Reference no: EM132958939

Question - Your audit client, Prestige Co, is a national hotel group with substantial cash resources. Its accounting functions are well managed and the group accounting policies are rigorously applied. The company's financial year end is 30 June.

Prestige has been seeking to acquire a construction company for some time in order to bring in-house the building and refurbishment of hotels and related leisure facilities (eg swimming pools, squash courts and restaurants). Prestige's management has recently identified.

Resort Construction Co as a potential target and has urgently requested that you undertake a limited due diligence review lasting two days next week.

Further to its preliminary talks with Resort's management, Prestige has provided you with the following brief on Resort Construction Co.

The chief executive, managing director and finance director are all family members and major shareholders. The company name has an established reputation for quality constructions.

Due to a recession in the building trade the company has been operating at its overdraft limit for the last 18 months and has been close to breaching debt covenants on several occasions.

Resort's accounting policies are generally less prudent than those of Prestige (eg assets are depreciated over longer estimated useful lives).

Contract revenue is recognized on the percentage of completion method, measured by reference to costs incurred to date. Provisions are made for loss-making contracts.

The company's management team includes a qualified and experienced quantity surveyor. Their main responsibilities include:

Supervising quarterly physical counts at major construction sites

Comparing costs to date against quarterly rolling budgets

Determining profits and losses by contract at each financial year end

Although much of the labour is provided under subcontracts all construction work is supervised by full-time site managers.

In February 20X2 Resort received a claim that a site on which it built a housing development in 20W4 was not properly drained and is now subsiding. Residents are demanding rectification and claiming damages. Resort has referred the matter to its legal counsel and denied all liability, as the site preparation was subcontracted to Sarwar Services Co. No provisions have been made in respect of the claims, nor has any disclosure been made.

The auditor's report on Resort's financial statements for the year to 31 December 20X1 was signed, without modification, in September 20X2.

Required -

(a) Explain the meaning of the term 'due diligence' and identify some practical examples of this type of assignment.

(b) Identify and explain the specific matters to be clarified in the terms of engagement for this due diligence review of Resort Construction Co.

(c) Recommend the principal additional information that should be made available for your review of Resort Construction Co, and explain the need for the information.