Question 2b

You are a manager in the business advisory department of Goleen & Co. Your firm has been approached to provide assurance to Baltimore Co, a company which is not an audit client of your firm, on a potential acquisition. You have just had a conversation with Mark Clear, Baltimore Co’s managing director, who made the following comments:

‘Baltimore Co is a book publisher specialising in publishing textbooks and academic journals. In the last few years the market has changed significantly, with the majority of customers purchasing books from online sellers.

This has led to a reduction in profits, and we recognise that we need to diversify our product range in order to survive. As a result of this, we decided to offer a subscription-based website to customers, which would provide the customer with access to our full range of textbooks and journals online.

‘On investigating how to set up this website, we found that we lack sufficient knowledge and resources to develop it ourselves and began to look for another company which has the necessary skills, with a view to acquiring the company. We have identified Mizzen Co as a potential acquisition, and we have approached the bank for a loan which will be used to finance the acquisition if it goes ahead.

‘Baltimore Co has not previously acquired another company. We would like to engage your firm to provide guidance regarding the acquisition. I understand that a due diligence review would be advisable prior to deciding on whether to go ahead with the acquisition, but the other directors are not sure that this is required, and they don’t understand what the review would involve. They are also unsure about the type of conclusion that would be issued and whether it would be similar to the opinion in an audit report.

‘To help me brief the other directors and using the information I have provided, I would like you to:

Identify and explain the matters which you would focus on in your due diligence review and recommend the additional information which you will need to perform your work. (16 marks)

Mark Clear has sent you the following information about Mizzen Co:

Company background

Mizzen Co was established four years ago by two university graduates, Vic Sandhu and Lou Lien, who secured funds from a venture capitalist company, BizGrow, to set up the company. Vic and Lou created a new type of website interface which has proven extremely popular, and which led to the company growing rapidly and building a good reputation. They continue to innovate and have won awards for website design. Vic and Lou have a minority shareholding in Mizzen Co.

Mizzen Co employs 50 people and operates from premises owned by BizGrow, for which a nominal rent of $1,000 is paid annually. The company uses few assets other than computer equipment and fixtures and fittings.

The biggest expense is wages and salaries and due to increased demand for website development, freelance specialists have been used in the last six months. According to the most recent audited financial statements, Mizzen Co has a bank balance of $500,000.

The company has three revenue streams:

1. Developing and maintaining websites for corporate customers. Mizzen Co charges a one-off fee to its customers for the initial development of a website and for maintaining the website for two years. The amount of this fee depends on the size and complexity of the website and averages at $10,000 per website. The customer can then choose to pay another one-off fee, averaging $2,000, for Mizzen Co to provide maintenance for a further five years.

2. Mizzen Co has also developed a subscription-based website on which it provides access to technical material for computer specialists. Customers pay an annual fee of $250 which gives them unlimited access to the website. This accounts for approximately 30% of Mizzen Co’s total revenue.

3. The company has built up several customer databases which are made available, for a fee, to other companies for marketing purposes. This is the smallest revenue stream, accounting for approximately 20% of Mizzen Co’s total revenue.

Extracts from audited financial statements

Statement of profit or loss and other comprehensive income

year ended
30 sept
2013
year ended
30 sept2012
year ended
30 sept2011
year ended
30 sept2010
$'000 $'000 $'000 $'000
revenue 4268 3450 2150 500
operating expenses -2118 -2010 -1290 -1000
-------- -------- -------- --------
operating profit / (loss) 2150 1440 860 (500)
finance costs -250 -250 -250 ----
-------- -------- -------- --------
profit / (loss) before tax 1900 1190 610 (500)
tax expense -475 -300 -140 ----
-------- -------- -------- --------
profit / (loss) for the year 1425 890 470 (500)
-------- -------- -------- --------

There were no items of other comprehensive income recognised in any year.

Required:

Respond to the request from Mark Clear.