FROM: Arthur Cuvier
SUBJECT: Audit approach and issues relating to the audit approach of Secondo SA and its consolidation report
Secondo SA is a subsidiary of Prime plc group that is located in Avalonia. The Hutton LLP is the auditing firm of Prime plc group and all its subsidiaries except the Secondo SA since the Hutton LLP does not have an office in Avalonia. Following this, a local firm audits Secondo SA. Audit done previously had established the competency of the local firm. Secondo SA is a strong subsidiary due to the stability of the currency in Avalonia compared to the UK pound that has been declining over the years, however, risk assessment should be focused towards the local auditing firm. From the review of the financial statements of the year ending 31 December 2016, Secondo SA is being sued by a customer for losses arising due to late delivery and the defective operation of a machine that was purchased on April 2016.
From this, the competency of the audit report is put to question as poor internal control systems are exercised leading to poor timing and late delivery of components. Besides, IFRS 7 financial instruments: disclosures requires the company to make full disclosures of information about the significance of financial instruments nature and extent of risk arising from those financial instruments. Provision for depreciation should be made to cover for the losses arising from defective machines. This provision reduces the reported profit. Strong internal controls and efficiency should have been able to avoid a lawsuit and damages resulting from it. IAS 37 provisions, contingent liabilities and contingent assets, the CFO of secondo SA should make provisions on contingent liability; this is a possible obligation depending on whether some uncertain future event occurs. The amount incurred in the lawsuit should be provided for. Lack of this provision inflate the profits reported. IAS 37.36 the amount offered as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date or transfer it to the third party. Since there is, a 20% chance of losing the case, provisions made should be adequate to cover the legal claim; legal cost estimated less the amount already made as provision.
Analysis of the consolidated results of the Secondo SA shows the following:
Although Secondo SA is operating in a stable economy and the currency is relatively stable in comparison with the UK pound, its revenue and profit from operations is relatively low, which may be due to reasons such as poor utilization of resources or not producing to its capacity. The results of Tertiary limited, which operates with low revenues, assets and share capital comparing it with secondo SA, are high. In addition, Tertiary Ltd operates in the UK where the currency is declining and so can be said of the economy. This comparison shows a loophole, such as inefficient management, in the operations of the Secondo SA that leads to low revenues and relatively low profits. The profit for the year of Secondo SA is considerably low in comparison with the other subsidiaries. This shows some weakness in internal operations of the company which may include: high wastage of resources, weak internal controls, mismanagement and embezzlement of funds and the resources, poor quality of the components produced and low production runs. All this should be outlined in the risk assessment report of the local audit firm of the Secondo SA and submitted in the AGM.
The purpose of the due diligence report is to provide a detailed analysis relating to the Britannicus's financial performance to the management of Prime plc group so that they can make an informed decision of whether to buy all the shares of Britannicus or not.
Britannicus is a private company located in Brussels that deals with the manufacture of shelving and storage systems. It has been successful in the domestic market. Britannicus has an automated production process that may be reducing the selling price of the products and thus competing favorably in the market.
Britannicus has two directors who run the company on a day-to-day basis. Further, these directors control 50% of the share capital. According to a financial report provided by the directors of Britannicus and reviewed by Hutton LLP, financial statements prepared by Britannicus are under the requirement of the IFRS and subject to annual audit per the terms of the loan agreements and banking facility agreement signed by the directors. Britannicus also has an established customer list and brand name.
Britannicus has patented a unique automated production process that the Prime plc group may have a scope to use. Britannicus operates in the domestic market where it has gained a substantial customer base and made itself a brand name. The two directors earn a salary of EUR40000 each, and the other remuneration in regards to dividends is paid. Only the finance director has a salary of EUR80,000. If the two directors were to be paid a commercial wage, it would be up to EUR200,000. It should be noted that Britannicus does not have outstanding long-term liabilities as they were cleared in the previous year. The directors of Britannicus have suggested that the purchase price could be based on a multiple of averaging earnings for the last two years.
Following the above considerations and the analysis done below, Prime plc group should be able to determine whether to acquire Britannicus or not.
Acquiring Britannicus would translate that the expenses regarding directors' remuneration are increased to a tune of EUR200,000, which is the commercial rate. This means that salaries for the two directors and the finance director would increase expenses by approximately EUR440,000. However, the director's fee and remuneration can be set by the board of directors and is usually a fixed fee, which might be double of the ordinary director. The automated production process of Britannicus would increase the revenues generated and improve competition with the local industries were it to be incorporated in the production systems of Prime plc group. The management of Prime plc group has an issue with the inflated stock at year-end. The management of Prime plc group should note that inventory manipulation which refers to either deflation or inflation of inventory, is a technique used by some companies to report a higher net income. Inflated stock translate to a lower cost of goods leading to higher incomes. A company reporting higher incomes can negotiate for loans from lenders. Prime plc group should establish that this is not the case in Britannicus. The Prime plc group should evaluate the expected cash flows generated by the new product that is to be created. The reduction of finance expenses from EUR76.000 to EUR2,000 should be analyzed, and the question to answer is whether the efficiency that brought about the decline in finance expense, that is, through outsourcing and logistics operations can be sustained and its consistency guaranteed. The retained earnings of the two years are relatively higher than the equity, therefore the cost of acquisition would be substantial.
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