A

erospace Lighting Inc. (ALI)previously a private company based in Chicago

has been a leading supplier of airplane cabin lighting systems for nearly ten years.

Until recently, ALI had been satisfied with its profits and had sold all its products

to Bombardier, a major aerospace company in Canada. This comfortable position began to

change in 2003, when a large publicly traded German company (BmG) acquired 100 percent

of ALI.

For ALI, the transition from a private, independent company to a subsidiary of a public

conglomerate has not been an easy one. Before the takeover, ALIs management was af-

forded the luxury of making decisions and taking risks that affected only one owner. Being

just one arm of a much larger international company, however, now requires ALI to satisfy

more than its own personnel. Members of BmGs executive team dominate ALIs board of

directors. These individuals have been very critical of ALIs management, particularly in

the area of financial performance. Beginning with the first board meeting in 2003, the

German executive team has scrutinized ALIs operating results and has never hesitated to

remind ALI management that BmG views ALI as an investment that is evaluated based on

its return to BmG stockholders. BmG does not tolerate any failures to meet financial targets,

and is willing to replace entire management teams if required. BmGs executives take very

seriously the Financial Handbook that they establish each year to communicate the parent

companys financial principles, including equity and capital borrowing guidelines, monthly

reporting requirements, and profit expectations.

Since the acquisition, ALI has been pursuing a rapid expansion strategy. The German

parent company directed ALI to enter the U.S. aerospace supply industry in 2004, and

quickly increase the number of U.S. contracts on which it bid, with the goal of increasing

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Issues in Accounting Education, August 2006

EXHIBIT 1

Notes from Review of Predecessor Auditors Working Papers

1. Boeing, Lockheed Martin, and Raytheon have jointly formed several policies aimed at reducing

their overhead costs. One policy is that they will not respond to confirmation requests from external

auditors. Another policy is that they generate a single check for each supplier every 20 to 55 days

for the outstanding balance recorded at the payment date. The payment cycle period for each

supplier varies, depending on its status as a preferred-A or preferred-B supplier. ALI is currently

a preferred-B supplier to the U.S. companies, so it is paid every 55 days. The U.S. aerospace

manufacturers also have begun expecting reductions in bid prices from suppliers as the suppliers

gain experience with their production processes. Bombardier has not yet adopted policies such as

these, but is expected to do so by 2007.

2. In November 2003, ALI acquired a 47% equity interest in GlueCo for $5 million. ALIs financial

statements for the 2004 fiscal year disclosed that GlueCo was accounted for using the equity

method, but ALIs management contended that they did not exert significant influence and, con-

sequently, did not report their share of GlueCos loss of $1.4 million in 2004. A loss of a similar

amount is expected for 2005. The audit opinion in 2004 was not qualified for this issue.

3. On February 8, 2004, a manufacturing plant leased by ALI in Milwaukee was lost in a fire. ALI

filed with its insurance company, claiming total damages of $6.8 million. As of July 31, 2004,

ALI had recorded a $3.0 million receivable that was included in other current assets. This amount

comprised the net book value of previous plant assets of $1.7 million, plus an accrual for business

interruption insurance of $1.3 million. The predecessor auditor confirmed the details of the claim

with one of ALIs external attorneys.

4. ALI disclosed its economic dependence on Bombardier in the 2004 financial statement notes.

5. The predecessor auditor had set materiality at $1.1 million.

its revenues by 50 percent in 2005. To reach this goal, ALI adopted a strategy of submitting

bid prices to U.S. manufacturers that, after adjusting for exchange rates, are approximately

20 percent lower than the prices ALI charges to Bombardier. This strategy has been suc-

cessful so far, as ALI now has several large contracts with Boeing, Lockheed Martin, and

Raytheonthe largest aerospace manufacturers in the U.S. ALI has already begun prepar-

ing to work on these contracts, having accumulated a significant quantity of raw materials

inventory to use in producing goods for Boeing, Lockheed Martin, and Raytheon, as well

as Bombardier.

ALIs management team has not discussed its new strategy with its board because

management believes BmG is interested in financial results rather than the means by which

they are achieved. ALIs management team also wants to keep this strategy quiet because

if Bombardiers executives were to hear about it, they would likely discontinue their rela-

tionship with ALI or immediately demand a lower price, as well as insist on a refund of

any excess prices charged in previous years.

Just last week, on June 29, 2005, your firms German affiliate was appointed worldwide

audit services provider for BmGs July 31, 2005 year-end. Another firm had provided audit

services for BmG and all its subsidiaries in the previous year, but BmGs executive team

was dissatisfied with the auditors inability to identify significant business risks that they

believed should have been brought to their attention. Your firms office in Munich asked

your Chicago office to perform the audit of ALI for its year ended July 31, 2005, and to

provide your audit working papers to the Munich office by September 5, 2005. Because

BmGs stock is not traded on a U.S. exchange, the company and its subsidiaries are not

subject to the provisions of the Sarbanes-Oxley Act of 2002.

A recently promoted partner in your Chicago office has been assigned the responsibility

for the 2005 ALI audit. She has communicated with ALIs predecessor auditor and has

provided you with the notes from her review of the predecessors working papers (see

Exhibit 1). She also has obtained information from preliminary discussions with ALIs CFO

Aerospace Lighting, Inc. (ALI): Linking Business Strategy to Audit Planning

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Issues in Accounting Education, August 2006

EXHIBIT 2

Notes from Discussion with ALIs CFO

1. With ALIs success in bidding on contracts with the big aerospace manufacturers in the U.S., ALI

is projecting a 55% increase in sales revenue, from $99 million in fiscal 2004 to $152 million in

2005. The majority of this increase has come from sales to the U.S. aerospace companies, which

in 2005 comprise one-third of total revenues. In 2004, sales to these companies were less than 1%

of total revenues. The increased sales volume will increase gross profit from $21.5 million in 2004

to a projected $23.0 million in 2005. Although ALIs gross profit percentage on Bombardier sales

has remained steady at 22%, the U.S. contracts are projected to cause the overall margin to fall

from 22% in 2004 to a projected 15% in 2005.

2. During the 2005 fiscal year, ALIs insurance company offered $5.1 million for the claim regarding

the fire at the Milwaukee plant. Of this amount, ALI received $1.3 million. The CFO claims that

ALI will not accept the insurance companys offer, arguing that ALI deserves full compensation.

ALI plans to report the $5.5 million difference between its total claim and the amount received at

year-end as a receivable in other current assets.

3. All of ALIs bid submissions and sales transactions with Boeing, Lockheed Martin, and Raytheon

are now being processed through Exostaran electronic independent trading exchange (ITX). This

business-to-business website was started by the three largest U.S. aerospace companies to enhance

their ability to transact with suppliers and customers, and also to share data about their own

production costs. Exostar is now soliciting aerospace companies from other countries to participate

in the ITX so that it can truly become a global hub for all aerospace transactions. It has been

rumored that the U.K.s BAE Systems and Canadas Bombardier are currently talking with Exostar

about joining the ITX later this summer. Industry experts fully expect these companies will join

soon because ITXs in other related industries have grown rapidly and yielded significant cost

savings for many of their participants. Presently, it appears that ALIs auditors will not be allowed

to directly examine Exostars accounting system.

4. ALI has a variety of debt agreements, many of which require the company to meet certain debt

covenant ratios. The most binding of these requirements is for a minimum current ratio of 1.5:1

on the audited financial statements for fiscal years ending July 31. Had this covenant been applied

to ALIs unaudited financial statements at June 30, 2005, it would have been breached.

5. BmG has instituted a performance pay plan for its subsidiaries in 2005. The plan grants BmG

stock options to executives of BmGs subsidiaries that meet or exceed the expectations established

in BmGs Financial Handbook.

6. ALIs CFO estimates that the companys 2005 year-end financial statements will report approxi-

mately $10 million in net income before tax, $100 million of total assets, of which $30 million

will be current, and $19 million in current liabilities.

(see Exhibit 2). The partner has asked youas an audit seniorto prepare a memo dis-

cussing the important audit issues and any other matters she should consider regarding the

upcoming year-end engagement. She reminds you that she is required to obtain second

partner approval of audit plans developed for high-risk client engagements. She expects

your memo will help her to (1) assess whether ALI should be considered a high-risk

engagement, (2) justify that assessment to other partners in the firm, and (3) outline what

will be required of you and other members of the audit team to ensure the firm meets the

high expectations that BmG has for its auditors.

REQUIREMENTS

Prepare a memo that addresses the following issues and their impact on ALIs financial

statements and / or the audit plan:

a. Client Business Risks

b. Auditor Business Risk

c. Audit Risks (including inherent and control risk)