In the audit of Bright Chemicals Ltd, a large public company, you have been assigned responsibility for obtaining background information for the audit. Your firm is auditing the client for the first time as a result of a dispute between Bright and the previous auditor over valuation of work-in-process inventory.

Bright Chemicals has been highly successful in the past two decades, primarily because of successful mergers negotiated by Bert Randolph, the managing director and chairman of the board. Even though the industry as a whole has suffered dramatic setbacks in recent years, Bright has been able to secure strong earnings and growth until the last financial year when results began to show a downturn. Randolph has hired an aggressive group of young executives by combining modest salaries with an unusually generous profit-sharing plan.

A major difficulty you face in the new audit is that the computer software system installed five years ago now has serious problems in handling and processing the increased volume of data. Randolph believes that profits come primarily from intelligent and aggressive action based on forecasts, not by relying on historical data. Most of the forecast data are generated by the sales and production department, rather than by the accounting department. The personnel in the accounting department seem competent but are somewhat overworked and underpaid relative to other employees. A recent change that will potentially improve record keeping is the progressive installation of sophisticated new computer equipment. Not all the accounting records have been changed to the new system as yet, but perpetual inventory and sales/accounts receivable modules have been converted. Because of the serious problems with the old computer system software, the old and new inventory/sales systems were not run in parallel before implementing the new system and discarding the old one. Most of the computer time is being reserved for production and marketing, as Randolph considers that these areas are more essential to operations than 'bookkeeping'.

The first six months' financial statements for the current year include a profit that is only about 10% less than the first six months of the preceding year, which is somewhat surprising considering the reduced sales volume and the disposal of a segment of the business, Mercury Supplies Pty Ltd. The disposal of this segment was considered necessary because it had become increasingly unprofitable over the previous four years. At the time of its acquisition from Roger Randolph, who is a brother to Bert Randolph, the company was highly profitable and was considered a highly desirable purchase. The main customer of Mercury Supplies was Saturn Holdings Ltd, a company owned by Roger Randolph. Gradually, the market for Mercury's products declined as Saturn Holdings Ltd began diversifying and phasing out its primary products in favour of more profitable business. Saturn Holdings is no longer buying from Mercury, so Bright had no option but to sell Mercury.

According to financial analysts, the main difficulties facing Bright are severe under-financing and a pending legal case arising from employee health problems at one of the chemical production plants. Cash flow is also tight because of an excessive amount of current and long-term debt because of the depressed capital markets. Management is reluctant to obtain equity capital at this point because the increased number of shares would decrease the earnings per share by more than 10%. At present, Randolph is negotiating with several cash-rich companies in the hope of being able to merge with them as a means of overcoming the capital problems and restoring liquidity.

REQUIRED

a. List the main concerns you should have in the audit of Bright Chemicals and explain why they are potential problems. (Many of these 'concerns' will represent inherent risks in the audit of Bright Chemicals.)

b. State the appropriate approach to investigating the significance of each item you listed in part (a).