Question Tag: Financial Distress

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  • 25 Marks

AA – May 2019 – L2 – Q3 – Audit and Assurance Risk Environment

Discusses audit procedures related to inventory misstatement and indicators and audit procedures for going concern assessment.

Damongo Ltd (Damongo) is a computer hardware specialist and has been trading for over ten years. Damongo is the only hardware specialist listed on the Ghana Stock Exchange within five years after incorporation.

The company is funded partly through overdrafts and loans and also by several large shareholders. The year-end is 31 December 2017. Damongo has experienced significant growth in previous years. However, in the current year, a new competitor, HardWare Specialist Co (HardWare), has entered the market and through competitive pricing has gained considerable market share from Damongo. One of Damongo’s large customers has stopped trading with them and has moved its business to HardWare. In addition, a number of Damongo’s specialist developers have left the company and joined HardWare. Damongo has found it difficult to replace these employees due to the level of their skills and knowledge. Damongo has just received notification that its main supplier who provides the company with specialist electrical equipment has ceased trading.

Damongo is looking to develop new products to differentiate itself from the rest of its competitors. It has approached its shareholders to finance this development, however, they declined to invest further in Damongo. Damongo’s loan is long term and it has met all repayments on time. The overdraft has increased significantly over the year and the directors have informed you that the overdraft facility is due for renewal next month, and they are confident it will be renewed.

The directors have produced a cash flow forecast which shows a significantly worsening position in the coming 12 months. They are confident that the new products being developed is viable. Damongo has trading history of significant growth and they believe it is unnecessary to make any disclosures in the financial statements regarding going concern.

At the year end, Damongo received notification from one of its customers that the hardware installed for the customers’ online ordering system has not been operating correctly. As a result, the customer has lost significant revenue and has informed Damongo that they intend to take legal action against them for loss of earnings. Damongo has investigated the problem post year end and discovered that other work-in-progress is similarly affected and inventory should be written down. The Finance Director believes that as this misstatement was identified after the year end, it can be amended in the 2017 financial statements.

Required:
a) Describe THREE (3) procedures the auditors of Damongo Ltd should undertake in relation to the uncorrected inventory misstatement identified above.
(6 marks)

b) Explain FIVE (5) going concern potential indicators of Damongo Ltd.
(10 marks)

c) Identify SIX (6) going concern audit procedures which you should perform for Damongo Ltd.
(6 marks)

d) The auditors have been informed that Damongo’s bankers will not take a decision on the overdraft facility until after the audit report is completed. The directors have now agreed to include some going concern disclosures. Describe the impact on the audit report of Damongo Ltd if the auditor believes the company is a going concern but that this is subject to a material uncertainty.
(3 marks)

a) Procedures in relation to the uncorrected inventory misstatement:

  1. Assess the Extent of the Misstatement: Test a large sample of inventory items to assess the full extent of the misstatement and its potential impact on the financial statements.
  2. Discussion with Management: Engage with Damongo Ltd’s management to understand why the inventory misstatement occurred and whether the company intends to correct it.
  3. Compare to Materiality: Compare the misstatement to the materiality threshold. If the misstatement is material, request that adjustments be made to the financial statements to correct the inventory values.

b) Going concern potential indicators of Damongo Ltd:

  1. Increased Competition: A new competitor, HardWare Specialist Co, has gained significant market share, impacting Damongo’s future revenue.
  2. Loss of Key Customers: A significant customer has stopped trading with Damongo, further reducing revenue streams.
  3. Departure of Key Employees: Key specialist developers have left the company, which may hinder the company’s ability to develop new products and maintain competitiveness.
  4. Supplier Ceased Trading: Damongo’s main supplier has ceased trading, potentially affecting the company’s ability to continue operations or forcing it to find more costly alternatives.
  5. Worsening Cash Flow: The company’s cash flow forecast indicates a worsening position over the next 12 months, raising concerns about liquidity and solvency.

c) Going concern audit procedures for Damongo Ltd:

  1. Review Cash Flow Forecasts: Evaluate the assumptions used in the company’s cash flow forecasts and test them for reasonableness.
  2. Perform Sensitivity Analysis: Assess how changes in key assumptions impact the cash flow forecast and the company’s ability to meet its obligations.
  3. Post-Year-End Sales Review: Examine sales data and orders received after the year-end to assess whether there is evidence of recovery or deterioration in performance.
  4. Bank Confirmation: Obtain confirmation from the bank regarding the overdraft renewal and any associated conditions.
  5. Discussions with Management: Discuss with management their plans to mitigate any liquidity concerns and seek new funding.
  6. Legal Correspondence: Review correspondence with legal advisors about the likelihood and impact of potential legal claims from customers.

d) Impact on audit report if material uncertainty exists but the company is a going concern:

  • If the going concern assumption is appropriate but there is a material uncertainty, the audit report should include an emphasis of matter paragraph.
  • The paragraph should state that the opinion is not modified but highlight the existence of a material uncertainty, cross-referencing the relevant disclosures in the financial statements.
  • If the disclosures made by management are inadequate, the audit opinion will need to be qualified or adverse depending on the materiality and pervasiveness of the issue.
  • 10 Marks

CSEG – May 2019 – L2 – Q4a – Corporate governance framework

Discuss how inadequate corporate governance contributed to the financial distress in the Ghanaian banking sector.

The banking sector in Ghana has witnessed the withdrawal of licenses of seven indigenous commercial banks by the Bank of Ghana. These banks were in serious financial distress that they had to be taken over by another bank. UT Bank and Capital Bank were taken over by the GCB Bank in 2017 because they were in serious financial distress. The Bank of Ghana in August 2018 created the Consolidated Bank Ghana Limited to take over Unibank, Beige Bank, Sovereign Bank, The Royal Bank, and Construction Bank for similar reasons.

Different views about who or what was to blame for the crisis have been advanced, but many commentators agree that senior bankers and the Bank of Ghana had failed to recognize the early signs or ignored the indicators until it was too late. When companies collapse, there is often evidence of poor corporate governance.

Required:
Discuss FOUR (4) ways in which the difficulties faced by these banks may have been attributable to weak or inadequate corporate governance systems.

Inadequate Corporate Governance Systems and Their Contribution to the Financial Distress in the Ghanaian Banking Sector

  1. Failure to Review Internal Control Systems:
    • It is a requirement of good corporate governance that the board of directors should review the effectiveness of the system of internal control (including financial, operational, and compliance controls) and risk management. However, it is probable that in some banks, the systems of control were inadequate for their purpose. The complexity of banking operations may have exceeded the board’s understanding, leading to insufficient oversight and excessive uncontrolled risk.
  2. Dominance by Key Individuals:
    • In some banks, there may have been a dominance of power by key individuals such as the CEO or board chairpersons, which could have led to poor decision-making. The non-executive directors (NEDs) may not have acted effectively as a counter-balance to these dominant figures, allowing high-risk strategies to proceed unchecked.
  3. Ineffective Non-Executive Directors (NEDs):
    • The supervisory role of NEDs is crucial in corporate governance. However, in these cases, the NEDs may have failed to provide the necessary challenge to management’s decisions, particularly those involving high risk. This raises questions about the effectiveness of annual performance evaluations of NEDs and their ability to contribute meaningfully to board decisions.
  4. Lack of Transparency in Financial Reporting:
    • Transparency in financial reporting is essential for good governance. The financial statements of these banks may have been overly complex, making it difficult for even experienced investors to understand the true financial position of the banks. This lack of clarity could have prevented shareholders and regulators from identifying the extent of the banks’ financial difficulties in time to take corrective action.
  • 8 Marks

FM – Nov 2017 – L2 – Q4a – Working Capital Management

Explain the concept of overtrading, its symptoms, and how firms can overcome this situation.

Before the credit crunch, tenanted-pub firms borrowed cheaply in order to buy up back street boozers. But the debt crisis and the resulting slowdown have left the tenanted-pub industry nursing the hangover from hell.” – Financial Times, November 27/28, 2010.

Required:
Explain the term “overtrading” and in your answer show how the financial backers could diagnose (or misdiagnose) the main symptoms of this condition, the various possible causes of such symptoms, and how firms could overcome this situation. (8 marks)

Definition of Overtrading:
Overtrading occurs when a business expands its sales and operations beyond the capacity of its current financial resources. This typically results in insufficient working capital to support the increased level of business, leading to liquidity problems despite appearing profitable on paper.

Symptoms of Overtrading: Financial backers of tenanted-pub firms might notice the following symptoms of overtrading:

  • Declining Liquidity Ratios: The increased investment in current assets needed to support the expanded sales is financed mainly by short-term sources like creditors and bank overdrafts, leading to declining current and quick ratios.
  • High Sales-to-Equity Ratio: Sales increase rapidly in relation to equity, causing a sharp rise in the ratio of sales to equity.
  • Increased Gearing: The firm takes on more debt, leading to higher gearing ratios, which indicate a greater reliance on borrowed funds.
  • Negative or Declining Net Working Capital: The net working capital may decline or even become negative, which means that current liabilities exceed current assets, creating potential liquidity crises.

Possible Causes of Overtrading Symptoms:

  • Rapid Expansion: The firm may have expanded its operations too quickly without securing adequate long-term funding.
  • High Inflation: In periods of high inflation, sales turnover and working capital requirements can increase sharply in nominal terms, creating the appearance of overtrading.
  • Loan Repayment Pressures: Repaying loans without raising sufficient long-term funds can drain cash, exacerbating liquidity problems.
  • Excessive Dividend Payouts: High dividend payouts may deplete equity, worsening the firm’s liquidity position.
  • Misallocation of Funds: Using short-term funds to finance long-term investments can lead to symptoms similar to overtrading.

Overcoming Overtrading:

  • Improve Working Capital Management: Firms should focus on better inventory control, credit policy, and debt collection to reduce the investment in current assets required to support sales.
  • Secure Long-term Financing: The firm should arrange for long-term sources of funds to finance the working capital needs, thus improving the net working capital position.
  • Restrict Sales Growth: Limiting the growth in turnover to manageable levels can prevent the firm from stretching its financial resources too thin.
  • Careful Financial Planning: Financial planning should include considerations for maintaining adequate liquidity to support expansion.

(8 marks)

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