PROFESSIONAL LEVEL EXAMINATION

BUSINESS PLANNING: BANKING

SAMPLE PAPER

(2.5 hours)

BUSINESS PLANNING: BANKING

SAMPLE PAPER
This paper consists of THREE questions (100 marks).
1.

Assume the current date is 27 October 2015.

You are an audit senior working for Moores and Manson (MM), a firm of ICAEW
Chartered Accountants. MM audits Finsbury Bank plc (FB) and is commencing the
final audit of FB for the year ended 30 September 2015.

FB has historically had two lines of business: loans to UK banks and mortgages to
retail customers in the UK.

In early 2014, the FB board decided to expand into a third line of business, offering
loans to non-UK corporate customers. This was made possible by expanding FBs
credit approval committee with additional experienced members.

You have received the following email:

From: Audit partner, MM

To: Audit senior, MM
Date: 27 October 2015
Subject: FB audit for the year ended 30 September 2015

The final audit of FB is starting next week, but unfortunately the engagement
manager has gone on sick leave. I would like you to commence audit procedures
on loans and advances. There are also some financial reporting issues which
need to be considered.

The client has provided extracts from FBs draft financial statements with
explanatory notes highlighting outstanding issues (Exhibit 1). I am concerned
about the adequacy of impairments. The client has also provided an extract from
its credit risk disclosure note (Exhibit 2).

FBs finance director has informed me that a fixed rate loan made to Argyle Bank
plc (Argyle) (Exhibit 1) has become an issue. Argyle paid the interest due on
30 September 2015, but its board has since informed FB that no further interest
will be paid and that only 70% of the principal will now be repaid on the
redemption date. The market yield on debt of this risk class is 6.5% per annum.
The finance director has expressed concern about how the regulators will view the
extent of FBs non-performing loans and impairments, given the results of its non-
UK loan book (Exhibit 1).

I would like you to prepare a working paper addressing the following:

i. Set out and explain the correct financial reporting treatment of the loan to
Argyle in accordance with IAS 39. Provide supporting calculations,
including any appropriate impairment.

ii. Set out and explain the key audit risks and the related audit procedures to
be performed for each of the three lines of business in Exhibit 1:
UK banks (including but not limited to Argyle);
UK retail mortgages; and
Non UK corporates.
 iii. Explain briefly how the treatment of Argyles loan in FBs financial
statements would differ under IFRS 9 compared to IAS 39. Further
calculations are not required.

iv. Analyse the data in Exhibit 1 in relation to non-performing loans and

impairments. Explain and evaluate any risks that may concern the
regulators.

v. In relation to the financial disclosures and regulatory reporting, for each of

the three product lines:
Briefly set out key additional credit risk disclosures, which would
enhance the quality of FBs disclosures, for each of the three factors
highlighted in Exhibit 2; and
Calculate the expected loss and discuss its impact on FBs
regulatory capital resources for the year ended 30 September 2015.
Also explain how this expected loss differs from the financial
reporting treatment under both IAS 39 and IFRS 9.

Requirement

Prepare the briefing notes requested by the audit partner.

Total: 43 marks

Exhibit 1: FBs draft financial statements for the year ended 30 September 2015
with explanatory notes highlighting outstanding issues

Loans and advances disclosure note

30 Sept 2015 30 Sept 2014

000 000
Gross loans and advances to UK banks 125,987 125,706
Individually assessed impairment allowance (2,152) (153)
Net loans and advances to UK banks 123,835 125,553

Gross mortgage loans to UK retail customers 433,001 441,230

Individually assessed impairment allowance (1,605) (1,588)
Collectively assessed impairment allowance (15,353) (14,492)
Net mortgage loans to UK retail customers 416,043 425,150

Gross loans and advances to non-UK corporates 123,576 26,498

Individually assessed impairment allowance (12,975) (1,654)
Collectively assessed impairment allowance (2,022) (564)
Net loans and advances to non-UK corporates 108,579 24,280
Performing and non-performing loans at 30 September 2015

Loans and advances

UK banks UK retail Non UK
mortgages corporates
000 000 000
Performing loans
Neither past due nor impaired 121,438 399,951 29,565
Up to 30 days past due but not impaired 650 7,700 35,740
Total performing loans 122,088 407,651 65,305
Non-performing loans
Past due but not impaired
- 91 - 120 days past due 640 5,370 10,550
- 120 - 150 days past due -- -- 7,400
Past due but not impaired 640 5,370 17,950
Individually assessed impaired loans 3,259 19,980 40,321
Individually assessed impairment (2,152) (1,605) (12,975)
allowance
Individually assessed impaired loans, 1,107 18,375 27,346
net
Total non-performing loans: gross 3,899 25,350 58,271
Total non-performing loans: net 1,747 23,745 45,296

Gross loans and advances 125,987 433,001 123,576

Individually assessed impairment (2,152) (1,605) (12,975)
allowance
Collectively assessed impairment - (15,353) (2,022)
allowance
Net loans and advances 123,835 416,043 108,579

Explanatory notes

Loans and advances are all measured at amortised cost less impairments. During the
year ended 30 September 2015 there are a number of issues:

(1) Loan notes - Argyle

On 1 October 2012, FB purchased 50,000 100 3% loan notes for 4,518,150, which
had been issued by Argyle. Redemption of the loan notes is to be at par on
30 September 2022. Until 30 September 2014, Argyle made payments in accordance
with the terms of the loan agreement.
FB uses the advanced internal ratings based (IRB) approach to calculate credit risk
capital requirements. Under the IRB model the measurement of Argyles credit risk
grade was comparable to an external ratings agency grade ABB.

Recently however Standard and Poor have downgraded Argyles loan notes to BBB.
The loan notes, measured at amortised cost, had an annual effective interest rate of
4.2% on 1 October 2012.

(2) Mortgage loans to retail customers (UK)

FB has large exposure in the UK mortgage market. We are examining the
consequences of rising house prices and interest rates changes on our mortgage
book.

(3) Loans and advances to non-UK customers

FB has developed a strategy of lending to non UK customers (from early 2014). We
are constantly monitoring the macro economic conditions in the geographical regions
in which we lend. Recently there has been some economic uncertainty in some
regions.

(4) Equity

30 Sep 2015 30 Sep 2014

000 000
Share capital 1,854 1,821
Reserves 67,794 67,548

Exhibit 2: Credit risk disclosures

FB aims to enhance its credit risk disclosures and its relevance to users by continuing
to adopt the British Bankers Association Code for Financial Reporting Disclosure (the
BBA Code) and implementing the guidance provided by the Enhanced Disclosure
Task Force.

In particular, FB is looking to enhance the quality of its disclosures by providing further

information on the following factors across the three product lines;

Loan To Value (LTV) and credit risk concentration

Impaired loans
Forbearance

FB also aims to disclose its expected loss (EL) on all three portfolios. For the UK
portfolios, FB estimates that it will recover only 60% of its exposure if the borrower
defaults. The likelihood of this occurring is 0.3% for retail mortgage customers, and
0.1% for UK bank customers. In relation to lending to non-UK corporates, FB
estimates that it will recover only 40% of its exposure if borrowers default, however,
the likelihood of this occurring is 0.5%. In light of this, FBs senior management expect
the EL across all portfolios to be significantly higher than the previous year.
2.
Assume that the current date is 27 July 2015

You are an ICAEW Chartered Accountant, employed as a relationship manager in the

small and medium enterprises (SME) department at First Bank plc (First Bank). You
are responsible for analysing corporate loan applications from customers in your
portfolio, making recommendations and submitting these to the credit sanction
department for a decision on whether to make the loan.

You have recently received information from a new customer, Aardvark Bicycle
Company Ltd (ABC). Based upon this information, you are in the process of
performing quantitative and qualitative analysis to submit the first draft of your report
on ABC to the credit sanction team.

Customer loan application

ABC manufactures racing bicycles and spare parts. It also imports a range of lower
cost, commuter bicycles. ABC sells its own racing bicycles and imported bicycles
through a small chain of shops located in and around London. These sales are all
made to individual customers, normally paying by credit card. ABC also exports its
own racing bicycles to retailers in the USA and France.

ABC plans to build and operate a third shop in Bristol, almost 200 kilometres distance
from the London shops. It is applying to First Bank for a 1 million, 5-year loan, in
order to finance this expansion plan.

The ABC board, has provided you with background information about its business and
the purpose of the loan application (Exhibit 1). Also provided are extracts from ABCs
forecast management accounts for the years ending 31 December 2015 and
31 December 2016 (Exhibit 2) and the projected cash flows from the proposed Bristol
shop (Exhibit 3).

Managers instructions

Your manager, James Brown, has recently sent you an email about the SME
departments performance and budgeted target for the current month (Exhibit 4).

James Brown has asked you to produce a working paper in which you:

prepare qualitative and quantitative credit analysis and assess the

creditworthiness of ABC and the affordability of the loan. Set out any additional
information that should be obtained in order to make a final decision on ABCs
loan application;

outline appropriate key terms and conditions to be included in a loan

agreement with ABC, assuming First Bank will provide the loan to ABC;
 explain the key assurance procedures that should be carried out in order to
provide comfort over the information used in the qualitative and quantitative
credit analysis; and

provide reasoned advice, on the basis of the above analysis, setting out and
justifying the maximum amount of any loan which you would recommend (on a
preliminary basis) First Bank to provide to ABC.

Requirements

i. Prepare the working paper requested by James Brown.

ii. Explain the ethical implications of James Browns email (Exhibit 4). Set out the
actions you should take.
Total: 36 marks

Exhibit 1 Background information

ABC manufactures and sells bicycles and spare parts. The shares of ABC are owned
by the two founders, Alex Andrews and Sam Simms, who are both engineers. They set
up the company 15 years ago, obtaining finance by using their savings and some
personal borrowing, secured on their own homes, to subscribe for the initial share
capital. There was also some initial corporate borrowing by ABC, for which Alex and
Sam supplied personal guarantees. Alex and Sam are the only two directors on the
board and they work full time in the business.

ABC experienced high growth initially, benefiting from growth in the UK racing bicycle
market. However, during the last three years, it has faced competition from new
entrants attracted to the growing bicycle market, particularly lower cost importers. As a
consequence, demand for ABCs racing bicycle in London has fallen.

The ABC board therefore decided to expand geographically by opening a shop in

Bristol, as market research showed that there is a growing demand for racing bicycles
in that region.

In January 2014, ABC purchased a plot of land in Bristol for 3.4 million, financed by a
loan from Lander Bank plc. This loan was a 3.4 million, 3% fixed rate, 6-year loan,
secured by a fixed charge over the land in Bristol.

All of ABCs loans taken out prior to 2014 were from Lander Bank plc and are secured
by fixed charges over property. All pre-2014 loans are repayable in 2021.

The ABC directors are applying for a loan from First Bank to finance the construction
and initial working capital of the new shop in Bristol, near the land previously
purchased. Building will commence as soon as a loan is granted and continue until the
end of 2015. The shop will open on 1 January 2016.

The ABC directors have applied for a 1 million, 5-year loan from First Bank at a fixed
annual interest rate of 4%.
Exhibit 2 ABC: Extracts from management accounts

The forecast management accounts for the year ending 31 December 2016 include
the expected trading results of the Bristol shop. ABC adopts the historical cost model
for its financial statements.

Forecast statements of profit or loss for the years ending 31

December

2016 2015
'000 '000
Revenue 18,178 17,464
Less: Cost of sales (8,180) (6,811)
Gross profit 9,998 10,653
Less: Distribution costs (1,373) (933)
Administrative expenses (5,240) (5,257)
Profit from operations 3,385 4,463
Finance costs (617) (529)
Profit before tax 2,768 3,934
Income tax expense (1,094) (1,023)
Profit for the year 1,674 2,911

ABC: Statements of financial position at 31 December

2016 2015
000 000

Assets
Non-Current Assets
Property 16,231 13,849
Plant and equipment 7,684 7,800
23,915 21,649

Current Assets
Inventories 2,812 2,555
Trade receivables 3,114 2,373
Cash - 154
5,926 5,082
Total Assets 29,841 26,731

Equity and Liabilities

Equity
Ordinary share capital 2,700 2,700
Retained earnings 15,818 14,144
18,518 16,844
Non-current liabilities
Long-term loans 8,300 7,770
Current liabilities
Trade payables 1,218 1,185
Income tax liability 1,416 932
Bank overdraft 389 -
3,023 2,117
Total liabilities 11,323 9,887
Total Equity and Liabilities 29,841 26,731

ABC: Forecast statement of cash flows for the year ending 31 December 2016

Cash flows from operating activities '000

Profit before tax 2,768
Depreciation and impairment charge 1,550
Interest expense 617
Increase in inventories (257)
Increase in receivables (741)
Increase in payables 33
Cash generated from operations 3,970
Interest paid (617)
Income taxes paid (610)
Net cash from operating activities 2,743

Cash flows from investing activities

Purchase of property, plant and equipment (3,816)

Cash flows from financing activities

Increase in long term loan 530

Decrease in cash and cash equivalents (543)

Cash and cash equivalents at beginning of period 154
Cash and cash equivalents at end of period (389)

Additional information

1. Analysis of revenue
%
Retail sales of:
Own manufactured racing bicycles and spares 40
Imported commuter bicycles 10

Sales to retailers in USA and France 50

100
 These shares of revenue have remained constant for a number of years.

2. Key ratios
2016 2015
Gross margin 55.0% 61.0%
Operating margin 18.6% 25.6%
Debt / equity 46.9% 46.1%
Interest cover 5.5 8.4
Receivables days 63 days 50 days
Inventory days 126 days 137 days

Exhibit 3 Expansion: Bristol project forecast cash flows 2016 to 2020

The Bristol shop will require a total investment of 1 million for the new building,
fixtures and working capital. The new shop will be opened on 1 January 2016.

Projected operating cash flows for the Bristol shop

Years ending 2016 2017 2018 2019 2020

31 December

Sales revenue 225,000 375,000 675,000 550,000 400,000

Costs
(includes fixed (180,000) (255,000) (405,000) (342,500) (267,500)
and variable)

Working (60,000) (5,000) (20,000) - -

capital
requirements

Net cash flow (15,000) 115,000 250,000 207,500 132,500

Forecasts beyond 2020 have not yet been estimated due to the uncertainties involved
over such a long time horizon.

Exhibit 4 Email from James Brown

The SME departments target for new loans for the current month (July 2015) is
5 million. There is significant budgetary pressure from senior management for the
monthly targets to be achieved.

At the close of business yesterday (26 July 2015), the SME department had granted
loans totalling 4.1 million. This means that the department now only has four days to
meet the July target.
As a team, we are responsible for meeting the target and our performance is closely
monitored by the ABC board.

I would like you to give careful consideration to the application by ABC for a loan of 1
million. We hope to win ABC as a new client for First Bank and retain it for the
foreseeable future.
 3.

Assume the current date is 31 December 2015.

You are a trainee ICAEW Chartered Accountant working for BritBank in its internal
audit department. BritBank is based in the UK.

The BritBank board currently expects the Bank of England base rate to remain at
0.5% over the next year to 31 December 2016. However, it has decided to perform a
stress test, examining a scenario where the base rate increases by 75 basis points to
1.25% on 1 January 2016, and then remains at that level indefinitely. In response to
this, it is assumed that the 3-month LIBOR will increase by 100 basis points from 0.6%
to 1.6% on 1 January 2016.

John Calvin, the head of internal audit, is a member of the BritBanks risk
management committee. He has asked you to assess the risks arising to BritBank
from the impact of a possible future increase in the base rate and he has provided the
following information from the Asset/Liability Committee (ALCO). These assets and
liabilities have been identified as being of potential concern if the base rate changes.

In preparation for the next meeting of the risk management committee, John Calvin
has sent you a schedule of key financial assets and liabilities (Exhibit).

The risk management committee wishes to manage any significant risks that may
arise from an interest rate change. John has suggested the following risk management
strategies:

Interest rate swap

Interest rate futures

Requirements:

John Calvin has asked you to prepare briefing notes addressing each of the following:

i. In respect of the suggested stress test:

a. Based on the financial assets and liabilities illustrated in the schedule

(Exhibit), calculate BritBanks projected net interest income for the year ended
31 December 2016, based on the assumption that the Bank of England base
rate remains at 0.5% and the 3-month LIBOR at 0.6%.

b. Calculate the impact of the assumed 75 basis point increase in the base rate
and the 100 basis point increase in the 3 month LIBOR on BritBanks net
interest income projected for the year ended 31 December 2016.

c. Based on the financial assets and liabilities illustrated in the schedule

(Exhibit), discuss the net duration position (duration gap) of BritBank and the
significance of net duration position (duration gap) as an indication of interest
rate risk for the bank. No calculations are required.
 d. Identify the risks to the bank that the risk management committee would need
to consider in the event of a 75 basis point increase in base rates. Explain
how these risks arise.

e. Explain and evaluate the two risk management strategies that John has
suggested. Explain the financial reporting treatment of each strategy.
Calculations are not required.

ii. In relation to BritBanks financial assets and liabilities of concern to ALCO, explain
the regulatory reporting risks, referring to Basel III pillar 3 disclosures, that would
arise for the bank relating to:

Liquidity and funding risk

Interest rate risk

Total: 21 marks

Exhibit:
Schedule of key financial assets and liabilities at 31 December 2015 which are
of concern to ALCO

Re-
Financial Assets 000 Description Maturity pricing Duration

Commercial 550,000 Fixed rate 4.5% 10 year - 7.5 years

mortgages

Floating rate
3
Corporate loans 550,000 3 months LIBOR + 3 years 3 months
months
3%

Financial
Liabilities
Customer Current
300,000 Zero rate - 0 months
deposits but stable
Interbank Floating rate 3 3
700,000 6 months 3 months
deposits months LIBOR months