Section B – TWO questions ONLY to be attempted
3、(a) You are a manager in one of the assurance departments of Leopard & Co, a large firm of Chartered Certified Accountants. You are currently assigned to a due diligence engagement for one of your firm’s audit clients, Cheetah Co, a manufacturer of bespoke furniture. The audit of Cheetah Co is conducted by a team from a different department; you have never been involved in the audit of this client.
The engagement is to conduct a financial and operational due diligence review of Zebra Co, a company which has been identified as a potential acquisition target by Cheetah Co, due to the synergies offered and the potential to expand the existing production facilities. As part of the due diligence review, you have been asked to provide a valuation of Zebra Co’s assets and liabilities and an analysis of the company’s operating profit forecasts. This will assist Cheetah Co in determining an appropriate purchase price for Zebra Co.
During the engagement fieldwork your team identified two matters, which require your further consideration, as follows:
1. While reviewing correspondence with customers in relation to outstanding receivables, one of the team found a letter from a large retailer, for which Zebra Co produces a number of unique products, providing advanced notice that they are not renewing their purchasing agreement when the current one expires. The customer advised that they are switching to a new entrant to the market who is substantially cheaper than Zebra Co. A brief analysis identified that the customer provides, on average, almost 5% of Zebra Co’s annual revenues.
2. Zebra Co owns a piece of land which was given to it as a gift by the local authorities ten years ago. The land surrounds the entrance to the main production premises and is designated as a nature reserve. Restrictions were imposed on the usage of the land which also limit who the owner is able to sell the land to in the future. The land has zero carrying value in the financial statements.
No additional matters have arisen for your consideration. You are also aware that the financial statements for the last ten years have been audited and no modifications have been made to the auditor’s opinion during this period.
Required:
In respect of the two matters identified above:
(i) Explain why each matter requires further investigation as part of the due diligence review, and (6 marks)
(ii) Recommend the investigation procedures to be performed. (6 marks)
(b) The management team of Cheetah Co has also approached Leopard & Co to ask whether representatives of the firm would be available to attend a meeting with the company’s bankers, who they are hoping will finance the acquisition of Zebra Co, to support the management team in conveying the suitability of the acquisition of Zebra Co. For the meeting the bank requires the most up-to-date interim accounts of Cheetah Co with the accompanying auditor’s independent interim review report. Your firm is due to complete the interim review shortly and the management team of Cheetah Co has requested that the interim review is completed quickly so that it does not hold up negotiations with the bank, stating that if it does, it may affect the outcome of the next audit tender, which is due to take place after the completion of this year’s audit.
Required：
Comment on the ethical and professional issues raised, and recommend any actions which should be taken in respect of the request from the management team of Cheetah Co. (8 marks)
(a) (i) Why the matters require further investigation
Termination of contract
Impact on forecasts
The loss of the customer may lead to a reduction in forecast revenue by as much as 5% per year. This may also lead to a reduction in costs specifically relevant to servicing the customer. For example, sales staff specifically allocated to servicing this client
This is significant because the forecast future cash flows of Zebra Co will be critical in determining the value of the company and the price offered by Cheetah Co. It is therefore vital to establish all of the potential revenue and cost implications of the loss of the customer to ascertain the impact on the purchase price.
Wider implications of new competitor
The customer referred to has switched to a new, cheaper supplier. This may have wider implications if the new supplier is directly targeting the customers of Zebra Co. It is possible that other customers may switch to the new supplier in the future, which would have further implications on future revenue and cost forecasts.
It may not be possible to determine the potential impact of the new supplier at this point, which increases the level of uncertainty associated with the potential acquisition. Cheetah Co may be able to use this uncertainty as a tool for bargaining with the owners of Zebra Co over the final agreed price.
Possible impairment of other assets
The loss of a major customer may be an indication of impairment of the assets of Zebra Co. This will be particularly relevant if Zebra Co holds specific assets for manufacturing the unique furniture products made for this client.
As well as production assets, Zebra Co may also be holding inventories which are specifically relevant to the customer which cannot be re-used elsewhere or sold to other customers. If this is the case, these inventories will almost certainly be impaired.
If not performed at the year end, it may now be appropriate to conduct an impairment review to ensure that the valuation of the assets, as presented in the financial statements, is still appropriate in the circumstances.
Gifted land
Possible restriction on sale
The restriction on the sale of the land may mean that Zebra Co is prohibited from including the land as part of the acquisition by Cheetah Co. It is likely that following acquisition, Cheetah Co will not be able to initiate a sale of the land to an external company or develop or change its current use. This may act as a deal breaker if Cheetah Co is not able to obtain control over the land surrounding the entrance to the production facilities.
If Zebra Co is not permitted to include the land as part of the deal with Cheetah Co, then this may also have an impact on the purchase price as the owners of Zebra Co may have attributed some value to the land in their expectation of the price which they can achieve. If so, it will be important to ascertain the value attributed to the land by the owners to negotiate the reduction of the purchase price.
Possible limitation on future usage
If the land can be included as part of the acquisition deal, the restrictions may also mean that Cheetah Co is not able to use the land for their intended purpose, such as the future expansion of production facilities, resulting in the acquisition of Zebra Co not being an appropriate strategic fit for Cheetah Co if one of the key aims is future expansion. If this is the case, then this will severely limit the value of the land to the company.
If the land can be acquired but cannot be developed, it is likely that there will be ongoing maintenance costs and potentially other requirements and conditions regarding the upkeep of the nature reserve set out by the local authority, which need to be understood as part of the review. The cost of maintenance may result in a net annual cost to the business and this needs to be quantified as part of the due diligence work.
It will be vital to ascertain what restrictions are in place and whether the directors of Cheetah Co believe they can extract any value from the use of the land.
Based upon this, the directors of Cheetah Co may wish to try and negotiate the purchase of Zebra Co without the associated land or they may wish to negotiate a lower price based on the restricted usage.
Uncertainty regarding valuation
It may be difficult to accurately value the piece of land. The value attributed to it in the financial statements is zero, so this may not provide an appropriate basis for estimating the resale value. A land valuation expert may be able to provide an estimation of the current market value of the land without restriction on its use but they may find it difficult to accurately value how much it is worth with the local authority restrictions. It may also be difficult to value the land based on the future cash flows attributable to it if it is not currently in use and its future usage is uncertain.
As a result, the valuation of the land may become a point of significant negotiation between the directors of Cheetah Co and Zebra Co. This may also become a deal breaker if the two parties are unable to reach agreement on the matter.
(ii) Procedures
Termination of contract
Analytically review the total historic value of revenue earned from the customer to help determine an appropriate estimate for the potential loss of future revenues and cash inflows.
Enquire of management whether the loss of the customer will have any other repercussions, such as the sale of specific assets or the redundancy of staff and the costs associated with this if such action was required.
Perform an analytical review to identify other major customers by value of revenue contributions to the business. For all major customers identified, review any supply agreements/contracts in place to determine when they expire.
If any contracts with major customers are due to expire within the next few years, enquire of management whether any discussions have taken place with those customers in relation to renegotiating the terms.
Obtain any correspondence available with the identified major customers to identify whether there is any indication that they may attempt to either renegotiate the terms of their agreements or switch them to a new supplier.
Enquire of a relevant manager, such as a production manager or sales manager, whether there is any specific inventory which has been produced in relation to the customer who is not renewing their agreement. If this is the case, obtain a breakdown of the total inventories produced for this client and discuss with management whether they will be able to sell this inventory at full price given the notice to terminate the contract.
Inspect the forecasts prepared by management to ensure that the changes to the revenue and cost streams identified above have been appropriately incorporated
Gifted land
Review the terms supplied when the land was originally gifted to Zebra Co. Identify the specific restrictions in relation to how the land may be used and who the land may be sold to in the future.
Enquire of a legal adviser whether this will have any impact in relation to the sale of the land to Cheetah Co and their consequent usage of it.
Engage a land valuation expert to provide a valuation of the land. Ask them to consider the implications of the restrictions imposed upon the land in the valuation.
If Zebra Co is not permitted to sell the land, or the restrictions imposed on the usage of the land are too restrictive, seek legal advice in relation to the potential options, including whether the land can be gifted back to the local authority prior to the acquisition.
Inspect the forecasts prepared by the management of Zebra Co to identify the specific forecast costs and revenues associated with the usage of the land. Prepare a revised version of the forecasts which excludes these revenues and costs to identify the potential implications on the forecasts if the deal is conducted excluding the gifted land.
(b) Ethical and other professional issues
Advocacy threat
Accompanying the client to a meeting with their bankers will create an advocacy threat to objectivity as Leopard & Co may be perceived to be representatives of Cheetah Co.
This is particularly relevant as the bank may wish to establish a number of facts relating to the suitability of providing finance to Cheetah Co. For example, they may ask for representations that the company will continue as a going concern and that any forecast cash flows presented are accurate. As Cheetah Co’s auditor, these questions may be directed at the firm’s representatives and the bank may take any response provided to their questions as assurance over these matters.
Management responsibility
Leopard & Co must also be careful that in providing services relating to the potential acquisition of Zebra Co and the associated financing arrangements that the firm is not assuming a management responsibility. Although the terms of the engagement have not yet been confirmed, it is likely that by attending the meeting with the client, the audit firm will give the impression of supporting the acquisition of Zebra Co and therefore give credit to the decision.
The IESBA Code of Ethics for Professional Accountants (the Code) specifically states that the firm shall not assume a management responsibility for an audit client as the threats created would be so significant that no safeguards could reduce the threats to an acceptable level.
Self-review threat – loan transaction
The Code specifically states that providing assistance in finance raising transactions for audit clients also creates a self-review threat to objectivity. A self-review threat arises where the outcome or consequences of a corporate finance service provided by the audit firm may be material to the financial statements under review.
This is a particular problem as the transaction will directly affect the financial statements, which the audit team will be responsible for auditing in consequent financial periods and therefore the audit team is likely to be more accepting of information provided or may not investigate issues as thoroughly, as the team may feel that much of this has been done via the due diligence.
Self-review threat – interim review
Reviewing the work of the team engaged in the interim financial statements review would also create a self-review threat to objectivity as the audit team would be reviewing the work of another team within the audit firm.
It may be perceived externally that the purpose of reviewing the progress of the interim review is to ensure that any output from this does not impact the attempt by Cheetah Co to secure the loan finance.
Intimidation threat
The request by Cheetah Co to ensure that the interim review does not impede the application for a loan may be perceived as intimidation by the client. It appears as though they are putting pressure on Leopard & Co to finish the work based on the deadlines imposed by the bank, rather than those originally agreed with the client. This may force the auditor into changing their approach to any remaining procedures which would be considered to be undue influence of the client over the procedures performed.
This appears to be supported by a further threat relating to the upcoming tender for the audit. The management team of Cheetah Co appears to be suggesting that failing to ensure the interim review is completed on time for the loan decision may have an adverse impact on any consequent tender bid.
Purpose of meeting
It is not clear why representatives of Leopard & Co have been invited to attend the meeting with the bank. The purpose of both the due diligence service and the interim review is to report to the directors and owners of Cheetah Co, respectively. The firm has no responsibility to report to any third party, including potential lenders.
There may be an expectation for Leopard & Co to provide assurances to the bank in relation to the accuracy of forecasts presented or the financial position of Cheetah Co. If this is the case, it is outside the scope of any of the current engagements and Leopard & Co would not be in a position to provide this assurance.
Actions
The firm should ascertain the purpose of attending the meeting with the bank; if there is any expectation that it will provide assurances to the bank, then the request should be declined, explaining to Cheetah Co that the firm’s responsibilities extend to reporting to the management and the owners of the company and not to any third parties.
If there is no expectation to provide any assurances and the firm is expected to attend the meeting solely in regard to the role of providing due diligence services to Cheetah Co and assisting them in determining a purchase price, then it may be possible for representatives of Leopard & Co to attend. It must be made clear, however, that no members of the audit team/ interim audit team will be able to attend and the firm will not be permitted to make any representations to the bank. A written representation should be obtained from management clarifying these points. In order to reduce the risk of Leopard & Co assuming a management responsibility, the representation should also state that Cheetah Co has assigned responsibility for the final decisions relating to the acquisition and financing to a suitably experienced individual within the company. Futher, that Cheetah Co’s management will provide oversight of the services performed, will evaluate the adequacy of the outcome of the services for the purposes of Cheetah Co, and accept responsibility for the actions to be taken as a result of the services performed by Leopard & Co.
On balance, Leopard & Co may consider that the threats, both real and perceived, are too great and it would be most prudent not to attend the meeting. If this is the case, Leopard & Co should politely decline the invitation, explaining the reasons why it is inappropriate.
Leopard & Co should communicate with the directors of Cheetah Co explaining that the firm is unable to be involved in the interim review or to review any of the working papers. Leopard & Co should explain the reasons to the client. The firm should also explain that, if the client has any concerns, they should communicate with the interim review engagement partner to ascertain a reasonable timeframe for conclusion of this engagement.