Reference no: EM13557822

Verity, a limited liability company, has a credit facility with Cranley Bank of $6 million. The facility is due to expire on 31 December 20X1. The overdraft in the recently audited statement of financial position at

30 September 20X1 is $5.5 million. The directors of Verity have started negotiations with their bankers for a renewal of the facility and to increase the amount to $9 million. To support this request the bank has asked Verity to provide a business plan for the coming 12 months consisting of a cash flow forecast supported by a forecast statement of profit or loss and other comprehensive income and statement of financial position. The management of Verity has produced a cash flow forecast for the period

1 October 20X1 to 30 September 20X2 and, at the request of the bank, has asked the auditor to examine and report on it.

The audit manager, who has recently completed Verity's audit, has been asked to make a preliminary examination of the cash flow forecast and supporting material and she has noted the following observations.

(1) The cash flows from sales are based on the assumption of an overall increase in sales of 24% compared to the previous financial year. Analysis shows that this is based on an increase in selling price of 5% and an increase in the volume of sales of 18%. Just over a quarter of all Verity's sales are made to foreign customers.

(2) The cost of sales in the recently audited statement of profit or loss and other comprehensive income to 30 September 20X1 was 80% of sales revenue, giving a gross profit of 20%. In the forecast statement of profit or loss and other comprehensive income for the year to 30 September 20X2 the cost of sales has fallen to 72%, giving a gross profit of 28%. Manufacturing costs are made up of approximately one third each of materials, labour and production overheads.

(3) The trade receivables collection period used in the cash flow forecast to 30 September 20X2 is 61 days.

In the year to 30 September 20X1 this period averaged 93 days. Management has stated that it is its intention to inform all customers of a new standard 60 day credit period. In addition an early settlement discount of 1% will apply to customers who settle their account within 30 days of the statement.

Conversely the credit period for trade payables has been extended from an average of 45 days in the current year to 90 days in the forecast.

(4) The cash flow forecast showed that the maximum credit required during the period would rise to nearly $9 million in August 20X2.

Required

(a) Describe the general matters an auditor should consider before accepting an engagement as a reporting accountant on forecast financial information.

(b) Detail the procedures that the reporting accountant should undertake in relation to the cash flow forecast of Verity for the year to 30 September 20X2.

(c) The negotiations with Cranley Bank resulted in a renewal of Verity's existing credit facility of $6 million, but the bank would not agree to increase it to $9 million. As a result of this Verity issued a circular to its existing shareholders inviting them to subscribe for a new $3 million issue of debentures. The purpose of the circular was to show the intended use and the future benefits from the debenture issue. It was supported by the same forecast financial information, including the accountant's report, that had been provided to Cranley Bank. However the directors of Verity had removed all references to its original purpose and restricted distribution.

The trading results of the first half of the year to 30 September 20X2 showed that the forecast information was proving to be over optimistic and that Verity was beginning to experience cash flow difficulties.

Discuss the basis on which a reporting accountant should form an opinion on forecast information, and consider whether the reporting accountants of Verity may be liable to:

• Cranley Bank
• The investors who subscribe for the new debentures