MEDIX (ACCA - JUNE 2008)

You are a senior audit manager in Mitchell & Co, a firm of Chartered Certified Accountants.
You are reviewing some information regarding a potential new audit client, Medix Co, a
supplier of medical instruments. Extracts from notes taken at a meeting that you recently
held with the finance director of Medix Co, Ricardo Feller, are shown below:

Meeting notes – meeting held 1 June 2008 with Ricardo Feller

Medix Co is a provider of specialized surgical instruments used in medical procedures. The

company is owner managed, has a financial year ending 30 June 2008, and has invited our firm to
be appointed as auditor for the forthcoming year-end. The audit is not going out to tender. Ricardo
Feller has been with the company since January 2008, following the departure of the previous
finance director, who is currently taking legal action against Medix Co for unfair dismissal.

Medix Co manufactures surgical instruments which are sold to hospitals and clinics. Due to the
increased use of laser surgery in the last four years, demand for traditional metal surgical
instruments, which provided 75% of revenue in the year ended 30 June 2007, has declined rapidly,
Medix Co is expanding into the provision of laser surgery equipment, but research and
development is at an early stage. The directors feel confident that the laser instruments currently
being designed will eventually receive the necessary license for commercial production, and that
the laser product will replace surgical instruments as a leading source of revenue. There is currently
one scientist working on the laser equipment, subcontracted by Medix Co on a freelance basis. The
building in which the research is being carried out has recently been significantly extended by the
construction of a large laboratory.

A considerable revenue stream is derived from agents who are not employed by Medix Co. the
agents earn a commission based on the value of sales they have secured for Medix Co during the
year. There are many suppliers into the market and agents are used by all manufacturers as a
means of marketing and distributing their products.

The company’s manufacturing facility is located in another country, where operating costs are
significantly lower. The facility is under the control of a local manager who visits the head office of
Medix Co annually for a meeting with senior management. Products are imported via aeroplane.
The overseas plant and equipment is owned by the company and was constructed 12 years ago
specifically for the manufacture of metal surgical instruments.

The company has a bank overdraft facility and makes use of the facility most months. A significant
bank loan, which will carry a variable interest rate, is currently being negotiated. The terms of the
loan will be finalized once the audit financial statements have been viewed by the bank.

After receiving permission from Medix Co, you held a discussion with the current audit
partner of Medix Co, Mick Evans, runs a small accounting and audit practice of which he is
one of two partners. Mic told you the following:

‘Medix Co has been an audit client for three year. We took over from the previous auditors
following a disagreement between them and the directors of Medix Co over fees. As we are a
small practice with low overheads we could offer lower fees than our predecessors. We could

Hasnain R. Badami, ACA

 do the audit very quickly, which pleased the client, as they like to keep costs as low as
possible.
During our audits we have found the internal systems and controls to be quite weak. Despite
our recommendations, there always seemed to be a lack of interest in making improvements
to the accounting systems, as this was seen to be a ‘waste of money’. There have been two
investigations by the tax authorities, which we did not deal with, as we are not tax experts. In
the end the directors sorted it all out, and I believe that the tax matter is now resolved.
We never had a problem getting access to accounting books and records. However, the
managing director, Jon Tate, once gave us what he described as ‘the wrong cash book’ by
mistake, and replaced it with the ‘proper vision’ later in the day. We never found out why he
was keeping to cash books, but cash was an immaterial cost so we didn’t worry it too much.
We are resigning as directors because the work load is too much for our small practice, and as
Medix Co is our only audit client we have decided to focus on providing non-audit services in
the future.’
You have also found a recent press cutting regarding Medix Co:

Extract from local newspaper – business section, 2 June 2008

It appears that local company Medix Co has breached local planning regulations by building an
extension to its research and development for which no local authority approval has been given.
The land on which the premises is situated has protected status as a ‘greenfield’ site which means
approval by local authority is necessary for any modification to commercial buildings.

A representative of the local planning office stated today: ‘We feel that this is a serious breach of
regulations and it is not the first time that Medix Co has deliberately ignored planning rules. The
company was successfully sued in 2003 for constructing an access road without receiving planning
permission, and we are considering taking legal action in respect of this further breach of planning
regulations. We are taking steps to ensure that these premises should be shut down within a
month. A similar breach of regulations by a different company last year resulted in the demolition
of the building.’

Required

(a) Using the information provided, identify and explain the principal business risks facing
Medix Co.
(12 marks)

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Hasnain R. Badami, ACA