Question Tag: IAS 37

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  • 3 Marks

FR – Nov 2023 – L2 – Q2d – Financial Reporting Standards and Their Applications

Explain the financial reporting treatment of decommissioning costs in the financial statements of Taini Ltd under IAS 37.

Taini Ltd (Taini) is a listed mining company that operates in the Bono Region with a ten-year term concession commencing on 1 April 2022. After the expiry of the current mining term, Taini has a duty to rehabilitate the area. These rehabilitations are anticipated to cost GH¢12.09 million on April 1, 2032. On April 1, 2022, the present value of the restoration cost was calculated using the company’s 8% cost of capital at GH¢5.6 million.

Required:
In accordance with IAS 37: Provisions, Contingent Liabilities and Contingent Assets, explain the financial reporting treatment of the above transaction in the financial statements of Taini Ltd for the year ended 31 March 2023.

Any amount recorded at the present value of future cash flows should be adjusted as time passes. The adjustment allows for the fact that the time to maturity is shorter. The adjustment is measured as the opening balance multiplied by the original discount rate.

Here, GH¢5.6 million × 8% gives GH¢0.448 million. This is charged (debited) to profit or loss (finance costs) and increases the present value of the provision (credit entry).

Debit profit or loss GH¢0.448 million
Credit provision for restoration GH¢0.448 million
Alternatively:

DR Non-current Asset GH¢5.6 million

CR Provision for decommissioning cost GH¢5.6 million
(To initially recognise the asset and liability relating to decommissioning cost.)

DR Statement of profit or loss (depreciation) GH¢0.56 million

CR Non-current asset GH¢0.56 million
(To recognise depreciation charge for the year.)

DR Statement of profit or loss (unwound discount) GH¢0.448 million

CR Provision for decommissioning cost GH¢0.448 million
(To recognise the unwound discount on the liability for the year.)

(Total: 3 marks)

  • 3 Marks

FR – July 2023 – L2 – Q2d – Contingent Liabilities and Assets (IAS 37)

Explanation of contingent liabilities and contingent assets according to IAS 37.

The objective of IAS 37: Provisions, Contingent Liabilities, and Contingent Assets is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities, and contingent assets, and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing, and amount.

Required:
Explain Contingent Liability and Contingent Asset as used in the statement above.
(Total: 3 marks)

Contingent Liability:

  • A possible obligation depending on whether some uncertain future event occurs, or
  • A present obligation, but payment is not probable, or the amount cannot be measured reliably.
    (1.5 marks)

Contingent Asset:

  • A possible asset that arises from past events, and
  • Whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.
    (1.5 marks)
  • 10 Marks

AA – Mar 2023 – L2 – Q4a – Completion Procedures and Reporting

Explain the auditor's responsibilities regarding subsequent events and how a legal claim should be reported in financial statements.

You are an audit assistant for an audit client with a year-end of 31 December 2021. A major customer has instituted a legal action against the company for faulty goods supplied after the year-end. A recently recruited intern who was part of your team was of the opinion that because of the cut-off assertion, any event after 31 December 2021 should not affect the financial statements and therefore the auditor should have no responsibility for issues occurring after the reporting year.

Following your audit of the client, you have concluded that there is a possibility, but not a probability, that the claim will be successful. However, management has decided not to make a provision or disclosure in the financial statements for this matter.

Required:
In reference to the preamble:
i) Describe the auditor’s responsibility for subsequent events occurring between:

  • The year-end date and the date the auditor’s report is signed; and
  • The date the auditor’s report is signed and the date the financial statements are issued. (6 marks)

ii) Explain how the matter should be reported in the financial statements. (4 marks)

i) Auditor’s Responsibility for Subsequent Events:

  • Between the year-end date and the date the auditor’s report is signed:
    The auditor has an active duty to design and perform audit procedures to obtain sufficient and appropriate evidence for all events that require adjustment or disclosure in the financial statements. These events must be identified and appropriately reported in the financial statements. The procedures should be performed as close as possible to the date of the auditor’s report. The auditor should also seek written representations from management regarding subsequent events up to the date of the report. If any material subsequent events requiring adjustment or disclosure are not addressed, the auditor may need to modify the audit opinion.
  • Between the date the auditor’s report is signed and the date the financial statements are issued:
    After the auditor’s report is signed, the auditor is not required to perform audit procedures or make any additional inquiries regarding subsequent events. However, if the auditor becomes aware of facts that could materially affect the financial statements, they must:

    • Discuss the matter with management.
    • Determine if the financial statements need to be amended.
    • If necessary, perform additional audit procedures related to the amendment(s).
      The auditor should also extend their review of subsequent events up to the date of the new audit report if the financial statements are amended.

(6 marks)

ii) Reporting the Legal Claim in the Financial Statements:
As the audit concluded that the likelihood of the legal claim being successful is only possible (not probable), IAS 37 requires the company to disclose the contingent liability in a note to the financial statements. The disclosure should include:

  • A description of the nature of the contingent liability.
  • An estimate of its financial effect.
  • Indications of uncertainties surrounding the timing and amount.
  • The possibility of any reimbursement from third parties, if applicable.

(4 marks)

  • 15 Marks

AA – Nov 2017 – L2 – Q5a – Audit and Assurance Risk Environment

Summary: Discuss the impact of an ongoing lawsuit on the audit report if the matter remains unresolved.

Lexon Institute provides tuition for accountancy studies writing professional examinations. You are the audit manager of DAR and Co. Chartered Accountants. The following were identified during the financial audit of Lexon. Revenue is GH¢30m, Profit before tax is GH¢10 million and total assets is GH¢25 million.

i) The regulator of the Accountancy profession has filed a lawsuit against Lexon Institute for GH¢3.9 million alleging a non-compliance with the Regulators rules and regulations for running a tuition center. This case is ongoing and will not be resolved prior to the audit report being signed. The matter is disclosed as a contingent liability.
(4 marks)

ii) Depreciation has been calculated on the total of land and buildings. In previous years it has only been charged on buildings. Total depreciation is GH¢2·5 million and the element charged to land is GH¢2 million.
(4 marks)

iii) Lexon Institute’s computerised purchases is backed up daily, however for a period of three months the purchases records and the back-ups have been corrupted, and therefore cannot be accessed. Purchases for these three months amounted to GH¢4m.
(4 marks)

Required:
Discuss each of these issues and describe the impact on the audit report if the above issues remain unresolved.

(Total: 15 marks)

i)

  • Materiality: The GH¢3.9 million lawsuit represents 39% of Lexon Institute’s profit before tax (GH¢3.9 million/ GH¢10 million), making it a material issue that could influence users of the financial statements.
  • Contingent Liability Disclosure: Since the lawsuit is ongoing and the outcome is uncertain, Lexon has appropriately disclosed the matter as a contingent liability in accordance with IAS 37. However, if management fails to adequately disclose this, it would require the auditor to modify the report.
  • Audit Report Impact: If Lexon properly discloses the contingent liability but the outcome remains unresolved, the auditor may issue an unmodified opinion with an emphasis of matter paragraph to highlight the uncertainty surrounding the lawsuit and its potential impact on the financial statements.
  • Qualification: If Lexon fails to disclose the contingent liability, the auditor would issue a qualified opinion due to material misstatement, as this omission would affect the users’ understanding of the financial position of the company.

(4 marks)

ii)

  • Depreciation on Land and Buildings
    Depreciation has been provided on the land element of property, plant, and equipment, and this is contrary to IAS 16 “Property, Plant and Equipment,” as depreciation should only be charged on buildings and not land. Land typically does not have a finite useful life, and hence it should not be subject to depreciation.
  • Materiality
    The error is material, as it represents 20% of the profit before tax (GH¢2 million out of a profit before tax of GH¢10 million). Given the materiality, the financial statements are misstated if this error is not corrected, and this could mislead the users of the financial statements.
  • Audit Report Impact
    If management does not correct this error, the audit report will need to be modified. Since management has not complied with IAS 16, and the error is material but not pervasive, the auditor will issue a qualified opinion. The opinion will be “except for” the misstatement related to the depreciation charged on land.
  • Basis for Qualified Opinion
    A basis for qualified opinion paragraph will be required to explain the material misstatement related to the depreciation charged on land. The opinion paragraph will be qualified “except for” the material misstatement.

(4 marks)

iii)

  • Corruption of Purchases Records
    Lexon Institute’s purchases records and backups have been corrupted for a period of three months, and the purchases during this time amounted to GH¢4 million. This represents 40% of profit before tax (GH¢4 million out of GH¢10 million). This is a material issue, as it impacts the completeness of recorded purchases.
  • Audit Evidence
    The auditor must attempt to verify the purchases by other means, such as reviewing supplier invoices, delivery notes, or payment records. If this alternative evidence cannot be obtained, the completeness of purchases for the three-month period will not be verifiable.
  • Audit Report Impact
    If the auditor cannot obtain sufficient appropriate audit evidence for these purchases, and the amount involved is material, the auditor will need to modify the audit report. Given that the issue relates to a material but not pervasive element of purchases, the auditor will issue a qualified opinion due to limitation of scope.
  • Basis for Qualified Opinion
    A basis for qualified opinion paragraph will be required, explaining the limitation in obtaining sufficient appropriate audit evidence for purchases during the three-month period. The opinion paragraph will be qualified “except for” the limitation of scope regarding the purchases records.

(4 marks)

 

 

  • 10 Marks

AA – May 2021 – L2 – Q5b – Completion Procedures and Reporting

Discuss the impact of unresolved issues related to redundancy provision and contingent liability on the Auditor’s report.

Logistics Ltd is a logistics and freight forwarding company based in the port city of Takoradi, and you are the Audit Manager in charge of the year-end audit. The draft financial statements show a profit before tax of GH¢2.6 million and total assets of GH¢18 million.

In your discussion with management, the following issues came up:

i) Management informed you that due to the ongoing coronavirus pandemic, shipping from China has slowed down considerably, and as a result, many employees have been laid off. A redundancy provision of GH¢220,000 is included in the draft financial statements. The audit review and calculations confirmed that the redundancy provision should be GH¢450,000. The Finance Director is, however, not willing to adjust the draft financial statements. (5 marks)

ii) An employee has filed a wrongful dismissal lawsuit against Logistics Ltd for GH¢1.2 million. This case is ongoing and will not be resolved before the Auditor’s report is signed. The matter is disclosed as a contingent liability. (5 marks)

Required:
Discuss each of the issues and describe their impact on the Auditor’s report, if any, should these issues remain unresolved in terms of ISA 705 (revised); Modification of the Auditor’s Opinion.

i) Redundancy Provision:
Under IAS 37 (Provisions, Contingent Liabilities, and Contingent Assets), if the economic outflow to discharge an obligation is probable, a provision must be recognized. Logistics Ltd has under-declared the provision for employee redundancy by GH¢230,000, which represents 8.5% of profit before tax (GH¢230,000/ GH¢2.6 million). This is material but not pervasive.

Impact on Auditor’s Report:
According to ISA 705 (Revised), the Auditor should inform those charged with governance about the Finance Director’s refusal to adjust the provision. If management does not amend the financial statements, the Auditor should issue a qualified opinion due to the material misstatement in the financial statements. The basis for the opinion should include the description and quantification of the financial effects of the under-declared provision. (5 marks)

ii) Contingent Liability:
The wrongful dismissal lawsuit for GH¢1.2 million represents 46% of profit before tax (GH¢1.2 million / GH¢2.6 million), making it a material issue. Under IAS 37, contingent liabilities must be disclosed if the economic outflow is possible. Logistics Ltd has disclosed this matter as a contingent liability.

Impact on Auditor’s Report:
If the matter remains unresolved, the Auditor should issue a qualified opinion based on materiality. The basis for the qualified opinion should explain the disclosure of the contingent liability and its potential impact. Since the outcome of the lawsuit is uncertain, it should be disclosed in the contingent liability note in the financial statements. (5 marks)

  • 10 Marks

AA – April 2022 – L2 – Q4a – Completion Procedures and Reporting

Discusses the need to amend financial statements based on subsequent events and the auditor's responsibility in the post-year-end period.

a) Aseye Ltd is in the manufacturing sector and its year-end is 30 September 2019. The final audit is nearly complete and it is proposed that the financial statements and audit report will be signed on 10 November 2019. Revenue for the year is GH¢80 million and profit before taxation is GH¢9 million. Subsequent to the year-end, a lawsuit was filed against Aseye Ltd. Below are the details of the lawsuit:

A key supplier of Aseye Ltd is suing the company for breach of contract. The lawsuit was filed on 10 October 2019, and the sum claimed by the supplier is GH¢2 million. This has been disclosed as a contingent liability in the notes to the financial statements; however, correspondence has just been received from the supplier indicating that they are willing to settle the case for a payment by Aseye Ltd of GH¢1 million. It is likely that the company will agree to this.

Required:
i) For the event above:

  • Discuss whether the financial statements require amendment. (2 marks)
  • Describe audit procedures that should be performed to enable the Auditor to draw a conclusion on the amendment. (2 marks)

ii) Describe the auditor’s responsibility for subsequent events occurring between:

  • The year-end date and the date the auditor’s report is signed. (3 marks)
  • The date the auditor’s report is signed and the date the financial statements are issued. (3 marks)

i) Financial Statement Amendment:

  • The financial statements should be amended as the event provides evidence of a condition that existed at the reporting date (30 September 2019). The contingent liability should be adjusted from GH¢2 million to a provision of GH¢1 million, as it is probable that Aseye Ltd will agree to this settlement. This is in accordance with IAS 37: Provisions, Contingent Liabilities and Contingent Assets.

Audit Procedures:

  • Review correspondence with the supplier to confirm the settlement amount of GH¢1 million.
  • Discuss with management to verify their intention to settle the lawsuit for GH¢1 million.
  • Obtain a written representation from management confirming the likelihood of settling for GH¢1 million.
  • Contact the company’s legal advisors to assess the probability and amount of the settlement.

ii) Auditor’s Responsibility:

  • Between year-end date and the date the auditor’s report is signed:
    The auditor has an active responsibility to perform procedures to identify subsequent events that require adjustment or disclosure. This includes reviewing management procedures, inquiring of management, and considering if further adjustments are necessary based on subsequent events, as outlined by ISA 560: Subsequent Events.
  • Between the date the auditor’s report is signed and the date the financial statements are issued:
    After the report is signed, the auditor is not required to perform any audit procedures unless they become aware of facts that may materially affect the financial statements. If such events occur, the auditor should discuss them with management and determine whether the financial statements need to be amended. If amendments are made, the auditor may need to extend their review to cover the period up to the new report date.
  • 5 Marks

FR – May 2017 – L2 – Q2a – Financial Reporting Standards and Their Applications

Discuss how to account for the cost of site reclamation and the financial effects of an earthquake.

Akakpo Ltd obtained a license free of charge from the government to dig and operate a gold mine. Akakpo Ltd spent GH¢6 million digging and preparing the mine for operation and erecting buildings on site. The mine commenced operations on 1 September 2014. The license requires that at the end of the mine’s useful life of 20 years, the site must be reclaimed, all buildings and equipment must be removed, and the site landscaped. At 31 August 2015, Akakpo Ltd estimated that the cost in 19 years’ time of the removal and landscaping would be GH¢5 million, and its present value is GH¢3 million.

On 31 October 2015, there was a massive earthquake in the area, and Akakpo Ltd’s mine shaft was badly damaged. It is estimated that the mine will be closed for at least six months and will cost GH¢1 million to repair.

Required:

i) Demonstrate how Akakpo Ltd should record the cost of the site reclamation as at 31 August 2015 in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
(3 marks)

ii) Explain how Akakpo Ltd should treat the effects of the earthquake in its financial statements for the year ended 31 August 2015 in accordance with IAS 10 Events after the Reporting Period.
(2 marks)

i) IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires that future costs of reinstatement be provided for as soon as they become an unavoidable commitment. The mine’s license requires the work to be done, so there is a commitment as soon as the mine starts operations. The present value of the full cost must be provided for. GH¢3 million will be credited to provisions and added to the cost of the non-current asset.
(3 marks)

ii) The earthquake occurred after the end of the accounting period. Assets and liabilities at 31 August 2014 were not affected. The earthquake is indicative of conditions that arose after the reporting period and does not give any further evidence in relation to assets and liabilities in existence at the reporting date. Therefore, according to IAS 10 Events after the Reporting Period, it will be classified as a non-adjusting event after the reporting period. The cost of the repairs will be charged to the Statement of Comprehensive Income in the period when it is incurred. Due to the impact on Akakpo Ltd (closure and loss of earnings for six months), the earthquake and an estimate of its effect will need to be disclosed by way of a note in Akakpo Ltd’s financial statements for the year ended 31 August 2015.

  • 6 Marks

CR – Nov 2021 – L3 – Q2c – IAS 38: Intangible Assets

Advise Zunka Ltd on how to account for the cost of adapting equipment and the provision for potential damages in a legal case for patent infringement.

Zunka Ltd (Zunka) is a private pharmaceutical company in Ghana, which imports medical equipment manufactured under a patent. Zunka subsequently adapts the equipment to fit the market in Ghana and sells the equipment under its own brand name. Zunka originally spent GH¢6 million in developing the know-how required to adapt the equipment, and, in addition, it costs GH¢100,000 to adapt each piece of equipment. Zunka has capitalised the cost of the know-how and the cost of adapting each piece of equipment sold as patent rights.

Zunka is being sued for patent infringement by Sajida Ltd (Sajida), the owner of the original patent, on the grounds that Zunka has not materially changed the original product by its subsequent adaptation. If Sajida can prove infringement, the court is likely to order Zunka to pay damages and stop infringing its patent. Zunka’s lawyers are of the view that the court could conclude that Sajida’s patent claim is not valid.

Sajida has sued Zunka for GH¢10 million for using a specific patent and a further GH¢16 million for lost profit due to Zunka being a competitor in the market for this product. Zunka has offered GH¢14 million to settle both claims but has not received a response from Sajida.

As a result, the directors of Zunka estimate that the damages it faces will be between the amount offered by Zunka and the amount claimed by Sajida. The directors of Zunka would like advice as to whether they have correctly accounted for the costs of the adaptation of the equipment and whether they should make a provision for the potential damages in the above legal case in the financial statements for the year ended 31 March 2021.

Required:

Advise the directors of Zunka on how the above transaction should be accounted for in its financial statements for the year ended 31 March 2021 in accordance with relevant International Financial Reporting Standards (IFRS).

In accordance with IAS 38: Intangible Assets, the three features to intangible assets are:

  1. Identifiability: The asset must be separable or arise from contractual or other legal rights.
  2. Control: The entity controls the future economic benefits of the asset.
  3. Future Economic Benefits: The asset will generate probable future economic benefits.

In addition, the cost of the intangible asset should be capable of reliable measurement. Development costs are capitalised only after the technical and commercial feasibility of the asset have been established. The entity must intend and be able to complete the intangible asset, and either use it or sell it, and be able to demonstrate how the asset will generate future economic benefits.

It appears in principle that the above criteria may have been satisfied in the case of the costs of adapting the medical equipment imported by Zunka Ltd. However, only the costs incurred in developing the initial know-how of GH¢6 million may be capitalised, as these are the costs of establishing the technical and commercial feasibility of the equipment.

The costs of adapting each piece of equipment of GH¢100,000 are simply production costs to be included in cost of sales, and if the equipment is not sold, they should be included in the inventory valuation of the equipment.

Provisions under IAS 37:

IAS 37: Provisions, Contingent Liabilities, and Contingent Assets requires that a provision be recognised if the following conditions are met:

  1. There is a present obligation (legal or constructive) due to a past event.
  2. It is probable that an outflow of economic resources will be required to settle the obligation.
  3. The amount of the obligation can be estimated reliably.

An outflow of economic resources is deemed probable when the outflow of resources is more likely than not to occur. For an estimate of the amount of the obligation to be reliable, it is sufficient if a range of probable outcomes can be determined.

The amount recognised as a provision should be the best estimate of the expenditure that an entity would rationally pay to settle. Zunka Ltd’s lawyers feel that the court could conclude that the patent claim is not valid. However, Zunka Ltd has offered GH¢14 million to settle both claims without going to court. Therefore, this implies that Zunka Ltd believes that it is more likely than not that a present obligation exists, resulting from a past event.

The amount of the provision may not correspond to the amount which has been offered to Sajida Ltd, as there is no certainty that Sajida Ltd will accept the offer. Therefore, as it is difficult to determine the amount of the provision within a range of probable outcomes, IAS 37 states that where a continuous range of possible outcomes exists, and each point in that range is as likely as any other, the mid-point of the range should be used.

Thus, Zunka Ltd should recognise a provision of GH¢10 million in its financial statements at 31 March 2021 and disclose the uncertainties relating to the amount or timing of these cash outflows.

  • 7 Marks

CR – Apr 2022 – L3 – Q2b – IAS 19: Employee benefits

Recommend accounting treatment for pension obligations and restructuring costs in financial statements in accordance with relevant IFRS.

Kaase Ltd, a public limited company, operates in the technology sector in Ghana. The company has decided to restructure one of its business segments, affecting employees in two locations. In the first location (A), half of the factory units were closed by 31 March 2021, and the affected employees’ pension benefits were frozen. After restructuring, the present value of the defined benefit obligation in this location was GH¢8 million. Before restructuring, the value was GH¢10 million, and the fair value of plan assets was GH¢7 million, resulting in a net pension liability of GH¢3 million.

In the second location (B), all activities were discontinued, and employees will receive GH¢4 million in exchange for a pension liability of GH¢2.4 million. Kaase Ltd estimates that restructuring costs excluding pension costs will be GH¢6 million. No formal announcement has been made due to a planned rights issue. The pension liability is currently included in non-current liabilities.

Required:
Recommend the accounting treatment of the above transaction in the financial statement of Kaase Ltd, including financial statement extracts for the year ended 31 March 2021, in accordance with relevant International Financial Reporting Standards (IFRS).

The appropriate accounting treatment for the pension obligations and restructuring costs under IAS 19 (Employee Benefits) and IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) is as follows:

  1. Pension Obligations:
    • Location A: The present value of the pension obligation is reduced from GH¢10 million to GH¢8 million, resulting in a negative past service cost of GH¢2 million, which must be recognized in profit or loss. The fair value of plan assets remains at GH¢7 million, leaving a net pension liability of GH¢1 million after restructuring.
    • Location B: The pension obligation of GH¢2.4 million will be extinguished by a payment of GH¢4 million. This will result in a loss of GH¢1.6 million, which should also be recognized in profit or loss.
    • Both transactions should be accounted for in the financial statements by adjusting the pension obligation and recognizing the related gains or losses in profit or loss.
  2. Restructuring Costs:
    • Even though there has been no formal announcement of the restructuring, Kaase Ltd has begun implementing it. Under IAS 37, a provision of GH¢6 million for restructuring costs should be recognized at the year-end since the restructuring plan has been initiated, and the company has a constructive obligation.

Statement of Profit or Loss Extract:

Description GH¢ million
Negative past service cost (Location A) 2.0
Loss on settlement of pension obligation (Location B) (1.6)
Restructuring provision (6.0)

Statement of Financial Position Extract:

Description GH¢ million
Non-current liabilities:
Reduction in pension obligation (4.4)
Current liabilities:
Pension payment (Location B) 4.0
Restructuring provision 6.0

(Total: 7 marks)

 

  • 20 Marks

AAA – Dec 2023 – L3 – Q2 – Audit Evidence | Evaluation and Review

Evaluate the accounting treatment of cash-settled share-based payments, regulatory penalties, and property valuation, and outline relevant audit procedures for each.

You are the Manager responsible for the audit of Rail Expert Plc, a listed entity whose principal activity is the operation of a regional railway network. The audit for the year ended 28 February 2021 is the first year your firm is auditing Rail Expert Plc. The draft financial statements received from your client indicated a total asset of GH¢58 million and a profit before tax of GH¢7.4 million. The detailed audit fieldwork has started, and the audit supervisor has brought the following matters to your attention in relation to the testing of key accounting estimates:

a) Cash-settled share-based payment scheme
On 1 March 2020, Rail Expert Plc granted 550,000 share appreciation rights to 55 executives and senior employees of the company, with each eligible member of staff receiving 10,000 of the rights. The fair value of the rights was estimated on 28 February 2020 by an external expert using an options pricing model at GH¢4.50 each. Rail Expert Plc prides itself on good employee relations, and the senior management team has estimated that all 55 staff will qualify for the rights when they vest three years after the granting of the rights on 1 March 2020. The company recognized an expense of GH¢825,000 with its associated liability in the draft accounts. (7 marks)

b) Regulatory penalties
Rail Expert Plc has been subject to a review by the national railways regulator following a complaint from a member of staff with safety concerns. The regulator identified breaches in safety regulations and issued a penalty notice on 30 September 2020. Rail Expert Plc has appealed against the initial penalty payable. Negotiations with the regulator are still ongoing, and the amount payable has not yet been finalized. Rail Expert Plc currently estimates that the total penalty payable as a result of the breach will be GH¢1.3 million, which it expects to repay in equal annual installments over the next ten years, with the first payment falling due on 1 March 2021. The company’s draft statement of profit or loss for the current year recognizes an expense of GH¢1.3 million, and the draft statement of financial position includes a liability for the same amount. (7 marks)

c) Property development
Rail Expert Plc owns an industrial property which it has historically used as a maintenance depot for its engines and carriages. The company has an accounting policy of revaluing its properties to fair value, and at the interim audit, it was noted that the depot was recorded at a carrying amount of GH¢2.5 million in the non-current asset register. During the first week of the audit fieldwork, the audit supervisor identified a year-end journal which has uplifted the depot to a fair value of GH¢4.9 million in this year’s statement of financial position as at 28 February 2021. Management has advised that this represents the estimated sales value of the building following Rail Expert Plc’s plan to develop the building as a residential property. The client has confirmed that the property is suitable for conversion into residential apartments at an estimated cost of GH¢1.2 million and has negotiated secured finance for the development with their bank. The development will be subject to the payment of fees to the local council’s building regulator of GH¢173,000. (6 marks)

Required:
Evaluate the client’s accounting treatments above and state THREE (3) audit procedures you will undertake when auditing each of the transactions.

a) Cash-Settled Share-Based Payment Scheme

  • The expense recognized this year of GH¢825,000 in respect of the cash-settled share-based payment scheme represents 11.1% of profit before tax and is therefore material to Rail Expert Plc’s statement of profit or loss for the year. The related liability of GH¢825,000, which would be recognized on the statement of financial position, is on the borderline of materiality to assets at 1.4%.
  • IFRS 2 Share-Based Payment requires that for cash-settled share-based payment transactions, the entity should measure the services acquired and the liability incurred at the fair value of the liability. Moreover, it states that until the liability is settled, the entity should remeasure the fair value of the liability at the end of each reporting period and at the date of settlement, with any changes in fair value recognized in profit or loss for the period. In the case of Rail Expert Plc, the expense and the associated liability have been calculated based on the fair value of the rights as at the reporting date, and the treatment therefore complies with the requirements of IFRS 2 (GH¢4.50 x 550,000 x 1/3 = GH¢825,000).
  • IFRS 2 also requires that the amount recognized as an expense for cash-settled share-based payments should be based on the best available estimate of the number of awards that are expected to vest. The entity must therefore estimate the number of awards that are expected to vest. In this case, management’s estimate that all 55 staff will qualify for the rights appears to be based on a perception of good historic staff relations, which may be inaccurate, and the expectation that none of the eligible staff will leave over the three-year vesting period may prove to be unrealistic. The predictive nature of management’s estimate in this regard represents a challenge to the auditor as it is difficult to obtain reliable evidence.
  • The fair value estimate of GH¢4.50 is based on an options pricing model, which is an example of a complex valuation model which, according to ED-540, is built on significant estimates and assumptions and is therefore challenging to audit. The initial choice of which option-pricing model to use is also a matter of judgment and whichever model is selected, it will incorporate judgmental inputs such as the current risk-free interest rate and measures of share price volatility.

Audit Procedures:

  1. Obtain a copy of the contractual documentation for the share-based payment scheme and supporting file notes detailing principal terms, and confirm:
    • Grant date and vesting date.
    • Number of executives and senior employees awarded share appreciation rights.
    • Conditions attaching to the share appreciation rights.
  2. Perform an assessment of the appropriateness of the model used to value the share appreciation rights and confirm that it is in line with the requirements of IFRS 2.
  3. Obtain details of the external expert used and assess the appropriateness of their appointment by considering their professional certification, experience, reputation, and objectivity.

b) Regulatory Penalties

  • The expense recognized in this year’s statement of profit or loss for the year of GH¢1.3 million is material to both profit (17.6%) and assets (2.2%). According to IAS 37 Provisions, Contingent Liabilities, and Contingent Assets, the fine should be measured at its present value at the reporting date. IAS 37 states that where the effect of the time value of money is material, the amount of a provision should be the present value of the expenditures expected to be required to settle the obligation and that the discount rate used in the calculation should be a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. The cash flows for the repayment of the fine over the ten years should therefore be discounted at an appropriate rate to present value as at 28 February 2021.
  • The audit of the provision represents a challenge for the auditor in a number of respects. First, it is difficult to estimate the amount payable as it has not yet been finalized, and the amount currently recognized is an estimate based on management’s judgment. These difficulties are compounded by IAS 37 requirements to measure the provision at present value. The measurement process therefore also requires management to predict the payment dates and to identify an appropriate pre-tax rate to be applied as the discount factor. Both of these will require a significant level of management judgment which will be a challenge for the auditor to obtain sufficient relevant and reliable evidence on. Moreover, there is also the possibility of other provisions being needed in relation to the costs of remedying the safety issues which the regulator has identified and in relation to other potentially unidentified safety problems. Here, addressing the completeness assertion will represent a key challenge to the auditor as it is inherently difficult to predict all of the costs to be incurred in the future especially when they have not yet been determined.

Audit Procedures:

  1. Obtain a copy of the regulator’s notice detailing the date of the issue and any indication of the amount of the penalty to be paid by Rail Expert Plc.
  2. Obtain a copy of any draft installment agreement detailing the timing and amount of each repayment.
  3. Review Rail Expert Plc’s correspondence with the regulator for evidence of the amount payable and details of the repayment schedule.

c) Property Development

  • The proposed valuation of the property at GH¢4.9 million represents 8.4% of assets and is material to Rail Expert Plc’s statement of financial position as at 28 February 2021. According to IFRS 13 Fair Value Measurement, the fair value measurement of a non-financial asset should take into account a market participant’s ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant who would use the asset in its highest and best use.
  • The audit of the property development will be challenging for the auditor first because judgment will be required in order to identify the property’s highest and best use per IFRS 13. The auditor must ensure, for example, that the valuation is compared to the property’s fair value in its existing use as well as in any other potential uses. Indeed, there may be other potential uses which have not been considered.
  • IFRS 13 also states that the highest and best use of a non-financial asset such as a property must be:
    • Physically possible: This will therefore require independent expert confirmation that the conversion can be successfully undertaken.
    • Legally permissible: This will require obtaining confirmation of formal permission from the local planning authority.
    • Financially feasible: This will require a detailed assessment of whether Rail Expert Plc will have sufficient cash flows in order to fund the development through to completion.
  • According to IFRS 13, when considering alternative uses for non-financial assets, the valuation should include all costs associated with the alternative uses. Hence, if the proposed development does represent the highest and best use of the property, the valuation should be adjusted for all of its associated costs. The proposed valuation at GH¢4.9 million is not therefore in compliance with IFRS 13 and on the basis of the information available, the valuation should be GH¢3,527,000 (i.e., GH¢4.9 million – GH¢1.2 million – GH¢173,000). If the additional costs are fairly stated, therefore, the property is currently overstated by GH¢1.373 million (GH¢4.9 million – GH¢3,527,000). The auditor will, however, need external confirmation of the GH¢173,000 in fees from the local building regulator and will also need to obtain sufficient appropriate audit evidence that the conversion costs of GH¢1.2 million are fairly stated. The conversion costs will present a particular challenge to the auditor as they will be based on the estimation of industry experts and the amounts will be inherently uncertain. There may be unforeseen additional costs payable to complete the conversion which will be difficult for the auditor to identify and quantify.

Audit Procedures:

  1. Obtain a copy of the development plans and confirm that the property is physically suitable for conversion into residential apartments.
  2. Review the approval documentation from the local planning authority confirming that the development is legally permissible.
  3. Assess the reasonableness of the estimated conversion costs, possibly by obtaining an independent valuation or expert confirmation.
  4. Review the loan agreement with the bank to confirm that secured financing has been arranged and assess the company’s cash flow forecasts to ensure they can meet these costs.
  5. Confirm the GH¢173,000 fee payable to the local council’s building regulator by reviewing the agreement with the local authority or an invoice from the regulator.

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