- 14 Marks
AAA – L3 – Q50 – Audit-related services
Question
Your audit client, Presco Co (Presco), is a national hotel group with substantial cash resources. Its accounting functions are well managed, and the group accounting policies are rigorously applied. The company’s financial year end is 31 December.
Presco has been seeking to acquire a construction company for some time to bring in-house the building and refurbishment of hotels and related leisure facilities (e.g., swimming pools, squash courts, and restaurants).
Presco’s management has recently identified Robson Builders Co (Robson) as a potential target and has urgently requested that you undertake a limited due diligence review lasting two days next week.
Further to their preliminary talks with Robson’s management, Presco has provided you with the following brief on Robson Builders Co:
The chief executive, managing director, and finance director are all family members and major shareholders. The company name has an established reputation for quality constructions.
Due to a recession in the building trade, the company has been operating at its overdraft limit for the last 18 months and has been close to breaching debt covenants on several occasions.
Robson’s accounting policies are generally less prudent than those of Presco (e.g., assets are depreciated over longer estimated useful lives).
The company’s management team includes a qualified and experienced quantity surveyor. His main responsibilities include:
(1) supervising quarterly physical counts at major construction sites
(2) comparing costs to date against quarterly rolling budgets, and
(3) determining profits and losses by contract at each financial year end.
Although much of the labour is provided under subcontracts, all construction work is supervised by full-time site managers.
In August 20X7, Robson received a claim that a site on which it built a housing development in 20X4 was not properly drained and is now subsiding. Residents are demanding rectification and claiming damages. Robson has referred the matter to its lawyers and denied all liability, as the site preparation was subcontracted to Sarwar Services Co. No provisions have been made in respect of the claims, nor has any disclosure been made.
The auditor’s report on Robson’s financial statements for the year to 30 June 20X7 was signed, without modification, in March 20X8.
Required:
(a) Identify and explain the specific matters to be clarified in the terms of engagement for this due diligence review of Robson Builders Co. (b) State, with reasons, the principal additional information that should be made available for your review of Robson Builders Co.
Answer
(a) Terms of engagement – matters to be clarified Objective of the review: for example, to find and report facts relevant to Presco’s decision whether to acquire Robson. The terms should confirm whether Presco’s interest is in acquiring the company (i.e., the share capital) or its trading assets, as this will affect the nature and scope of the review. Presco’s management will be solely responsible for any decision made (e.g., any offer price made to purchase Robson). The nature and scope of the review and any standards/guidelines in accordance with which it will be conducted. That investigation will consist of enquiry (e.g., of the directors and the quantity surveyor) and analytical procedures (e.g., on budgeted information and prior period financial statements). The level of assurance will be ‘negative’. That is, that the material subject to review is free of material misstatement. It should be stated that an audit is not being performed and that an audit opinion will not be expressed. The timeframe for conducting the investigation (two days next week) and the deadline for reporting the findings. The records, documentation, and other information to which access will be unrestricted. This will be the subject of agreement between Presco and Robson. A responsibility/liability disclaimer that the engagement cannot be relied upon to disclose errors, illegal acts, or other irregularities (e.g., fraudulent financial reporting or misappropriations of Robson’s assets).
(b) Principal additional information Any service contracts with the directors or other members of the management team (e.g., the quantity surveyor). These may contain ‘exit’ or other settlement terms in the event that their services are no longer required after a takeover/buyout. Prior period financial statements (to 30 June 20X7) disclosing significant accounting policies and the key assumptions concerning the future (and other key sources of estimation uncertainty) that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities in the year to 30 June 20X8. For example, concerning:
- the outcome on the Sarwar dispute
- estimates for guarantees/claims for rectification The most recent management accounts and cash flow forecasts to assess the quality of management information being used for decision-making and control. In particular, in providing Robson with the means of keeping its cash flows within its overdraft limit. A copy of the signed bank agreement for the overdraft facility (and any other agreements with finance providers). Any breaches in debt covenants might result in penalties or contingent liabilities that Presco would have to bear if it acquired Robson. The standard terms of contracts with customers for construction works. In particular, for:
- guarantees given (e.g., for rectification under warranty)
- penalty clauses (e.g., in the event of overruns or non-completion)
- disclaimers (including conditions for invoking force majeure). Presco will want to make some allowance for settlement of liabilities arising on contracts already completed/in-progress when offering a price for Robson. Legal/correspondence files dealing with matters such as the claims of the residents of the housing development and Robson’s claim against Sarwar Services Co. Also, fee notes rendered by Robson’s legal advisers showing the costs incurred on matters referred to them. Robson’s insurer’s ‘cover note’ to determine Robson’s exposure for rectification work, damages, injuries to employees, etc. The quantity surveyor’s working papers for the last quarterly (presumably at 31 March 20X8) and the latest available rolling budgets. Particular attention should be given to loss-making contracts and those that have not been started. (Presco might seek to settle rather than complete them.). Type and frequency of constructions undertaken. Presco is interested in the building and refurbishment of hotels and leisure facilities. Robson’s experience in this area may not be extensive. Non-current asset register showing location of plant and equipment so that some test checking on physical existence might be undertaken (if an agreed-upon-procedure).
- Tags: Assurance services, Due diligence, Review engagement, Terms of engagement
- Level: Level 3
- Topic: Audit-Related Services
- Uploader: Salamat Hamid