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Administrative Studies
ADMS 4590
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ADMS 4590 M Professor Narmin Multani Date: September 12, 2007 To: Partner, A&B From: CA, A&B Re: Audit engagement and other issues of Curls and Slaps Inc (CSI) for the year ended August 31, 2007 Curls and Slaps Inc. (CSI) is a private company engaged in the business of providing ice hockey and curling activities to professionals and families, as well as other ice-rink related services. A&B has been requested to provide a financial statement audit for the year ended August 31, 2007, as well as to provide advice on a proposal, tax issues, and other issues within the company. CSI has provided statements for the years ended August 31, 2006 and 2007. Using this information, we have addressed client concerns as well as prepared a planning memo for the engagement. Management is requesting audited financial statements in accordance with ASPE for a bank, a primary user. As a key user, the bank is interested in CSIs cash position and compliance with loan covenants. The two founding shareholders of CSI are also interested in CSIs financial statements and cash position as they have each provided financing in the amount of $50,000 in common shares and $75,000 in long term debt. Finally, the main shareholder and manager of CSI, Wayne Greatgretsk, is concerned about profitability and the performance of the company, especially regarding CSIs cash position. Engagement Risk We have assessed engagement risk as high due to the following factors: First Time Audit Since this is the first time audit of CSI, engagement risk increases, as we are unfamiliar with CSIs operations. Further, CSI has never been audited or reviewed since the controller has not arranged for an audit since the companys inception. Therefore, there is a concern for the accuracy of financial statements as they may not be in accordance with ASPE and opening balances may contain errors. Management Integrity and Competency Concerns CSI has issued dividends of $120,000 during the year ending August 31, 2007, even though this has brought the company into a negative cash position (the cash account closed at a balance of $-11,300). We must review shareholder meeting minutes or look into dividend payments to see how the dividends were distributed and what basis was used to determine dividend payments. We suspect that the dividends were issued because management relied on the high net income and the cash balance to be positive by the end of the period. However, there seems to be a bigger problem regarding revenue recognition. Due to the revenue recognition policies selected by the controller, CSI appears to have overstated revenue for the last two years. We have recalculated the true net income for the past two years, and we have determined that revenue was recognized too early, or was not supposed to be recognized at all. We provide the calculations to this decision below. This leads us to question the competency and the integrity of management. Management should have noticed earlier that cash levels are not at expected levels and should have held back dividends in 2007 as the depleted cash position became more evident. CSI may be able to argue that the company is in the beginning stages, which would explain the negative cash balance (as starting up operations does tie up cash flows for the first few years). However, management should be aware of this as well, and should have reconsidered issuing dividends when cash is expected to be needed. The concern of management competence or integrity will increase the engagement risk. The use of aggressive revenue recognition policies also raises the engagement risk. In addition, the competency of Mats Sundin, controller of CSI, is under question. Regarding the revenue recognition policies, the financial statements were not prepared in accordance with Accounting Standards for Private Entities (ASPE). Tax returns for CSI have not been filed in 2006 and 2007, and, although a financial statement audit was required by the bank as one of the conditions for a loan, Mats Sundin has neglected to get an audit for the last year ending August 31, 2006. These omissions suggest that Mats Sundin does not have the competence required for one of his positions, and that the financial statements may contain more errors. This increases the engagement risk. As a result of CSI not filing its tax return for the year ending August 31, 2006, CSI may also be facing penalties from the Canada Revenue Agency. As a result of not requesting a financial statement audit in 2006, the bank may consider one of its covenants breached and may request immediate repayment of the outstanding loan. These actions may tie up CSI cash flows, or may threaten the continuing operations of the business. This is another factor that increases engagement risk. Financial Difficulties and Liquidity Crisis Due to the current revenue recognition policies, the Revenue and Receivables accounts are overstated. However, when recalculated using appropriate recognition policies, Revenue is considerably less. Due to the nature of the Jabber Football Club Inc. contract, it is inappropriate for CSI to record as much Receivable as they have. If CSI bases cash disbursement decisions off of this basis, then the liquidity of CSI is under threat. CSI has severely restricted cash flows due to a share investment account that obligates CSI to give refunds to customers at any time the customer decides to cancel his or her membership. In addition to this, CSI has bank loan obligations. Should CSI for any reason not meet the banks covenants (such as the requirement for audited financial statements for the period ending August 31, 2006, which was not neglected by the controller), the company may be required to repay the loan. At the moment, neither cash flow restriction can be met, and this may threaten future operating possibilities of the company. These risks increase the engagement risk. Furthermore, since CSI currently has a negative cash balance, with some other potential issues, it may be likely that CSI may not have the ability to pay A&B for the audit performed. This increases the engagement risk, and makes the engagement less appealing. High Fixed Costs and Low Variable Costs CSI currently has high fixed costs and low variable costs. This indicates that if the company does not meet revenue targets for the year, they still have to incur the fixed costs, 1 which can result in a substantial loss in earnings. This may also threaten the profitable continuation of the company, which increases engagement risk. Reliance on Jabber Football Club Inc (JFC) On September 1, 2006, CSI entered into a five year management contract with JFC. Wayne has expressed that the reason for positive earnings in fiscal 2007 is due to the commitment with JFC. Without the contract, CSI would have reported a loss. This indicates that CSI may be overly dependent on JFC and in the event that JFC withdraws their contract, CSI would face significant losses, increasing our engagement risk. Duckflac Insurance Company (Duck) Proposal CSI is considering a proposal by Duck to operate an ice rink located on Ducks premises. There is uncertainty regarding the proposal, especially since cash flows at CSI may be restricted and profits are not guaranteed, as with all new business ventures. This uncertainly raises the client business and engagement risks. Contingency - Lawsuit CSI has been advised of a potential lawsuit regarding the unauthorized use of pictures of a well-known Canadian former hockey player. The lawyer active for the complainant has advised that no legal action will be taken if CSI publicizes a charity with which the individual is associated, makes a donation of $100,000 to this charity, and ceases to use the promotional material that contains images of the hockey broadcaster. This increases our engagement risk as there may be potential lawsuit charges which may cause cash outflows, contributing further to the negative cash balance. This may also result in the recognition of a liability, which will increase total liabilities and may bring CSI to breach its bank covenants. Materiality The primary user of the financial statements is the bank that has provided CSI with a loan on the condition that an annual financial audit is done and total liabilities remain below $1.5 million. The two founding shareholders of CSI also rely on financial statements for CSIs cash position as they have each provided financing in the amount of $50,000 in common shares and $75,000 in long term debt. Wayne is also a shareholder, and he is unsure of what is happening to CSIs net income figures and cash flow position. As all three users are concerned about cash flows, we will set planning materiality based on the net income in fiscal 2007, adjusted based on our calculations using appropriate revenue and expense recognition procedures. Since this is our first time auditing CSI, considering the heavy reliance of users on audited financial statements and the high engagement risks and probabilities of material misstatements, we will use the lower 5% of the adjusted net income ( of $136,108). The calculations for the adjusted net income are provided in a section below. $136,108 x .05 = $6,805. Therefore $6,805 will be our planning materiality. We will also take into consideration performance materiality due to high risks associated with some accounts such as receivables, inventory, and cash. A performance materiality range of 25% to 50% lower than planning materiality will be chosen. However, we will set performance materiality at 50% of planning materiality since the bank relies heavily on statements and CSI is considering the acceptance of a new business proposal by Duck.
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