Butler Co is a new audit client of your firm. You are the manager responsible for the audit of the financial statements for the year ended 31 May 2011. Butler Co designs and manufactures aircraft engines and spare parts, and is a subsidiary of a multi-national group. Extracts from the draft financial statements are shown below:

Statement of financial position

Notes to the statement of financial position:

Note 1 Intangible assets comprise goodwill on the acquisition of subsidiaries ($80 million), and development costs capitalised on engine development projects ($120 million).

Note 2 Property, plant and equipment includes land and buildings valued at $25 million, over which a fixed charge exists.

Note 3 The deferred tax asset has arisen following several loss-making years suffered by the company. The asset represents the tax benefit of unutilised tax losses carried forward.

Note 4 Long-term borrowings include a debenture due for repayment in July 2012, and a loan from Butler Co’s parent company due for repayment in December 2012.

Note 5 Provisions relate to warranties provided to customers.

Note 6 Short-term borrowings comprise an overdraft ($25 million), a short term loan ($60 million) due for repayment in August 2011, and a bank loan ($715 million) repayable in September 2011.

You have received an email from the audit partner responsible for the audit of Butler Co:

To: Audit manager
From: Audit partner
Regarding: Butler Co – going concern issues

Hello

I understand that the audit work on Butler Co commences this week. I am concerned about the future of the company, as against a background of economic recession, sales have been declining, several significant customer contracts have been cancelled unexpectedly, and competition from overseas has damaged the market share previously enjoyed by Butler Co.

(i) Please prepare briefing notes, for my use, in which you identify and explain any matters arising from your review of the draft statement of financial position, and the cash flow forecast, which may cast significant doubt on the company’s ability to continue as a going concern. The cash flow forecast has just been sent to me from the client, and is attached. It covers only the first three months of the next financial year, the client is currently preparing the forecasts for the whole 12 month period. Please be sceptical when reviewing the forecast, as the assumptions may be optimistic. (10 marks)

(ii) In addition, please recommend the principal audit procedures to be carried out on the cash flow forecast. Your recommendations can be included in a separate section of the briefing notes. (8 marks)

Thanks

Attachment: Cash flow forecast for the three months to 31 August 2011

Notes to the cash flow forecast:

This cash flow forecast has been prepared by the management of Butler Co, and is based on the following assumptions:

1. Cash receipts from customers should accelerate given the anticipated improvement in economic conditions. In addition, the company has committed extra resources to the credit control function, in order to speed up collection of overdue debts.

2. The loan expected to be received in July 2011 is currently being negotiated with our parent company, Rubery Co.

3. The government subsidy will be received once our application has been approved. The subsidy is awarded to companies which operate in areas of high unemployment and it subsidises the wages and salaries paid to staff.

Required:

Respond to the email from the audit partner. (18 marks)

Note: The split of the mark allocation is shown within the partner’s email.

Professional marks will be awarded for presentation, and for the clarity of explanations provided. (2 marks)

(b) Given the information provided relating to Butler Co, it is likely that the auditor may conclude on completion of all necessary audit procedures, that the use of the going concern assumption in the financial statements is appropriate, but that a material uncertainty, or several uncertainties, exist regarding the company’s ability to continue as a going concern.

Required:

If audit procedures indicate that one or more material uncertainties exist regarding Butler Co’s ability to continue as a going concern:

Explain the matters that should be considered in forming the audit opinion and the potential impacts on the auditor’s report. (7 marks)