Question 3a i
(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:
In respect of the two matters identified above:
(i) Explain why each matter requires further investigation as part of the due diligence review, and (6 marks)