Briefing notes
To: Audit partner
From: Audit manager
Subject: Audit planning for Connolly Co, year ending 31 December 2014
Introduction
These briefing notes are prepared to assist in planning the audit of Connolly Co, our client operating in the pharmaceutical industry. Specifically, the briefing notes will evaluate the business risks facing our client, identify and explain four risks of material misstatement, recommend audit procedures in relation to a new brand acquired during the year, and finally explain ethical threats to our firm.
(a) Business risks
Licensing of products
A significant regulatory risk relates to the highly regulated nature of the industry in which the company operates. If any of Connolly Co’s products fail to be licensed for development and sale, it would mean that costs already incurred are wasted. Research and development costs are significant. For example, in 2014 the cash outflow in relation to research and development amounted to 7·5% of revenue, and the failure to obtain the necessary licences is a major threat to the company’s business objectives.
Patent infringements
In developing new products and improving existing products, Connolly Co must be careful not to breach any competitor’s existing patent. In the event of this occurring, significant legal costs could be incurred in defending the company’s legal position. Time and effort must be spent monitoring product developments to ensure legal compliance with existing patents. Similarly, while patents serve to protect Connolly Co’s products, if a competitor were found to be in breach of one of the company’s patents, costs of bringing legal action against that company could be substantial.
Advertising regulations
The company risks running inappropriate advertising campaigns, and failing to comply with local variations in regulatory requirements. For example, if television campaigns to promote products occurred in countries where this is not allowed, the company could face fines and reputational damage, with consequences for cash flow and revenue streams.
Skilled personnel
The nature of Connolly Co’s operations demands a skilled workforce with the necessary scientific knowledge to be able to develop new drugs. Loss of personnel, especially to competitors in the industry, would be a drain on the remaining resources and in the worst case scenario it could delay the development and launch of new products. It may be difficult to attract and retain skilled staff given the pending court case and potential reputational damage to the company.
Diversification and rapid growth
During the year Connolly Co has acquired a new brand name and range of products, and has also diversified into a new market, that of animal health products. While diversification has commercial and strategic advantages, it can bring risks. Management may struggle to deal with the increased number of operations which they need to monitor and control, or they may focus so much on ensuring the success of the new business segments that existing activities are neglected. There may also be additional costs associated with the diversification which puts pressure on cash and on the margins of the enlarged business. This may be the reason for the fall in operating profit of 10·8% and for the decline in operating margin from 24% to 20%.
Cash flow and liquidity issues
Connolly Co seems to be struggling to maintain its cash position, as this year its cash flow is negative by $1·2 million. Contributing factors to this will include the costs of acquiring the ‘Cold Comforts’ brand name, expenditure to launch the new animal-related product line, and the cash outflow in relation to on-going research and development, which has increased by 7·1% in the year. The first two of these are one-off issues and may not create a cause for concern over long-term cash management issues, but the company must be careful to maintain a positive cash inflow from its operating activities to provide a sound foundation for future activities.
Companies operating in this industry must be careful to manage cash flows due to the nature of the product lifecycle, meaning that large amounts have to be expended long before any revenue is generated, in some cases the time lag may be many years before any cash inflow is derived from expenditure on research activities.
The fact that the company has approached its bank to make cash available in the event of damages of $3 million having to be paid out indicates that the company is not very liquid, and is relying to some degree on external finance. If the bank refuses to extend existing borrowing facilities, the company may have to find finance from other sources, for example, from an alternative external provider of funds or from an issue of equity shares, which may be difficult to achieve and expensive. The company has relatively high gearing, which may deter potential providers of finance or discourage potential equity investors.
If finance is refused, the company may not be able to pay liabilities as they fall due, and other operational problems may arise, for example, an inability to continue to fund in-progress research and development projects. Ultimately this would result in a going concern problem, though much more information is needed to assess if this is a risk at this year end.
Court case and bad publicity
The court case against the company will create reputational damage, and publicity over people suffering side effects while participating in clinical trials will undoubtedly lead to bad publicity, affecting market share especially if competitors take advantage of the situation. It is also likely that the bad publicity will lead to increased scrutiny of the company’s activities making it more vulnerable should further problems arise.
Risk of overtrading
The fall in operating margin and earnings per share is a worrying sign for shareholders, though for the reasons explained above this may not be the start of a long-term trend as several events in this year have put one-off pressure on margins. However, there could be a risk of overtrading, as the company’s revenue has increased by 5·2%.
(b) Risks of material misstatement
Inherent risk of management bias
Connolly Co’s management is attempting to raise finance, and the bank will use its financial statements as part of their lending decision. There is therefore pressure on management to present a favourable position. This may lead to bias in how balances and transactions are measured and presented. For example, there is a risk that earnings management techniques are used to overstate revenue and understate expenses in order to maximise the profit recognised. Estimates included in the financial statements are also subject to higher risk. ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures states that auditors shall review the judgements and decisions made by management in the making of accounting estimates to identify whether there are indicators of management bias.
Research and development costs – recognition
There is a significant risk that the requirements of IAS 38 Intangible Assets have not been followed. Research costs must be expensed and strict criteria must be applied to development expenditure to determine whether it should be capitalised and recognised as an intangible asset. Development costs are capitalised only after technical and commercial feasibility of the asset for sale or use have been established, and Connolly Co must demonstrate an intention and ability to complete the development and that it will generate future economic benefits. The risk is that research costs have been inappropriately classified as development costs and then capitalised, overstating assets and understating expenses.
A specific risk relates to the drug which was being developed but in relation to which there have been side effects during the clinical trials. It is unlikely that the costs in relation to this product development continue to meet the criteria for capitalisation, so there is a risk that they have not been written off, overstating assets and profit.
Development costs – amortisation
When an intangible asset has a finite useful life, it should be amortised systematically over that life. For a development asset, the amortisation should correspond with the pattern of economic benefits generated from the sale of associated goods. The risk is that the amortisation period has not been appropriately assessed. For example, if a competitor introduces a successful rival product which reduces the period over which Connolly Co’s product will generate economic benefit, this should be reflected in a reduction in the period over which that product is amortised, resulting in an increased amortisation charge. The risk if this does not happen is that assets are overstated and expenses are understated.
Patents – recognition and amortisation
The cost of acquiring patents for products should be capitalised and recognised as an intangible asset as the patent provides protection over the economic benefit to be derived. If patent costs have been expensed rather than capitalised, this would understate assets and overstate expenses. Once recognised, patents should be amortised over the period of their duration, and non-amortisation will overstate assets and understate expenses.
Court case – provisions and contingent liabilities
The court case which has been brought against Connolly Co may give rise to a present obligation as a result of a past event, and if there is a probable outflow of economic benefit which can be measured reliably, then a provision should be recognised. The clinical trial took place in 2013, so the obligating event has occurred. Depending on the assessment of probability of the case going against Connolly Co, it may be that instead of a provision, a contingent liability exists. This would be the case if there is a possible, rather than probable, outflow of economic benefit. The risk is that either a necessary provision is not recognised, understating liabilities and expenses, or that a contingent liability is not appropriately disclosed in the notes to the financial statements, in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Legal fees relating to the court case should also be accrued if they have been incurred before the year end, and failure to do so will understate current liabilities and understate expenses.
Segmental reporting
The diversification into the new product area relating to animal health may warrant separate disclosure according to IFRS 8 Operating Segments. This requires listed companies to disclose in a note to the financial statements the performance of the company disaggregated over its operating or geographical segments, as the information is viewed by management. As the new product area has been successful and contributes 15% to revenue, it could be seen as a significant operating segment, and disclosure of its revenue, profit and other figures may be required. The risk is non-disclosure or incomplete disclosure of the necessary information.
Tutorial note: More than the required number of four risks of material misstatement have been included in this answer for illustrative purposes. Credit will be awarded for the identification and explanation of other relevant risks, e.g. in relation to the acquired brand name.
(c) Recommended audit procedures
– Review board minutes for evidence of discussion of the purchase of the acquired brand, and for its approval.
– Agree the cost of $5 million to the company’s cash book and bank statement.
– Obtain the purchase agreement and confirm the rights of Connolly Co in respect of the brand.
– Discuss with management the estimated useful life of the brand of 15 years and obtain an understanding of how 15 years has been determined as appropriate.
– If the 15-year useful life is a period stipulated in the purchase document, confirm to the terms of the agreement.
– If the 15-year useful life is based on the life expectancy of the product, obtain an understanding of the basis for this, for example, by reviewing a cash flow forecast of sales of the product. – Obtain any market research or customer satisfaction surveys to confi
– Consider whether there are any indicators of potential impairment at the year end by obtaining pre year-end sales information and reviewing terms of contracts to supply the products to pharmacies.
– Recalculate the amortisation expense for the year and agree the charge to the financial statements, and confirm adequacy of disclosure in the notes to the financial statements.
(d) Ethical threats
There are two ethical threats relevant to the audit firm. First, the bank has asked our firm to provide a guarantee in respect of the bank loan which may be advanced to our client. The provision of such a guarantee represents a financial interest in an audit client, and creates a self-interest threat because the audit firm has an interest in the financial position of the client, causing loss of objectivity when auditing the financial statements.
According to IESBA’s Code of Ethics for Professional Accountants (the Code), if an audit firm guarantees a loan to an audit client, the self-interest threat created would be so significant that no safeguards could reduce the threat to an acceptable level unless the loan or guarantee is immaterial to both the audit firm and the client. In this case the loan would be material as it represents 5% of Connolly Co’s total assets, and would also be considered material in nature because of the company’s need for the additional finance.
The second threat relates to Connolly Co’s request for our firm to provide advice on the new accounting and management information systems to be implemented next year. If the advice were given, it would constitute the provision of a non-assurance service to an audit client. The Code has detailed guidance in this area and specific requirements in the case of a public interest entity such as Connolly Co which is a listed entity.
The Code states that services related to IT systems including the design or implementation of hardware or software systems may create a self-review threat. This is because when auditing the financial statements the auditor would assess the systems which they had recommended, and an objective assessment would be difficult to achieve. There is also a risk of assuming the responsibility of management, especially as Connolly Co has little experience in this area, so would rely on the auditor’s suggestions and be less inclined to make their own decision.
In the case of an audit client which is a public interest entity, the Code states that an audit firm shall not provide services involving the design or implementation of IT systems which form a significant part of the internal control over financial reporting or which generate information which is significant to the client’s accounting records or financial statements on which the firm will express an opinion.
Therefore the audit firm should not provide a service to give advice on the accounting systems. With further clarification on the nature of the management information systems and the update required to them, it may be possible for the audit firm to provide a service to Connolly Co, as long as those systems are outside of the financial reporting system. However, it may be prudent for the audit firm to decline offering any advice on systems to the client.
These ethical issues should be discussed with those charged with governance of Connolly Co, with an explanation provided as to why the audit firm cannot guarantee the loan or provide the non-audit service to the company.
Conclusion
Connolly Co faces a variety of business risks, some of which are generic to the industry in which it operates, while others are more entity-specific. A number of risks of material misstatement have been discussed, and the audit planning must ensure that appropriate responses are designed for each of them. The purchase of a new brand will necessitate detailed audit testing. Two ethical issues have been raised by requests from the client for our firm to provide a loan guarantee and to provide advice on systems, both of which create significant threats to independence and objectivity, and the matters must be discussed with the client before advising that we are unable to provide the guarantee or to provide the systems advice.