Audit Plan

Martinrea International
Word Count: 2373

Introductory Audit
Executive Summary

Martinrea operates as an Original Equipment Manufacturer (OEM) in the automotive industry.

They are currently the third largest auto parts manufacturer in North America and service four

major clients: Nissan, General Motors, Ford and Chrysler.

Since consolidation and restructuring in 2001, Martinrea has experienced rapid growth with

revenues reaching a high of $2 billion in 2007. However, the production levels of the large

automobile manufacturers decreased significantly resulting in fewer orders and reduced revenues

for Martinrea. Looking forward, a recent increase in sales and efficiency combined with

emerging business opportunities provides an opportunity for profitable operations in 2010.

Furthermore, Martinrea has sufficient capital and credit to continue operations in the foreseen

future.

When conducting the audit, the high risk areas of Martinrea involve the valuation of their

goodwill and their acquired assets as it provides opportunity for material misstatements.

Depreciation and impairment expenses can be subjective. Therefore, it is important to verify

changes with a specialist and ensure they are properly disclosed. In addition, the sales and

collection, acquisition and payment and payroll and personnel do not pose a risk as a three

document paper trail, bank reconciliation and confirmation should determine any material

misstatements. Lastly, inventory should be lower than previous years as there has been a shift

towards reduced inventory within the industry. Any deviation should result in an investigation.

Based on the set audit risk, inherent risk and control risk, the planned detection risk suggests

20% of plants be audited. It is important to remain objective and avoid any pre-conceived

notions during the audit as the industry has changed significantly over the last year.
Industry and Internal Analysis

Headquartered in Vaughan, Ontario, Martinrea boasts approximately $600 million in fixed assets

across North America and a small part of Europe. However, it is still a relatively small to

medium sized player in the global automotive parts industry with 5600 employees spread

amongst 32 divisions. Martinrea operates as a Tier 1 and Tier 2 Original Equipment

Manufacturers (OEMs) in the automotive industry. Since its consolidation and restructuring in

2001, Martinrea has experienced rapid growth, reaching sales of $2 billion in 2007. Though 2009

sales remain above a billion dollars, Martinrea experienced a 30% decrease in sales during an

economic downturn that affected all major automotive markets.

The automotive industry is highly cyclical and dependent on consumer spending. Since the

downturn, personal net wealth has decreased and consumer accessibility to credit financing is

limited. Therefore, consumer spending on automobiles has greatly reduced. The dramatic decline

in automotive sales and the bankruptcy of many North American automotive suppliers sparked

industry consolidation and a 50% decrease in production in the first half of 2009.

The remaining financially stable companies in the industry have a growth strategy based on this

consolidation and diversification. As the North American auto industry is volatile, a global

manufacturing business strategy hedges against the risk of another North American downturn.

Martinrea is attempting to maintain liquidity, making only minor acquisitions. Overall, Martinrea

still lacks a presence in Asia, the strongest emerging market.

The recovery of the North American auto industry is expected to be very slow in comparison to

the growth seen in emerging markets. Many auto part manufacturers are taking the opportunity
to capitalize off of lower costs, fewer restrictions and an emerging middle class who stimulate

the demand for automobiles in these countries.

Since Martinrea’s operations are primarily spread across North America and requires inventory

to be transported, changes in duties and tariffs can have a large impact on margins. Additionally,

each manufacturing plant must adhere to varying environmental regulations to avoid fines and

litigation. These factors must be considered as Martinrea looks to further expand and acquire

firms internationally.

Through past acquisitions, Martinrea has gained a broad range of capabilities. It produces a

diverse range of auto components, assemblies and systems. The major raw materials used

include metal and stainless steel, 85% of which are purchased from car manufacturer resale

programs at a fixed price. This greatly reduces Martinrea’s exposure to price fluctuations.

Having moved towards a new strategic direction in 2001, Martinrea recognized immense growth

in its first five years to become the third largest OEM auto parts manufacturer in North America.

Nissan, General Motors, Ford and Chrysler consist of 87% of Martinrea’s sales. This dependence

creates in an inherent risk should any of these clients become insolvent or cancel a large order.

This would result in a significant, negative impact on Martinrea’s revenue and limit its ability to

continue operating. It is essential that Martinrea support these clients by ensuring on-time

delivery and high quality products at low prices that satisfy the downward pressure on prices

from buyers. In order to maintain high margins at such low prices, cost controls must be

enforced. This ensures efficient operations and the minimization of raw material costs through

the use of innovative manufacturing technology.

Although relatively sophisticated, the production processes for auto parts are easily replicated,

creating a highly competitive, fragmented industry. Martinrea differentiates itself through its

executive management and entrepreneurial outlook. Martinrea’s CEO, CFO and COO worked at

Magna International, North America’s largest OEM supplier, thus establishing business

relationships with all of their major customers. As well, the company has a philosophy that

attributes growth to innovation from all levels of business. This innovation has resulted in state

of the art manufacturing processes that allow for a competitive advantage in this saturated

market. Martinrea should look to improve its manufacturing efficiency as it reached

approximately 9% margins in 2009, 2% short of its objectives. The company has addressed some

of these cost control issues through restructuring, consolidation and renewed human capital

investments.

Financial Position

During a year where two of three major clients declared bankruptcy, Martinrea restructured to

endure the recession and is in a strong position for recovery. Although the company alone does

not currently have positive net earnings, its revenue is growing at a faster rate than the industry.

This last quarter, Martinrea increased revenues by 35% (versus industry growth of 17%) and is

nearing profitability. With increasing margins, Martinrea is expecting a return to profitability

with a future EPS of $0.15 Q1 (2010) from the loss of -$0.06 in Q4 (2009).

There are three major factors that will have a positive effect on profitability. Firstly, the increase

in sales resulted in a utilization of 65% in Q4 (2009) from 50% in Q3 (2009). The increased

sales and utilization will improve overall plant efficiency and contribution, ultimately improving

the bottom line. Secondly, in Q4 (2009), Martinrea hired and trained 900 new plant technicians.

The learning curve had a negative effect on plant efficiency as new employees (and returning
employees) were integrated into the restructured organization and were not as skilled or capable

as full time employees. As the employees are now well trained, efficiency and margins are

expected to increase, also improving profitability. Lastly, Martinrea is in a position to find new

business. As other smaller companies within the industry are unable to maintain operations,

Martinrea is in a position where they can act as a strategic consolidator to recruit new business

and clients. This is necessary to diversify their client base and increase their presence within the

industry.

Martinrea has three sources of capital. Their minor source of capital is a buildup of cash and

cash equivalents obtained through past profitable operations. In 2008, there was $60 million in

reserves within the company. Approximately $40 million was invested in the new plant

operating in Slovakia and the remaining $20 million is still within the company. This is an

attempt by management to keep the company as liquid as possible. Though the current economy

is promising, the industry has yet to return to pre-2008 production levels. Therefore, to mitigate

inherent risks within the industry, cash will guarantee continued operations. In addition,

Martinrea’s major source of capital is through equity. Recently, $55 million had been raised to

reduce the long term debt as well as finance their working capital gap. Lastly, Martinrea has

secured a $150 million line of credit. However, it has been financing its expansion through

equity to reduce risk and therefore the line of credit remains untouched. The company is

currently financially equipped to continue operations in the foreseen future.

The capital markets have embraced Martinrea. This is evident as the banks have yet to withdraw

or reduce their line of credit. The support of the banks substantiates Martinrea’s earnings

potential. As well, Martinrea recently raised $55 million through a private equity placement

through a syndicate of underwriters. In hindsight, Martinrea provided these investors with an

86% ROI over the last 10 months as shares purchased at $4.85 are now trading at $9.02. As a

financially sound company with increased earnings potential, the capital markets have helped

guarantee Martinrea’s position in the industry.

The quality of earnings is strong as the increase in earnings is attributable to higher sales and

minimized costs. Martinrea has pursued a growth strategy through acquisitions of undervalued

competitors with immense synergy potential. Although these acquisitions are costly, the

increases in sales, combined with a focus on margin improvement, will result in sustainable

earnings. In addition, due to the recent improvements by the large auto manufacturers, accounts

receivable from Martinrea’s main clients does not pose a severe credit risk. Lastly, it is

important to note that with the current economic situation, Martinrea has used conservative

accounting policies in a few situations. Recent valuations have impaired goodwill by $230

million and PP&E by an additional $7.3 million in 2008. These principles are in line with new

U.S. GAAP, stating that goodwill can only be impaired as opposed to depreciated. These

conservative accounting policies increase the quality of earnings.

The Audit Plan

The high risk areas of Martinrea involve the valuation of their goodwill and their acquired assets.

As Martinrea has been involved in both asset and enterprise acquisitions, there is opportunity for

subjectivity within the valuation of goodwill or assets. Therefore, there is very little control

within the organization to ensure that their values are properly represented on the financial

statements. In 2008, Martinrea recorded a $230 million goodwill impairment expense. This

expense is highly material as the value and reduction of goodwill is not an exact science. Such a

large reduction over the course of one year will result in a poor net income and a soaring return
on assets ratio. Although these are intangible assets, it has the potential to mislead a reader of

the financial statements and is therefore highly material. Furthermore, even though Martinrea

recently experienced a PP&E impairment expense of $7.3 million, the valuation was determined

through a discounted cash flow, thus adding to its subjective nature. As the base of materiality

for assets ranges from 0.5%-1% of the combined PP&E ($400 Million) and Long Term Assets

($200 Million), materiality is determined to range from $3 million to $6 million. Therefore, the

asset valuation is a high risk area when auditing the financial statements.

The lower risk cycles within the organization are their sales and collection, acquisition and

payment and payroll and personnel. Although traditionally, sales and collection or acquisition

and payment provide the best opportunities for financial misrepresentations, all transactions

within Martinrea are contractual with a paper trail. Confirmations between Martinrea and the

customers or suppliers would be quite easy and accurate as there are key suppliers and only four

major customers. Therefore, this reduces the risk of fraud or a material mistake within these two

cycles. Within the sales and collection cycle, there is a risk as to the ability of Martinrea

customers to follow through on their payables. Although the larger auto manufacturers are

posting profits with positive cash flows, there is still risk as to the appropriate levels of customer

credit. It is important to note that to date, the large auto manufacturers (specifically GM and

Chrysler who filed for bankruptcy) have paid all of their commitments to Martinrea in full. In

addition, payroll and personnel does not pose a risk as the majority of workers at Martin Rea are

paid hourly or with a salary. Hourly workers sign in and out electronically and salary workers

are paid bi-weekly on an annual rate. Although there are opportunities for fraud such as

collusion in the HR department or a fellow employee signing in a not present worker, these

amounts are minor and therefore, not material.

The inventory cycle does provide an opportunity to be overstated and therefore include a

possible material misstatement. However, basic operational strategy predominantly found in the

auto industry is to minimize inventory levels as it ties up large amounts of cash and provides

additional inventory holding costs. As well, the majority of Martinrea’s inventory are raw

materials and traded commodities. Therefore, a material misstatement in inventory will be more

evident as the value of a commodity is pre-set and any large amount of inventory will set off a

red flag within management and the audit committee as it is a business risk.

A basic control that Martinrea must use in its sales and collection cycle is a Three Document

paper trail which would require a purchase order, bill of lading, and a sales invoice in order to

record a sale as revenue. Similarly, in its acquisitions and payment cycle, the three document

paper trail applies. By linking these three documents together, it is a simple process to determine

the origin of any cash disbursements. In addition, to mitigate accounting or calculation errors, a

bank reconciliation will notify company management immediately of any significant

irregularities. Lastly, a budgeting process would be used as a key control system as it must be

approved by different managers within the organization. Although the budgeting process is

difficult for manufacturing companies as demand is an unknown, basic analytical procedures can

generate a sensitivity of demands and their respective budgets.

To mitigate material misstatements in the high risk areas of the business, it is suggested that an

independent specialist provide an objective valuation of the capital assets. Although this will not

solve the problem as to the exact valuation of these assets, it will provide an additional

benchmark to ensure any changes are not material and therefore do not pose a risk to the reader’s

of the financial statements.

With the knowledge of Martinrea’s high risk cycles, the audit can be allocated in a strategic

fashion to minimize the probability of missing an integral facet of the operations and issuing an

incomprehensive report. As Martinrea operates 31 plants in four countries, it is important to

ensure a proper statistical sample. Based on a low audit risk, high inherent risk and low control

risk, the planned detection risk will provide an outline as to how many plants need to be audited.

It is suggested based on the calculations that 20% or 6 factories be chosen. (Exhibit 1) To ensure

a complete sample, there must be an audit of at least one factory per country and unannounced

audit locations. It is vital to the audit that the new Slovakian facility be audited as many current

investors are monitoring the potential of this new market.

As the audit has not yet begun, it is important to remain objective and avoid any pre-conceived

notions as to the status of the company. Although Martinrea has received a standard unqualified

independent auditor’s report in recent years, the inherent risks of the economic crisis as well as

internal restructuring provide a degree of uncertainty within the organization. Similarly,

although management has declared that their internal controls are sound, it is important to

prepare and administer a proper set of control tests and tests of details prior to issuing a report.

In the event that Martinrea receives a standard unqualified independent auditor’s report as in

previous years, the auditors will conclude in their opinion that the financial statements are

presented fairly in all material respects in accordance with Canadian GAAP.

Exhibit 1

Formula
: Audit Risk = Inherent Risk x Control Risk x Planned Detection Risk

Values: 3% 70% 20% 20%