Question

II. Risk Assessment Case (20 points) You are the manager at Anaheim & Allen LLP, a regional CPA firm based in Southern California. In 2001-2009, Anaheim and Allen LLP was the external auditor of Romel Inc. a supplier of car engine components to many American and European car makers (most car makers manufacture their own engines). It has two main manufacturing plants, one in central California and one in Tennessee, a popular state for car component makers. 2002-2007 were the golden years of Romel and its volume grew more than 80% in the booming 6 years. In order to compete effectively in the North American market, it also took over the 2 largest car engine component maker in Canada, Roland Ltd., with a 30% premium over its quoted stock prices, in Q3 of 2007. This was the first M&A in the history of Romel Inc., since the management used to only rely on organic growth. The premium paid for this acquisition became the goodwill on the consolidated balance sheet and accounted for around 12% of total assets for the FY2007 and FY2008. As a result, Romel got two more plants, one in Toronto and one in Oshawa. The 2008-2009 Great Recession hit the automobile industry particularly hard: Ford, GM and Chrysler saw their sales declined 30-40% after the collapse of Lehman Brothers. In response, almost all kinds of car makers (American, European, and Asian ones) cut back their purchase volume for engine components dramatically since October 2008 Romel saw a big decline in revenue and profitability since Q4 2008. One major car maker even indefinitely cancelled its order in Q1 of 2009. This sudden decline unfortunately caught Romel by surprise, since its purchasing department ordered a large quantity of all kinds of raw materials or components in October 2008, based on a more optimistic budget set up in Dec 2007. There was also rumor that General Car Inc., a customer that accounts for 10% of total revenue of Romel Inc., might file Chapter 11 bankruptcy in Q3 of 2009. About 12% of Romel's outstanding A/R balances by the end of FY2007, FY2008 were from General Car Inc. Now is July 2009. You just visit Romel Inc. for a quarterly review of its performance. This visit will also help you to gather useful information in planning the 2009 annual audit of Romel The CEO Jack London told you that the management of Romel Inc. decided to restructure the business soon. The Canadian plant in the suburban Toronto will be shut and torn down, and land could be sold to a real estate developer. But since the plant land has been heavily contaminated by heavy metals such as lead and chromium used in the production process, the real estate developer demanded a costly decontamination before the land sale. Romel's corporate counsels in California and Canada both warned you that, without an explicit approval from the Minister of Environment in Ontario, this land sale might never get completed. The Californian plant will cut back its production capacity by 50% in response to overcapacity in the whole engine component industry, The management also plans to employ new production technology to make the remaining operation more efficient and more flexible: Revised production line will be able to produce a bigger variety of components for more different engines and machinery. Since Romel has a very tight cash flow now, the management expect that all of the $50 million for plant transformation has to be supported by a new bank loan. Required: Identify some key business risk factors for Romel Inc. and list probable material misstatements in the financial statements of Romel associated with these risks. Please give brief explanations (Tip: Please also give me specific account names. Speculative answers such as "total assets","total current assets", "total long term assets" "total liabilities "total liabilitus", "total current liabilitis" "total long term liabilities", shareholder's equity", net income operating income" & "retained earnings will result în loss points

Answer 1

Key Business Risk Factors:

1. The biggest risk remains that of the demand and supply chain. Even after the worst of the financial crisis is over, people might not want to invest in cars, this would mean continous lower demand of automotive car parts, further worsening the case for Romel Inc. as it has to take loan for the revised production facility.
2. Another risk comes as the from of permission from the Ministry of Environment. The sale of the plant is very important for the restructuring of the business of Romel Inc. The cash proceeds from the sale of the real estate will help in the whole process. The Ministry of Environment still might not get permission, thereby ruining the whole plan.
3. Even though the company has plans to manufacture the products efficiently, there is always a risk of changing technology. Electric vehicles and use of renewal energy in engines might render the currently being manufactured parts useless.

Now onto the probable material misstatements:

1. All big firms have account recievables and a fund for default for emergency cases. This is one such case where all of the automotive industry is hit. Some companies might go bankrupt and this way the default payments might go up. So, the account recievables figure might have to be adjusted, and some amount will have to be put down.
2. The company in order to show equal profits throughout the financial year, might not show current purchases this quarter and might push back the purchase amount to when the sales have increased. Thereby playing with the account payable account and purchases amount.
3. Subsequently, there might be misstatement in Inventory amount.