ICAN CASE STUDY SOLUTION TO MID DIET MOCK QUESTIONS

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1 ICAN CASE STUDY SOLUTION TO MID DIET MOCK QUESTIONS This is a case of a company in distress after some years of unsuccessful trading and some incident of mismanagement by the top executive. Tistol appears to be in serious financial crisis that requires immediate injection of fund to restructure the company. Apart from the deterioration of position of most of its plant and machinery, only one of its two generators is working. He four financial situation of the company had forced it to give a legal mortgage over its property of N75.7 million for an overdraft facilities of N5 million. A right issue which was undertaken to alleviate this problem was cornered by one of the directors and a major supplier of the company who with connivance of issuing house to acquired at right of N12.5 million. The result was a net cash inflow of only N220,000 inflow to the company out of the proceed ofn12.72 million. The declining fortune of the company appeared to be a general trend for older companies in the industry. This is the understanding that the review of the years of operating loss of other three competitors of Tistol reveals. In this declining state of operating performance of the company, its management became engaged in unethical and corrupt practices as in trussed in: Appointment of auditor who accepted offer without recourse to the old and existing auditor whose appointment was not formally terminated. STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 1

2 Bribery of VAT official to pacify the threat of taking the company to court. Presentation of management accounts with inflated profit based on manipulation of work in progress The current performance which already revealed a loss N12.6 million appear a bundle that makes the bank contacted to be reluctant in supporting the proposed restructuring exercise. The new CEO himself knew that to sell such proposal to any financer is near impossible. ANALYSIS OF QUESTIONS Question 1.1 (a) (b) This question tests that understanding what makes a company a going concern and whether such sections are still applicable to Tistol. The question require the identification of critical issues that are apparent which ought to have appear in the Report of Auditors. Question 1.2 (a) Specific provision of the statement of Accounting Standard on the Valuation of stock is required STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 2

3 (b) The question test understanding of basic purpose of the statement of significant accounting policies in a company s financial statement. Questions 1.3 This question tests the knowledge of share valuation under the theory of finance as it relates to: Identification of method of determining a market value of shares. The margin principle for valuing a right issue below the current market price. A discussion of what is theoretical ex-right force. The computation of the benefit or otherwise of a shareholder who intends to sell his right. Question 1.4 This question tests the knowledge of statutory provision of Nigerian Tax Laws on defendant in remitting statutory debentures at the appropriate time. Question 1.5 The question tests the understanding of what constitute ethics and method behavior in the management of the affairs of a company. Question 1.6 STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 3

4 (a) (b) The question of margin information and factors a bank would consider in considering the request for a facility. Simple knowledge of financial ratio is required. SUGGESTED SOLUTION 1.1 (a) TISTOL Packaging s is going concern problems include the following:- 1. Turnover: Turnover dropped to N46.338m in 1999 from N47.330m in 1998 representing N965,00 change and a percentage drop of 20%. 2. Persistent Operating Loss The losses are significant with no immediate sign of improvement. Loss before taxation increased from N4.735m in 1998 to a staggering N8.394m in 1999 which is therefore 77.28% worse. The percentage operating loss on turnover in 1998 of N10.01% became aggravated in 1999 at 18.11%. 3. Working Capital / Liquidity Problem: Inadequate working capital, in eh face of bank overdraft and stock replacement loan totaling N5m. inability of TISTOL to generate enough cash to meet its commitment. This is reflected in TISOL inability to pay salaries and wages and even creditors/suppliers. This can be seen from the steady increase in creditors from 1995 to STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 4

5 4. Stiff competition affecting the packaging industry due to large number of entrants into the business therefore reducing the mark up on order. 5. Old and Obsolete Equipment: This has affected all the production facilities. 6. Non remittance of statutory deductions: Tax and other statutory deductions have not been remitted for the past two years. This can result into litigation. 7. Gross Profit: Reduction in gross profit from N3.212m in 1998 to N430,000 in (86.61%). 8. Inability of the company to raise credit. 9. The assets in the Balance Sheet are not truly represented. 10. Serious management problem as reflected in the lack of continuity. To review the going concern problems of TISTOL Packaging, the author of the company need to do the following: (i) (ii) Prepare an analytical review of the company s financial statements Carry out a general appraisal of the company s business in order to discover the precarious situation of the company. STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 5

6 (b) The auditor s report is not adequate for the following reasons: (i) The going concern problem of TISTOL was not reflected. (ii) The auditor s report ought to have been based on historical facts and not futuristic figures. (iii) The basis of opinion of the auditor can mislead the users of the financial statements. (iv) The auditor s opinion ought to have include a subject to qualification. SUGGESTED SOLUTION 1.2 (a) IAS 2 relates to Stock Valuation and it has the following major provisions: i. Methods of Stock Valuation adopted should be disclosed in the company s accounting policies. ii. Stock should be classified into their various headings. iii. Stock should be valued at the lower of cost and Net realizable value. iv. Goods in transit should be included only where the legal title is deemed to have passed to the firm. v. Work in progress and finished goods in a manufacturing concern should include raw materials, labour and attributable overheads. vi. In applying a method of valuation, stock may be treated individually or in a group. vii. Reasonable provision should be made for deterioration or normal spoilage. STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 6

7 viii. Where different methods are used to value different types of stock, these must be disclosed. The amounts held in each of the categories must be disclosed. The Chief Accountant in this case has not complied with the provision of SAS 4 as stated above. He has treated order received, on which work has not started, as work in progress which is a case of valuation of non-existing stock. (b) Accounting Policies are those bases, rules, principles, convention and procedures adopted in preparing and presenting financial statements. The following are the reasons why financial statements include accounting policies: i. To show the bases on which the whole Financial Statements are prepared, for example, historical cost concept. ii. To provide proper understanding of the valuation method adopted in arriving at the value of stock. iii. To show the method applied in arriving at the deprecation contained in the Financial Statement. iv. To provide basis for comparison within the industry of the company s operation. v. To comply with the legal framework. STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 7

8 SUGGESTED SOLUTION 1.3 a) Methods of determining price of shares: Net Asset Basis Net Asset No. of Ordianry Shares Earnings Basis Earnings attributable to Equity No. of Ordianry Shares Dividend Basis Dividend attributable to Equity No. of Ordianry Shares (i) P o = D o No growth situation K e (ii) P o = D 1 Constant growth situation K e g Discounted Future Earning Basis n s Et 1 + Et 2 + E 3...E n X DCF n t = 1 No. of Ordinary Shares STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 8

9 n s t = 1 E o X DCF n Berliner Method Takes into account both the asset value of company and its earnings potential. (i) Capitalization of future profits at acceptable rate of return. (ii) Net tangible assets = i+ii 2 No. of Shares Super Profit Basis Acual profit Normal profit No.of Shares Dual Capitalization Basis Recognizes the different types of assets tangible and intangible Tangible and Intangible Assets No. of Shares Calculation of share price: STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 9

10 (i) On Net Asset Basis = (ii) Net Asset No.of Shares N72,340,000 For 1999 = = 401.9k 18,000,000 = 402k or N4.02k It will be very difficult to determine the price of the company s share using other methods: Earning Basis The Company has recorded as loss in the year ending December Dividend Basis No dividend has been declared in the year due to the loss position. Discounted Future Earning Basis Although there is information on future earnings, there is no information on the cost of capital to discount the earnings. Berliner s Method There is no relevant information Super Profit There is no indication of the normal profit. Dual Capitalization - There is no relevant information. (b) The justification for quoting the rights at lower price than the price on the Stock Exchange: (i) It is necessary to attract patronage from the existing shareholders. (ii) It will ensure that the Company realize the expected revenue from the issue. This may not be possible if investors should purchase the shares on the floor of the Stock Exchange as a result of lower price. (c) There are three possible alternatives: (i) The value of the right = = Market Price Offer Price STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 10 2

11 =27.5k = Market Price - - Theoretical Ex right price = = 27.5k (ii) Theoretical ex-right price = = 117.5k or N1.175k (iii) Price of the right is 90k as stated in the question. (iv) Minimum price to sell 10,000 shares attracting 10,000 additional shares by right of 1:1 Price per right = 27.5k Price of 10,000 right issue = 27.5k x 10,000 = N2,750,00 STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 11

12 SUGGESTED SOLUTION 1.4 The Managing Director The TISOL Packaging Company Lagos. Attention: Mr. Ken Onilari Dear Sir, NON REMITTANCE OF STATUTORY DEDUCTIONS It has been discovered that your Company has failed to remit the following statutory deductions made in the last two years to the relevant State and Federal bodies: N 1. PAYE 250, NSIFT 105, NHF 195, ITF 65, VAT 1,750,000 IMPLICATIONS OF NON REMITTANCE STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 12

13 As you are, there are serious implications for the employees apart from the statutory provisions contained in the enabling laws setting up these relevant bodies which include fines, sanctions, litigations, etc against the Company. (a) (b) (c) (d) (e) Pay As You Earn (Paye) By this singular act of non remittance of N250,000 to the State Board of Internal Revenue (SBIR), employees may not have the benefit of obtaining their Tax Clearance Certificate (TCC) when required. The Company officials on their part according to Section 73 PITA , by failing to effect deductions to the SBIR or having deducted, failed to pay to the relevant tax authority within 30 days, are guilty of an offence and liable on conviction to the prevailing commercial rate. Nigerian Social Insurance Trust Fund (NSITF) Since this is a pension fund, non remittance of deductions of N105,000 would deprive the employees of the right to draw from the fund on retirement. National Housing Fund (NHF) The staff would not be able to obtain mortgage facilities since their deduction are not remitted. Industrial Training Fund (ITF) For non remittance of the statutory deductions of N65,000, your Company cannot draw from the pool of training fund available to the Industrial Training Fund Value Added Tax (VAT) STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 13

14 The Government frowns at non remittance of Value added Tax (VAT) since the Company is a collecting agent. According to the provisions of Section 15 (1) of the VAT Act 1993, amount payable on conviction is the amount of VAT plus 5% of the tax due at commercial rate of interest Section 31 of the Act also provides for a penalty of N5,000 for every month of failure to submit returns, while Section 32 says that on conviction every officer aiding and abetting the commission of any offence under the VAT Act is liable on conviction to a fine of N50,000 or 5 years imprisonment and every director, manager, secretary is severally liable. Powers available to the Tax authorities include: 1. Penalties for non remittance which include tax payable plus interest, at commercial rare. 2. The tax authorities have the power to distain the Company s properties or seal off the Company s premises. 3. The Tax authority can take the Company to the Tax tribunal (VAT) or Court. Your prompt response to the above issues and Payments to the relevant authorities of would save the Company avoidable costs and even embarrassments. Olu, Ade & Company (Chartered Accountants) Date: STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 14

15 Place: STARRY GOLD ACADEMY , , Page 15

16 SUGGESTED SOLUTION 1.5 (a) Ethical Problems Discovered Over statement of Stocks and Work-In-Progress The parting with money (N100,000) to secure a rescheduling of the payment of outstanding VAT. The arrangement of transferring the amounts outstanding on supply credit to equity. Each ethical issue could have been handled as follows:- Adopting the provision of SAS No. 4 as it relates to the valuation of work In Progress. Remittance of tax and other deductions as an when due. Ensure proper disclosure of all financial relationship between the director and the Company. All activities between the two parties should also be well documented. (b) The following professional ethics could be identified from the case: i. The auditor failed to identify the going concern problem of the Company even when it was obvious. Auditing guidelines states that the auditor should qualify his report with subject to where going concern problem is identified. ii. The Chief Accountant who allowed Work - In Progress which were not in existence to be valued and include in the management accounts with a view of deceiving the board. iii. Auditing guidelines require the new auditor to write to the former auditor before taking up an audit assignment. In this case, the former audit firm has been dissolved; therefore, no professional ethnics had been breached. SUGGESTED SOLUTION 1.6 STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 16

17 (a) The bankers will usually consider the following among others in advancing facilities to companies i. The ability of the Company to pay back the loan as at when due. ii. The ability of the Company to generate sufficient revenue to pay interest on the loan regularly. iii. The Company s capital contributions. iv. The purpose or objectives of the loan. v. Paste business relationship with the bank vi. Gearing and other existing debts. vii. Third party confirmations. viii. Statutory provisions. ix. Management competence. x. Industrial analysis. xi. General economic conditions. (b) Liquidity Ratios The liquidity ratios measure the firm s ability to meet its current obligations. The principal ratios are: (i) Current ratio = Current Assets Current Liabilities = CA CL = 0.67:1 STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 17

18 (ii) Quick ratio = = 1:1 Quick of Liquid Assets Current Liabilities = CA (Stock+Prepayment) CL = 0.5: COMMENT = 0.7:1.0 Both ratios have fallen over the two years and indicate that the company may not be able to meet its current obligations when due. Gearing Gearing position of the company can be evaluated as follows: Gearing = Fixed Interest Capital Equity/OrdinaryShares STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 18

19 However the gearing position could not be calculated because the company was financed by only equity (0:1) Profitability Trend (i) Activity Ratio - = Sales Capital Employed = 0.6 times = 5 times (ii) Gross Margin - Gross Profit Turnover x ,338 x 100 = 0.93% ,212 47,303 x 100 = 6.8% (iii) Net Margin - Net Profit Turnover x (8,394) 46,338 x 100 =(18.1)% STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 19

20 (4,735) 47,303 x 100 =(10.0)% STARRY GOLD ACADEMY , , info@starrygoldacademy.com, Page 20

21 STARRY GOLD ACADEMY , , Page 21