns relating to this project The EP information was fairly straightforward and built directly on

the AI material, as well as the fact that 4D needed to win as much new business as possible Stronger

candidates had a clear understanding of what information was required and could address this topic with

confidence but weaker candidates appeared to be less able to integrate the new information into their prior knowledge – merely concentrating on the EP information alone in their answers

Overall candidates demonstrated good levels of competence in assimilating and using information although weaker candidates did not always pick up a specific context presented in the EP

Structuring problems and solutions

For Requirement 1 most candidates performed the appropriate quality analysis on the 2011 financial statements both in the report and in their appendices by following the structure requested in the EP and integrating it with their preparatory analysis However, because the requirement was somewhat unpredictable, and because some

of the numbers required adjustments before the financial analysis was conducted (EBITDA), many candidates made errors in this section In other instances the analysis was not set in the context of the events surrounding 4D Many weak candidates simply ignored the losses on disposal of studio equipment both in the EBITDA

analysis and in the analysis of current assets and therefore provided poor analysis of 4D‟s results The current asset analysis was also a good example of weaker candidates not being able to see the bigger picture in their analysis Many weak candidates simply stated that non-current asset investment was down by 16% on 2010

non-No consideration was given to analysing the movement in non-current assets during the year to 2011, because although the comparative statement of financial position figures have only changed by £112k there is a very important story of additions, disposals, and annual depreciation contained in those figures A continuing problem for a minority of weaker candidates is the issue of the failure to analyse and present both absolute figures and percentage changes in their report Frequently both are needed, as in the analysis of gross profit (GP) and gross profit percentage (GP %age), where an absolute comparative figure may go in one direction but the percentage comparative figure goes in another more revealing direction, giving rise to a higher level comments about cost control and sales mix

In answering Requirement 2 most candidates correctly calculated the proposed audit adjustments and their impact on 4D‟s management accounts Strong candidates analysed the 4D position in relation to the bank

covenants both before and after the adjustments were made This enabled them to discuss the impact that all

conditions (including the new, net current asset, condition) were met before the adjustments but that 4D failed

the interest cover covenant after the adjustments were made Strong candidates calculated the amount by

which the interest cover condition was not met, as a financial figure, which left them in the position to discuss this breach with the bank Weaker candidates only calculated the failure in the interest cover in percentage terms; this incomplete calculation would have been almost irrelevant in the discussion with the bank Strong candidates performed a good positive analysis of the statement of cash flows and provided a clear commentary

on both the cash position and the changes which had taken place during the year Weaker candidates merely commented on the opening overdraft and closing positive balance – something which the bank would already know from its own records

For Requirement 3 stronger candidates used relevant parts of their previously prepared background analysis or took appropriate information from the AI which was augmented by their own research, and tied that into their analysis of the Foment proposal Strong candidates provided balanced analysis of the financial benefits and risks with the non-financial aspects (regulation and ethical concerns) Weaker candidates focused heavily on the financial benefits of this proposal but also raised concerns about the tight timescale for this work – without

remembering that 4D had managed to accomplish the delivery of the mini BBC series in a similarly tight

timescale These candidates did not really address the ethical dimensions of accepting this proposal, which made their analysis very lopsided

Overall the majority of candidates demonstrated that they could structure problems and provide solutions with competence

Applying judgement

Strong candidates made logical and appropriate judgements built on the analysis which they had conducted For Requirement 1 these candidates demonstrated that they recognised the interdependence between revenue streams and could discern that 4D was controlling specific production costs They also recognised that 4D

appeared to be changing its sales mix which was increasing its overall GP %age although they also pointed out that it was not possible to calculate accurately GP %ages on each revenue stream Stronger candidates also formed judgements which followed on from their financial analysis of non-current assets These included the opinion that losses on disposal may imply under-depreciation and that profit and the remaining assets may be

overstated They also commented on the fact that any change to non-current asset book value would impact the loan covenant conditions Weaker candidates failed to make these necessary judgements

Good candidates also demonstrated the necessity to show a level of balance in their judgement This could be seen in Requirement 2, when forming a professional judgement meant balancing (i) making the audit

adjustments as proposed, in the context of some opposition from Stephanie Shan, with (ii) the need to present a strong position to the bank Strong candidates provided opinions about the historical strength of 4D and

identified the cause of the current breach (profit is artificially low due to one-off significant losses on disposals) but also made it clear that the bank needed to be told about the adjustments Weaker candidates provided judgements which included trying to browbeat the auditors into making the lowest financial adjustments which would permit 4D not to breach its covenants – they were applying their judgement (and other skills) in the wrong direction

Good candidates demonstrated clear judgement in Requirement 3 by providing a clear evaluation of the risks and benefits of the Foment plc advertising proposal Their judgements included the risk evaluation of the impact

on existing work particularly with the BBC and DfE as well as the fact that 4D could become reliant on Foment, from whom there maybe the risk of future non-payment Strong candidates also raised questions about the exact nature of Foment products and the fact that there would be tension between Foment‟s ethical standards and 4D‟s Weaker candidates concentrated on the risks of this contract both in financial and non-financial terms

– although in some cases it was not helped by poor mathematics: “4D should not go ahead with this project because it will only receive £60k (£6m / 10) [sic] for each advertisement which is less than on current work, and its costs will be higher”

In the 4D case study, as in most case study exams, a weakness in applying judgement throughout the report can be positively correlated with a failure overall Weaker candidates did not demonstrate that they had applied clear judgement in their answers and in a significant number of answers weaker candidates failed to state any judgement at all Some of the judgements provided did not follow from the analysis which had occurred and there were frequent examples of poor judgement with little logic Many offered no balanced judgement at all in their reports simply advocating either the benefits or, more usually, the risks of a course of action Most

candidates who failed overall showed little evidence of this important professional skill

Conclusions and Recommendations

Strong candidates provided clear and logical conclusions throughout their reports which followed on from the analysis and judgement in their scripts – this was particularly relevant in Requirement 1: “The effect of removing

the depreciation (£574k) and unusually high losses on disposal (£675k) to arrive at EBITDA emphasises that in

a more normal year 4D would achieve a sufficient operating profit” Stronger candidates also provided

appropriate commercial recommendations, where relevant to the requirement – such as in Requirement 3: “The

4D directors should consider reducing their salaries which will improve the operating profit They should take their financial compensation as dividends – this would enable 4D to meet the interest cover covenant

conditions”

Weaker candidates failed to provide many conclusions and those that they did provide were brief and frequently did not follow logically from their scripts Weaker candidates also rarely offered any recommendations or else made particularly poor or inappropriate recommendations

Executive summary

Strong candidates provided logical executive summaries appropriately aimed at the correct audience – the 4D board Good executive summaries covered all three aspects of the report equally and contained clear numerical information together with appropriate analytical extracts from the body of the report (and the relevant

appendices) Well written executive summaries used the essential points from judgements made in the main body of the report and presented clear conclusions and recommendations for their readers These summaries were concise without being too short and were around 15% of the length of the body of the report

Although there was evidence of poor planning and time management this only existed in a minority of

candidates A noticeable problem which affected weaker candidates was the poor standard of judgement and conclusions in this section An additional problem was that many candidates failed to present the key facts and any of the important figures from the report Most of the problems appear to be due to poor writing technique and the failure to bring the appropriate facts forward from the main body of the report There was also the intractable problem of attempting to summarise a weak or unbalanced report which inevitably leads to a weak or unbalanced executive summary

A number of students made inappropriate and mundane statements and recommendations to the 4D board, given the general economic background and specific business context, such as: “the directors of 4D need to be careful they are not overstretched” or that “4D needs to invent some new characters for the Spindles village”

These remarks are both patronising and banal and would not impress the board of 4D No report reader would

be prepared to accept such poor quality generic advice and candidates who write such statements in their scripts receive little credit either

Requirement 1: Review of 4Ds 2011 financial performance

This financial statement analysis requirement was well answered by the vast majority of candidates although there were some significant specific areas of weakness in many scripts The fact that financial statement

analysis is a consistent element in the Case Study reflects the real-life work of a Chartered Accountant and candidates are expected to be able to conduct this type of analysis with sufficient and – better still – clear competence in order to pass the exam Inevitably with a requirement for which candidates have to prepare an appendix, there is always the risk that they will spend too much time on both the calculations and report writing for this section – however, there was little evidence of this particular exam technique weakness in this case Candidates had clearly paid attention to the instruction on page 1 of the EP that the report should be balanced

across each of the three detailed requirements and had planned accordingly

The requirement to analyse 4D‟s actual results for the year to 30 September 2011 was well anticipated and most candidates were properly prepared – by having analysed 4D‟s previous financial statements in the AI

(Exhibit 6) – and candidates followed the instructions provided in the EP The required analysis was clearly

defined: a review of revenue; gross profit and EBITDA evaluating these figures against the previous year‟s results It also required an analysis of 4D‟s revenue streams and investment in non-current assets set against the background of studio closure and disposal of studio equipment at a loss

In the year to 30 September 2011, 4D has been experiencing what most UK businesses are experiencing – it is

a normal business fighting hard for survival in the recession It appears to be well managed and it is controlling its costs and reducing its business operations where necessary The heavy losses on disposal are unlikely to be repeated – these have hit the reported profit figures for 2011 hard, but not the cash position Given the external recessionary events it is performing as well as it can, but will have to continue its stringent management of operations, costs and cash control

This requirement produced sufficient competent grades (SC or CC) in the vast majority of scripts Most

candidates providing a clear analysis of revenue (falling because of the recession) and gross profit (GP %age rising indicating good control of costs or changing sales mix) together with an analysis of the different revenue streams Good candidates demonstrated their understanding of EBITDA by correctly adjusting the operating profit for depreciation and losses on disposal, thereby identifying the significant impact of the closure of the studio Top candidates considered the issue of under-depreciation which had contributed to these losses and the possible impact on the value of remaining non-current assets and the implications for the loan covenant Weaker candidates made a less convincing attempt at the financial analysis Their weaknesses appeared in all aspects of their analytical work: they wrote about “like for like” revenue thereby missing the point that the

majority of 4D‟s film projects are one-off in nature; they frequently missed the fact that although GP had fallen in absolute terms it had risen in percentage terms (and so offered no comment on control of costs or the change in revenue mix); they could not define EBITDA correctly and simply analysed operating profit (and thereby