4-June 2017

Professional Level – Business Planning: Banking – June 2017
MARK PLAN AND EXAMINER’S COMMENTARY
The marking plan set out below was that used to mark these questions. Markers were encouraged to use
discretion and to award partial marks where a point was either not explained fully or made by implication.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.
Question 1 – Friar plc
Total Marks: 40
General comments
The candidate is placed in the role of an audit senior working on the external audit of Friar plc (Friar). The
focus is on unsecured lending to retail customers and the specific risks and issues this creates for the
bank. Friar has reduced its risk appetite and has suffered from an increase in credit card fraud, due in part
to cybercrime.
The candidate is required to identify key audit risks and describe related audit procedures. There are two
financial reporting issues to deal with focusing on impairments and the impact of IFRS 9 implementation.
Regulatory skills are tested through the calculation of the liquidity coverage ratio and identifying that Friar
has calculated it incorrectly. Ethics is tested by the engagement partner requesting information from a
former audit partner who is now working at Friar to help with the imminent audit tender.
1.1 Audit risks and related procedures
Audit risk Audit procedure

Consumer lending balances are Obtain evidence that the prior period's closing balances have
misstated in value or do not exist. been brought forward correctly to the current period.
Conduct back testing to ensure that there is appropriate

supporting documentation for loans originated and that they
are being recorded in the general ledger to test for
completeness.
Obtain documents showing reconciliations of general ledger

are being performed to draft disclosures.
Impairments are understated because: Request and review the draft disclosure of non-performing
 loans are unsecured; loans to assess whether all identified non-performing loans
 there are new lower customer are captured.
income thresholds for personal
loans and overdrafts; and Select a sample of loans classified as performing to assess
 the impairment allowance whether the classification is correct.
against consumer lending is a
lower percentage of the total in Assess a sample of loans in each of the past due
2017. classifications i.e. loans due past 3, 6 and 9 months to ensure
that these are being correctly categorised.
Perform analytical procedure to compare the impairment

allowance coverage with prior year and discuss any
anomalies with financial control.
Review the impairment models for reasonableness including

the assumptions embedded in the models such as overdrafts
become impaired when more than 3 months outstanding.
Assess whether using a historical default rate for personal

loans is appropriate given the new lower customer income
threshold used by Friar. A higher default rate may be more
appropriate.
Copyright © ICAEW 2017. All rights reserved Page 1 of 16

Check that the impairment allowance models have been

approved by the relevant management committee.
Compare the current emergence period with Friar’s historical

records.
Ensure that any individually significant loans have been

assessed for impaired separately from the collective
allowance by reviewing outstanding lending balances by size.
Forbearance policies have been applied Review the forbearance policy of Friar and compare it against
to avoid recognising impairments. the definition of default agreed by the board and its sub-
committees.
Perform sample testing to ensure that all forborne accounts

are being recognised per the forbearance policy.
Assess the ageing (that is the period of missed payments) of

the book especially on forborne accounts to check whether
further impairment allowances are required.
Review a sample of forborne accounts where revolving credit

has been provided to assess the risk of refinancing.
Origination of new lending is outside the Review a sample of new accounts against Friar’s risk appetite
risk appetite, especially for credit cards to ensure the limits have been adhered to.
where the risk appetite has been
tightened. Assess whether adequate affordability checks have been
conducted by reviewing a sample of applications.
Compare Friar’s credit checks to those conducted by the

industry i.e. banks commonly use credit bureau information to
assess credit worthiness of customers.
Observe whether the firm captures sensitivity of economic

factors (like interest rates and unemployment) in its lending
decisions.
Cyber-attacks may lead to financial fines Perform controls testing assessing the robustness of IT
and loss of consumer confidence controls to withstand cyber-attacks.
affecting going concern basis.
Perform controls testing on data security controls.
Review the internal audit assessments and evaluate whether

this issue has been escalated to senior management.
Assess whether claims are expected from customers which

will need to be provided for by Friar.
Consumer lending is breaching Review regulatory letters from the Prudential Regulatory
regulatory and industry standards Authority and Financial Conduct Authority to identify if there
are any breaches of consumer standards.
Review the level of overall and upheld complaints received by

Friar against industry standards. Ensure that contentious
complaints are being provided for if necessary.

Examiner’s comment
The overall performance of candidates on this requirement was very good. Many candidates gained full
marks.
Some good candidates used the figures provided in the question to frame their risks, for example the
percentage of total assets that comprises unsecured lending and percentage changes in balances and
impairment allowances.
The majority of candidates used the scenario in the question to identify risks associated with Friar
introducing a lower customer income threshold on personal loans and overdrafts whilst reducing its risk
appetite on credit cards. Candidates also discussed credit card fraud, include cybercrime and relevant
controls testing, and the impairment allowance methodology.
Candidates did not blindly copy answers from the question bank as has been seen, and commented upon,
in previous BP:B exams. Risks and procedures were generally tailored to the scenario provided in the
question.
Duplication of procedures is not rewarded for the three lending categories of personal loans, overdrafts
and credit cards. Candidates would save time by discussing risks and procedures applicable to the
unsecured lending balance as a whole, and then discussing individual differences.
Total possible marks 19

Maximum full marks 16

1.2 Financial reporting treatment under IAS 39 and IFRS 9
Issue (1) Increase in impairment allowances
IAS 39 requires an impairment review to be carried out when there is objective evidence of impairment.
The impairment review compares the carrying amount of the asset with its recoverable amount, calculated
as the present value of the estimated future cash flows, discounted at the original effective rate. Objective
evidence of impairment includes significant financial difficulty of the issuer, default in payments and
granting concessions to the borrower. Friar’s increase in the volume of personal loans and advances with
lower customer income thresholds may lead to an increase in incurred losses under IAS 39.
IFRS 9 is effective for annual periods beginning on or after 1 January 2018. It introduces a new
impairment model based on expected losses, rather than incurred loss as per IAS 39. With the exception
of purchased or originated credit-impaired financial assets, expected credit losses are required to be
measured through an impairment loss allowance at an amount equal to:
 12-month expected credit losses (expected credit losses that result from those default events on
the financial instrument that are possible within 12 months after the reporting date). This applies to
financial assets on initial recognition; or
 Lifetime expected credit losses (expected credit losses that result from all possible default events
over the life of the financial instrument). This applies to financial assets where there has been a
significant deterioration in credit quality or default has occurred.
The IFRS 9 impairment model therefore results in earlier and timely recognition of credit losses than under
the IAS 39 incurred loss model. This is because it requires recognition of not only credit losses that have
already occurred, but also losses that are expected in the future.
Given Friar is increasing its personal loans and overdraft business which under the revised lower
customer income threshold carry a higher probability of default, its expected loss charge would increase
as the probability of default is one of the components used to calculate the expected loss charge
(probability of default x loss given default x exposure at default). Note that to date, Friar has experienced
very few losses incurred on these businesses and therefore the impairment allowance under the IAS39
incurred loss model would be lower than that under IFRS 9.
Issue (2) Forbearance policy
Under IFRS 9, an impairment loss allowance for lifetime expected credit losses is required for a financial
instrument if the credit risk on that financial instrument has increased significantly since initial recognition.
There is a rebuttable presumption that contractual payments more than 30 days past due constitute a
significant increase in credit risk. There is a rebuttable presumption of default if payment is more than 90
days past due.
Under IAS 39, impairment losses are recognised only after the default event has occurred. The significant
increases in credit risk until the default event happens are not considered in the measurement of credit
loss allowance. However, entering forbearance is an indicator of impairment and Friar must calculate the
present value of the new estimated future cash flows to assess if the recoverable amount is lower than the
carrying amount.
Friar currently offers forbearance to customers who are overdue on their payments for more than 180
days. Therefore, under IFRS 9, Friar will need to consider whether these forborne loans are in default and
provide reasonable and supportable information to support an alternative default criterion.
This requirement was answered well and most candidates dealt with both issues.
Candidates appeared to have a good grasp of the new principles of IFRS 9.
A minority of candidates did not specifically answer the forbearance point that it is an indicator of
impairment under IAS 39 and potentially a significant increase in credit risk under IFRS 9.


1.3 Liquidity coverage ratio

The liquidity coverage ratio (LCR) measures the short-term resilience of the liquidity risk profile of banks
by ensuring that they have sufficient high quality liquid assets (HQLA) to survive a significant stress
scenario lasting 30 calendar days. In light of this, the treasurer’s proposal for Friar to meet a 20-day
survival period in a stress scenario will not comply with the LCR rules.
The requirement to meet 100% LCR threshold began to be phased in from 1 January 2015 and will not be
fully implemented until 1 January 2019. Whilst Basel III recommends a 60% LCR requirement from
1 January 2015, the current requirement imposed by the PRA is for banks to meet a minimum LCR
requirement of 70% by 1 January 2016 and 80% by 1 January 2017.
Calculation of LCR
LCR = High quality liquid asset divided by net cash outflows over a 30-day period.
Calculation of HQLA
Level 1 assets are £300 million (UK government bonds) and must make up a minimum of 60% of the
HQLA portfolio. The total HQLA portfolio must therefore be a maximum of £500 million (300m/0.6). The
remaining £200 million (40% of HQLA) can be fulfilled by level 2 assets.
Corporate debt securities and covered bonds are level 2A assets valued at £150 million (25% x £600m).
Asset backed securities (ABS) total £150m (25% x £600m) and are classed as level 2B assets i.e. can
only make up 15% of the total HQLA. Therefore, only £75 million (£500m x 15%) of ABS can count
towards HQLA.
HQLA is therefore £500m split into £300 million (UK government bonds) level 1 assets plus £200 million
level 2 assets (maximum 40% of HQLA). Level 2 assets are split between £150 million of covered bonds
and corporate debt securities i.e. level 2A assets and £50 million of ABS i.e. level 2B assets.
Calculation of net cash outflows over a 30-day period

Cash outflows = £3,000 million (4,500 x 30/45) i.e. prorate the outflows over a 30-day period.
Cash inflows = £4,000 million but must be limited to 75% of outflows i.e. £2,250 million (3,000 x 75%).
Net cash outflows = Cash outflows – cash inflows
= £750 million (£3,000m – £2,250m)
LCR = High Quality Liquid Assets / Net cash outflows over a 30-day period
= £500m/£750m
= 66.7%
Friar’s current LCR position does not meet the 2017 regulatory requirement of 80% and does not reconcile
with the calculations of the treasurer i.e. that the LCR is above 100%.
Management will need to report the current position immediately to PRA explaining the error. It will also
need to submit a plan showing accretion of HQLA which will enable the firm to meet its LCR requirement.
A large number of candidates achieved full marks on this requirement. Candidates had clearly practised
this topic and thus were well prepared for it.


1.4 Ethical issued and actions
Cross, as a firm of ICAEW Chartered Accountants, must adhere to the Financial Reporting Council (FRC)
Ethical Standard. From the CFO’s email, it appears that he is suggesting seeking Sarah Moss’s (ex-
partner of Cross) help on the retendering process and has suggested that Cross incorporate her views on
key audit areas of impairments.
This threatens Cross breaching the principles of objectivity, confidentiality and integrity per the ICAEW
ethical code which suggests that a professional accountant should not allow bias, conflict of interest or
undue influence of others to override professional or business judgements. Further, a professional
accountant should be straightforward and honest in all professional and business relationships.
Therefore, we should not approach Sarah Moss to seek inside information or guidance in advance of the
formal tender process. Nor should we seek to influence her decision as a member of the audit committee
outside of the formal tender process.
Therefore, Cross should apply through the formal tendering process by following the set procedure and
setting out its case in front of the whole audit committee, without contacting or seeking to influence
members of the committee outside that process.
The audit team must ensure that sufficient professional scepticism is applied throughout the audit process
despite the familiarity threat through the connection to Sarah Moss. Safeguards would include ensuring
that the audit team comprises members who do not have a personal connection with Sarah.
Given the audit partner’s willingness to discuss the tender with Sarah inappropriately, it would be sensible
for you, as audit senior, to consult with another partner in the firm, or the ethics partner, to ensure that
your own objectivity and integrity are not compromised.
The ethics requirement was answered reasonably well. Examiner comments from December 2016 were
heeded and most candidates covered a variety of threats to ethical principles and outlined appropriate
actions to take.
Candidates must still take care to note whose ethical issues are being discussed. In this question, the
requirement asked for the issues facing Cross, the external auditor. Therefore, threats to Sarah Moss’s
integrity and/or threats to Friar plc are not relevant.


Question 2 – Alpha Bank
Total Marks: 35
General comments
The candidate reports to credit risk management at Alpha Bank (Alpha) and is analysing a lending
proposal from Precision Engineering Services plc (Precision). Precision wishes to take out a further term
loan with Alpha, in addition to its existing debt facilities, to finance the acquisition of Heritage Consulting
Ltd (Heritage).
There are two proposals outlined: Alpha may lend the full consideration amount of £50 million; or Alpha
may lend £35 million with deferred consideration raised by Precision through a rights issue.
The candidate is provided with the terms of each proposal, summary financial information and preliminary
ratios.
2.1 Credit analysis of two lending proposals
Introduction
You are required to undertake both qualitative and quantitative analysis of the corporate lending proposal
received from Precision Engineering Services Limited (Precision) to support the financing of the
acquisition of Heritage Consulting Limited (Heritage).
As a longstanding corporate customer Alpha Bank (Alpha) would like to offer finance to Precision if the risk
parameters are acceptable.
Analysis of the application
1. Loan suitability
2. Affordability
3. Viability
4. Security
5. Financial stability
6. Capital structure
7. Track record of management
1. Loan suitability
The executive management team of Precision is considering the most appropriate capital structure that
will enable it to successfully conclude the proposed acquisition of 100% of the shares in Heritage. The
strategic rationale would appear to be logical as they are seeking to more fully integrate the business
model through the supply chain to strengthen the underlying customer service proposition and enhance
financial returns for shareholders.
The purchase price for Heritage of £50 million would seem to be represent a reasonable price / earnings
multiple of approximately 6.4 times, particularly if there are short-term commercial benefits from cross-
selling into the existing client base (some of which may overlap) alongside cost synergies from economies
of scale and reducing duplication.
The current financial health of the Precision group would indicate some capacity to raise additional senior
debt.
The two options proposed by the management of Precision include 100% external financing of the
transaction which would normally represent a meaningful challenge for lenders:
Option 1
A new £50 million term loan (TL) to enable Precision to pay the full acquisition consideration on
completion of the transaction (day 1).

Option 2
A new £35 million TL representing 70% of the acquisition price payable on day 1 with the residual
consideration of £18 million (£15 million + £3 million additional compensation) payable 18 months
following the transaction completion date. Precision will need to raise additional equity by way of a rights
issue.
Whilst it is likely the bank would hold a preference for option 2, there would be a risk of the company not
being able to raise additional shareholder funds to complete the transaction. Additionally, there would be
security available to the bank as a risk mitigant and they would also benefit from higher pricing should they
become comfortable with the repayment capacity and underlying risk of option 1.
2. Affordability
Whilst Precision is currently reasonably conservatively financed in terms of interest coverage, gearing and
leverage, the proposed additional debt required to finance the acquisition will negatively impact the capital
structure.
The interest cover is forecast to remain strong due to the strength of the underlying operating profits
(PBIT). The Precision budget (excluding Heritage) for 2018 shows finance costs of £3.5 million (48,500 –
45,000) and interest cover to be approximately 14 times (48,500/3,500) which is well above the covenant
requirement.
Following the Heritage acquisition, finance costs will obviously increase. If Alpha advances the full £50
million, finance costs will increase by £1.325 million (£50m x 2.65%). Interest cover would however still be
11.1 times ((48,500+5,085)/(3,500+1,325)).
If Alpha advances £35 million, finance costs will increase by £857,500 (£35m x 2.45%). Interest cover
would clearly be higher at 12.3 times ((48,500+5,085)/(3,500+858)).
This may be an opportune time for the company to lock into relatively low borrowing costs by
contemplating sensible forward hedging via fixed rates or vanilla interest rate swaps.
3. Viability
The current bank financing arrangements do not incorporate a scheduled amortisation of the £75 million
TL facility which remains subject to bullet repayment on maturity. This benefits the company’s ongoing
free cash flow and ability to sustain capital investments into the growth and efficiency of the core
operations.
However, the new TL (both options 1 and 2) would include capital repayments of £5 million per annum,
being £2.5m bi-annual payments thus materially reducing future cash flows.
A cash flow forecast can be compiled from the summarised financial information provided to include the
proposed acquisition of Heritage. The 2018 forecasts are compared by using the current 2018 forecasts
for Precision (excluding the acquisition) and the consolidated post-acquisition cash flows (including
Heritage) which will give a sense of the expected repayment capacity.
The figures below are based on consolidating Heritage for the full year to 31 March 2018 to give an
indication of affordability in future years.
Precision (excluding Precision + Heritage
Heritage) (post acquisition)
2018 2018
£’000 £’000
Post-tax profit 36,500 39,125 1
Deduct: dividends (28,765) (28,765)2
Retained profits 7,735 10,360
Add back: depreciation (EBITDA – PBIT) 21,500 24,265 3
Deduct: increase in working capital (2,059) 4 (2,059)4
Deduct: capital expenditure (23,180) (25,945)5
Free cash flow (post interest) 3,996 6,621

1. Includes post tax profit for Heritage less the additional finance costs associated with the new £50
million TL (£36,500 + £3,950 - £1,325).
2. Dividend policy unchanged post-acquisition
3. Includes depreciation for Heritage (EBITDA 7,850 – PBIT 5,085) £2.765 million.
4. Increase due to additional £1 million of working capital for every £20 million of Precision revenue
((560,000 – 518,820)/ 20,000). Heritage is working capital cash neutral.
5. Includes capital expenditure for Heritage, i.e. £2.765 million which is equal to depreciation.
The new TL, £50 million or £35 million, would result in very tight cash flow coverage of capital and interest.
This would require much greater scrutiny and, due to the marginal headroom, should be included in the
revised covenant suite.
The difference in interest costs would make only a marginal difference to the overall serviceability of the
increased debt – the main impact would be the proposed £5 million per annum capital repayments.
The management advise that working capital is expected to be relatively stable for both Precision and
Heritage; this would require further investigation to better understand the construct and aged spread of
both receivables and payables, and also the inventory strategy. Significant capital remains committed to
both receivables and inventory – an example being that a one-day reduction in receivables would release
more than £1.5 million of cash flow into the working capital cycle. 2018 receivables equal £75.18 million
(49/365 x 560,000) compared with receivables of £73.64 million if receivables days were reduced by one
day (48/365 x 560,000).
This means that if receivables could be reduced by 10 days across the next 18 months, the additional free
cash would allow the company to make the second acquisition payment from cash flow without the need
to seek additional funding from shareholders. This would also represent a meaningful contribution to value
creation from more efficient and disciplined financial management.
4. Security
Lenders need to take security in support of specific corporate transactions.
Alpha should consider taking security when (1) the underlying strength of the borrower or the level of
uncertainty about its future ability to generate sustainable cash flow is such that it would be prudent to lend
on a secured basis, (2) where it is lending for the purpose of acquiring a specific asset, or (3) where the
disposal of a specific asset (the security) represents the bank’s principal source of repayment.
The security requirement will also be determined by:

- The underlying strength of the borrower – this will include the macro business environment,
management quality, track record, financial health, outlook, etc.
- The term of the advance – the longer the term, the greater uncertainty is likely to prevail in terms of
the borrower being able to repay the facilities.
- Pricing – the remuneration package for the bank needs to align with the underlying credit risks.
In this case, there are two distinct lending options for the bank to consider, one of which includes some
element of tangible security and the other not. Both facilities are proposed over the same five-year term.
Option 1 - £50 million TL
- Due to this facility providing 100% of the acquisition financing (excluding associated costs), the
corporate customer has offered some security on the assets of the target company being acquired.
- The summary financials would suggest the main tangible company assets that would be captured
under the fixed and floating charge include the main business premises and the receivables with
values at the 2017 reporting date of £7.2 million and £9.658 million respectively.
- This would provide direct tangible security support for the additional £15 million term loan proposed
under option 1 – whilst there would be a security shortfall on day 1, this would quickly reduce with the
benefit of the TL being repaid at £5 million pa.
- The bank should also obtain an up to date professional valuation on the property as this is now
becoming quite stale.

Option 2 - £35 million TL

- This facility is structured to fund only 70% of the acquisition consideration on day 1 with the remaining
£18 million (including £3 million deferment payment) being payable in 18 months from a proposed
rights issue or share placement by the company.
- Due to the fact that more than 30% of the payment risk is being taken by the company, there is no
offer of security for the bank – the facility would be unsecured.
- The structure of the facility would mean the repayments are the same as for option 1 (£50 million)
meaning the residual loan on maturity would be lower at £10 million (versus £25 million) and therefore
less refinancing risk.
The bank would need to consider the overall risk associated with the two options and whether assets are
already held as security for other borrowings.
5. Financial stability
The business appears to be well established and in reasonable financial health that will provide the
platform for the acquisition.
The overall funding structure is sensible and whilst 100% financing is being requested, the repayment
profile of £5 million per annum (approximately £100,000 per week) represents a meaningful risk mitigant
for the lender.
Precision has developed a solid financial position with net assets of £182.8 million and a market
capitalisation of £570 million. Additionally, the sustained commitment into a progressive cash dividend
evidences financial discipline by the management team by not reinvesting into value destroying projects.
Whilst the company is seeking to expand its underlying earnings power it remains crucial to maintain the
financial health of the company post the proposed acquisition.
Whilst the increased level of debt would fall within reasonable gearing, leverage and interest cover
parameters, the impact on cash flow remains of some concern due mainly to the commitment to £5 million
per annum of capital repayments on the new term loan.
Consequently, any sensitised (downside) case of the company’s base forecasts would likely show the
inability to service the capital and interest payments from the company’s core operations. This would
mean the company would either need to use its own balance sheet cash resources or make additional
drawings from the RCF to finance the term loan payments. Clearly, this would not be sustainable.
6. Capital structure
The gearing of Precision at the last reporting date, 31 March 2017, was acceptable at 79% using net
debt/equity ((141,547 – 3,256)/175,065) and leverage was also within general corporate parameters at 2.1
times ((141,547 – 3,256)/66,265), evidencing reasonably conservative financial management and
discipline. The quality of both earnings and asset values are taken as acceptable.
The proposed acquisition of Heritage will impact on the balance sheet structure by adding both debt and
assets. The resultant forecast gearing would be estimated as follows at 31 March 2018:
£’000 £’000 £’000
Option 1 – TL £50 million
Net borrowings 142,500 + 50,000 3,750 196,250
Less: cash 3,500 - 3,500
Net debt 189,000 3,750 192,750
Equity 182,800 – 1,325 3,950 (PAT) 185,425
Gearing 1.04 times

Net borrowings 142,500 + 35,000 3,750 181,250
Less: cash 3,500 - 3,500
Net debt 174,000 3,750 177,750
Equity 182,800 - 858 3,950 (PAT) 185,892
Gearing 0.96 times

The capital structure remains acceptable and within the covenant of 1.5 with moderate use of external
debt facilities to finance strategic manoeuvres and expanded core operations.
There is also only a modest impact when comparing the two alternative funding options, meaning the
additional £15 million of term loan debt constitutes a relatively small element of the overall funding
structure.
The proposed acquisition of Heritage will have the following impact on leverage at 31 March 2018:
£’000 £’000 £’000

Net borrowings 142,500 + 50,000 3,750 196,250
Less: cash 3,500 - 3,500
Net debt 189,000 3,750 192,750
EBITDA 70,000 7,850 77,850
Leverage 2.48

Net borrowings 142,500 + 35,000 3,750 181,250
Less: cash 3,500 - 3,500
Net debt 174,000 3,750 177,750
EBITDA 70,000 7,850 77,850
Leverage 2.28
It is likely that the current leverage covenant of 2.5 times would need to be renegotiated for both term loan
options due to the near breach of option 1 and restricted headroom of option 2 although there would be
scope to reduce this new covenant back to 2,5 times as the loans are repaid and shareholder funds
increase through retained profits.
New covenants may include:
Covenant Current Proposed

Senior interest cover (minimum) 3.0x 4.0x
Leverage (maximum) 2.5x 3.0x
Gearing (maximum) 1.5x 1.5x
Cash coverage (minimum) - 1.1x
7. Track record of management
The quality, balance and track record of the management team is a significant area of analysis and
consideration for banks.
The limited information on the Precision management team would suggest relative stability with the same
executives having been in office for the past five years which would indicate there may have been some
changes following the financial crisis. This length of service is generally a positive signal to the bank
particularly for a plc.
It can safely be assumed that the track record of the current management team has been satisfactory
through this period as they will be subject to shareholder voting on their individual appointments each
year. As there is no specific information provided on their ages, experiences, capabilities, future ambitions,
etc. the bank should look further into their backgrounds, the structure of the board, how they operate as a
team, any notable ‘gaps’ particularly strategically and acquisition integration, and the mix and quality of the
non-executive directors (NEDs) that remain crucial to maintain corporate governance robustness and
discipline.
Further discussions should be undertaken with the management team to better understand the strategic
rationale supporting the proposed acquisition of Heritage and any future plans they may have for change-
of-ownership transactions that will enable the company to reallocate resources and execute specific
strategies. This will underpin the medium-term corporate strategy that will align with the term of the new
loan.

Answers to this requirement varied widely. Some candidates demonstrated excellent skills in interpreting
information, whereas other candidates provided very brief answers with repetition of data from the
question and little analysis thereof.
A cash flow forecast was not explicitly provided in the question and most candidates correctly identified
that it would be essential to obtain one. Very few candidates realised that a cash flow forecast could be
generated from the information provided, especially given that EBITDA is provided and information about
working capital movements is given.
Candidates must try to draw meaningful conclusions from the information, rather than simply restate a
ratio from the question and add “this is concerning” or “this is good”. Deeper analysis of Precision as a
standalone company and Precision and Heritage as a new group would have gained additional marks.

2.2 Additional financial due diligence
The financial due diligence would usually be undertaken by a reputable firm of accountants for the
company (Precision) with this then being subject to reliance agreements and further analysis by the
lending bankers. The financial due diligence will seek to identify the principal risks pre-acquisition which
may impact on both the level of debt funding and eventual purchase price.
The main areas of focus of an independent review are likely to include:

- Historic trading including the quality of the financial information and audited statements
- Assets and liabilities – quality and up to date valuations and adequacy of provisions
- Review of the market and industry in which the business operates (PESTEL or similar)
- Budgets and forecasts are reasonable and accurate
- Insightful sensitivities are undertaken
- Taxation implications
- Contingent liabilities such as pension funds
- Capital expenditure adequacy
-
The lender will likely focus on specific additional information on such a transaction, including:
- A deeper understanding of the commercial considerations for the proposed acquisition and also of the
industry sector in which the company operates
- Last three years audited accounts for both Precision and Heritage
- Internal reporting standards, frequency and quality for both
- Any specific adjustments to EBITDA
- Integration of internal finance functions – efficiency, effectiveness and governance
- Recent monthly or quarterly management information and how they align with the audited financial
statements for both companies
- Receivables and payables spread and duration analysis for both companies – the receivables ledger
may provide some security for the bank
- Inventory management and strategy for both companies
- General working capital management – including cash and liquidity philosophy and management
- Budgeting and forecasting – process and analysis undertaken including sensitivities
- Cash flow, statement of profit or loss, and statement of financial position forecasts for the next five
years together with the underlying assumptions of management – focus should be on the business
model fundamentals including sales volumes and mix, product and service price and mix, gross
margins and contribution, operating costs, working capital, capital expenditure, exchange rate risks,
etc.
- Supply chain analysis including customers and suppliers – spread and relationships, pricing leverage,
etc.
- Short and medium-term investment needs

This will be further supported by both commercial and legal due diligence ahead of completing the
transaction.
Candidates performed variably on this requirement depending on how well they managed their time.
Some candidates used the December 2016 paper answers which had a slightly different requirement and
a different scenario. Candidates wasted time by stating the objective of obtaining the additional information
as well as what due diligence should be undertaken. Candidates also wrote inappropriate procedures such
as assessing fair value assumptions for financial assets and liabilities which are applicable to the analysis
of a bank but are less applicable to an engineering consultancy firm.

2.3 Reasoned recommendation
There would be no right or wrong answer to this lending scenario as both options would have pros and
cons for the lending banker.
Option 1 £50 million term loan
+ Minimal impact on affordability compared with option 2

+ Security to be provided
+ Enhanced economic returns for Alpha
+ Less risk of Precision not being able to raise funds or make the second consideration payment
- 100% financing on day 1 which increases the risk to Alpha
- Proposed security package does not cover the additional exposure unless Precision’s assets are
included as security (if not already encumbered)
- Higher refinancing risk
Option 2 £35 million term loan
+ Lower exposure on day 1 reduces the risk to Alpha

+ Not funding 100% of the acquisition consideration reducing risk to Alpha
+ Residual funding risk remains with Precision
+ Lower refinancing risk
- Potential for company funding risk which would negatively impact the lender
- No security
- Lower economic returns to Alpha
Whichever option is proposed, there should be robust analysis of the information provided to justify
specific recommendations.
There may be scope to reduce the £5 million per annum TL repayment, in particular across the first two
years to allow time and capacity for the acquisition to be fully integrated.
There may also be alternatives including leasing, hire purchase, trade finance, etc. that may enable
Precision to mobilise its balance sheet and have more flexibility into the financing structure.
Not all candidates attempted this requirement. Good answers scored highly and it was the analysis of
each proposal that generated marks rather than which conclusion candidates arrived at.


Question 3 – Zuy Bank
Total Marks: 25
General comments
The candidate works in internal audit monitoring interest rate risk. Zuy Bank (Zuy) is based in the country
of Mastegonia and is a traditional savings bank. There is an interest rate reduction in Mastegonia and the
candidate is required to analyse the impact of this reduction on Zuy.
3.1 (a) Amended forecast statement of profit or loss
Forecast net income

Year ending 31 May 2018 (MC million)
Interest income (Working) 105.125

Interest expense (Working) (35.000)
Net interest income 70.125
Net commission income 10.000
Operating expenses (50.000)
Impairment allowance for loan losses (20.000)
Profit before tax 22.125
Tax (3.038)
Net profit 7.087
Working:
Forecast interest
income/(expense)
At 31 May Yield at NEW for year ending
2017 official rate 31 May 2018
Assets (MC million) Description of MC 0.25% (MC million)
Cash 100 Non-interest bearing – Nil

Reserves with CBoM 50 Floating official rate 0.25% 0.125
Floating MCIBOR
Loans 2,800 0.95% + 2.8% 3.75% 105.000
Total 2,950 105.125
Liabilities and equity

Deposits – current
accounts 750 Non-interest bearing – Nil
Deposits – term 1,550 Fixed 1.75% (27.125)
Floating MCIBOR
Debt securities issued 450 0.95% + 0.8% 1.75% (7.875)
Total liabilities 2,750 (35.000)

3.1 (b) Impact of reduction in MC official rate on Zuy’s net profit
Interest rate risk in a low interest rate environment relates to the decline in Zuy’s interest income combined
with a limited ability to reduce its funding costs. Zuy is particularly exposed because of its heavy reliance
on deposit funding including term deposits which pay a fixed 1.75% interest. Passing lower interest rates
to customers would mean lowering the fixed rate in their term deposits.
Zuy does benefit from lower interest expense in its debt securities funding but that is not sufficient to
compensate for lower interest rates on loans.
Overall, the 50 basis point decline reduces net interest income by 15% to MC 70.125 million (from MC
82.125 million at the previous official rate).
Zuy is particularly exposed to interest rate risk because net interest income accounts for a large proportion
of revenues and because of its relatively high operating expenses. Assuming that net commission income,
operating expenses and impairment allowances do not change after the reduction in interest rates, Zuy’s
net income declines by more than 200% to MC 7.087 million (from MC 15.487 million).
In reality, if CBoM is successful in stimulating the economy, impairment allowances might decline to Zuy’s
benefit. On the other hand, Zuy’s margins are so thin, with projected return on equity of 7.087/ 200 = 3.5%
at lower rates. Therefore, any slight deterioration in expenses, other income or loan losses could actually
push Zuy into net losses.
Part (a) of this requirement was very well attempted with many candidates scoring full marks. Part (b) was
reasonably well answered with some detailed answers gaining full marks but more brief answers gaining
far fewer marks.

3.2 Capital adequacy and solvency
The current capital ratio of Zuy is 200 /1,960 = 10.2% which is higher than the minimum Basel III
requirement of 8%.
However, if the capital conservation buffer of 2.5% is included, Zuy would fall short of the requirements.
There is insufficient information to determine the quality of capital as CET1 should form 4.5% of the
minimum requirements.
Since the key and best quality source of capital is shareholders’ equity, strong profits allow banks to
increase capital via earnings retention, while losses deplete capital. Zuy’s net income is projected to be
very low at lower interest rates. The decline in profitability does not push Zuy into losses and therefore
does not consume capital as long as Zuy limits dividends distribution to shareholders.
Most candidates performed reasonably on this requirement. Surprisingly, given the answer to requirement
3.1, very few candidates identified that further interest rate cuts could reduce profits which impacts
retained earnings and capital adequacy.
Candidates are reminded that it is useful to attempt requirements in order to assist with understanding the
scenario.


3.3 Key risks, hedging strategies and financial reporting implications
Key risks for Zuy are liquidity, interest rate and credit risk. It has no foreign exchange risk. Liquidity risk
cannot be hedged and Zuy will need to maintain adequate cash and central bank reserves to meet
outflows (and any prudential liquidity requirements). Credit risk cannot be adequately hedged for loans to
medium sized entities although credit default swaps could be used for large counterparties.
For interest rate risk, Zuy could choose to enter into interest rate swaps that would be receive floating, pay
fixed. These swaps are derivatives and would be measured at fair value through profit or loss. If Zuy is
able to identify a hedging relationship between the loans and advances it is protecting and the swaps, it
may be able to hedge account for the loans and advances, reducing profit and loss volatility.
It should be noted that, unless Zuy is able to use hedge accounting (which is difficult in a bank context due
to many small loans), use of interest rate swaps will cause capital volatility.
If a swap with notional 1000 MC million were issued, with legs of for example MCIBOR and 0.3%, this
would reduce the gap:
Cash instruments Swap Net
Assets (receive floating) 2,800 (1,000) 1,800

Liabilities (pay floating) (450) 1,000 (1,450)
Net 2,350 350
If such a swap had been in place before the reduction in interest rates, then it would have been beneficial
for Zuy, as it would have protected profits from the reduction in interest rates. However, now that interest
rates have been reduced, it may not be beneficial to take out such a swap. This is because interest rates
cannot reduce much further. As Zuy’s assets reprice faster than the liabilities, a rising interest rate
environment results in increased profit.
However, when interest rates have returned to normal levels, Zuy should consider such a swap to protect
against profit or loss volatility and capital volatility.
To be able to use hedge accounting Zuy would need to demonstrate that there is an economic link
between the cashflows arising from its assets and the cash flows under the interest rate swap.
Effectiveness must be measured reliably and be within the range of 80% - 125%. Zuy must designate the
interest rate swap contract as a hedge instrument and outline the risk management objective of the hedge
on its initiation.
Zuy is protecting the variable cash inflows from its variable rate financial assets which generates a cash
flow hedge arrangement. The gains or losses on the hedge instrument (interest rate swap) must be held in
reserves until the investment income from the financial assets hits profit or loss.
There was some evidence of poor time management affecting the length of some answers to 3.3 but
nearly all candidates attempted it.
A significant majority of candidates used illustrative numbers correctly, to demonstrate the interest rate
swap hedging strategy. Some candidates also used illustrative numbers to demonstrate hedging using
interest rate futures which were awarded marks.


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Professional Level – Business Planning: Banking – June 2017

MARK PLAN AND EXAMINER’S COMMENTARY

Question 1 – Friar plc

1.1 Audit risks and related procedures

Audit risk Audit procedure

Conduct back testing to ensure that there is appropriate

Obtain documents showing reconciliations of general ledger

Perform analytical procedure to compare the impairment

Review the impairment models for reasonableness including

Assess whether using a historical default rate for personal

Copyright © ICAEW 2017. All rights reserved Page 1 of 16

Check that the impairment allowance models have been

Compare the current emergence period with Friar’s historical

Ensure that any individually significant loans have been

Perform sample testing to ensure that all forborne accounts

Assess the ageing (that is the period of missed payments) of

Review a sample of forborne accounts where revolving credit

Compare Friar’s credit checks to those conducted by the

Observe whether the firm captures sensitivity of economic

Review the internal audit assessments and evaluate whether

Assess whether claims are expected from customers which

Review the level of overall and upheld complaints received by

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Total possible marks 19

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1.2 Financial reporting treatment under IAS 39 and IFRS 9

Issue (1) Increase in impairment allowances

Issue (2) Forbearance policy

Candidates appeared to have a good grasp of the new principles of IFRS 9.

Total possible marks 9

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1.3 Liquidity coverage ratio

Calculation of net cash outflows over a 30-day period

Total possible marks 9

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1.4 Ethical issued and actions

Total possible marks 7

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Question 2 – Alpha Bank

2.1 Credit analysis of two lending proposals

Analysis of the application

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Lenders need to take security in support of specific corporate transactions.

The security requirement will also be determined by:

Option 1 - £50 million TL

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Option 2 - £35 million TL

Option 2 – TL £35 million

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£’000 £’000 £’000

Option 2 – TL £35 million

New covenants may include:

Covenant Current Proposed

7. Track record of management

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Total possible marks 24

2.2 Additional financial due diligence

The main areas of focus of an independent review are likely to include:

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