Exam focus
Examination of projections and forecasts feature regularly in the exam. This is usually in the context of supporting a loan application, or as part of a going concern assessment for an audit. As the transactions haven’t happened yet, procedures will focus on testing the reasonableness of the assumptions management have used when preparing the forecast.
1 What is prospective financial information (PFI)?
A accountant may be asked to give an assurance opinion on prospective (i.e. future) financial information. Guidance on examining PFI is given in ISAE 3400 The Examination of Prospective Financial Information.
Definitions
Prospective financial information means financial information based on assumptions about events that may occur in the future and possible actions by an entity. It may be in the form of a forecast or a projection, or a combination of both. [ISAE 3400, 3]
Forecast
PFI prepared on the basis of assumptions as to future events that management expects to take place and the actions management expects to take (best-estimate assumptions). [ISAE 3400, 4]
Projection
PFI prepared on the basis of hypothetical assumptions about future events and management actions that are not necessarily expected to take place, or a mixture of best estimate and hypothetical assumptions. [ISAE 3400, 5]
A hypothetical illustration is a depiction of anticipated outcomes based on uncertain future events and actions.
Types of forecast Profit forecast
Shows expected revenues and costs prepared on an accruals basis in the same way as a statement of profit or loss.
Forecast revenues will include amounts for sales expected to be made during the forecast period regardless of whether the customer is expected to pay for the goods during the forecast period.
Depreciation will be included based on the expected level of assets held during the forecast period calculated using the company’s usual depreciation rate.
Cash flow forecast
Shows expected cash payments and receipts reflecting the amount and timing of the expected cash flows.
Forecast receipts will take into consideration payment terms given to customers and expected bad debts (a bad debt will not result in a cash inflow).
Depreciation is not a cash expense therefore will not appear in the forecast. Instead a payment to acquire an asset will be included as a cash outflow and proceeds from the disposal of an asset will be included as a cash inflow.
Principles of useful PFI
PFI can be issued:
As an internal management tool, e.g. to support a possible capital investment, or
For distribution to third parties in, for example:
– In a prospectus
– In an annual report
– To inform lenders or to support an application for finance. [ISAE 3400, 6]
Ultimately the usefulness of PFI depends on the requirements of the end user. Consider, for example, the different decisions and information needs of a prospective lender and shareholder. The unifying qualities of good PFI are that reports must:
Address the specific needs of the user
Be prepared on a timely basis to enable decisions to be taken.
2 Acceptance considerations
In general, like an audit engagement, the accountant must consider the risk of involvement with the PFI. The greater the risk of giving an inappropriate report, the greater the risk of legal claims and loss of reputation. Ultimately, if the risk is too high the engagement should be politely declined.
ISAE 3400, 10 requires the accountant to consider the following:
| Matter under consideration | Reason |
| The intended use of the information, | Information for external use will be relied |
| such as internal management or | upon by third parties, potentially for |
| external users. | making investment decisions. |
| This makes it riskier for the accountant | |
| because the consequences of issuing an | |
| inappropriate report will be more severe. | |
| Whether the information will be for | Information for general distribution will |
| general or limited distribution. | result in the assignment being potentially |
| more risky as a larger audience will be | |
| relying on it. | |
| 14 | ||||
| The nature of the assumptions (e.g. | Forecasts and projections cannot be | |||
| best- estimate or hypothetical). | verified with any certainty because the | |||
| outcome is unknown, however: | ||||
| If information is best-estimate, it | ||||
| should be a reasonable | ||||
| approximation as to what might | ||||
| actually happen. | ||||
| Where the assumptions are | ||||
| hypothetical, they will be much more | ||||
| difficult to validate as there is likely | ||||
| to be little to support them and | ||||
| therefore the assignment holds | ||||
| higher risk. | ||||
| The engagement should not be accepted | ||||
| if the assumptions are clearly unrealistic | ||||
| or if it is expected that the PFI will be | ||||
| inappropriate for its intended use. | ||||
| The elements to be included in the | The engagement will be higher risk if the | |||
| information. | PFI includes elements of which the | |||
| accountant has little knowledge or that | ||||
| are extremely complex or highly | ||||
| subjective. | ||||
| The period covered by the | Short-term forecasts are likely to be more | |||
| information. | easily verified than projections looking out | |||
| over a longer period. | ||||
The terms of engagement
An engagement to report on PFI does not constitute an audit. However, the prospective client may not appreciate this fact. Agreeing the terms of engagement is therefore critical to avoid misunderstandings with the client. Typically the engagement letter should specify the following terms:
The nature of procedures performed.
The type of assurance offered, i.e. limited. The form of conclusion given, i.e. negative.
Management’s responsibilities, which are to prepare the PFI and to establish appropriate assumptions.
Restrictions on the use and distribution of the assurance report.
The basis of setting the fees.
3 Level of assurance
Due to the uncertainty surrounding forecasts and projections, and due to the limited nature of the procedures performed during the accountant’s review, only limited (moderate) assurance can be offered for PFI engagements. [ISAE 3400, 9]
The conclusion will be expressed negatively, i.e. ‘Nothing has come to our attention to suggest the assumptions used in the forecast don’t provide a reasonable basis for the forecast’.
4 Procedures
The practitioner should obtain a sufficient level of knowledge of the business to be able to evaluate whether all significant assumptions required for the preparation of the PFI have been identified.
This requires knowledge of the processes used to prepare the PFI including:
Internal controls over the system used to prepare the PFI.
Nature of documentation to support management’s assumptions.
The extent to which statistical, mathematical and computer assisted techniques are used.
Methods used to develop and apply assumptions.
Accuracy of PFI prepared in prior periods and reasons for significant variances.
[ISAE 3400, 13]
The practitioner should also consider the following when determining the nature, timing and extent of procedures:
The likelihood of material misstatement.
Knowledge obtained during any previous engagements.
Management’s competence at preparing prospective financial information.
The extent to which the information is affected by management’s judgment.
The reliability of the underlying data.
[ISAE 3400, 17]
Analytical procedures can be used to identify any unusual fluctuations between the forecast and past performance of the company or industry expectations for the forecast period.
Enquiry can be used to follow up on any fluctuations identified as well as being used to establish the assumptions used by management when preparing the forecast.
Inspection may be used where items included in the forecast are already established and in progress, for example:
Inspection of existing loan or lease agreements to agree the repayments included in the forecast.
Inspection of quotations or price lists to agree forecast costs for new assets.
Inspection of recent utility bills to assess the reasonableness of forecast utility costs.
Written representations
The practitioner should obtain written representations from management regarding:
The intended use of the PFI
The completeness of significant management assumptions Management’s acceptance of its responsibility for the PFI. [ISAE 3400, 25]
It is not appropriate for the practitioner to rely solely on such representations. The practitioner must appropriately plan, perform and review a range of procedures to enable them to obtain sufficient appropriate for the purposes of offering assurance.
PFI procedures: Specific examples
The specific procedures performed on an engagement will depend on the information requirements of the users and the report under scrutiny. However, examples of general procedures include:
Comparison of forecast amounts to historic performance to ensure consistency. Whilst future results will not always follow previous trends, historical patterns give an indication of the capacity of the business. It is also important to consider that rapid growth is unlikely and potentially damaging to a business (overtrading).
Comparison of forecast amounts to actual results. It is likely that by the time a PFI review is actually conducted some of that period may have elapsed. Internally produced management accounts may therefore be available to assess actual performance for the first few months of the forecast period.
Forecasts for previous periods may also be assessed in comparison to actual results to assess how accurately management have forecast in the past.
Reasonably certain incomes and costs (such as loan interest) may be verified by inspecting documents such as orders, contracts, loan agreements, lease contracts etc.
Comparison of accounting policies/estimates used in forecasts in comparison to financial statements, e.g. depreciation rates.
Inspection of the non-current asset register to identify if assets are approaching the end of their useful lives and require replacement.
Comparisons of working capital amounts/liquidity to assess whether liabilities can be met and the company can finance its short term resourcing requirements.
Comparison of the relationships between the reported figures, for example if a significant increase in revenue is supported by increased production costs, advertising costs and distribution costs.
Calculation of key ratios such as:
– Gross profit margin
– Net margin
– Receivables days
– Payables days
– Inventory days.
Typical enquiries may include:
– When do loan agreements expire?
– Whether further forms of finance are being sought?
– Whether any new customer/supplier contracts have been agreed since the year-end?
– Have any new capital purchases been agreed?
– Has the company invested in any product research/ development and if so what are the results?
– Has the company conducted any market research and again what are the results?
– Have there been any new competitors/products in the market place.
This list is by no way exhaustive and is very general in nature. The purpose of the examples is that they all consider events or circumstances that will have an impact on the business in the future. Note that none of the enquiries are vague, such as “how do you forecast sales?” They try and identify issues that will directly impact management’s forecasts.
In the exam you will be required to suggest procedures that are relevant to the scenario.
5
The key elements of the assurance report are summarised below:
Title and addressee.
Identification of the subject matter i.e. the forecast information. Reference to any applicable laws or standards (e.g. ISAE 3400).
A statement that it is management’s responsibility to prepare the PFI. accountant’s responsibilities and basis of opinion.
A reference to the purpose and restricted distribution of the PFI.
A statement of negative assurance as to whether the assumptions provide a reasonable basis for the PFI.
An opinion on whether the PFI is properly prepared on the basis of the assumptions and is presented in accordance with the relevant financial framework.
Appropriate caveats about the achievability of the results given the nature of assumptions and inherent limitations in the forecasting process.
accountant’s signature and address.
Date of the report.
[ISAE 3400, 27]
Illustration: PFI report wording
Based on our examination of the supporting the assumptions, nothing has come to our attention which causes us to believe that these assumptions do not provide a reasonable basis for the forecast. Further, in our opinion, the forecast is properly prepared on the basis of the assumptions and is presented in accordance with…
Actual results are likely to be different from the forecast since anticipated events frequently do not occur as expected and the variation may be material.
Approach to exam questions: PFI
Read the requirement carefully to make sure you are clear on whether you are examining a profit forecast or a cash flow forecast.
A profit forecast should be based on an accruals assumption i.e. the level of revenue and expenses expected to be earned and incurred during the forecast period.
A cash flow forecast should be based on a cash basis i.e. the cash inflows and outflows expected during the forecast period.
In particular, non-cash expenses such as depreciation will not be relevant for a cash flow forecast but will be relevant for a profit forecast.
One way to approach an answer is to assume that the client’s starting point for preparing the forecast is the prior year actual results. From here they will:
Remove items which will not be relevant going forward e.g. if they are discontinuing an activity the costs and revenues/receipts and payments for this activity should not be included in the forecast once it has ceased. Remember to consider one-off costs as a result of the discontinued activity such as profit/loss on disposal of assets or proceeds from the disposal of assets. Redundancy costs should also be included if staff are to be made redundant rather than redeployed within the organisation.
Add in any new costs or revenues e.g. if they are expanding the business there may be more assets acquired and people employed. Within a profit forecast you would expect to see increased depreciation and payroll costs. Within a cash flow forecast you would expect to see payments to acquire assets and increased payments to employees.
Adjust revenues and expenses/receipts and payments for inflation or growth in respect of items that are expected to continue.
The assurance provider’s procedures will focus on whether the figures included in the forecast look reasonable.
For new items this might be achieved by inspecting quotations or market research data.
For items to be excluded, review the forecast to ensure they are no longer included.
For items of a continuing nature, comparison with prior year management accounts can be performed.
Professional scepticism is important as the company is likely to want the forecasts to be as optimistic as possible in order to secure the finance. Your procedures should challenge the assumptions used by management.
Test your understanding 1– Imperiol
Imperiol, a limited liability company, manufactures and distributes electrical and telecommunications accessories, household durables (e.g. sink and shower units) and building systems (e.g. air-conditioning, solar heating, security systems). The company has undergone several business restructurings in recent years. Finance is to be sought from both a bank and a venture capitalist in order to implement the board’s latest restructuring proposals.
You are a manager at Hal Falcon, a firm of Chartered Certified Accountants. You have been approached by Paulo Gandalf, the chief finance officer of Imperiol, to provide a report on the company’s business plan for the year to 31 December 20X5.
From a brief telephone conversation with Paulo Gandalf you have ascertained that the proposed restructuring will involve discontinuing all operations except for building systems, where the greatest opportunity for increasing product innovation is believed to lie. Imperiol’s strategy is to become the market leader in providing ‘total building system solutions’ using new fibre optic technology to link building systems. A major benefit of the restructuring is expected to be a lower ongoing cost base. As part of the restructuring it is likely that the accounting functions, including internal audit, will be outsourced.
You have obtained a copy of Imperiol’s Interim Report for the six months to 30 June 20X4 on which the company’s auditors, Discorpio, provide a conclusion giving negative assurance. The following information has been extracted from the Interim Financial Report:
- Chairman’s statement
The economic climate is less certain than it was a few months ago and performance has been affected by a severe decline in the electrical accessories market. Management’s response will be to gain market share and reduce the cost base.
- Statement of financial position
| 30 June 20X4 | 31 December | ||
| (unaudited) | 20X3 | ||
| $m | $m | ||
| Intangible assets | 83.5 | 72.6 | |
| Non-current assets | 69.6 | 63.8 | |
| Inventory | 25.2 | 20.8 | |
| Trade receivables | 59.9 | 50.2 | |
| Cash | 8.3 | 23.8 | |
| ––––– | ––––– | ||
| Total assets | 246.5 | 231.2 | |
| Non-current liabilities – | |||
| borrowing | 65.4 | 45.7 | |
| Current liabilities | 55.6 | 57.0 | |
| Equity and liabilities: | ––––– | ––––– | |
| Share capital | 30.4 | 30.4 | |
| Reserves | 6.0 | 9.1 | |
| Accumulated profit | 89.1 | 89.0 | |
| ––––– | ––––– | ||
| 246.5 | 231.2 | ||
| ––––– | ––––– |
- Continuing and discontinuing operations
| Six months to | Year to | ||||
| 30 June 20X4 | 31 December | ||||
| (unaudited) | 20X3 | ||||
| Revenue | $m | $m | |||
| Continuing operations | |||||
| Electrical and | |||||
| telecommunication accessories | 55.3 | 118.9 | |||
| Household durables | 37.9 | 77.0 | |||
| Building systems | 53.7 | 94.9 | |||
| ––––– | ––––– | ||||
| Total continuing | 146.9 | 290.8 | |||
| Discontinued | – | 65.3 | |||
| Total revenue | 146.9 | 356.1 | |||
| Operating profit before interest | ––––– | ––––– | |||
| and taxation – continuing | |||||
| operations | 13.4 | 32.2 | |||
| ––––– | ––––– | ||||
| 434 | |||||
Required:
- Identify and explain the matters Hal Falcon should consider before accepting the engagement to report on Imperiol’s
prospective financial information. (5 marks)
- Describe the procedures that a professional accountant should undertake in order to provide an assurance report on the prospective financial information of Imperiol for the year to
31 December 20X5. (10 marks)
(Total: 15 marks)
Test your understanding 1 – Imperiol
- Matters to be considered before accepting the engagement Form of the PFI
The accountant must consider the form of prospective financial information. This could include any, or all, of the following elements:
– a statement of business objectives and goals
– profit forecasts
– budgeted statements of financial position
– cash budgets
– capital budgets
– a statement of assumptions and variables.
It is vital that Hal Falcon establishes which elements of the report they are being asked to examine. This will significantly affect the risk of the engagement and the procedures they are required to perform, e.g. procedures for a profit forecast will be different from those relevant to a cash flow forecast.
Level of assurance
It must be clarified that only limited assurance can be offered due to the uncertainty of forecasts. The conclusion will be worded negatively.
The conclusion is focused on whether:
– the assumptions are reasonable and consistent with the purpose of the information
– the PFI is properly prepared on the basis of the assumptions
– the PFI is prepared on a consistent basis with historical financial statements, using appropriate accounting principles.
Access to information
To enable this to be performed efficiently, Imperiol must ensure that access to all relevant information and staff is made available. Any restrictions would lead to a breach of engagement terms and a potential disclaimer of conclusion.
Permission to communicate with auditors
When an accountant is asked to perform additional work for a client, they should be granted permission to speak to any other accountants or auditors that the company uses in order to obtain relevant information. Hal Falcon should request permission to communicate with Discorpio, in the form of a professional etiquette letter. If this is not given, the engagement should be declined.
Consider why the auditors, Discorpio, have not been used
To provide a report on the reasonableness of the forecast, a good understanding of the company is required. The auditor is usually the party with the most understanding. The use of a different firm poses a risk as Imperiol may be hoping that a different firm will not identify that the assumptions are not reasonable.
Period covered by the examination
Paulo Gandalf has requested a review of the forecasts to 31 December 20X5. This does not appear to be particularly extensive and it is likely that a provider of significant finance would seek a longer forecast period. Before accepting the engagement Hal Falcon should confirm in the engagement letter that the only period being examined (and requested by the financiers) is to 31 December 20X5.
Reliance on the report by third parties
The report is likely to be used to raise finance. Hal Falcon must agree the distribution of the report prior to accepting. The greater the number of parties that place reliance on the report, the greater the risk involved. Therefore Hal Falcon must seek to reduce this risk by limiting liability to specific parties and by writing appropriate caveats/disclaimers in the final report.
Authority of Paulo Gandalf to request the work
Hal Falcon should also establish what authority Paulo Gandalf has to appoint them. He may not be empowered by the board and if he is responsible for the preparation of the PFI it may appear to impair Hal Falcon’s objectivity if Paulo makes the appointment.
Competence/knowledge of Imperiol
Having never audited Imperiol Hal Falcon should consider whether they have the competence and experience to successfully review the PFI. If they have little knowledge of the building system’s industry their ability to assess the assumptions about future performance may be questioned. In particular, if the deadlines are tight there will be little room for extensive planning and knowledge gathering. Under those circumstances the existing auditor may be better placed to assign a team.
Risk
It appears as though Imperiol have undertaken a number of restructuring initiatives. They discontinued some businesses in 20X3 and it appears in the future they will continue to strip away operations until they are left with nothing but building systems. This may suggest that Imperiol is unstable. This increases the risk that forecasts will be inappropriate.
Independence
As Hal Falcon are not the auditors, independence cannot be assumed. The firm needs to ensure there are no threats to objectivity that would prevent them from accepting the engagement. If the firm is not independent, any user of the report may not trust it to be reliable.
Other matters
Hal Falcon could also consider the following before deciding whether to proceed or not:
– The nature of assumptions underlying the preparation of the PFI: i.e. best-estimate or hypothetical.
– Whether there may be an opportunity to offer other services to Imperiol, e.g. internal audit.
– Fees and whether the fee will be appropriate for the level of risk of the engagement.
– Integrity of the preparer of the forecast.
- Procedures to be performed General procedures
– Compare the forecast for 20X3 to the results achieved in 20X3 to assess management’s competence at preparing PFI.
– Compare the forecast to previous performance to identify if they are in keeping with historical trends. Any significant distortions from historical trends would require explanation.
– Compare accounting policies used in the forecast to the historical accounts to ensure consistency.
– Obtain written representation from management that they acknowledge their responsibility for the forecasts, that they believe the assumptions used in the forecast are reasonable and confirmation of the intended use of the forecast.
– Recalculate the forecast to verify the arithmetic accuracy.
Specific procedures
Discontinued operations
– Enquire of management how soon the remainder of the operations to be discontinued will be wound down or sold and ensure this timescale is reflected in the forecast.
– Review the forecast costs for impairment charges in respect of the intangible assets. Intangible assets for those activities which are discontinuing may be significantly impaired.
– Enquire of management whether the non-current assets relating to discontinued activities will be sold, scrapped or used elsewhere in the business.
– Inspect second hand prices or correspondence from buyers to consider the reasonableness of disposal proceeds in the cash forecast and the consistency of gains/losses on disposals in the profit forecast. There may already be sale agreements in place.
– Recalculate the forecast profits/losses on disposal using the proceeds verified above to confirm accuracy.
– Enquire of management whether any of the inventory held relates to discontinued operations. If so, review the valuation to ensure that any write downs have been made if it cannot be sold.
New structure
– Review the forecast to ensure the new forms of finance have been included e.g. interest charges.
– Enquire whether any amounts or rates have been discussed. If there is documentary (for example, an agreement that is contingent upon the PFI), review this to ensure it is accurately reflected in the PFI.
– Review the forecast to ensure the expected increase in fibre optic products has been reflected in the forecast purchases of inventory.
– Compare the forecasts to actual performance in 20X3 and 20X4. The PFI should reflect a reduction in staff costs and an increase in professional fees due to the outsourcing of accounts.
– Enquire of the directors what they believe the extent of the
benefit will be from outsourcing accounting functions.
– Compare the forecast outsourcing fees to any quotes/tenders received from professional firms.
– Obtain details of salaries for the staff to be made redundant and the redundancy terms, and calculate the expected redundancy cost. Compare with the forecast figure to ensure it is reasonable.
Changing performance
– Enquire of management what they consider to be the key variables which underpin building systems revenue growth. Therefore any assumptions of growth for building systems will require close scrutiny as this is to be the only revenue stream.
– Compare forecast sales in the PFI with any internal management accounts or marketing based forecasts to ensure that the amounts are consistent with the key assumptions of future profitability.
– Enquire of management what their sales terms are. The receivables days at the end of June 20X4 are 74 days. This is considerably higher than 20X3 (51 days) and the effect of this should be discussed with management. In particular, the cash flow forecast should be reviewed to ensure that it is consistent with the deterioration in credit control.
– Discuss what might happen if Imperiol only manages to raise part of the finance. They may not have sufficient resources to develop the newer fibre optic technology, which could lead to reservations about going concern.
