ACCA AAA ^INT Syllabus F. Other Assignments - Due Diligence - Past Papers ^{1 / 1}

(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:

(i) Explain why each matter requires further investigation as part of the due diligence review, and (6 marks)

You are a manager in the assurance department at Raphael & Co, a firm of Chartered Certified Accountants. Your firm has been appointed by Sanzio Co to perform a due diligence review of a potential acquisition target, Titian Tyres Co.

As part of the due diligence review and to allow for consideration of an appropriate offer price, Sanzio Co has requested that you identify and value all the assets and liabilities of Titian Tyres Co, including items which may not currently be reported in the statement of financial position.

Sanzio Co is a large, privately owned company operating only in this country, which sells spare parts and accessories for cars, vans and bicycles. Titian Tyres Co is a national chain of vehicle service centres, specialising in the repair and replacement of tyres, although the company also offers a complete range of engine and bodywork services as well. If the acquisition is successful, the management of Sanzio Co intends to open a Titian Tyres service centre in each of its stores.

One of the reasons for Titian Tyres Co’s success is their internally generated customer database, which records all customer service details. Using the information contained on the database software, the company’s operating system automatically informs previous customers when their vehicle is due for its next service via email, mobile phone text or automated letter. It also informs a customer service team to telephone the customer if they fail to book a service within two weeks of receiving the notification. According to the management of Titian Tyres Co, repeat business makes up over 60% of annual sales and management believes that this is a distinct competitive advantage over other service centres.

Titian Tyres Co also recently purchased a licence to distribute a new, innovative tyre which was designed and patented in the United States. The tyre is made of 100% recycled materials and, due to a new manufacturing process, is more hardwearing and therefore needs replacing less often. Titian Tyres Co paid $5 million for the licence in January 2015 and the company is currently the sole, licenced distributor in this country.

During a brief review of Titian Tyres Co’s financial statements for the year ended 30 June 2015, you notice a contingent liability disclosure in the notes relating to compensation claims made after the fitting of faulty engine parts during 2014. The management of Titian Tyres Co has stated that the fault lies with the manufacturer of the part and that they have made a claim against the manufacturer for the total amount sought by the affected customers.

Required:
(a) Describe the purpose of a due diligence assignment and compare the scope of a due diligence assignment with that of an audit of historical financial statements. (6 marks)

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:

Discuss THREE benefits to Baltimore Co of a due diligence review being performed on Mizzen Co. (6 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

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

Required:

Respond to the request from Mark Clear.

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

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

Required:

Respond to the request from Mark Clear.

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:

Describe the type of conclusion which would be issued for a due diligence report and compare this to an audit report.’ (3 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

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

Required:

Respond to the request from Mark Clear.

Jacob Co, an audit client of your firm, is a large privately owned company whose operations involve a repair and maintenance service for domestic customers. The company offers a range of services, such as plumbing and electrical repairs and maintenance, and the repair of domestic appliances such as washing machines and cookers, as well as dealing with emergencies such as damage caused by flooding. All work is covered by a two-year warranty.

The directors of Jacob Co have been seeking to acquire expertise in the repair and maintenance of swimming pools and hot-tubs as this is a service increasingly requested, but not offered by the company. They have recently identified Locke Co as a potential acquisition.

Preliminary discussions have been held between the directors of the two companies with a view to the acquisition of Locke Co by Jacob Co. This will be the first acquisition performed by the current management team of Jacob Co. Your firm has been asked to perform a due diligence review on Locke Co prior to further discussions taking place. You have been provided with the following information regarding Locke Co:

Locke Co is owner-managed, with three of the five board members being the original founders of the company, which was incorporated thirty years ago. The head office is located in a prestigious building, which is owned by the founders’ family estate. The company recently acquired a separate piece of land on which a new head office is to be built.

The company has grown rapidly in the last three years as more affluent customers can afford the cost of installing and maintaining swimming pools and hot-tubs. The expansion was funded by a significant bank loan. The company relies on an overdraft facility in the winter months when less operating cash inflows arise from maintenance work.

Locke Co enjoys a good reputation, though this was tarnished last year by a complaint by a famous actor who claimed that, following maintenance of his swimming pool by Locke Co’s employees, the water contained a chemical which damaged his skin. A court case is on-going and is attracting media attention.

The company’s financial year end is 31 August. Its accounting function is outsourced to Austin Co, a local provider of accounting and tax services.

Required:

(a) Explain THREE potential benefits of an externally provided due diligence review to Jacob Co. (6 marks)

(b) Recommend additional information which should be made available for your firm’s due diligence review, and explain the need for the information. (12 marks)