To : Audit engagement partner

From : Audit manager

Subject : Audit planning – Connolly Co

Introduction

The briefing notes prepared relates to the business risks and related risks of material misstatements to
be considered when planning the audit. Further, the principal audit procedures to be performed have
also been considered with relation to the brand name and the several ethical issues relevant to the audit
firm and their possible actions are also considered.

Business risks

International operations – Connolly Co sells its pharmaceutical products all over the world exposing
itself towards the risks put forth by foreign exchange.Since the company is present in different
countries , there is a risk of non compliance with local laws and regulations which could adversely affect
its operations. Additionally , any political or economic instability in the countries in which the company
conducts its operations would make it difficult to plan and budget the entity’s operations and may cause
the company to not reach its targets.

Licensing requirement – Since the company operates in the pharmaceutical industry , there exists a
requirement to gets the products licensed for use to the customers . Inability to obtain the licenses
would cause the costs already incurred to be wasteful. Additionally, it poses a threat to the company’s
business objectives and leads to the company not fulfilling the customer’s demands

High competition – Connolly operates in an industry which is highly competitive , which puts a pressure
upon the company to cut prices in order to stay competitive. More a highly competitive industry is prone
to constant changes , which may require additional costs in order for the company to maintain its market
share.

Regulatory requirements – News drugs in production by the company are in the research and
development stage subject to strict regulatory requirements. Having stringent regulatory requirements
puts the company at risk to non-comply , which could lead to investigation by the authority causing
reputational damage to the company and occurrence of additional costs to the company in the from of
fines or penalties. In certain cases , production may need to be ceased.
Patent infringement – In the industry in which Connolly operates , patents rights are defended. Potential
patent infringement puts the company at risk of incurring significant legal costs in defending their legal
position. Moreover, significant time and effort is needed in order to monitor the product development in
order to ensure legal compliance with the existing patents. Additionally, patent infringement by a
competitor to Connolly would result in significant costs and time which could be substantial to the
company.

Skilled personnel – The success of the medicines produced by Connolly Co depends on the highly skilled
scientists which are difficult to retain due to the increasing competition. Loss of skilled personnel,
especially to the competitors of Connolly Co would be a reduction in the resources of Connolly. In a
worst case scenario , it could delay the production and launch of new products leading to unfulfilled
customer demand

Diversification – Connolly Co is diversifying into a new market. Although, this has brought strategic and
commercial advantages , lack of consistency in the operations would cause the management to deal with
the additional operations , which needs control and supervision. The existing business operations may
also suffer due to the increased attention towards the new market operations. There may also be
additional costs which puts a pressure on the liquidity of the business.

Use of brand name – Connolly Co has acquired the brand name “Cold Comforts” , under which some of
its products are sold. The benefits related to this investment would take some time to materialize , which
would result in a lower return than one anticipated by the company. Additionally, any reputational
damage to the Cold Comforts brand would effect the revenue of the products sold by Connolly Co under
its brand name.

Overdependence on overseas supplier – The company sources all of its packaging from a overseas
supplier. Over-dependence on a particular supplier would expose the company to the risk of increased
costs. Overall , since the supplier is overseas and the packaging is denominated in foreign currency , it
exposes the company to risks of the volatility in the exchange rates.

Risks of material misstatement

1. International operations – Connolly Co sells its pharmaceutical products all over the world
exposing itself towards the risks put forth by foreign exchange. In accordance with IAS 21 , all
foreign transaction are to be translated at the spot rate. If the company fails to do so or
translates the revenue at an inappropriate spot rate , then the revenue of the company may be
over/under stated
2. Licensing requirement – Since the company operates in the pharmaceutical industry , there
exists a requirement to gets the products licensed for use to the customers . In accordance with
IAS 38 Intangible Assets , only those developmental expenditure which meets the criteria for
recognition is considered as an intangible asset. If the company fails to obtain the licenses
related to the drugs manufactured , it fails to meet the criteria of intention to sell or use and
hence need to be expensed off to the statement of profit or loss. Failure in doing so will result in
the intangible assets being overstated and the expenses being understated.

3. High competition – Connolly operates in an industry which is highly competitive , which puts a
pressure upon the company to cut prices in order to stay competitive. This would result in
decline in the selling price of the product and in turn the NRV of the product. In accordance with
IAS 2 Inventories , inventory should be valued at the lower of cost and NRV. If the NRV of the
inventory is below the cost , then these need to be written down or else the inventory in the
books will be overstated leading to the profits to be overstated in the statement of profit or loss.

4. Regulatory requirements – News drugs in production by the company are in the research and
development stage subject to strict regulatory requirements. Having stringent regulatory
requirements puts the company at risk to non-comply. According to IAS 37 Provisions,
Contingent Liabilities and Contingent Assets , if there exists a present obligation (penalty) as a
result of a past event (non-compliance) , then the company will need to recognize a provision is
payment is certain or a contingent liability otherwise. Failing to do so results in the liabilities
being understated and the profits being overstated.

5. Patent infringement – In the industry in which Connolly operates , patents rights are defended.
Potential patent infringement puts the company at risk of incurring significant legal costs in
defending their legal position. . According to IAS 37 Provisions, Contingent Liabilities and
Contingent Assets , if there exists a present obligation (penalty) as a result of a past event (non-
compliance) , then the company will need to recognize a provision is payment is certain or a
contingent liability otherwise. Failing to do so results in the liabilities being understated and the
profits being overstated

6. Skilled personnel – The success of the medicines produced by Connolly Co depends on the
highly skilled scientists which are difficult to retain due to the increasing competition. Loss of
skilled personnel, especially to the competitors of Connolly Co would be a reduction in the
resources , which goes against IAS 38 Intangible Assets , in which sufficient resources are
necessary in order for a development cost to be recognized as an intangible asset. This would
cause the intangible assets to be overstated within the financial statements.

7.
8. Overdependence on overseas supplier – The company sources all of its packaging from a
overseas supplier. Over-dependence on a particular supplier would expose the company to the
risk of increased costs. This causes the selling price of the product to increase which would result
in the cost of the product increasing. In accordance with IAS 2 Inventories , Inventory should be
valued at lower of cost and NRV , which otherwise would result in the inventory being
understated within the financial statements.

9. Existing legal claim – In accordance with IAS 37 Provisions, Contingent Liabilities and
Contingent Assets , a provision needs to be recognized if the firm has a present
obligation due to a past event , which can be reliably measured and whose cash outflow
is probable. Eventhough the claim is believed to be not successful , the cash outflow of
$3 million is certain and hence a provision needs to be recognized in the financial
statements which otherwise would lead to the liabilities being understated and the
profits within the statement of profit or loss being overstated