Professional Level – Options Module, Paper P7 (INT)
Advanced Audit and Assurance (International) December 2012 Answers 1 (a) Briefing notes
To: Audit Partner
From: Audit Manager
Regarding: Audit planning and ethical issues in respect of Grohl Co Introduction
These briefing notes evaluate the business risks facing Grohl Co, and identify and explain four risks of material misstatement to be considered in planning the audit of the financial statements for the year ended 30 November 2012. In addition, two ethical issues are discussed and relevant actions recommended. (i) Business risks
Imported goods – exchange rate fluctuations
Grohl Co relies on a key component of its production process being imported from overseas. This exposes the company to exchange rate volatility and consequentially cash flow fluctuations. The company chooses not to mitigate this risk by using forward exchange contracts, which may not be a wise strategy for a business so reliant on imports. Exchange gains and losses can also cause volatility in profits, and as the company already has a loss for the year, any adverse movements in exchange rates may quickly increase this loss.
Imported goods – transportation issues
Heavy reliance on imports means that transportation costs will be high, and with fuel costs continuing to increase this will put pressure on Grohl Co’s margins. It is not just the cost that is an issue – reliance on imports is risky as supply could be disrupted due to aviation problems, such as the grounding of aircraft after volcanic eruptions or terrorist activities.
Reliance on imported goods increases the likelihood of a stock out. Unless Grohl Co keeps a reasonable level of copper wiring as inventory, production would have to be halted if supply were interrupted, creating idle time and inefficiencies, and causing loss of customer goodwill.
Reliance on single supplier
All of Grohl Co’s copper wiring is supplied by one overseas supplier. This level of reliance is extremely risky, as any disruption to the supplier’s operations, for example, due to financial difficulties or political interference, could result in the curtailment of supply, leading to similar problems of stock outs and halted production as discussed above. Quality control issues
Since appointing the new supplier of copper wiring, Grohl Co has subsequently experienced quality control issues with circuit boards, which could result in losing customers (discussed further below). This may have been due to changing supplier as part of a cost-cutting exercise. Given that the new supplier is overseas, it may make resolving the quality control issues more difficult. Additional costs may have to be incurred to ensure the quality of goods received, for example, extra costs in relation to electrical testing of the copper wiring. The company’s operating margins for 2012 are already low at only 4% (2011 – 7·2%), and additional costs will put further pressure on margins. High-technology and competitive industry
Grohl Co sells into a high-technology industry, with computers and mobile phones being subject to rapid product development. It is likely that Grohl Co will need to adapt quickly to changing demands in the marketplace, but it may not have the resources to do this.
Grohl Co operates in a very competitive market. With many suppliers chasing the same customer base, there will be extreme pressure to cut prices in order to remain competitive. As discussed above, the company’s operating margins are already low, so competition based on price would not seem to be an option. Reliance on key customers
Grohl Co relies on only 20 key customers to generate its domestic revenue, which accounts for approximately half of its total revenue. In a competitive market, it may be difficult to retain customers without cutting prices, which will place further pressure on profit margins. In addition, the product quality issue in November could mean that some contracts are cancelled,...