Understanding of the Client

Risk of Material Misstatement at Financial Statement Level

Section A: Understanding of the Client

• Salix Pharmaceuticals is a specialty pharmaceutical company. It is engaged in purchasing, developing and trading in medicines and equipment's helpful for gastrointestinal disorders.
• The company's head office is located in North Conecticut, State of Delaware.
• Salix is listed on NASDAQ stock exchange.
• Company is considering merger with Valeant Pharmaceuticals International such that Salix would become a subsidiary of Valeant in the recent future.
• On 28^th of January, 2015 the company identified that its earlier quarter statements would be restated considering certain errors and shall not be relied upon.
• Company's subsidiary Santarus along with its licensor has commenced a case in US district court against Par Pharmaceuticals Ltd. for infringement of its six patents.
• Company had made an announcement that its leadership would change in the end of January and the company would have an acting chief executive officer till a new CEO is selected.
• Company has Xifaxantablets as their base pharmaceutical products and in case any day the consumption of these tablets is unaccepted by the customers, the company may be majorly negatively affected.
• Company has taken large amount of borrowings, which have potentially booked its future income for payment of interest and repayment of the debt.
• The company has already sold a large amount of its products to the wholesalers. This may mean that its sales in future would be narrowed by the stock already available with those wholesalers.
• To stay in the industry, company has to continuously keep innovating. While innovations on a continuous basis may not be possible, company also needs to work upon financing them, since already it is holding large amount of debts with covenants which may impede its ability to take further debt.
• Company has made a loss of US dollar 414911 thousands in 2014 which in itself questions the ability of the entity to continue in future.

Section B: Risk Assessment

Risk of Material Misstatement at Financial Statement Level

1. Control Environment –Company has recently received a change in management and it has been accompanied by a decision of the entity to become subsidiary of Valent Pharmaceuticals Ltd. This raises substantial questions on the difference between management and ownership in the company. While the company is facing these situations, its subsidiary has initiated a claim for infringement of patents, which requires an assessment as to whether the company is considering earning through this prospect, because its other prospects may have been closed.
2. Fraud – Presently there are no described fraud cases in the entity. But it has been highlighted that the company has sold excess stock to the wholesalers which can impede their ability to take in more stock. And, considering that the company is making losses even when additional stock has been supplied to wholesalers shows chances of fraud.
3. Going Concern – The companyhas taken large amount of borrowings with covenant which restrict it from taking further loans. In the present industry where it is not having funds to carry out the necessary innovations, it seems that this covenant would result in hindering the ability of company to continue as a going concern. Further this borrowing comes with interest payment requirement when the company is incurring losses, this too can be assessed as a factor which questions going concern assumption.

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Risk of Material Misstatement at Assertion Level

1. Completeness assertion on Sales – It is related as to whether all sales that have increased the level of stock with the wholesalers have been accounted for.
2. Occurrence of research and development expenditure – The company is out of funds, and the income statement shows an expenditure of US $170,289 thousands. It needs to be considered as to whether it has even occurred.
3. Rights on Assets – Salix is facing critical condition, this may have encouraged the management to show bogus assets or those assets which are not theirs.
4. Allocation of absorption of intangible assets – Company has shown high amount of intangible assets absorption, it needs to be assessed whether allocation on yearly basis is right.
5. Classification of Borrowings – No significant asset has been added to the financial, but a huge borrowing has been added. It puts a question as to whether the borrowing has been rightly classified as long term borrowing.
6. Valuation of retained earnings – A negative figure of retained earning has been presented in the financial; a valuation basis needs to be assessed.

Risk Conclusion

At the financial statement level the control environment is not effective, depicting that the control risk is high for the business. Further, if the fraud and going concern be considered at the financial statement level, they are also high. In relation to the assertion level, each of the six assertions considered are depicting certain type of risks. The completeness assertion is depicting high risk due to inclusion of excessive sales to the figure. As for the occurrence assertion, research and development expenditure shown in the profit and loss depicts fraud risk. Right on assets assertion evaluation also highlights the possibility on depicting assets as owned when the business does not actually have a right on the assets. On the allocation assertion, excessive absorption of intangible assets has been provided, which again indicates a risk. Finally for classification assertion and valuation assertion too risk has been highlighted due to the expectation of wrong classification and negative retained earnings figure. Thus since the risk at financial statement level and the risk at assertion level both are high, the inherent risk associated with the financials of Salix Pharmaceuticals Ltd is high. Now, the final risk that needs to be assessed is detection risk. Since it has been considered that a major population would be selected and among the population 50% would be necessarily considered, it is expected that the detection risk would be low. However, considering the different fraud risk factors which show that there may be an involvement of management in fraud, which makes it difficult for the auditor to detect the misstatement, again increases the risk factor. Thus as per the AR model

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Audit Risk        = Inherent Risk x Control Risk x Detection Risk
= High x High x High
= High
Therefore the total audit risk for the audit is high. The assessment concludes that the overall company is located in high risk. This means that there are high probabilities that the auditor may not be able to detect the material misstatements in the financial statements.

Section C: Materiality Decisions

Since the company is making losses, materiality level cannot be set at Net Profit Income; therefore on the basis of average income of past three years that is $ 94152, materiality has been set at $42,368. The computation is as follows:
Materiality Calculation
Testing Level of the audit = Standard
Therefore assurance level of the materiality = 2.0
Materiality Base = Average Income for three years = $94,152
Materiality = 50% of Materiality Base               = 50% x $ 94,152                    = $ 47,076
Less: Most Likely Error = 10% of Materiality    = 10% x $47,076                     = $   4,708
Precision is 90%                                                                                                           = $ 42,368
Population Considered = Population above Materiality with Precision at 90%
= This means every account with balance above $42,368 at any time in the year would be considered in population
Sample Size                              = 50% of the population on the basis of risk
Planning Materiality would be the same, until the audit progresses further and additional conditions are recognized. Presently we are on the lower end of the range, due to high possibility of material misstatements. The users of the audit report are the shareholders of the company, whose holding would be transferred to Valeant. Therefore the objective is to ensure that any misstatement which reduces the value of their holding is identified properly.

Section D: Preliminary Analytical Procedures

A common size and horizontal analysis against the previous two years has been made, and it presents that the company had been performing satisfactorily till last year. It was only in 2014 when the company took borrowings and went into losses. Ratios like gross profit ratio, which is 70.20% in this year, and debt to assets ratio which is about 0.5, have been computed. These ratios suggest that while the factory operations of the company are still successful, there are other operations which are restricting its path to continue into unforeseen.

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What could go wrong?

• Sales can be overstated in the coming years to show the worth of company to be taken as a subsidiary.
• There can be overstatement of assets to ensure that the comparison between it and balance sheet's borrowing level which has been shown as long term debt can be retained.
• The company may not be able to provide the profits expected by the Valeant Inc for merger. This may lead in the holding company reducing the operations of Salex Pharmaceuticals in future.
• The company can also loss the present patent claim it has filed, which can result in further endangering the prospects of going concern of the organization through putting on more cash charge.