The cash flow forecast of Rope Co

When a company has prepared a cash flow forecast as part of their assessment of going concern, in accordance with ISA 570 Going Concern the auditor needs to evaluate the reliability of the underlying data used to prepare the forecast and to determine whether there is adequate support for the assumptions underlying the forecast. There are a number of issues relating to the forecast which raise concerns about the assessment of Rope Co’s going concern status and therefore warrant further investigation.

Receipts from customers 

There was little growth in cash receipts in the second half of the year ended 30 September 2016 (0·8%), yet in each consequent six-month period management predicts a significant rise in receipts of between 1·7% and 3·0%.

This could be based on overly optimistic forecasts in relation to sales growth for the same period. If sales forecasts are too optimistic, this could eliminate the forecast small positive cash flows, which could leave the company in a net overdraft position for the entire two-year period.

The movement in relation to customer receipts is a key assumption underpinning the return to a positive cash position and needs to be scrutinised further.

Salaries and other payments

While annual receipts from customers and payments to suppliers are forecast to rise during the forecast period by 8·5% and 9·4%, respectively, the amounts attributable to salaries and other operating payments are only forecast to rise by 4·1%.

This is based on management’s simple assumption of a general 2% annual inflation in these costs. This seems to be overly simplistic and will require further investigation. Salary costs could be forecast using a more sophisticated methodology based on required employee numbers and average wages/salaries.

The significant forecast increase in sales suggests that operating activities will increase over the next two years and it might be expected that staff requirements may increase in line with this. For similar reasons, it is likely that a larger increase in other operating costs would be required to match the increased administrative burden of producing and selling more goods and/or services.

Sale of investments

Management is planning to sell some investments in listed shareholdings for $500,000 to repay a loan to the chief executive. At 30 September 2016, however, the fair value of the investments was only $350,000. As the fair value of these investments is revalued at the end of each year based upon the current share price, this is assumed to reflect the amount at which the shares were trading at the end of September. Management is therefore expecting the shares to increase in value by $150,000 in the space of two years, which represents a 43% rise. This is an extremely optimistic assumption in comparison to average rates of growth across most stock markets.

It therefore appears likely that there will be a shortfall in the amount raised to repay Mr Stewart. Rope Co will therefore have to supplement the amount received from selling investments with cash from other sources, which will lead to a reduction in the cash position in comparison to the forecasts.

Repayment of the bank loan

The bank loan is due for repayment 15 months after the year end. Management is assuming that they will be able to fund the repayment with a new loan facility from the same finance provider. Without any agreement in place from the provider, this represents a significant assumption.

Without a new facility Rope Co will have no means with which to repay their obligation, which could lead to the lender taking action to recover the loan amount. This could include seizing assets which were provided as security over the loan or commencing insolvency proceedings. In either case, this could have a significant impact on Rope Co’s ability to trade into the foreseeable future and, therefore, the loan repayment event represents a material uncertainty which may need to be fully disclosed in the financial statements of Rope Co in accordance with IAS 1 Presentation of Financial Statements.

Missing cash flows

There seems to be a lack of consideration of a number of non-operating cash flows which one might expect to see in a two-year forecast. For example, most companies maintain a practice of regular replacement of old, inefficient tangible non-current assets as opposed to making larger, less regular replacements which may create a significant drain on cash resources in one particular year. The forecast currently has no allocation for capital investment. In a similar fashion, there are no cash flows related to tax and dividend payments. It is possible that such transactions have been overlooked in the preparation of the forecast.

Further audit procedures

– Obtain a copy of the latest interim financial statements and compare the actual post year-end sales performance with the forecast sales upon which the cash flow forecast is based.

– Discuss with management the rationale for the expected increase in customer receipts and where possible confirm this to customer correspondence, orders or contracts.

– Inspect the documentation detailing the terms of the loan with Mr Stewart to confirm the amount outstanding and the agreed date of repayment.

– Inspect the terms of the bank loan to confirm the final amount due for repayment, the date of repayment and whether any assets have been accepted as security for the loan.

– Enquire of management whether they have entered into any negotiations with their bank, or any other financial institution, to provide a replacement loan in January 2018. If so, request corroborating evidence such as signed agreements, agreements in principle or correspondence with the financial institutions.

– Enquire of management whether they have any contingency plans in place to repay both loans on time should they not be able to raise the required amount through selling investments and obtaining new loan agreements.

– Perform an analytical review of actual monthly payroll costs incurred obtained from the payroll department. Include any available payment periods after 30 September 2016 to help ascertain whether management’s assumptions regarding salaries are appropriate. Seek corroborating evidence for any fluctuations in cost such as HR records confirming pay awards and changes in staff.

– Perform an analytical review of actual other operational costs and consider the level of other costs as a percentage of sales. Compare this to the levels included in the forecast. Investigate any significant differences.

– Corroborate the lack of investment in new tangible non-current assets by performing an analytical review of the levels of additions and disposals over the last, say, five years to see if this supports the absence of any allocation for this in the short-term future and consider this in light of our understanding of the entity and its production process.

– Compare the cash flow forecasts to any capital expenditure forecasts prepared by Rope Co to ensure that the cash flow forecast is consistent with this. Ask management to explain any differences identified.

– Review the non-current asset register and identify any assets with a zero or negligible carrying value which could indicate that the assets have fulfilled their useful lives and are due for replacement.

– Inspect the cash book post year end to see if there are any significant cash transactions which do not appear to have been included in the forecasts, in particular cash transactions relating to purchases or disposals of assets and dividend payments.

– Review the outcome of previous forecasts prepared by management to assess how effective management has been in the past at preparing accurate forecasts.

– Obtain written representations from management confirming that they have no intention to either purchase or dispose of non-current assets or to pay dividends over the next two years.

Matters relating to the loan from Mr J Stewart

Related party transaction

As a key member of staff at Rope Co, the loan from the chief executive represents a related party transaction. As such, the transaction and related outstanding balances must be fully disclosed in the financial statements in accordance with IAS 24 Related Party Disclosures.

This means that the nature of the related party relationship, the nature and the amount of the loan, the amounts outstanding at the year end and the terms and conditions of the loan, including a description of the fixed charge, must be disclosed in the notes to the financial statements.

Interest free loan measurement

The loan was received during the current year ended 30 September 2016. The loan liability should have been initially recorded at its fair value, which would normally be the transaction price of $500,000. IFRS 9 Financial Instruments, however, states that in the case of an interest free loan, the fair value should be measured as the present value of all future cash flows discounted using the prevailing market rates for similar instruments.

While it will be difficult to identify a similar instrument due to the nature of the relationship between the lender and the company, a similar instrument should be identified based upon the currency used, the loan term and any other similar factors, for example, a three-year, $ loan from a bank.

At the year end, the outstanding loan liability should have been measured using the amortised cost method and the effective interest calculated should be recognised as a finance charge in the statement of profit or loss.

Further audit procedures

– Inspect the loan agreement to confirm the amounts loaned to the company, and the other relevant terms including the rate of interest, the repayment date and the associated penalties for late payment.

– Inspect the related party disclosures in the financial statements to ensure that they provide sufficient information and accurately reflect the terms and amounts relating to the transaction.

– Additional procedures will need to be performed regarding the completeness of related party transactions as the loan with Mr Stewart was not identified through normal audit procedures.

– The market rate used in the calculation of the fair value of the loan should be compared to a range of suitable instruments, e.g. three-year bank loans, to ascertain its appropriateness. Following this, the calculation should be checked for arithmetical accuracy.

– The amount recorded for the initial loan value and the year-end value should be recalculated using the appropriate discount factor and market rate to confirm the arithmetical accuracy of management’s calculations.

– Review the loan liability recognised in the financial statements to ensure that the appropriate, discounted figure has been used.

– Reconcile the effective interest rate for 2016 from the amortised cost calculation to the finance charges in the statement of profit or loss to confirm that this is appropriately included in profits.