Aerospace Lighting Inc. (ALI)—previously a private company based in Chicago—has

ID: 411881 • Letter: A

Question

Aerospace Lighting Inc. (ALI)—previously a private company based in Chicago—has been a leading supplier of airplane cabin lighting systems for nearly ten years. Until recently, ALI had been satisfied with its profits and had sold all its products to Bombardier, a major aerospace company in Canada. This comfortable position began to change in 2013, when a large publicly traded multi-national company (BmG) acquired 100 percent of ALI.

For ALI, the transition from a private, independent company to a subsidiary of a public conglomerate has not been an easy one. Before the takeover, ALI’s management was afforded the luxury of making decisions and taking risks that affected only one owner. Being just one arm of a much larger international company, however, now requires ALI to satisfy more than its own personnel. Members of BmG’s executive team dominate ALI’s board of directors. These individuals have been very critical of ALI’s management, particularly in the area of financial performance. Beginning with the first board meeting in 2013, the new BMG executive team has scrutinized ALI’s operating results and has never hesitated to remind ALI management that BmG views ALI as an investment that is evaluated based on its return to BmG stockholders. BmG does not tolerate any failures to meet financial targets, and is willing to replace entire management teams if required. BmG’s executives take very seriously the ‘‘Financial Handbook’’ that they establish each year to communicate the parent company’s financial principles, including equity and capital borrowing guidelines, monthly reporting requirements, and profit expectations.

Since the acquisition, ALI has been pursuing a rapid expansion strategy. The German parent company directed ALI to enter the U.S. aerospace supply industry in 2014, and quickly increase the number of U.S. contracts on which it bid, with the goal of increasing its revenues by 50 percent in 2015. To reach this goal, ALI adopted a strategy of submitting bid prices to U.S. manufacturers that, after adjusting for exchange rates, are approximately 20 percent lower than the prices ALI charges to Bombardier. This strategy has been successful so far, as ALI now has several large contracts with Boeing, Lockheed Martin, and Raytheon—the largest aerospace manufacturers in the U.S. ALI has already begun preparing to work on these contracts, having accumulated a significant quantity of raw materials inventory to use in producing goods for Boeing, Lockheed Martin, and Raytheon, as well as Bombardier.

ALI’s management team has not discussed its new strategy with its board because management believes BmG is interested in financial results rather than the means by which they are achieved. ALI’s management team also wants to keep this strategy quiet because if Bombardier’s executives were to hear about it, they would likely discontinue their relationship with ALI or immediately demand a lower price, as well as insist on a refund of any excess prices charged in previous years.

Required:

Prepare a brief planning memo to the Audit Partner for the ALI audit engagement (you can use the attached sample memo as a guide to help you organize your memo/address the key areas). Your memo should summarize business risks & financial reporting risks for the audit as well as assess engagement risk and set audit risk. (You can use bullets to summarize each of these.) Also calculate planning materiality and identify critical accounts and/or audit areas with a brief explanation as to why they are critical or what the audit challenge is.

EXHIBIT 1

Notes from Review of Predecessor Auditor’s Working Papers

1. Boeing, Lockheed Martin, and Raytheon have jointly formed several policies aimed at reducing

their overhead costs. One policy is that they will not respond to confirmation requests from external

auditors. Another policy is that they generate a single check for each supplier every 20 to 55 days

for the outstanding balance recorded at the payment date. The payment cycle period for each

supplier varies, depending on its status as a preferred-A or preferred-B supplier. ALI is currently

a preferred-B supplier to the U.S. companies, so it is paid every 55 days. The U.S. aerospace

manufacturers also have begun expecting reductions in bid prices from suppliers as the suppliers

gain experience with their production processes. Bombardier has not yet adopted policies such as

these, but is expected to do so by 2017.

2. On February 8, 2014, a manufacturing plant leased by ALI in Milwaukee was lost in a fire. ALI

filed with its insurance company, claiming total damages of $6.8 million. As of July 31, 2014,

ALI had recorded a $3.0 million receivable that was included in other current assets. This amount

comprised the net book value of previous plant assets of $1.7 million, plus an accrual for business

interruption insurance of $1.3 million. The predecessor auditor confirmed the details of the claim

with one of ALI’s external attorneys.

3. ALI disclosed its economic dependence on Bombardier in the 2014 financial statement notes.

4. The predecessor auditor had set materiality at $1.1 million

EXHIBIT 2

Notes from Discussion with ALI’s CFO

1. With ALI’s success in bidding on contracts with the big aerospace manufacturers in the U.S., ALI

is projecting a 55% increase in sales revenue, from $99 million in fiscal 2014 to $152 million in

2015. The majority of this increase has come from sales to the U.S. aerospace companies, which

in 2015 comprise one-third of total revenues. In 2014, sales to these companies were less than 1%

of total revenues. The increased sales volume will increase gross profit from $21.5 million in 2014

to a projected $23.0 million in 2015. Although ALI’s gross profit percentage on Bombardier sales

has remained steady at 22%, the U.S. contracts are projected to cause the overall margin to fall

from 22% in 2014 to a projected 15% in 2015.

2. During the 2015 fiscal year, ALI’s insurance company offered $5.1 million for the claim regarding

the fire at the Milwaukee plant. Of this amount, ALI received $1.3 million. The CFO claims that

ALI will not accept the insurance company’s offer, arguing that ALI deserves full compensation.

ALI plans to report the $5.5 million difference between its total claim and the amount received at

year-end as a receivable in other current assets.

3. All of ALI’s bid submissions and sales transactions with Boeing, Lockheed Martin, and Raytheon

are now being processed through Exostar—an electronic independent trading exchange (ITX). This

business-to-business website was started by the three largest U.S. aerospace companies to enhance

their ability to transact with suppliers and customers, and also to share data about their own

production costs. Exostar is now soliciting aerospace companies from other countries to participate

in the ITX so that it can truly become a global hub for all aerospace transactions. It has been

rumored that the U.K.’s BAE Systems and Canada’s Bombardier are currently talking with Exostar

about joining the ITX later this summer. Industry experts fully expect these companies will join

soon because ITXs in other related industries have grown rapidly and yielded significant cost

savings for many of their participants. Presently, it appears that ALI’s auditors will not be allowed

to directly examine Exostar’s accounting system.

4. ALI has a variety of debt agreements, many of which require the company to meet certain debt

covenant ratios. The most binding of these requirements is for a minimum current ratio of 1.5:1

on the audited financial statements for fiscal years ending July 31. Had this covenant been applied

to ALI’s unaudited financial statements at June 30, 2015, it would have been breached.

5. BmG has instituted a performance pay plan for its subsidiaries in 2015. The plan grants BmG

stock options to executives of BmG’s subsidiaries that meet or exceed the expectations established

in BmG’s ‘‘Financial Handbook.’’

6. ALI’s CFO estimates that the company’s 2015 year-end financial statements will report approximately

$10 million in net income before tax, $100 million of total assets, of which $30 million will be current, and $19 million

in current liabilities.

Here is an outline you can use for a planning memorandum..

Date:

To: Partner [or file]

From: [auditor name]

Re: Planning for the year end [date] of [client name]

Memo Objective & Client Overview

The purpose of this memo is to document the significant risks, critical accounts and planning materiality for the audit of ALI.

Brief summary of client’s business/industry (1-2 sentences)

Business Risks & financial reporting risks

Identify changes in management, strategy, economic pressures etc.

Consider quality of accounting team, audit committee, internal audit, AIS system, controls etc.

Engagement Risk & Audit Risk

Provide support and make a conclusion on engagement risk and set audit risk. (If this was a new client, this analysis would be more in depth; if it is a continuing client, you will highlight those new issues that would heighten engagement risk/impact audit risk).

Some factors to consider:

Management integrity, prior year audit experience (if a new client address any specific issues), financial health of the entity, users of F/S, regulatory /reporting requirements, deadlines)

Recommended Materiality

Set planning materiality (using prescribed benchmarks and qualitative considerations. Provide support for overall materiality. (Discuss key users and any factors that would influence their decisions, proposed base, proposed benchmark, or percentage, and any data issues).

Based upon user needs, identify any areas that may require a specific materiality if appropriate.

Identify Significant Accounts -- Develop an Audit Strategy that Reflects Response to Risks Identified

Identify significant or hi-risk accounts. ( Summarize/reference analytical analysis as applicable). Summarize critical accounting concerns and/or the important audit considerations./ challenges.

Just last week, on June 29, 2015, your firm’s was appointed worldwide audit services provider for BmG’s July 31, 2015 year-end. Another firm had provided audit services for BmG and all its subsidiaries in the previous year, but BmG’s executive team was dissatisfied with the auditors’ inability to identify significant business risks that they believed should have been brought to their attention. Your Chicago office has been asked by the lead engagement team (based in Boston) to perform the audit of ALI for its year ended July 31, 2015, and to provide your audit working papers by September 5, 2015. A recently promoted partner in your Chicago office has been assigned the responsibility for the 2015 ALI audit. She has communicated with ALI’s predecessor auditor and has provided you with the notes from her review of the predecessor’s working papers (see Exhibit 1). She also has obtained information from preliminary discussions with ALI’s CFO (see Exhibit 2). She has asked you to meet with her to discuss the client and your assessment of key risks as well as the preliminary planning considerations.