AUDIT PLANNING MEMORANDUM

AUDIT PLANNING MEMORANDUM Asia Manufacturing Company, Inc. Audit Planning Memorandum December 31, 20X5 A. AUDIT AND REPORTING REQUIREMENTS This engagement is a repeat, regular annual examination of the financial statements of Asia Manufacturing Company, Inc. (AMCI) for the year ending December 31, 20X5. AMCI has been an audit client for the last 10 years. Our examination should enable us to: 1. Express an opinion on AMCIs financial statements which are to be included in the annual report to stockholders; 2. Assist in the preparation of supplementary schedules for filing with the Securities Exchange Commission (SEC); 3. Prepare income tax return and supplementary schedules which are to be filed with the Bureau of Internal Revenue (BIR), and 4. Make comments and recommendations regarding internal accounting controls and other aspects of the Companys operations. B. BUSINESS AND INDUSTRY CONDITIONS Some of the more significant information and current developments since the last examination are as follows: 1. The Companys Business Asia Manufacturing Company, Inc. is engaged in the assembly/manufacturing of home entertainment equipment consisting of television, radio and stereo sets and domestic refrigeration appliances which include refrigerators and freezers. The companys main office and plant are located in Marikina, Metro Manila. It maintains warehouses in Cebu, Davao, and Dagupan. The Company is registered with the Board of Investments (BOI) under Republic Act No. 6135 as a preferred non-pioneer enterprise for the manufacture and export of electronic products. The company caters largely to the domestic market through an organized network of franchised dealers. At the beginning of the third quarters, the Company made its first concentrated effort to sell products internationally. Both domestic and foreign markets are expected to increase significantly over the next several years. The Company believes that it will continue to be one of the leaders in industry because of its entrenched international markets. However, market conditions in the industry are influenced by aggressive competition. The company (and the industry as a whole) is dependent on imports for some of its raw material requirements. During the current year, the Government in cooperation with the industry approved the implementation of the Electronics Local Content Program. This program seeks to making mandatory the use of local raw materials and parts for the manufacture of electronic components. In line with this program, the Company implemented its plans for the construction of an electrolytic capacitor plant which will eventually supply the Company and industry require

Page 1

AUDIT PLANNING MEMORANDUM

some of its raw material requirements, the Company increased its investment in ABC Corporation, a major supplier. The company is also expanding its colour TV line in anticipation of the increase in demand for this product. 2. Company Ownership and Management The company is listed in the local stock exchange and has approximately 150 stockholders. The significant stockholders are Summa Electronics, Inc. (21.5%) and Ong Estate, Inc. (15%). The combined ownership of directors and officers amounts to approximately 20%. The Board of Directors consists of three Company officers, seven outside directors and the Companys legal counsel. The Boards regular meetings are held every month where detailed financial and operating information is reviewed. Special meetings are called whenever there are urgent matters to be acted upon In April 19X5, Mr.Joselito Tiu resigned as a Company Comptroller and Mr. J. Ponce was hired to take his place. The other members of the management team are: Hector Dionisio, president; Allan Viray, executive vice president-finance and administration, and Manolo Cruz, corporate secretary. As part of our initial planning efforts, we met with the members of the management team to discuss the Company operations and results to date. Each of the above officers is included in the Companys profit sharing plan covering managerial employees. The management group represents an experienced and knowledgeable team concerned about growth and stability of the Company. The team is known to be conservative in spite of the fact that the operating results affect their directly. 3. Financial Characteristics The company has been very profitable in the last three years. The company has continued to outpace the industry in terms of growth of sales and profits. Significant financial information for the first six months of the current year (budgeted and actual) compared with last years actual results follows:

Page 2

AUDIT PLANNING MEMORANDUM

Six Months Ended 6-30-X5 Budget Actual Sales Gross Profit Net Income Current Assets Current Liabilities Net Working Capital PPE - net Total Assets Long-term Debt Stockholders' Equity Current ratio Debt to equity ratio Gross profit ratio Ratio of net income to Sales 72489173 19219054 3502819 70308439 17879430 3279111 50520117 38118324 12401793 25177890 85906001 13311723 34475954 1.32:1 1.49:1 25% 5%

Year-Ended 12-31-X4 112279578 30135719 4318458 46889336 31177149 15712187 23712187 74098984 11724992 31196843 1.5:1 1.37:1 27% 4%

Historically, cash flow has been sufficient to finance normal operations primarily because the Company has maintained an acceptable accounts receivable turnover rate in the face of rising sales. However, the expansion of the Companys business, its capital expenditures program and additional investment in an affiliate could create potential liquidity problems. Additional long-term borrowings have been obtained to finance the capital expenditure program and plans are being finalized to increase the Companys authorized capital stock. C. SPECIAL AUDIT RISKS AND AREAS REQUIRING SPECIAL ACCOUNTING AND AUDITING EMPHASIS Based on our understanding of the clients business and industry, our observations from the preliminary review of the interim financial statements and our evaluation of the audit identified in last years audit, we have determined that there are no special audit risks associated with the general business or management environment. However, we have identified the following areas that require special accounting and auditing emphasis: 1. Historically, inventories have been a critical area in the audit examination because of its materiality. Raw materials and finished goods inventories are characteristically susceptible to obsolescence caused by factors such as rapid technological advances in the industry and extensive product development activities resulting in the introduction of new models and new features for existing product lines. Because of these conditions, certain of the Companys products have been moving very slowly. Closely attention will have to be given to the realizability of these products, including related raw materials and work in process. The Company procures some of its raw material requirements from ABC Corporation, an affiliate. To provide for a reliable source of raw material supply, the Company at the beginning of the year purchased from a third party an additional equity interest of 20% in this company thereby increasing the level of its ownership to 30%. With this additional investment, the Company gained
Page 3

2.

AUDIT PLANNING MEMORANDUM

3.

a seat in tht Board and is now in a position to exercise significant influence over the affairs of the investee. The company has decided to adopt the equity method of accounting for this investment. We should take up this matter with the management and arrange to have audited financial statements in time for the completion of the audit. This accounting change may require restatement of prior years financial statements and also changes in the wordings of the report and notes to financial statements. Additionally, we should scrutinize very closely transactions with this affiliate and ensure that these are carried out on arms length basis The company has obtained additional long-term debt during the current year to finance the construction of the electrolytic capacitor plant. The agreement covering the loan contains provisions relating to the maintenance of current and debt to equity ratios. Based on the June 30, 19X5 interim financial statements; the margin of compliance with these covenants was very narrow. If the company continues with its capital expenditure program and if the plans for the increase in capitalization do not materialize, certain provisions of the loan agreement could be violated. The company is currently negotiating an amendment of the credit agreement and at the same time finalizing plans to increase its authorized capital stock. We should carefully review the terms of the loan agreement and any amendment thereto and determine whether the Company is in compliance with the provisions of the agreement.

D. SCOPE OF EXAMINATION The company has not placed any restrictions on our examination. The audit coverage in terms of specific accounts and locations are as follows: a. Accounts Receivable The normal confirmation procedures for local and foreign customers will be performed subject to the results of our study and evaluation of internal control. b. Accounts Payable Accounts with affiliate supplier will be circularized in addition to selected independent supplier accounts. c. Inventories Inventory observation will be carried out at the plant. Since the level of inventories at the provincial warehouses is not that significant, these will no longer be observed by us but will be covered by the internal auditors. d. Property, Plant and Equipment The on-going construction of the electrolytic capacitor plant and the modernization of the color TB production line will be inspected in conjunction with the inventory observation at the plant. E. CLIENTS ASSISTANCE We have arranged with the Comptroller for the preparation of the various schedules and/or analyses needed to expedite the audit. We have discussed with the staff concerned the format in which the schedules/analyses are to be prepared, the pertinent information to be included and the estimated dates they are required. This has been confirmed in writing in our letter dated July 25, 19X5.

F. USING THE WORK OF INTERNAL AUDITORS

Page 4

AUDIT PLANNING MEMORANDUM

The companys Internal Audit Department is composed of the Internal Audit Manager and two audit staff. The Company plans to increase the internal audit staff to five persons. As part of the initial planning actions, we reviewed the scope of work and findings of the Internal Audit Department. The internal audit activities have been confined to the preparation of the documentation for the Companys system of controls, surprise count of cash funds, preparation of bank reconciliation statements, and inspection of physical operations. We have made arrangements for the internal auditors to assist us in terms of updating the internal control systems documentation, coordination of the annual physical inventory taking, inventory compilation work and preparation of schedules and analyses required for the audit. G. ANTICIPATED RELIANCE ON INTERNAL CONTROL. Based on our preliminary discussion with the client, our experience in past audits, the volume the Companys transactions and the size of its accounting staff, it appears that the Company has established fairly high level of discipline over basic controls in most areas of its accounting activity. Accordingly, the Internal Control Questionnaires will be used in evaluating the Companys control system. This decision will be reassessed upon completion of our compliance procedures. Revenue Cycle Controls over revenue have generally been strong. Accounts receivable will be substantiated as of October 31, 19X5. Production Cycle Controls over inventories, historically, have been a problem because detailed inventory records are maintained in quantities only and not integrated with the general ledger. Book to physical adjustments have been significant in the past. In June 19X5, the Company introduced the use of perpetual inventory records that are fully integrated with the general ledger. However, problems have been encountered in the periodic reconciliation procedures. Although measures have been taken to resolve these problems, the Company does not anticipate the new inventory control system to be fully installed and operational until the end of the year or early next year. To avoid any problems, it was agreed that that a complete physical count will have to be taken at the year-end. Accordingly, the controls in the production cycle and those relating to the maintenance of perpetual inventory records for raw materials and finished goods in the expenditure and revenue cycles will no longer be evaluated. Emphasis will be placed on substantiating the year-end inventory balances. Expenditure Cycle Controls over purchases and payrolls he been evaluated in the past to be fairly adequate. These will be evaluated and testes for compliance again this year. To achieve greater audit efficiency, the verification of property, plant and equipment and investment will be performed primarily through the application of substantive test procedures and not on the basis of reliance on internal controls. H. MATERIALITY LEVEL The overall materiality factor for this years audit is P250, 000. This represents about 3% of the average of the net income for last year and the projected income for the current year. However, for audit purposes, all adjustments above P100,000 will be recorded. I. SIGNIFICANT DATES AND TIMINGOF WORK The following are tentative dates of importance pertaining to the audit engagement: Understanding and Preliminary Internal Control System Evaluation of August 1 15, 19X5

Page 5

AUDIT PLANNING MEMORANDUM

Compliance Testing (Interim test period will cover January 1 September 15, 19X5 transactions) Insurance of Management Letter on Preliminary Work Inventory Observation Confirmation of Receivables as of October 31 Completion of Field Work Discussion of Financial Statements Draft with client Issuance of Financial Report Submission of Management Letter on Final Work Filing of Final Income Tax Return with the BIR Filing of Financial Statements and Supplementary Schedules with SEC J. STAFFING

Various dates Starting August 16 September 30 December 31 November 15 February 15, 19X6 February 28 March 15 March 31 April 5 April 5

The individuals who will be assigned to the engagement are the following: Partner in Charge Bernard Lazaro Manager Staff in Charge Assistants Genesis Aguilar Edward Aquino Edel Castillo Philip Reyes Arturo Manansala Joselito Ang K. OVERALL TIME ESTIMATES Actual time charges in 20X4 were 911 hours. The budget for 20X5 will be 825 hours due to our initial overall assessment of the nature of the problems and additional assistance to be extended by the client for the current year.

L. DISCUSSION WITH CLIENT PERSONNEL We have held the following meetings to discuss various audit planning actions:

Page 6

AUDIT PLANNING MEMORANDUM

1. On July 11, 20X5, Bernard Lazaro, partner, and I met with the principal officers of the Company regarding the following: a. Areas of accounting and auditing emphasis b. Audit scope c. Assistance from Company staff and d. Significant dates and timing of work 2. On July 23, 20X5, Edward Aquino, staff in charge, and I met with the Comptroller, the accounting and internal audit managers to discuss their work plan since our last examination and areas of coordination.

Prepared by:

G. AGUILAR Manager Approved by:

B. LAZARO Engagement Partner

Page 7