You are a trainee accountant in the first year of your training contract. You are involved in the year-end audit of Manufacta Holdings Ltd ('MHL'), a manufacturing company listed on the JSE Ltd. MHL recently appointed the auditing firm that you are training with as its external auditor. The directors of the group wish to express explicit and unreserved compliance with International Financial Reporting Standards (IFRS) in their financial statements. The company has a 31 December year end.

The senior trainee accountant on the engagement has delegated a number of outstanding audit issues to you and requested that you review the following audit work papers and then address these issues:

Work paper reference
Work paper description

A1
Lease agreement with Professional Properties (Pty) Ltd
B1
Broad-based employee share ownership plan
C1

Financial instruments

Information on relevant accounting policies

It is the accounting policy of the company to depreciate items of property, plant and equipment over their expected useful lives on the straight-line basis. These items have no residual values for purposes of depreciation. These estimates are reviewed and confirmed annually.
Land and buildings are subsequently measured according to the cost model and plant according to the revaluation model in terms of IAS 16,

Property, plant and equipment. 1

Manufacta Holdings Ltd
Year end: 31 December 2007
Prepared by: AC Trainee
Date: 17 January 2008
Lease agreement
Reviewed by:
Date:
WP
A1
1/2
Executive summary of the lease agreement

MHL leases its head office building from Professional Properties (Pty) Ltd on the following terms:

• The lease agreement is for ten years;
• MHL has the option to extend the lease term for a further five years at the end of the initial ten-year period; and
• The lease agreement states explicitly that the legal title of neither the head office building nor the land on which it is situated will at any stage transfer to MHL during the initial or extended lease terms.

The head office building had an estimated economic (and useful) life of 20 years at the date of inception of the lease agreement.

The building became available for use on 1 January 2006 but was only physically occupied on 1 February 2006.

MHL is considering the construction of its own building in the near future and it is unlikely that the company will extend the lease term for the current head office building.

Details of the lease agreement

The following information relates to the lease agreement with Professional Properties (Pty) Ltd:

Date of inception and date of commencement of the lease agreement
1 January 2006
#
Asset leased
Manufacta House
Erf 2201, Sandton CBD
Johannesburg 2000
#
Lease term
Ten (10) years (initial lease term)
Five (5) years (extension at the option of the lessee)
#
Instalment
R250 000
Payable monthly in arrears, commencing on 31 January 2006
#
Interest rate implicit in the lease agreement
12% per annum
^ *
Legend
# = Agreed to the lease agreement
^ = Recalculated and confirmed to be correct in terms of IAS 17, Leases
* = Recalculated and confirmed to be correct in terms of the lease agreement
2
Manufacta Holdings Ltd
Year end: 31 December 2007
Prepared by: AC Trainee
Date: 17 January 2008
Lease agreement
Reviewed by:
Date:
WP
A1
2/2

The fair value of the leasehold interest in the head office building comprises 80% of the aggregate fair value of the leasehold interest in the property. The relative fair values of the leasehold interests in the head office building and in the land on which it is situated on 1 January 2006 were calculated in terms of the requirements of IAS 17, Leases.

In contrast the fair values of the land and the head office building were as follows on 1 January 2006:
?? Land R2,5 million
?? Head office building R15 million
MHL processed only the following journal entries for the years ended 31 December 2006 and 31 December 2007 in their accounting records:
R'000
R'000
31/12/06
Operating lease expense (income statement)
Bank
Operating lease instalments from 1 January 2006 to 31 December 2006
3 000
3 000
31/12/06
SARS (balance sheet)
Tax (income statement)
Tax deduction from 1 January 2006 to 31 December 2006
870
870
31/12/07
Operating lease expense (income statement)
Bank
Operating lease instalments from 1 January 2007 to 31 December 2007
3 000
3 000
31/12/07
SARS (balance sheet)
Tax (income statement)
Tax deduction from 1 January 2007 to 31 December 2007
870
870
Value-added Tax (VAT) is not applicable to the lease agreement.
The normal company tax rate is 29%.
Planning materiality is R5 million.
3
Manufacta Holdings Ltd
Year end: 31 December 2007
Prepared by: AC Trainee
Date: 26 January 2008
Broad-based employee share ownership plan
Reviewed by:
Date:
WP
B1
Details of the broad-based employee share ownership plan

On 1 January 2006, MHL launched a broad-based employee share ownership plan, called Ingwe. In terms of the plan, share options were granted to all 2 500 of its employees.

The terms of the Ingwe plan provide for the following:

• The options will vest on 31 December 2010, provided that the employee is still in the employ of MHL on that date.
• A performance condition also exists in terms of which the share options will only vest if MHL's share price is R85 per share or more on the vesting date.
• Each employee is entitled to 100 share options with an exercise price of R25 per share.
• When exercised, each share option will entitle the holder to one share in MHL.
On 1 April 2007, after negotiations with the trade unions, MHL agreed to decrease the exercise price from R25 per share to R20 per share.
The fair value per share option measured reliably on each date, taking into account the relevant performance condition, was as follows:

Date
Before being
re-priced
After being
re-priced
R
R
1 January 2006
15
n.a.
31 December 2006
25
n.a.
1 April 2007
40
52
31 December 2007
60
68

The actual number of employees on each date, and corresponding estimate of the number of employees on 31 December 2010 based on that date, are as follows:
Date
Actual
Estimate for
31 December 2010
1 January 2006
2 500
2 457
31 December 2006
2 479
2 412
1 April 2007
2 431
2 372
31 December 2007
2 377
2 312

The Ingwe plan has been accounted for as a cash-settled share-based payment transaction in the annual financial statements and draft pre-closing trial balance of MHL for the 2006 and 2007 financial years. This classification is incorrect in terms of IFRS 2, Share-based payment. The effect of the error is considered to be material.

No journal entries have yet been processed to correct the error.

Manufacta Holdings Ltd
Year end: 31 December 2007
Prepared by: AC Trainee
Date: 21 January 2008
Financial instruments
Reviewed by:
Date:
WP
C1

Information relating to debentures issued

MHL required short-term financing during the 2007 financial year and accordingly issued 1 000 convertible debentures with a face value of R10 000 per debenture at par value on 1 July 2007 for cash. The debentures bear coupon interest at 10% per annum. Interest is compounded and payable annually.

Each debenture is convertible on 30 June 2010, at the option of the holder, into a number of ordinary shares of MHL worth R10 000 at that date. Debentures that are not converted will be settled in cash at par value on 30 June 2010.

Based on his past experience with similar transactions, the financial director of MHL is of the opinion that the debentures will all be converted into ordinary shares. He has proposed that the full proceeds from the debenture issue be classified as equity.

The cumulative present value table is provided on page 7.

REQUIRED

Discuss, with reasons, whether you agree with Manufacta Holdings Ltd's classification of the lease agreement with Professional Properties (Pty) Ltd. Also address the accounting recognition of the current and deferred income taxes associated with the classification of the lease agreement.

Based on the information provided, prepare the correcting journal entries necessary to correctly reflect the broad-based employee share ownership plan in the books of Manufacta Holdings Ltd for the financial year ended 31 December 2007.
Ignore the effects of tax arising from this transaction.

(b)(ii)  Describe the audit procedures that should be performed to test the broad-based employee share ownership plan for purposes of the audit of Manufacta Holdings Ltd for the financial year ended 31 December 2007.
Your answer should not include detailed audit procedures on measurement, presentation and disclosure.

(c)(i) Discuss, with reasons, the appropriateness of the recognition and measurement of the convertible debentures issued on 1 July 2007 by Manufacta Holdings Ltd as proposed by its financial director. Should you consider the proposed treatment inappropriate, you should recommend an appropriate alternative.

Your solution should address the classification of the convertible debentures in terms of IAS 32, Financial instruments: presentation by Manufacta Holdings Ltd as well as the appropriate recognition and measurement in terms of IAS 39, Financial instruments: recognition and measurement, where applicable.

Ignore all issues relating to note disclosure and tax.

(c)(ii)

Discuss, with reasons, how the convertible debentures should be dealt with when calculating the basic and diluted earnings per share of Manufacta Holdings Ltd for the year ended 31 December 2007.

CUMULATIVE PRESENT VALUE TABLE
Year
10%
11%
12%
13%
14%
15%
16%
1
0,909
0,901
0,893
0,885
0,877
0,870
0,862
2
1,736
1,713
1,690
1,668
1,647
1,626
1,605
3
2,487
2,444
2,402
2,361
2,322
2,283
2,246
4
3,170
3,102
3,037
2,974
2,914
2,855
2,798
5
3,791
3,696
3,605
3,517
3,433
3,352
3,274
6
4,355
4,231
4,111
3,998
3,889
3,784
3,685
7
4,868
4,712
4,564
4,423
4,288
4,160
4,039
8
5,335
5,146
4,968
4,799
4,639
4,487
4,344
9
5,759
5,537
5,328
5,132
4,946
4,772
4,607
10
6,145
5,889
5,650
5,426
5,216
5,019
4,833
11
6,495
6,207
5,938
5,687
5,453
5,234
5,029
12
6,814
6,492
6,194
5,918
5,660
5,421
5,197