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QUESTION 1 95 marks
You are the audit senior in charge of the group audit of Ezweni Ltd, a holding company listed on
the JSE Ltd. Your audit firm is responsible for the audit of all of the companies in the group and
you are currently completing the audit for the year ended 28 February 2006. The group uses
International Financial Reporting Standards (IFRS) in the preparation of their annual financial
statements.
The group carries on trade in the clothing industry and consists of the following individual
companies that all play a role in the production chain of the group:
• The holding company – Ezweni Ltd
• Four subsidiaries
o Retail Ltd, a retail company;
o Manufacture Ltd, a manufacturing company;
o Property Ltd, a property investment company; and
o Foreign Ltd, clothing manufacturer and distributor in the United States of America.
The following information was extracted from the audited financial packs received from the
auditors of the individual companies in the group for the year ended 28 February 2006:
Ezweni
Ltd
R’000
Retail
Ltd
R’000
Manufacture
Ltd
R’000
Property
Ltd
R’000
Foreign
Ltd
US $’000
Profit after taxation 35 500 65 800 55 300 15 700 6 900
Dividends paid:
28 February 2006 (25 000) (20 000) (40 000)
(2 000) (500)
Retained earnings:
1 March 2005
85 600
240 300
310 900
45 600
12 800
Additional information on the companies in the group
Ezweni Ltd
The income received by Ezweni Ltd consists mainly of income from lease agreements and
dividends received from subsidiaries. Ezweni Ltd has also incurred operating expenses which
have been deducted correctly in order to calculate the profit after taxation. Ezweni Ltd has
issued share capital of 2 million equity shares (with a par value of R1 per share) that were all
issued at R2 above par value. No shares were issued during the year ended 28 February 2006.
On 1 March 2005 the remuneration committee of the board of Ezweni Ltd decided to reward
eight of its directors, as part of a performance management scheme to link the directors’
interests with the interest of the shareholders. The details of the scheme are as follows:
• Participants may elect, at grant date, to receive 10 000 share options or 10 000 share
appreciation rights. On the grant date five directors chose share options while three
chose share appreciation rights.
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• The share options give the directors the right to obtain shares in Ezweni Ltd. The directors
must remain in the employ of the group for three years, and the options will only vest if the
share price is R95 or higher on 29 February 2008.
• The share appreciation rights entitle the directors to receive, in cash, the increase in the
share price over R58 at 29 February 2008. The directors must remain in the employ of the
group for three years, and the rights will only vest if the share price is R95 or higher on
29 February 2008.
• On 1 March 2005 the Ezweni Ltd share price was R60. The options have a strike price of
R58. On that date an independent valuer determined that the fair value of the options was
R20 each. The valuer used the binomial option pricing model, which takes into account
market conditions.
• By 28 February 2006 the Ezweni Ltd share price had fallen to R50 and the fair value of
the option, determined using the binomial option pricing model, was R10. The directors
are of the opinion that the company’s share price will not reach R95 at 29 February 2008.
• On 1 February 2006 one of Ezweni Ltd’s directors resigned. That director had previously
chosen to receive share options. No further directors were expected to leave the company
up to 29 February 2008.
Retail Ltd
Retail Ltd is a retailer that sells clothing through its own retail outlets. Retail Ltd acquires its
inventory from Manufacture Ltd (see information below). Ezweni Ltd acquired its 80%
investment in Retail Ltd at the incorporation of the company on 1 March 2002 for R5,2 million
when the equity of Retail Ltd consisted of the following:
R’000
Share capital (R1 par value shares)
Share premium
1 000
5 250
Because of its strategic importance to the group, Ezweni Ltd was willing to pay a premium for
the interest in Retail Ltd.
Manufacture Ltd
Manufacture Ltd is a manufacturing company which is responsible for the manufacture of all of
the finished goods sold by Retail Ltd. Ezweni Ltd acquired all the share capital of Manufacture
Ltd on 1 July 2001 for R120 million when the equity of Manufacture Ltd consisted of the
following:
R’000
Share capital (R1 par value shares)
Retained earnings
100
125 900
The assets and liabilities were all considered to be fairly valued in the accounting records of
Manufacture Ltd at the date of acquisition by Ezweni Ltd.
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Manufacture Ltd was unable to obtain the required financing to purchase non-specialised
manufacturing machinery from a financial institution. Ezweni Ltd therefore decided to purchase
the machinery and lease it to Manufacture Ltd. Ezweni Ltd acquired the manufacturing
machinery on 1 March 2003 at a cost of R15 million (excluding VAT). On the same date it
entered into a lease agreement with Manufacture Ltd in terms of which Ezweni Ltd leased the
non-specialised manufacturing machinery to Manufacture Ltd. Ezweni Ltd qualifies for a capital
allowance of 20% per annum on cost price in respect of the manufacturing machinery for
income tax purposes.
The lease agreement between the two companies contains no special arrangements and all
terms are considered to be market-related. The lease agreement between the two parties
contains amongst others the following conditions:
Commencement of the lease term
Cash cost price (fair value) of the machinery
(including VAT at 14%) on which lease is based
Economic life of the manufacturing machinery
Lease term
Rate implicit in the lease
Incremental borrowing rate
Unguaranteed residual value (including VAT at 14%)
Instalments
1 March 2003
R22,8 million
10 years
6 years
10%
11%
R2 million
Payable monthly in arrears
It has been clearly stipulated in the lease agreement that Manufacture Ltd will not at any stage
during or after the lease term obtain ownership of the manufacturing machinery. The group
expects the useful life of the production machinery to be the same as its economic life. The
machine is used for a qualifying purpose in terms of the Value-Added Tax Act and both
Manufacture Ltd and Ezweni Ltd are registered VAT vendors.
Manufacture Ltd sells all of its manufactured inventories to Retail Ltd at a gross profit margin of
20% calculated on manufactured cost price. The inventory account in the general ledger of
Retail Ltd reflected the following closing inventories on hand (at cost to Retail Ltd):
