Case study november 2011 illustrative script 2 ICAEW

This candidate achieved sufficient competent grades in Executive Summary and Requirement 2 audit adjustments and meeting with the bank but did not achieve sufficient competent grades in

Trang 1

SECOND ILLUSTRATIVE SCRIPT AND EXAMINERS’ COMMENTS

In the commentary below extracts from the scripts are shown in quotation marks and in italics;

spelling, grammar, sentence construction and punctuation from the original script have been retained The commentary follows the order and numbering of the script with references to the topics in the marking key It should be read in conjunction with the review of the First Illustrative Script and also the full Examiners’ Report for this session

Examiners’ comments – overview

This script failed the exam It is around average length (but as always this depends on the actual handwriting), addresses all the key issues and contains some strong sections In terms of

professional skills this candidate achieved overall competent grades – Clearly Competent (CC) and

Sufficiently Competent (SC) – in 5 out of 9 grade boxes for Assimilating and Using Information; in 6 out of 12 for Structuring Problems and Solutions; 2 out of 12 for Applying Judgement and 5 out of 9 for Conclusions and Recommendations

The original 21-page length of the manuscript version was broken down as follows:

• Cover and contents – 2 pages

• Executive summary – 2 pages

• Report (main body) – 12 pages

• Appendices/workings – 5 pages

The 12 pages of the main body of the report address the key issues and together with the appropriate appendices demonstrate good planning and a good balance in answering the main requirements This candidate achieved sufficient competent grades in Executive Summary and Requirement 2 (audit adjustments and meeting with the bank) but did not achieve sufficient competent grades in either Requirement 1 (financial analysis) or Requirement 3 (evaluation of Foment proposal)

Terms of reference and executive summary

This internal report starts with a terms of reference section, which is not necessary, but which is seen

as being part of a contents summary The executive summary (ES) has an overall introduction and then addresses each of the sections of the report It is properly headed up but given the introduction it

is shorter on each of the main sections than average – although there is evidence of planning in compiling this summary, there is possibly some evidence of time pressure

The two main pages of the ES are split fairly evenly between the introduction and the three topics The summary of the financial analysis of 4D’s management accounts contains a few of the numbers which are part of the main numerical analysis, but these are insufficient and are mostly absolute figures Mention is made of “profit after tax” which was not required and is irrelevant One paragraph out of the four under this heading is indicative of the erroneous analysis and tone of this section:

“However, there are signs that the results for the year are not so bad as they initially seem If the one off revenue from the BBC in 2010 of £1 million is removed from the comparative, revenue has fallen

by just over £1 million which in the current economic climate is not too bad” This apologetic approach

and inability to summarise and analyse the actual declining results is a real weakness

In the section dealing with the proposed audit adjustments the ES again contains an unnecessary

reference to after-tax figures and then provides only the broad, bland advice that “4D communicate regularly and effectively with the bank” with no clear, positive cash analysis provided In the review of

the Foment proposal section the candidate presents a very brief summary of the financial benefits against a brief, broad analysis of the risks to brand damage with no real consideration of any ethical issues

Trang 2

Although the executive summary covered all areas it was only sufficiently competent in presenting the basic information from the report but was insufficiently competent on judgement, conclusions and recommendations

To score better grades on this section, the candidate could have provided better judgement and

conclusions on each of the sections required in the report

Review of 4D’s 2011 financial performance [Requirement 1]

The financial statement analysis in this section is accompanied by Appendices 1 & 2 (see detailed commentary below) These appendices support the comparative analysis of revenue, gross profit and revenue streams in percentage and absolute terms, as well as providing an EBITDA figure

This section starts with a brief, but not wholly relevant introduction The analysis of revenue then starts by detailing the fact that 2009 was a bumper year for the film industry as a whole

Unfortunately, although correct, it is probably not relevant to 4D’s current (2011) position The

candidate then spends time concentrating on the “£1 million one-off” BBC income – if it were removed

from 2010 then the fall in 2011 would not “appear too concerning” – which does not address the problem at all (Amongst other things it would just mean the fall and situation in 2010 would have been worse.) The analysis continues with an appropriate commentary on the reduction in the DfE

budget and possible associated declines in 4D revenue It also identifies that advertisement

production is a successful revenue stream The analysis of gross profit and part of the analysis of EBITDA (as far as it goes) is clear and accurate – as is the judgement on these items However there

is no mention of the word depreciation, despite it being part of the EBITDA calculation in the

appendix, and the loss on disposal does not feature at all Instead the analysis under the heading of

EBITDA contains some irrelevant and unnecessary commentary on overheads There is no analysis

of non-current assets which was specifically emphasised in the requirement The conclusions and recommendations follow the scattered quality of the analysis and contain weak and bland advice:

“They also need to reconsider staff numbers in times of economic downturn and ensure they are not paying for unnecessary staff hours However, in doing this they also need to ensure that the long term strategy of the company is considered”

Throughout this section although there is some evidence of awareness of both the broader economic situation and impact on 4D’s results, the style of the analysis seems to be to want to soften the blow

of a difficult year, rather than addressing the harsh reality of events – in particular an unwillingness to

mention the disposal of non-current assets at a huge loss! This was a weak section of the answer

To score better grades on Requirement 1, the candidate could have:

• Provided better comparative analysis of actual revenue/streams for 2011 against 2010

• Included the loss on disposal in EBITDA and considered its implications for 4D

• Provided some detailed analysis of non-current assets including: acquisitions, disposals and depreciation and the possible implications on the value of remaining assets and reported profits

• Provided stronger conclusions and relevant recommendations

Proposed audit adjustments [Requirement 2]

The financial data analysis in this section is accompanied by Appendices 3-5, which provide a good, clear and relevant numerical platform from which to comment on the proposed adjustments These

appendices contain accurate calculations, but stop one step short of completion

In the introductory section the candidate sets the scene for 4D: “The company finds itself between needing to make the required audit adjustments in order to get an unmodified audit report; and not wanting to make the audit adjustments in order to stay within the loan covenant limits” – the dilemma

succinctly expressed ‘in a nutshell’

Trang 3

The critical impact of the adjustments is correctly stated: “If all four adjustments were processed this would bring operating profit down to just £206k from £381k as shown in Appendix 3” However, the

candidate then spends time calculating percentage margins on various decreasing figures – all of which are irrelevant to the question in this topic of how to deal with the bank Sadly, despite having calculated all the steps correctly this candidate failed to present the final calculation of just how much the breach actually was and therefore what the negotiation with the bank would focus on

Despite having already identified the potential problem the candidate then spends two whole sections within this topic assessing the adjustments against the existing and new covenant conditions In fact it

is not until the concluding paragraph under Section 2.3 that the script contains the starting point for

the negotiation with the bank: “The main problem of this company is its ability to control and manage costs [and, dare one say, the losses on disposal] Its statement of financial position and asset values appears healthy” However these (positive) points are not then developed by querying whether the

asset values might, in fact, be overstated

Although this script deals with the audit adjustments and the implications of processing (or not

processing and causing a modified report) correctly, the report is much less clear on the negotiations with the bank – not least because the actual figure of the interest cover covenant breach is never established, either in the report or in the appendix The result of the absence of a clear figure is

apparent in some of the broader and more vague suggestions made concerning the meeting: “You can discuss with the bank what detailed forecasts can be done and what immediate plans can be put

in place for cutting costs for example monitoring staff numbers in line with revenue” Although the

report does mention the change from opening overdraft to closing positive balance at the bank, it

offers no positive story, for the meeting, for the route between those two figures

The final conclusions and recommendations, particularly as far as the bank meeting is concerned, are not strong or convincing

• Provided absolute figures for the interest cover covenant breach in the body of the report

• Discussed the one-off impact of the loss on disposal on the covenant breach

• Analysed the movements on the statement of cash flows providing a full positive story to the bank

• Expressed more practical and precise conclusions and recommendations

Foment’s proposal [Requirement 3]

The candidate has a scene-setting paragraph concerning the Foment proposal in the opening section:

“This proposal is not only asking 4D to create a ‘ground breaking advertising campaign’ but is also requesting that the Spindles characters feature in this campaign” The report continues by presenting

the significant financial benefits and the potential positive spin-offs for Spindles and 4D

Although there is a need to balance the risks, relating to future revenue, this candidate actually makes

conflicting statements concerning the Spindles ‘life’ in the risks section: “The key risk is that the

Spindles characters could be nearing the end of their product life cycle and by associating them with a new product, neither the product nor Spindles would succeed There is also the risk that by using them in such an extensive campaign over a 2 year period that it could drain any life the Spindles characters had and exhaust the revenue potential” This conflict over whether to exploit Spindles

‘remaining life’ is difficult to unravel Some of the other non-financial risks identified are totally

marginal (or wrong): “4D has never operated overseas before and therefore clarification needs to be sought regarding any foreign exchange”

The report does recognise the immediate positive financial benefits that this proposal might bring, as well as touching on some of the possible opportunities which might flow to 4D but it is an imprecise

discussion: “It could also open up more opportunities to work on big advertising campaigns, both with

Trang 4

and without the Spindles characters It is an area their creative expertise excels in and this should continue to be built on”

Although there is a short section on the ethics relating to this venture it is a rather woolly series of paragraphs and does not focus on the real ethical problems which such a link-up might create This section on conclusions and recommendations does not, in fact, arrive at a conclusion and the

recommendations are weak

• Provided a more comprehensive analysis of the financial risks of this proposal

• Provided a more detailed analysis of the non-financial benefits and risks of this proposal

• Discussed confirming the nature of the Foment products Addressed the ethical concerns in more detail

• Provided a firm conclusion and clear recommendations

Appendices

Appendices 1 & 2

These relate to the financial statement analysis (Requirement 1) Appendix 1 provides a series of clearly laid out columnar analyses of the 4D revenue streams for 2011 compared with 2010 The analysis of movements between the years is made in both absolute and percentage terms In the detail provided a clear analysis of sales mix has been calculated, including a column on 2009 – which may be seen to be appropriate in terms of trend analysis Importantly the correct movement in gross profit margin has been identified In Appendix 2 the calculation of EBITDA indicates that the candidate understands what should be included under this heading, for both 2011 and 2010, but does not include the significant loss on disposal or make the comparison with revenue, which would have completed this analysis Overall these are relevant working documents which provide a partial basis for the analysis provided in the body of the report

Appendix 3 - 5

These appendices relate to the proposed audit adjustments (Requirement 2) The calculations shown concerning the proposed adjustments are correct together with their impact on 4D’s management accounts The appendices also show the impact of these adjustments on the two original loan

covenants conditions and the (correct – net current asset) new loan covenant condition The figures are clearly analysed in both percentage and absolute terms Despite the fact that the final calculation for the actual loan cover breach is not provided these appendices are good working documents which provide a clear basis for the numerical information shown in the body of the report

These appendices demonstrate that the candidate knew what had to be done and provided much of the numerical evidence from which to write some clear analysis

Overall paper

Despite the fact that the content was weak in sections the overall script was well structured and clear following a logical format in answering the requirements There were some lapses in style and

grammar but overall the language used was appropriate The report was balanced appropriately between the three sections but the ES was very short There were some unnecessary facts

presented given the target audience, but the report had good financial explanations where needed The competent grades awarded for the overall paper rewarded a clearly written, if fundamentally weak, script

Trang 5

SECOND ILLUSTRATIVE SCRIPT AND EXAMINERS’ COMMENTS

Report to the Board of Directors to Analyse 4D’s recent results and evaluate future strategy for the company

Trang 6

Terms of Reference

As requested this report has been prepared to deal with the proposed audit adjustments and future strategies of 4D This report covers

• A review of 4D’s results for its year to 30 September 2011

• The impact of the proposed audit adjustments on 4D’s draft management accounts and any implications for loan covenants

• An evaluation of a proposed advertising campaign using the Spindles characters

The report is based on information provided by our management and has been prepared for the Board of Directors of 4D Limited, it is private and confidential

Executive Summary

4D has benefited from historic growth and remains a profitable company However, with poor working capital management, a high investment in fixed assets and a recent downturn in the economy, the company has started to suffer

The market is extremely competitive with substitute products and new entrants, but with the creation of the

‘Spindles’ characters, 4D have managed to capitalise on this success

With a strong reputation and experienced Directors, 4D should be able to formulate a clear strategy to enable them to confirm future funding and help see them survive the recession

This report analyses the current financial position and results of 4D and goes on to look at potential future strategies

1 – Review of 4D’s results for the year

With revenue falling by £2,009 million in the year to just £13,928 and profit after tax falling to just £187, it

appears that 4D have had a tough year

However, there are signs that the results for the year are not so bad as they initially seem If the one off revenue from the BBC in 2010 of £1 million is removed from the comparative, revenue has fallen by just over £1 million which in the current economic climate is not too bad

Gross profit has also remained fairly consistent despite the fall in revenue which means gross profit margin has improved to be 40.4% This is most likely to be as a result of changes in revenue mix as the balance has shifted towards those revenue streams generating greater profits

Operating costs however are where the results for the year are not so successful as costs have not been managed in line with falls in revenue

Trang 7

2 – Impact of proposed audit adjustments

The total effect of the proposed audit adjustments is a reduction in profit of £175 While this may not seem detrimental or material, with profit levels sitting very low, it has a big effect on the bottom line of the company, reducing profit after tax to just £12

It is this effect on profit which then has an effect on the covenants in place from the bank loan The covenant regarding the operating profit levels is no longer met and as a result, 4D risk having their funding withdrawn If this funding was withdrawn it would bring into question the going concern of the company

In light of this inability to meet the covenant, it is essential that 4D communicate regularly and effectively with the bank and work with bank to ensure forecasts and cash management is in place to improve the situation

3 – Advertising proposal

The proposal to work as an advertising campaign with an existing client would potentially bring in £6 million revenue and £2.97 m of gross profit as well as generating more revenue from DVD and merchandise sales This has big financial advantages to a company which is struggling to secure its future

However, there are many risks involved with this proposal such as the remaining popularity of the Spindles characters, further reliance on the Spindles characters and the time scales involved Further to this the directors also need to consider whether they want to associate themselves and their work with foods and products which can lead to obesity

Trang 8

1) Review of 4D’s results for the year to 30 September 2011

Since revenue peaked in 2009, it has been clear that conditions are tough for 4D both as a result of the

downturn in the economy and as a result of the company not having a clear direction for future growth The

2010 and the 2011 management accounts highlight how difficult conditions currently are for 4D

1.1 Revenue

Revenue has fallen by £2,009 million to £13,928k in 2011 Revenue was at its peak in 2009 but we are aware that 2009 was a bumper year in the UK film industry with total UK gross box office takings for the year up 11%

on 2008 While 4D’s revenue does not all come from film commissions, 4D may well have benefited from this boost in the industry

In 2010 however, the only revenue stream to grow was that of commission of films boosted by a £1 million contract from the BBC for Spindles programmes

If this £1 million one off revenue is removed, the decrease in revenue between 2011 and 2010 is just over £1 million at 6.8% fall In light of tough economic trading conditions this doesn’t appear too concerning

As Appendix 1 shows the revenue mix between the revenue streams appears to have shifted in 2011 Again, if

we remove the £1 million one off revenue from commissions, the proportion of this stream in 2010 reduces from 26.4% of revenue to 21.8% which then doesn’t make 2011’s proportion of 21.4% appear unreasonable

The sale of DVD’s and the sale of merchandise have continued to fall with income of £6.7 million (4078 + 2638)

in 2011 compared to £7.7 million (4611 + 3134) in 2010 A majority of these sales come from Spindles products and the contract with the Department of Education

In October 2010, the government announced that the Department of Education would have its budget cut by between 10% and 20% which may have had an effect on the contract with 4D

This fall in revenue may also further indicate that the Spindles products and characters are nearing the end of their product cycle and failing to bring in revenue as was seen in 2009 Despite this, as Appendix 1 shows the contribution in % terms is relatively consistent

The only revenue stream which has increased is that of advertisement which has increased by £861 to £1,889

as shown in Appendix 1 While it may have been thought that companies would be reducing such expenditure because of the recession, the opposite appears to have happened whereby companies are actually doing more aggressive, innovative advertising in order to get sales

4D pride themselves on their reputation for innovation and creative advertising and this seems to have benefited them here in 2011

Gross profit

Gross profit has only fallen by £265 from £5,898 to £5633 as shown in Appendix 1 With gross profit remaining fairly consistent despite the falls in revenue, gross profit has actually improved to 40.4%

While this may be as a result of better cost management and planning, it is more likely to lie in the revenue mix While accurate profit margins cannot be calculated for each profit stream, by taking typical contracts, the

margins generated by advertising is 49.5% with an increase in advertising revenue and a bigger contribution, with a relatively high profit margin, it is going to help overall gross profit margins

Also with a decrease in commissions and DVD/merchandise sales, which only brought in approximately

between 26% and 31.6% gross profit margins, this will have an effect on overall profit margins

EBITDA

As Appendix 2 shows, EBITDA has fallen from £1209 to £955 This is despite an improvement in gross profit margins

Trang 9

This therefore suggests that overheads and operating costs have not been managed as well as costs of sales If

we take salaries and wages, these have only reduced by £62 from £2967 to £2905 Salaries contribute 55.3% of overhead costs and if these are not managed it has a detrimental effect on operating profits and further to the EBITDA calculation as shown

Conclusions and recommendations

2011 has proved to be somewhat of a mixed year While revenues appear to have been drastically reduced by removing the £1 million one off revenue, they have actually only reduced by 6.8% and gross profit margins have improved

However, it appears that the improvement in gross profit margins is as a result of the change in revenue rather than cost management as overheads and operating costs have continued to cause problems and reducing the bottom line profit

4D needs to focus on winning new work and building on the improvements in advertising revenue stream It is also key that they generate a succession plan for Spindles

They also need to reconsider staff numbers in times of economic downturn and ensure they are not paying for unnecessary staff hours However, in doing this they also need to ensure that the long term strategy of the company is considered

Trang 10

2) Impact of the proposed audit adjustments

4D are currently financed by the £2 million loan and although their cash balance has improved in the year, there are limited alternative sources of funding available As a result, if the loan was recalled through failure to meet the covenants, it would bring into question the company’s ability to continue as a going concern

The company therefore finds itself between needing to make the required audit adjustments in order to get an unmodified audit report; and not wanting to make the audit adjustments in order to stay within the loan covenant limits

2.1 Impact on the management accounts

Individually the four adjustments proposed by the auditors do not have a significant effect on the management accounts, but if all four adjustments were processed this would bring operating profit down to just £206 from

£381 as shown in Appendix 3 This reduction in operating profit of £175 then has a further impact on operating profit margins and profit after tax for the year

Prior to any adjustments, operating profit margin was just 2.7%, but with the proposed adjustments this reduces even further to 1.5% This brings into serious question the entity and the managements’ ability to control costs After the proposed adjustments, profit after tax is just £12 (£187 - £175) Profit was at its peak in 2008 at £683,

so to reduce profits to £12 will bring into question the future of the company and put off any future investors

2.2 Assessment against existing loan agreement

Under the existing loan agreement, there are two covenants on the financial statements One regarding the value of non-current assets and one regarding operating profit

None of the audit adjustments affect non-current assets and despite the amount of assets that have been disposed of in the year after review of surplus and obsolete assets this covenant is still met In 2011, as show in Appendix 4, there would have to be a minimum net book value of £1,320 and value on the SOFP is £1,610 However, all of the audit adjustments affect operating profit and even before any adjustments were processed, operating profit at £381 was very close to not meeting the required level of £342 as calculated in Appendix 4 A fall of just £39 would have been required for this covenant to no longer be met

Therefore, with a fall in profit of £175 from the proposed audit adjustments this covenant is no longer met All of the required adjustments go the same way and reduce profit and while it may be possible to try and compromise

on some of the adjustments (the inventory provision ones) it is still not likely to increase profits enough to meet the covenant

The WIP and deferred income adjustments would be difficult to compromise on and these alone reduce profit by

£50 which would take operating profit below the required level

Định dạng
Số trang	18
Dung lượng	85,22 KB