Case study november 2011 illustrative script 1 ICAEW

This candidate achieved a clear majority of the competent grades in Executive Summary and Requirement 1 financial analysis and a majority of competent grades in both Requirement 2 audit

FIRST ILLUSTRATIVE SCRIPT AND EXAMINERS’ COMMENTS

In the commentary below extracts from the scripts are shown in quotation marks and 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 Second Illustrative Script and also the full Examiners’ Report for this session

Examiners’ comments – overview

This script achieved a pass in the 1st quartile 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 8 out of 9 grade boxes for Assimilating and Using Information; in 9 out of 12 for Structuring Problems and Solutions; 8 out of 12 for Applying Judgement and 5 out of 9 for Conclusions and Recommendations

The original 22-page length of the manuscript version was broken down as follows

• Cover and contents – 1 page

• Terms of reference and executive summary – 4 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 a clear majority of the competent grades in Executive Summary and

Requirement 1 (financial analysis) and a majority of competent grades in both Requirement 2 (audit adjustments and meeting with the bank) and 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 acts as

a contents summary The remainder of the executive summary (ES) is well structured with clear headings to sections and covers all three areas of the report – there is evidence of some good

planning in compiling this summary, and no suggestion of time pressure

The three main pages of the ES are split fairly evenly between the three topics The summary of the financial analysis of 4D’s management accounts contains some of the appropriate numerical analysis, both absolute figures and percentages, covering the key areas which need to be considered In the section dealing with the proposed audit adjustments the ES contains the appropriate figures for the adjustments and their impact on loan covenant conditions as well as identifying the positive points concerning 4D’s cash to be emphasised at the bank meeting Similarly in the review of the Foment proposal the candidate presents a summary of the financial benefits against the risks of brand

damage and also brings in some of the ethical issues

The executive summary covered all areas and was sufficiently competent in the use of numbers and clearly competent in the quality of discussion It was mainly competent on judgement, conclusions and recommendations – apart from the financial analysis section

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

conclusions on the analysis of 4D’s financial results

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

The financial statement analysis in this section is accompanied by Appendix 1 (see detailed

commentary below) This appendix supports the comparative analysis of revenues, gross profit,

revenue streams, EBITDA and 4D’s investment in non-current assets in both percentage and

absolute terms – it is a thorough piece of work from which the report can be written

The review starts with a brief introduction then, as specified in the requirement, moves to an

appropriate analysis of revenue comparing 2011 against 2010 The analysis starts with the overall position of decline and then gives details of the individual streams The analysis is both in absolute

and percentage terms and provides relevant commentary on the numerical work: “Both DVD and

merchandise sales, linked to film commissions that promote brands like the Spindles, fell 12% to

£4.1m and 16% to £2.6m respectively” This analysis has not only described the changes but also

picks up the inter-dependence and linkage in revenue streams

Evidence of broader business awareness and research lies in other areas of the analysis:

“Advertisement production revenue has impressively grown by 84% to £1.9m, as corporate

advertising spend recovers from the recession (Advertising Association)

Although the start of the analysis of gross profit is not quite as clear as it might be the analysis still

identifies the main issue of improvement over the previous year and provides a reason: "This is

attributable to a change in revenue mix towards higher margin products, such as advertisement production for which its share of revenue increased from 6% to 14%”

The analysis under the heading of EBITDA contains some irrelevant commentary on overheads which

was not part of the requirement Although the candidate refers to “Stripping out loss on disposal” what

has been done (correctly) is to add back the loss to arrive at the correct EBITDA However, in the report there is no comparison with the prior year figure and no comparison against revenue

In the commentary provided on investment in non-current assets the candidate picks up on the fact

that “there is limited scope for further asset disposal however, due to the need to comply with the

bank covenants of the loan these assets are secured against” Throughout this script there is good

cross-referencing between topics – a sign that this candidate is linking the whole 4D scenario

The conclusions are consistent with the analysis but are not developed in sufficient depth However

the recommendation that 4D should “maintain [the] level of non-current asset expenditure to protect

quality and covenants” is a sensible commercial point

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

• Provided better comparative analysis of EBITDA and its relationship with total revenue

• Provided some more consideration of the reason for the loss on disposal and the possible

implications on the value of remaining assets and reported profits

• Provided better conclusions and relevant recommendations in the report

Proposed audit adjustments [Requirement 2]

The financial data analysis in this section is accompanied by Appendix 2, which provides a good numerical platform from which to comment on the proposed audit adjustments Although this

appendix contains some superfluous calculations, most of the information shown is appropriate and

correct for this section of the report and the audit adjustments are clearly presented

The candidate starts this topic by setting the scene: “4D’s bank loan covenants require an unmodified

audit report to be issued within three months of the year end, creating pressure to accept the

proposed audit adjustments, however they require careful consideration as they may leave 4D in breach of the financial covenants.”

With these points in mind the candidate then discusses the effect of the proposed audit adjustments

on the management accounts and the impact on the bank covenants The two existing loan

covenants and the new covenant are correctly discussed The breach of the interest cover is

334% to 180% due to the decrease in operating profit” The report then continues: “The covenant breach means 4D will have to repay the exposed amount of the loan as the other option of directors’ guarantees is not possible.” However, although the actual amount of the breach of £136k is calculated

and disclosed in Appendix 2, this figure has not been carried forward into the body of the report

although it does appear in the ES

This candidate does explain how the negotiations will be conducted and mentions appropriate

negotiating points for the meeting with the bank

The candidate considers the different matters proposed by the auditors for adjustment and the

potential for discussing and negotiating each of these with the auditors before coming to the astute

conclusion that “even if the adjustments to inventory are not required 4D will remain in breach of its

interest cover covenant.” Throughout this section the candidate has also shown good awareness of

the non-financial covenant conditions – in this instance the need for an unmodified report

The report has a section on cash flow and cash position which emphasises the positive elements such as the significant improvement in the cash balance from the prior year and the increase in cash

generated from operations “consistent with the improvement in EBITDA”( a good link from topic 2 back to topic 1) It also states “significant cash generated is utilised for capital expenditure … [which]

is important to maintain quality and comply with bank covenants”

In the conclusions and recommendations the candidate re-emphasises the positive element in cash

movements and goes on to say that [4D should] “negotiate with the bank regarding the covenant

breach as due to a one-off loss on disposal” These conclusions and recommendations are in

agreement with, and develop logically from, this section of the report

To score better grades on Requirement 2, the candidate could have:

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

• Presented a fuller analysis of movements on the statement of cash flows so as to give a full

positive story to the bank

• Expressed the conclusions and recommendations more clearly

Foment’s proposal [Requirement 3]

This section of the report is accompanied by Appendix 3 The candidate starts with a scene-setting paragraph of the reasons for considering this proposal seriously The report continues by presenting the significant financial benefits It identifies the sum involved and the timeframe over which it will be earned However, like many others, the candidate makes an error in the calculation of the margin, using figures from the AI relating to a standard advertisement contract (rather than for this specific proposal), and applies the previous absolute figure given for costs in the AI rather than using the percentage of costs against the revenue being earned – implying, erroneously, a truly massive

contribution from this proposal The report also mentions the upfront nature of the payment terms and

states: “The £1.5m (25% of £6m total) would cover the total loan repayment if required considering

the current covenant breach.” This section of the report also identifies that any increased publicity for

the Spindles brand would result in an increase in revenues of related DVDs and merchandise

The section on risks identifies the fact that the Spindles success “is based on its clean and positive

image, which may be tainted by being associated with an unhealthy drinks product” The initial

comment is correct but there is no evidence that Foment’s products are unhealthy – this was a

common error The report goes on to identify the impact which any tainting of the brand might have on

an organisation such as the DfE The report recognises other risks concerning the directors’ time There is also an evaluation of the possibility that Foment may be a possible credit risk in the future There is also a short section on the ethics of this venture concerning the advertising regulations and

the possibility that the association of Spindles may “influence the behaviour of children and persuade

them to buy a product” – which would not be acceptable

This section concludes after weighing up the fact that although this would be a financially beneficial

proposal (a 93% margin!) 4D should not accept it because the proposal “indicates the strength of the

Spindles brand that can be further commercialised with lower risks” – an unambiguous decision

To score better grades on Requirement 3, the candidate could have:

• Provided a more comprehensive analysis of the non-financial benefits of this proposal

• Discussed confirming the nature of the Foment products which may be perfectly healthy

• Used more appropriate assumptions in the appendix

Appendices

Appendix 1

This relates to the financial statement analysis (Requirement 1) and provides a series of well laid out columnar analyses of the summarised 4D income statement extracts 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 In the analysis of gross profit this candidate has attempted to analyse the gross profit for each revenue stream – which is not strictly possible from the information provided and which has clearly taken time to do However, the correct movement in total gross profit has been identified The calculation of EBITDA indicates that this candidate understands what should be included under this heading, both for 2011 and 2010, but does not calculate the EBITDA margin, which would have completed this analysis In the section dealing with investment in non-current assets this candidate reviews the components in non-current assets, which provides some interesting but not totally relevant detail Overall this is an adequate, relevant working document which provides a basis for the analysis provided in the body of the report

Appendix 2

This appendix relates to the proposed audit adjustments (Requirement 2) The calculations of the proposed adjustments are correct, together with their impact on 4D’s management accounts The appendix also shows the impact of these adjustments on the two original loan covenants conditions and the new (net current asset) loan covenant condition The figures are clearly presented in both percentage and absolute terms This is a good working document which provides a clear basis for the numerical information shown in the body of the report

Appendix 3

This very brief appendix relates to the Foment proposal (Requirement 3) The calculation shown provides an incorrect or naive summary of the possible margin from this proposal based on an

extraction of information concerning the costs and contribution of the production of short

advertisements in the AI This is not a particularly helpful appendix

With the provisos indicated above, these appendices demonstrate that the candidate knew what had

to be done and provided the numerical evidence from which to write some clear analysis

Overall paper

This was a well-structured answer which followed a logical format in answering the detailed

requirements There were lapses in style and grammar but overall the language used was

appropriate The report was balanced appropriately between the three sections and also clearly written with the target audience in mind, with good financial explanations where needed and no unnecessary facts provided to the board about their business The clearly competent grades gained under ‘overall paper’ reflected the result for the script as a whole

ILLUSTRATIVE SCRIPT 1

REPORT

TO: The Board of 4D

FROM: Ali Monet

DATE: 9 November 2011

SUBJECT: 4D’s financial performance, proposed audit adjustments, and proposed advertising campaign for

Foment plc

Terms of Reference

This report has been prepared for the Board of 4D in light of the September 2011 management accounts and the proposed audit adjustments and advertising campaign for Foment plc

It addresses 4D’s:

1) Financial performance and position to September 2011

2) Proposed audit adjustments and their implications on the loan covenants

3) Proposed advertising campaign for Foment plc

The report is based on September 2011 management accounts and other internally available information

Executive Summary

4D’s business is contracting with a continued weak economy forcing a restructure Performance is threatening a breach of bank covenants, whilst a new revenue stream is likely to be required

1 Financial performance

Revenue fell 13% to £13.9m due to a decline in all revenue streams except advertisement production

Gross margins improved 37% to 40% as its overall decline of 4% to £5.6m less than the revenue decline Stripping out loss on disposal of assets EBITDA increased 30% to £1.6m, indicating sound cash generation Non-current assets fell 30% to £1.0m as the second studio closed; however there was continued strong

investment with additions only 16% down to £586k

It is recommended a new revenue stream is required to reverse the decline and to maintain non-current asset investment level not to compromise profit

In conclusion, the business has contracted but profits not as much

2 Audit adjustments

The proposed audit adjustments decrease operating profit 46% to £206k and net current assets 7% to £2.2m There is no change to non-current assets, which at 134% of the loan amount outstanding has comfortable headroom of 18% or £290k on the 110% threshold

The decrease in operating profit means interest cover required of 300% is breached as it is reduced to 180% Although there is scope to negotiate with the auditors on the inventory write-down adjustments, these alone would not increase operating profit the required 60%, or £136k to be compliant

Despite the audit adjustments, net current assets remain compliant at the 150% of loan threshold at 185% with 19% or £421k headroom

The cash balance improved from £84k to £419k as cash generated from operations increased 30% to £1.6m despite a 16% increase in working capital investment to £2.08m

It is recommended to discuss this breach in covenant with the bank emphasising a strong cash inflow currently

To conclude, even with negotiation with the auditors, the loan covenant of interest cover will still be breached; however, there is a strong cash inflow to advise the bank on

3 Foment plc’s proposal

Financially the proposal is attractive generating £6m of revenue over the years that will increase revenue back

to in excess of £15m

At a margin of 93% and a contribution of £5.6m, it indicates the potential of the Spindles brand

An up-front £1.5m payment in advance would cover all the loan balance if required to be repaid

There are though significant risks of being associated with an unhealthy drinks product that could damage the Spindles clean brand

Also the DFE may stop its commissioning of films due to excessive commercialisation, preventing significant future exposure of children to the brand which would reduce auxiliary revenue streams of merchandise and DVD sales

The key ethical issues are the strict advertising rules for children to comply with, particularly as an unhealthy drink There is a threat of further tightening of these rules

It is recommended to consult with the DFE before accepting the proposal or other commercial ventures with the Spindles

The proposal should be rejected as the risks are too great to the mature Spindles brand and other lucrative less risky proposals should be sought

1 Financial Review (Figures per Appendix 1)

After a history of growth 4D is experiencing a contraction of its business due to continued weak economic conditions, the maturity of the Spindles brand and the decline of the DVD industry

1.1 Revenue

Revenue fell 13% to £13.9m in 2011

The decrease was across all revenue streams except advertisement production

Film commissions fell 29% to £2.98m, partially due to the one-off £1m Christmas Special contract in the prior year

Its decline may continue as operating capacity is now reduced following the closing of the second studio Both DVD and merchandise sales, linked to film commissions that promote brands like the Spindles, also fell 12% to £4.1m and 16% to £2.6m respectively

The DVD increase is linked to its industry decline, with it contracting 22% since 2008 (The Guardian) as newer online technology emerges

The decrease in corporate DVD revenue of 21% to £1.9m is likely to be a result of the weak economy currently Advertisement production revenue has impressively grown by 84% to £1.9m, as corporate advertising spend recovers from the recession (Advertising Association)

Although it does not, and will not offset the entire decrease in other revenue streams, there is opportunities particularly in the online advertising market

Studio hire out remains an insignificant revenue stream at £0.4m and 3% of total revenue; and will decline in future with the reduced capacity from July 2011

1.2 Gross profit

Gross profit fell 4% to £5.6m, a decrease less than the 13% of revenue

The reduced decrease is due to an improved gross profit margin of 40% compared to 37%

This is attributable to a change in revenue mix towards higher margin products, such as advertisement

production to which its share of revenue increased from 6% to 14%

1.3 EBITDA

EBITDA fell 21% to £0.096m as the business contracted with revenue’s 13% decline and £675k of losses on disposal included within EBITDA

Additionally, overheads as a percentage of revenue increased from 34% to 38%, although this includes

depreciation and loss on disposal, it does indicate cost control difficulties due to fixed costs as the business size contracts

Going forward, it is important to maintain advertisement expenditure as it is key to generate revenue; and also staff training so not to compromise quality

Stripping out loss on disposal, EBITDA increased 30% to £1.6m, which highlights the one-off impact that the asset disposals had on profit and cash flow

It indicates there is potential for decent profits and cash generation in the future, particularly with higher margin products such as advertising increasing in significance

1.4 Investment in non-current assets

The carry value of non-current assets fell 30% to £1.6m because of the restructuring closure of a studio

The key movements were -24% to £0.23m for property improvements and -37% to £1m for the studio

There is limited scope for further asset disposal however, due to the need to comply with the bank covenants of the loan these assets are secured against

Additions only fell 16% to £586k, which is important for both covenant compliance and quality of product

Revenue fell 13% to £13.9m as all major revenue streams decreased except advertisement production

Margins improved due to the shift towards a higher margin revenue mix; and excluding the loss on disposal EBITDA improved 30% to £1.6m

Non-current assets fell 30% to £1m due to the studio closure

Recommendations

• To find a new revenue stream as advertisement production will not offset all the decline

• Take care when cost cutting so not to damage quality

• To maintain level of non-current asset expenditure to protect quality and covenants

2 Audit adjustments (Figures per Appendix 2)

4D’s bank loan covenants require an unmodified audit report to be issued within 3 months of year-end creating pressure to accept the proposed audit adjustments; however they require careful consideration as they may leave 4D in breach of the financial covenants

Operating profit would decrease 46% to £206k as all four adjustments decrease operating profit

There is no impact to non-current assets which remain at £1.6m

Net current assets would fall 7% to £2.2m, again with all adjustments leaving a negative effect

The non-current asset to loan ratio remains 134%, with a comfortable 18% or £290k decrease to assets needed

to breach the 110% threshold

Interest cover of 300% is required; however the adjustments change the cover from 334% to 180% due to the decrease in operating profit

The covenant breach means 4D will have to repay the exposed amount of the loan as the other options of directors’ guarantees is not possible

There is potential room to negotiate with the bank as within operating profit is nearly £0.7m of one-off losses on disposal and a potential increase to future profits with the Foment plc advertisement proposal (requirement 3) Despite a decrease to the net current assets, the 150% threshold is not breached with the amended ratio of 185% leaving sufficient headroom of 19% or £421k of net current assets

2.3 Audit adjustment considerations

There is limited scope to negotiate with the auditor on the £20k WIP adjustment and £30k deferred income as treatment requires consistency with accounting policies, another loan covenant

A full provision of the obsolete Spindles DVDs may have scope for negotiation as some cost is likely to be recoverable selling the DVDs to a different market such as overseas, or to schools with budget cuts

There is potential for negotiation on the merchandise as well because it is unlikely that damage to packaging will mean rectifying costs is higher than the original inventory cost with inventory held on the lower of cost and net realisable value

However, even if the adjustments to inventory are not required, 4D will remain in breach of its interest cover covenant

There was significant improvement in the cash balance from the prior year, going from - £84k to £419k

This was primarily due to an increase in cash generated from operations which rose 30% to £1.6m, consistent with the improvement in EBITDA (section 1)

This will however decline in the future if 4D’s business continues to contract

The investment in working capital, however, increased 16% to £2.08m having a negative impact on cash and indicates its poor management particularly with revenue falling in the year

Significant cash generated is utilised for capital expenditure and despite a studio closure it fell only 16% to

£586k