FurniDex Limited ('FurniDex') is a manufacturing group listed on the JSE Securities Exchange (JSE). The chief financial officer of the group recently contacted A&P Incorporated, the audit firm at which you are a first-year trainee accountant, requesting the firm to accept the appointment as auditors of FurniDex and all its subsidiaries (except for two subsidiaries based in Japan which are audited by a Japanese audit firm).
McCaw Incorporated audits the property associates of FurniDex (see below). It has come to your attention that McCaw Incorporated also audits Finance Bank. The outcome of the preengagement meeting held with FurniDex was satisfactory and the FurniDex group (excluding its property associates and the two Japanese subsidiaries) was accepted as an audit client of the firm. Mr Peter Kaplan was appointed as the group audit engagement partner.
Background information about the FurniDex group
The FurniDex group's financial results for the reporting period ended 31 December 2011 are
as follows:
Divisions Revenue Operating
profit/(loss)
Net
operating
assets
R million R million R million
Gauteng 1 177 40 657
Western and Eastern Cape 176 5 42
Rest of South Africa 204 (58) 139
Japan 611 34 568
Property associates - share of profit (see note) 5
Total 2 168 26 1 406
The group's comparative financial results for the reporting period ended 31 December 2010
are as follows:
Divisions Revenue Operating
profit/(loss)
Net
operating
assets
R million R million R million
Gauteng 1 084 38 621
Western and Eastern Cape 150 3 40
Rest of South Africa 189 27 133
Japan 567 31 542
Property associates - share of profit (see note) 4
Total 1 990 103 1 336
Note
The South African properties, which the various companies within the FurniDex group occupy, are financed by Finance Bank and each property is held in a separate company. Finance Bank owns 75% of the shares of each company, with FurniDex holding the balance of the ownership interest. Rentals are paid to the property companies and the property companies pay dividends, on a semi-annual basis, to their owners. All these property
2 companies are correctly accounted for as associates in terms of IAS 28, Investments in Associates, by the FurniDex group. The following information relating to the Audit Committee has been provided to you by the
company secretary:
Director's name Age
Number of
Audit
Committee
meetings
attended
Nature of directorship
Period
serving
as
director
(years)
Arthur Young
(Chairman)
76 0 Independent
non-executive director
9
John McDowell 66 1 Independent
non-executive director
9
Henry Munro 21 1 Independent
non-executive director
3
Jackie Matheson 51 1 Chief Financial Officer 2
Herman Bothman 52 0 Chief Executive Officer 2
The Audit Committee had one scheduled meeting during the financial year ended 31 December 2011. Four members need to be present to form a quorum.
The FurniDex group has always expressed explicit and unreserved compliance with International Financial Reporting Standards (IFRS) in its separate and consolidated annual financial statements. A formal evaluation of the performance of the Audit Committee is performed every six years.
The following unresolved accounting matters have been identified during a preliminary meeting with the accountant of the FurniDex group:
1 Eastern Cape plant
FurniDex owns a large manufacturing plant in the Eastern Cape. During the 2011 reporting period, FurniDex decided to relocate its Eastern Cape plant to Gauteng. The group accordingly needed to decommission its Eastern Cape plant and dispose of the remaining assets.
1.1 Provision for environmental rehabilitation
FurniDex leased the land on which the plant is located. According to the contract, the land must be restored to its original condition when the plant is decommissioned. The group financial accountant said: 'A provision has not been recognised to date for environmental rehabilitation and will be recognised for the first time in the 2011 reporting period, as FurniDex intends to decommission the plant during the next reporting period and the group had never before intended to decommission the plant.'
The plant was brought into production on 1 January 2005. On the same date, an environmental expert reliably estimated that 20% of the damage to the environment had been caused by the original commissioning of the plant on the leased land. The remaining damage would be caused evenly over the expected useful life of the plant of 20 years, during which the plant would produce inventory for the FurniDex group. These estimates have remained unchanged since that date. Environmental rehabilitation activities only commenced on 1 August 2011, after the plant had been decommissioned.
3 The plant is measured in accordance with the cost model of IAS 16, Property, Plant and Equipment.
1.2 Termination of electricity purchase contract
In order to secure electricity supply at its Eastern Cape plant, FurniDex entered into a noncancellable 'take or pay' electricity contract with Powerful Limited ('Powerful'), the electricity utility company, on 1 January 2005. In terms of this contract FurniDex pays a minimum of R100 000 per month in arrears for a fixed amount of electricity. This amount is payable even if FurniDex uses less than the fixed amount of electricity during the month. An additional amount is payable on a variable basis if FurniDex uses more than the fixed amount during a month. The electricity contract comes to an end on 31 December 2024.
Fulfilment of the arrangement with the electricity utility company is not dependent on the use of a specific asset.
FurniDex ceased operations at its Eastern Cape plant on 30 June 2011. On that date, FurniDex had managed to sell the fixed amount of electricity to Box-It Proprietary Limited ('Box-It'), another local manufacturing entity. The terms of the contract between FurniDex and Box-It are the same as those in the original agreement between FurniDex and Powerful except that Box-It will only pay R90 000 per month for the fixed amount of electricity.
2 FurniDex's carbon footprint
The Kyoto Protocol is an international agreement linked to the United Nations Framework Convention on Climate Change. The major feature of the Kyoto Protocol is that it sets binding targets for 37 industrialised countries and the European community for reducing greenhouse gas (GHG) emissions.
Companies in countries subject to the Kyoto Protocol aim to achieve their GHG emission reduction targets by acquiring certified emission reduction (CER) certificates from companies based in developing countries such as South Africa.
FurniDex recently underwent a GHG assessment as part of its carbon offsetting strategy.
FurniDex has always been very conscious of its contributions to a 'greener' environment through the development of alternative projects such as solar and wind energy. FurniDex wants to take advantage of the Kyoto Protocol's potential economic and environmental benefits relating to its environmentally-friendly projects, and especially the trade in CER certificates.
The FurniDex Sandton factory converted from coal-based energy supplies to a fully solarbased power plant in 2008, which resulted in an average annual reduction of 18 000 tonnes of carbon dioxide emissions. The company as a result received CERs from the United Nations on 31 October 2011.
The CERs awarded to FurniDex are reliably estimated to have a total fair value of R10 million.
3 Share option scheme
On 1 January 2010 FurniDex share options were granted to the 50 current employees of FurniDex. The share options become exercisable at any stage after vesting and lapse on 31 December 2015.
4 Vesting is conditional upon the following:
· The completion of three years' service with FurniDex.
· The average sales volume increases per annum over the vesting period of three years as indicated below:
Average sales volume increase required by FurniDex over
the three years
Share options
per employee
Between 5% and 10% per annum 8 000
Between 10% and 15% per annum 9 000
Over 15% per annum 10 000
· The share price of FurniDex is R125 per share or more on 31 December 2012.
Management's estimates and actual findings with regard to the scheme:
· Sales volume
Date
Actual average sales
volume increase
achieved
Management's estimate of
average sales volume
increase over the remaining
vesting period
At 31 December 2010 16% per annum 12% per annum
At 31 December 2011 12% per annum 12% per annum
· Share price: FurniDex reliably estimated, at the grant date of the share options, that there was an 80% probability that the target share price of R125 per share would be achieved by 31 December 2012. On 31 December 2011 FurniDex reliably estimated that there was a 30% probability that the target share price of R125 per share would be achieved by 31 December 2012. FurniDex shares traded at R105 per share on the JSE on 31 December 2011.
· Staff turnover: During 2010 three employees left FurniDex and were immediately replaced. On 31 December 2010 FurniDex reliably estimated that only two more employees would leave during the remaining vesting period. During 2011, however, two more employees left FurniDex, but were not replaced. On 31 December 2011, FurniDex reliably estimated that only one more employee would leave FurniDex during the remaining vesting period.
· The fair value of the share options at grant date was determined to be R23 per share option, and reflects the effects of any market conditions specified in the terms and conditions of the share options granted.
· The FurniDex share price declined steadily during the 2010 financial reporting period, resulting in a share price of R115 per share as at 31 December 2010. FurniDex repriced the share options to an exercise price of R90 per share, instead of R100 per share, on 31 December 2010. The fair value of the share options at that date increased to R30 per share option due to the decrease in their exercise price. On 31 December 2010, before taking into account the effect of the re-pricing of the share options, the fair value of the share options was R16 per share option.
5 Transaction with a director
In 2010 Mr Manual Jordan decided to resign from his directorship at FurniDex. He had been part of FurniDex's management since its inception and had taken up 40 000 ordinary shares at incorporation at a par value of R10 per share. On 1 January 2011 he entered into an agreement with FurniDex whereby FurniDex would buy back all his shares pursuant to his resignation as director.
The agreement contained the following terms and conditions:
· Mr Jordan will be paid R125 per share in cash, which is considered to be a fair price.
· The total purchase consideration will be paid on 1 January 2013.
· The shares will be transferred to FurniDex on 1 January 2012.
No other transactions of a similar nature took place during the year ended 31 December 2011.
5 Acquisition of controlling interest in AfriFurn Proprietary Limited On 31 December 2011, FurniDex concluded an agreement with the current shareholders of AfriFurn Proprietary Limited ('AfriFurn') for the acquisition of a 51% controlling interest in AfriFurn by FurniDex.
None of the previous shareholders were employees of AfriFurn and therefore no part of the purchase consideration is dependent on future service to AfriFurn.
The purchase price of the ownership interest has been, and will be, settled as follows by FurniDex, at the dates specified below:
On 31 December 2011 · R10 million cash.
· Financial assets owned by FurniDex, with a carrying amount of R5 million and fair value of R8 million, were transferred to the shareholders of AfriFurn.
· Issue of 50 000 ordinary shares in FurniDex.
· Issue of one million mandatorily redeemable, cumulative 10% R2 preference shares in FurniDex.
o Dividends are payable annually in arrears.
o The preference shares are redeemable exactly five years after the acquisition date, at a premium of 10% on face
value.
On 31 December 2012 · R3 million cash depending on the following:
o The profit before tax of AfriFurn for the financial reporting period ended 31 December 2012 increases by at least 5%.
o FurniDex has reliably estimated that there is a 90% probability that this profit target will be achieved by AfriFurn with regard to the 2012 financial reporting period, due to the cash injection of working capital that FurniDex will be able to effect after the acquisition date. The fair value of this obligation was deemed to be R2 500 000 at 31 December 2011.
6 General information applicable to the FurniDex group of companies
The nominal, pre-tax discount rate applicable to FurniDex is 10% per annum. This rate was applicable to all financial reporting periods under review.