PAPER 2 100 marks

1 Introduction

The South African Multinational Paper Group Ltd (‘SAMP’ or ‘the Group’) is a producer and
retailer of paper and pulp products. SAMP was founded in 1936 and listed on the
Johannesburg Stock Exchange in 1937. SAMP’s headquarters are based in Gauteng and it
has pulping mills and paper production plants across KwaZulu-Natal and Mpumalanga.

SAMP has investments in various companies, including in Maastrict Mills B.V. (‘Maastrict’), a
subsidiary based in the Netherlands. Maastrict comprises 15% of SAMP’s total assets.
Firehouse Auditors Inc. (‘Firehouse’), a large South African audit firm, has been the auditors
of SAMP for the past eight years.

2 SAMP product lines

SAMP has the following product lines:

• Graphic paper (GrP) – GrP is used for printed communication purposes and includes two
types of paper grade, namely coated paper and newsprint.

• Speciality packaging paper (SPP) – SPP is made from sustainably sourced wood, hay
or hemp and is used for product packaging. The production of SPP emits lower carbon
dioxide and uses approximately 40% less water than the production of GrPs.

• Dissolving wood pulp (DWP) – DWP has a wide range of uses, such as modifiers in
lipsticks, washing machine tablets and fillers in fat-free yoghurt, and is also used to make
viscose fibres for use in textiles (clothing). DWP is made from pulp from fast-growing trees.

3 Industry information

Due to a consumer shift toward digital media and advertising and environmentally friendly
products, there has been a severe decline in the demand for GrP products in the paper and
forestry products industry.

The demand for SPP products has increased sharply as consumers move to e-commerce and
choose companies that use sustainably sourced carbon-neutral paper packaging.

The demand for DWP has increased significantly due to its wide applicability in various
industries. DWP is easily available and sustainable, which is expected to further push the
growth of the global DWP market.

This has created and increased the need to restructure production capacity away from GrP
product lines in favour of SPP and DWP product lines.

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 4 SAMP paper production and operational information

To produce its products, SAMP uses two main pulping processes:

• Kraft pulping – This process yields pulp for production of GrP and/or SPP. The pulp can
be used to produce DWP if the woodchips used in kraft pulping are first steamed at high
temperatures. This additional process does however result in increased consumption of
timber in the production process.

• Sulphite pulping – This process yields pulp for the production of DWP.

Since incorporation, SAMP’s focus has been the manufacture and sale of GrPs. The growth
in demand for GrPs from the 1940s to 2010 saw SAMP increasing production of regular wood
pulp by means of kraft pulping at its South African pulping mills. SAMP produces a small
amount of DWP and SPP at certain pulping mills in KwaZulu-Natal.

Due to the decline in the demand for GrP over the last decade, SAMP’s earnings have been
declining steadily. This has led to lower cash reserves and increased debt levels, as gross
and net profit margins continue to decline.

The reduced revenue growth and profit margins resulted in a significant decline in SAMP’s
share price. Accordingly, SAMP’s shareholders are advocating for improved operating
efficiency by disposing of the GrP operations to fund investment of more sustainable and
profitable product lines and to reduce debt.

SAMP management is considering the following:

• The disposal of older, inefficient mills producing mainly GrP;
• Restructuring production capacity by converting machines that produce GrP to the
production of SPP; and
• Converting kraft pulping mills to increase the production of DWP.

Management has established a task team to investigate these considerations, as well as other
areas to improve earnings, such as cost savings and retrenchments. The task team is led by
the new chief research and innovation officer, Charl Mondy.

The information below relates to the operations of SAMP for the financial year ended
31 December 2022 (FY2022), with related suggestions from the task team.

4.1 Disposal of the investment in Maastrict

SAMP acquired 60 000 shares in Maastrict for EUR376 616. This acquisition was correctly
recognised as a business combination on 1 January 2008 in terms of IFRS 3 Business
Combinations.

Maastrict acquires kraft pulp from SAMP’s South African mills, which it then converts into GrP
at its pulping mill. Maastrict receives raw material when needed and does not hold inventory
from SAMP on hand. The functional currency of Maastrict is the Euro.

Maastrict represents a separate geographical area of operations for SAMP.

On 1 January 2008, SAMP valued the land on which Maastrict’s mill is situated at EUR200 000
more than the carrying amount at which it is reflected in the separate accounting records of

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Maastrict. The carrying amounts of all the other assets and liabilities of Maastrict were equal
to their fair values on this date.

On the recommendation of the task team, SAMP disposed of its total shareholding of 60 000
shares in Maastrict on 31 March 2022. This disposal did not comply with the criteria for
classification as non-current assets held for sale until the date of disposal. The proceeds of
the sale of the shares were received in cash as follows:
• EUR926 327 on 31 March 2022; and
• EUR611 921 on 31 March 2023.

Extracts of financial information relating to Maastrict is provided below:

Maastrict
Extract from the trial balance as at 31 December 2022
Details EUR ZAR
Ordinary share capital (shares of EUR1 each)* 100 000 1 037 000
Retained earnings
At 1 January 2008 250 000 2 592 500
From 2 January 2008 to 31 December 2021 2 089 000 28 101 228
Revaluation surplus – arose on 1 January 2011 and relates
to the land on which the mill is situated 450 000 ?
Loss after tax for the year ended FY2022 (862 000) ?
The ZAR amounts have been correctly translated from EUR (functional currency) in
accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates for
consolidation purposes.
* Unchanged for all periods under consideration.

Maastrict
Extract of the summarised statement of profit or loss
and other comprehensive income
for the year ended 31 December 2022
1 January 2022 – 1 April 2022 –
Total for FY2022
31 March 2022 31 December 2022
EUR EUR EUR
Revenue 275 000 825 000 1 100 000
Cost of sales (325 750) (977 250) (1 303 000)
Expenses (133 750) (649 250) (783 000)
Tax (expense)/income (31 000) 155 000 124 000

The relevant exchange rates are as follows:

Exchange rates EUR1 : ZAR

1 January 2008 10,370
1 January 2011 8,838
1 January 2021 17,802
31 December 2021 18,138
31 March 2022 16,193
31 December 2022 16,342
Average for the period
1 January 2008 – 31 December 2010 9,456
1 January 2022 – 31 March 2022 16,495
1 April 2022 – 31 December 2022 16,533
1 January 2022 – 31 December 2022 16,795
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 4.2 The SAMP Eastcreek coated paper production plant (‘Eastcreek’)

Eastcreek is situated in Mpumalanga and produces 23 000 metric tonnes of unique GrP per
annum. Eastcreek is the only SAMP plant that produces this type of unique GrP and it
represents a separate product line. Eastcreek receives kraft pulp from another SAMP
subsidiary and produces the unique GrP.

Eastcreek’s forecast net cash flows have declined significantly due to the reduced demand for
GrP products. However, there is still a market for the unique coated GrP products that
Eastcreek produces.

The task team recommended that Eastcreek be converted to produce SPP. At

31 December 2022, this recommendation had not yet been implemented.

Extracts of financial information relating to Eastcreek:

Eastcreek
Carrying
Date current assets Expected
amount
were acquired / life at
Cost at 1
Description Note non-current assets date
January
first brought into brought
2022
use into use
ZAR’000 ZAR’000
Land 1 1 January 2010 8 000 N/A 8 000
GrP paper factory
building 2 1 May 2010 9 700 30 years 5 604
Fourdrinier machine 3 1 April 2016 7 000 Various 5 630
Paper coating
machine 3 1 May 2016 3 310 10 years 1 434
Inventory 4 31 December 2022 1 580 N/A N/A

Eastcreek
Task team valuation report
Extract at 31 December 2022
Value in use
of current Value in use if
operations restructured Fair value
Description
(pre- to produce less costs to
restructure) SPP sell
ZAR’000 ZAR’000 ZAR’000
Eastcreek coated paper production
plant in total (land, GrP paper factory
building, Fourdrinier machine, paper
coating machine and inventory) 16 500 20 000 15 000

Note 1: Land

The land was initially acquired by SAMP for ZAR8 million with the intention of constructing the
Eastcreek paper production plant. The task team contracted and appointed James Ngidi as
its appraiser to determine the value of the land on 31 December 2022. James is an
independent sworn appraiser with 12 years of experience and is registered with the South
African Council for the Property Valuers Profession. He applied the International Valuation
Standards, which came into effect on 1 January 2022.
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James determined the fair value of the land to be ZAR6,8 million, based on its current use.
Because the land is close to SAMP’s other operations, it would be feasible to demolish the
Eastcreek paper plant and use the land for a plantation of trees used to produce DWP. James
determined that this would increase the production of DWP and increase the value of the land
to ZAR7,7 million. The cost of converting the land will be negligible and there are no legal
restrictions on this conversion. The land does not generate independent cash flows unless it
is disposed of.

The cost of disposal of the land, including legal fees, will amount to ZAR200 000. The land will
be sold once the factory building has been demolished, as the factory building has no use to
other market participants.

Note 2: Factory building

The factory building was constructed to meet very specific requirements related to housing
the original Fourdrinier machine as well as a paper-coating machine. The building would have
no other use to market participants. Therefore, should the machines be removed, the factory
building would have to be demolished and sold for its scrap value. It is not possible to
determine if the value in use is close to the factory building’s fair value less costs to sell.

Note 3: Fourdrinier and paper-coating machines

The Fourdrinier and paper-coating machines were replaced by new machines in 2016. These
new machines were customised to be specifically housed in the factory building.

The Fourdrinier machine pushes wet pulp on a mesh belt through a series of rollers which
dries the pulp. The Fourdrinier machine’s mesh belt and rollers need to be replaced on a
regular basis and have no residual value.

The mesh belt has a two-year useful life. The mesh belt currently being used was purchased
and brought into use on 31 December 2021 for ZAR800 000 and was correctly accounted for.

The rollers currently being used were purchased and brought into use on 30 June 2021 for
ZAR2,2 million and were correctly accounted for. The useful life of the rollers is five years.

The rest of the Fourdrinier machine has a useful life of 20 years and no residual value.

The dried flattened pulp is fed directly into the paper-coating machine. The paper-coating
machine has no residual value.

The fair values of the Fourdrinier machine and paper-coating machine, as determined by
quoted market prices, amounted to ZAR3,8 million and ZAR400 000 respectively on
31 December 2022. The costs of disposal of both machines are considered to be negligible.
The value in use of both machines cannot be determined as neither produce cash flows that
are independent of the factory building and each other.

Note 4: Inventory

There were 2 000 metric tonnes of GrP inventory on hand at 31 December 2022. There were
no raw materials or work-in-progress inventory on hand.

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 4.3 Restructuring: Management share incentive awards

On 31 December 2021 SAMP granted options to its executives to acquire its shares. These
options will mature on 31 December 2023 with a strike price equal to the SAMP share price at
the grant date. Due to the declining share price, current market conditions, and the aftermath
of Covid-19, these options are expected to remain out of the money until vesting. Accordingly,
executives are demotivated as they feel their share options are worthless, and that they have
little incentive to stay with the Group.

Charl, the chief research and innovation officer, proposed two alternatives for an incentive to
be added to the executives’ remuneration policy to try to retain them. Charl submitted the
proposal directly to the shareholders for consideration at the upcoming annual general
meeting (AGM).

Alternative 1
• A special cash bonus;
• A housing allowance, to be added to their monthly salaries; and
• A salary increase of 9%.

Alternative 2
• The issue of new share options to executives at a strike price lower than those of the
existing share options.

Prior to the AGM, the majority of shareholders expressed reservations about both alternatives.
They felt that this would defeat the purpose of the initial options agreed with the remuneration
committee to align management and shareholder interests. They did not want to reward
management for the poor performance and lack of insight into market trends in managing
SAMP to date. Furthermore, these remuneration incentives would not necessarily act as an
incentive to improve director performance – it would merely improve the executives’ financial
positions without clear performance-related targets. There would be no focus on company
objectives such as implementing strategies to achieve carbon-neutral production facilities or
lower its carbon dioxide footprint.

The shareholders noted that the Group was disposing of operations and considering
retrenching staff and at the same time asking for additional rewards for executives.
Furthermore, the shareholders themselves had suffered significant losses in investment value
due to the decline in the SAMP share price. The net losses would also be worsened by
approving these incentives.

5 Additional Information

• The presentation currency of the Group is the ZAR.

• The financial year end for all companies in the Group is 31 December.
• The profits and cash flows of all the companies in the Group occurred evenly throughout
the year, unless stated otherwise.
• The Group measures non-controlling interests at its proportionate share of the fair value
of the net assets at acquisition date.
• The Group measures investments in subsidiaries in its separate financial statements at
cost in terms of IAS 27 Separate Financial Statements.
• The Group measures land at a revalued amount and all items of property, plant and
equipment at cost in terms of IAS 16 Property, Plant and Equipment.

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• Depreciation is recognised on a straight-line basis over the useful life of the assets to
their residual values.
• The Group presents a single statement of profit or loss and other comprehensive
income.
• The Group presents the analysis of the results of a discontinued operation in the
statement of profit or loss and other comprehensive income.
• The Group presents items of other comprehensive income net of related tax in the
statement of profit or loss and other comprehensive income.
• The Group presents reclassification adjustments in the statement of profit or loss and
other comprehensive income.
• The corporate tax rate for all South African companies in the Group is 28% and the
capital gains inclusion rate is 80%. You may ignore changes and anticipated changes in
the corporate tax rate in South Africa.
• The corporate tax rate of the Netherlands is 25,8% and capital gains are taxed at 0%.
You may assume that other than the corporate tax rate, the tax legislation in the
Netherlands is the same as that of South Africa.
• An appropriate pre-tax discount rate is 1,82% per annum (compounded annually) for all
periods presented for amounts denominated in EUR.

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Paper 2
 INITIAL TEST OF COMPETENCE, JUNE 2023

PROFESSIONAL PAPER 2

This paper consists of two parts. Answer each part in a separate answer book.

Marks
PAPER 2 PART I – REQUIRED Sub- Total
total
(a) Present the information relating to Maastrict in the statement of profit
or loss and other comprehensive income of the Group for FY2022. 34

• Ignore the tax consequences that the Group would incur on the
disposal of Maastrict.
• Ignore the attribution of amounts to the equity holders of the
parent and the non-controlling interests.
• Ignore note disclosures.
• Ignore comparatives.
• Round amounts to the nearest ZAR.

Communication skills – presentation 1 35

(b) Prepare the journal entries that account for the information provided
in respect of Eastcreek in the financial records of SAMP for FY2022. 22

• Ignore all forms of tax.

• Ignore dates of journal entries.
• Ignore closing entries.
• Round amounts to the nearest ZAR.

Communication skills – presentation 1 23

Total for part I 58

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Paper 2 Part I required
 INITIAL TEST OF COMPETENCE, JUNE 2023

PROFESSIONAL PAPER 2

This paper consists of two parts. Answer each part in a separate answer book.

Marks
PAPER 2 PART II – REQUIRED Sub- Total
total
(c) Describe the substantive audit procedures that Firehouse should have
performed on the disposal of the investment in Maastrict and the
corresponding transactions in the separate financial statements of
SAMP for FY2022. 12

Communication skills – clarity of expression 1 13

(d) Describe the substantive audit procedures that Firehouse should have
performed on the fair value less cost to sell calculation of the land only
for FY2022. 7

Communication skills – clarity of expression 1 8

(e) With reference to the information contained in section 4.3 –
(i) critically evaluate the remuneration alternatives based on
good performance evaluation principles; and 6
(ii) discuss any business ethics and corporate governance
concerns you may have. 14

Communication skills – logical argument 1 21

Total for part II 42
TOTAL FOR PAPER 2 100

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Paper 2 Part II required