Question Tag: Regulatory Penalties

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.